Whenever we see a split between the indices, such as today's stronger tech market and weaker blue chips, it leaves us wondering who's in the lead. And that makes it harder to judge whether to be long or short the market. Today we saw the techs in the green nearly the whole day. On the opposite side of the fence was the DOW which couldn't make it out of negative territory except for a brief moment.
NDX was even stronger than the Nasdaq thanks to some big cap tech stocks. That's a good sign since you like to see the generals ahead of the troops. This year's rally has seen NDX outperforming the Nasdaq (COMPX) and that has been good for the overall rally. But when you look at a chart of the relative strength of NDX vs. the COMP you can see evidence that may be changing soon:
NDX vs. COMPX Relative Strength chart, Daily
The negative divergence at the current high suggests we're about to see a reversal and that would be worrisome for the bulls--you don't want to see the generals leading the retreat lower. As I'll show in the tech stocks, there are some things alerting me to the possibility that the tech rally might be finishing. I can't say the same thing about the blue chips so it's still anyone's game and certainly the bulls remain in control.
As expected, and as you can see in the numbers in the table at the beginning of this report, the volume has been light this holiday week. It makes it difficult to figure out if any particular day's move has much meaning if you're looking for volume to confirm it. But overall, price action since last Friday's lows has been very positive. If the bulls can keep the momentum going there's a good chance we'll see even the laggard DOW tack on another 100 points before worrying about a larger pullback (or more). But the combination of a lagging DOW and potential topping signs for techs has me a little concerned about whether the bulls can keep this up. We'll check it all out in the charts.
Bonds took a bit of a beating today and yields gapped up, with the 10-year yield jumping up over resistance:
10-year Yield (TNX) chart, Daily
The decline in TNX from the June high was forming a bullish descending wedge as it approached support at its broken downtrend line from January 2000. I mentioned last week to watch this level for support (it's also where the pullback had two equal legs down). The downtrend line was broken with today's gap up and the oscillators have been relieved of their overbought conditions. It looks good for a yield rally to a new high. I show resistance near 5.4%. Whether that then leads to just another pullback or the start of a longer term decline can't be known yet but it would set up a good opportunity to buy some bonds in case TNX starts back down.
This weekly chart of TNX helps keep things in perspective as to where it is in the ascending wedge pattern that is correcting the 2000-2003 decline.
10-year Yield (TNX) chart, Weekly
Once the bounce off the December low completes it should head back down to new lows (yes, below 3% as the economy slows way down).
Speaking of the economy, there are not many signs of slowing by the latest ISM (Institute of Supply Management) Services report. Just don't pay attention to that minor housing problem, the subprime mortgage problem, Bear Stearns and all the other cockroaches to follow and other signs of cracking in our foundation. Life is good, or so Wall Street wants you to believe.
I didn't have time to pull together the information I wanted to present on some critical pieces of evidence showing why we should be very concerned about where this market and our economy are perched but I'll try to get it by next Wednesday's report. Too many "distractions" with family and friends, beer and fireworks this week.
I put distraction in quotes because it's important to remember those distractions are what life is all about. This market will be here tomorrow and 100 years from now. Trust me, your kids will be gone in a flash and pretty soon you'll be reading the obituaries about your friends (hopefully not the other way around). Enjoy life as it's too short. But I digress. Onto the economic reports for today:
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Continuing claims jumped up much more significantly by 84K to 2.57M, also the highest since April. This is a sign of it becoming more difficult to find a job. The 4-week average of continuing claims rose by 9750 to 2.51M.
While not an official economic report, the ADP employment report showed employment grew by 150K in June, the fastest rate in seven months. Their report does not include government jobs and therefore their numbers suggest the payrolls number tomorrow morning will be about 175K (vs. the 125K the market is expecting). A higher number is a good thing except the market might interpret it as too good--it will increase the chance that the Fed will have to raise rates instead of lower them. So if the higher number is not priced in then we could see a negative reaction tomorrow (in the market's perverted sense of what is good and what is not good for it).
ADP's numbers showed service jobs (lower paying) increased by 163K while manufacturing jobs (higher paying) dropped by 13K. This is the best performance for each sector. For the past year ADP shows employment gains of 1.4M, the weakest number in 3 years. Not surprisingly the government's numbers show a gain of 1.62M private sector jobs (and even more when you include government jobs).
The new orders index fell to 56.9% from 57.4% so that's not a positive sign for next month's numbers. The employment index rose to 55.0% from 54.0% and prices-paid index fell to 65.5% from 66.4%.
After Monday's ISM Manufacturing index came in stronger, also the best it's been since April 2006, it would appear the economy is doing very well. This is of course a lagging indicator, and it has many economists forecasting a continuation of good times ahead. I'm not so sure about that, based on the patterns I see in the stock market (and the stock market leads the economy), but it's nice while it's lasting.
Gasoline supplies were up 1.8M barrels to 204.4M, which is down -4.7% from a year ago. Distillate (diesel, home heating oil) inventories were up +1.2M barrels to 121.6M. Helping increase the inventories of refined products was the fact that refinery utilization rates climbed to 90.4% from 89.4% the week before. But the combination of lower gasoline stocks and lower refinery utilization rates has kept gasoline prices high. But with gasoline inventories only 4.7M barrels below their normal range, maybe we'll see some relief soon. Probably not until after the summer driving season.
And now to the stock market. There haven't been many changes to the charts since last Wednesday's chart updates. Nothing jumps out and shouts "follow me!" But with today's rally in the techs, which made them look stronger, the charts actually have some bearish potential as we head into tomorrow.
Starting with the DOW, the only one of the major indices that ended the day in negative territory, it still leaves the door open as to whether we're going to see more rally into the summer or instead the start of a nastier decline.
DOW chart, Daily
Price has been consolidating since the June 1st high and that's potentially bullish for another leg higher in the rally from March. I show the Fib projection for the bullish wave count where the next leg up, wave-5, would equal the first leg up from the March low, wave-1, at 13793. There's higher bullish potential above 14K if it plows right through 13800.
Until the high on June 15th (13688) is exceeded there is still the possibility that the current bounce is merely correcting the June 15-26 decline and that once it's done there will be a hard sell off to follow. It takes a break below 13250 to tell us the bears are in control. Until then the bulls still have the ball.
DOW chart, 60-min
The uptrend line from March, through the June 12th low, was a brick wall to Tuesday's rally. That's also where the bounce from June 27th had two equal legs up and I was pointing out on the Market Monitor on Tuesday that it was a good setup for a short play. It was a short against Tuesday's high so any continuation higher from here would negate it.
And from here that's what I think will happen--it looks like it's ready to continue towards the 13650-13700 area, which is lower than the upside target on the daily chart. But if the DOW drops below today's 13513 low then it's probably on either the light green or dark red price paths. The light green path is still bullish but we could see a deep pullback first and then a continuation of the rally. That scenario would suggest a continuation of a choppy rally well into July and probably August. Bears want to see the DOW back below its broken downtrend line from June 20th.
SPX chart, Daily
SPX continues to mirror the DOW, although it was a tad stronger today. The a-b-c pullback from June 1st looks bullish and it calls for a new all-time high--probably with a push up to or above its March 2000 intraday high. Still, until the June 15th high is exceeded it's possible to call all the price action since the June 1st high as the start of a new leg down. If the bearish wave pattern is correct, which won't be known until the June 27th 1484 low is violated, then the next leg down will be a hard sell off.
SPX chart, 60-min
Today's pullback came within pennies of overlapping the high on June 29th (which the DOW did) and that would negate the bullish (green) wave count (wave-4 pullback can't overlap the top of wave-1) which would set up either the start of the next big leg down (dark red price path) or else a deeper pullback followed by another rally leg next week. The latter scenario, as mentioned for the DOW, would likely mean a choppy rally into August. A drop below the uptrend line from June 27th would be a heads up that something more bearish is happening.
Otherwise a continuation of the rally from here should see a push back up to at least retest the previous highs. The pattern on the 60-min chart does not show quite the same bullish potential as the daily chart (which points to the possibility it will rally up to 1558 as opposed to 1538 on the 60-min chart).
OEX chart, Daily
I pointed out last week that the OEX has a clean pattern and is one of the indices that gives me a stronger feeling that we're going to see the market rally higher. I like the Fib projections just above 716 to 723 for an upside target zone for the end of the rally. It takes a break back below its June 27th 683 to confirm the bears are in control, with a break below the June 29th 687 low to give us a heads up that it's coming.
Nasdaq-100 (NDX) chart, Daily
The techs got all the lovin' today and NDX rallied up to just shy of the top of a parallel up-channel for price action since May (which is a trend line along the highs since then). This trend line has turned back all previous rally attempts and I don't think I'd like to trust that it will break out this time. With low volume I suppose anything can happen but it's also true that you need volume to confirm a move. Daily stochastics is overbought as price nears the trend line and we have bearish divergences on MACD and RSI. This is not a recipe for a bullish breakout so beware.
Nasdaq-100 (NDX) chart, 60-min
The 60-min chart shows a close-up view of that trend line along the highs from May and how close it came at today's high. While it's possible we'll see a minor push higher on Friday morning, the short term price pattern of the rally from June 29th looked complete (5-waves completed) at today's high. It could certainly extend higher but again I wouldn't want to place my bets that way. In fact just before the close I recommended on the Market Monitor that the NDX/COMP set up a great short entry.
As shown on the chart, because of the very choppy price pattern over the past 2+ months, there are several possibilities for the next move and I show various degrees of a pullback/decline over the next week. If it's a shallow choppy pullback (dark green) then it will be time to switch sides and get long again. It takes a break below 1922 to confirm the bears have wrestled the ball away from the bulls.
One stock that has done a good job at identifying which direction the market may be headed is Google (GOOG). As a measure of bullish sentiment amongst traders, it could be considered its own sentiment indicator. Today's rally tagged some important upside targets so it will be important to watch what it does next.
Google (GOOG) chart, Daily
The trend line along the highs since January 2006, near 540, was exceeded today. Bulls will want to see that hold otherwise a drop back below the line will make today's high look like a throw-over to finish the rally. The top of what appears to be a bearish ascending wedge is just a bit higher--about 548 tomorrow. The EW pattern can be satisfactorily counted as complete with today's rally and therefore caution is advised. I'd even consider some short plays on GOOG if it drops back below 540. A drop below 519 would be confirmation that at least the leg up from May is finished.
The next two charts are of the Nasdaq (COMPX). The first chart is a weekly chart and the second one is a 60-min. Notice the similarity of the patterns and what this might be telling us.
Nasdaq (COMPX) chart, Weekly
The rally from July 2006 appears to be on its last legs. Notice the bearish divergence at the next highs, including today's. Price pressed right up the top of the wedge which is the trend line along the highs since November 2006. Weekly stochastics is overbought (sounds like my description of the daily NDX chart and I don't think that's coincidental). It closed slightly above the important Fib number of 2645.67 which is the 38% retracement of the 2000-2002 decline but on lower volume. You have to ask yourself if you'd rather be short or long the techs here for a longer term position.
Now look at the pattern on the 60-min chart:
Nasdaq (COMPX) chart, 60-min
Look familiar? This is a fractal pattern of what I just showed on the weekly chart. In my opinion the tech rally is coming to an end and the similarity of the patterns from weekly to intraday suggests the current buying spree in techs could be a last gasp (maybe even by the public that feels they've missed the rally, and they're the ones who like to buy the sexy techs). It doesn't mean this will roll over and die tomorrow (although it could) but again, the signals are there for you to at least be much more cautious about the long side than usual.
Russell-2000 (RUT) chart, Daily
The RUT's price pattern continues to baffle me. I'll be dipped if I can fit a trend line to that mess, figure out what all the overlap is all about, or where to place Fib projections. I see upside potential from 860 to 890 and it's not bearish until it breaks below 820. How's that for a spread? Follow the others if you're trading this one.
BIX banking index, Daily chart
The banks are either done with their bounce or in the middle of a larger 3-wave bounce (light red price path). I don't think this index will see the high side of the 200-dma again and a break back below 384 would be immediately bearish as it would be a confirmed break of its long term uptrend line from October 2005.
U.S. Home Construction Index chart, DJUSHB, Daily
The bounce off the July 2006 low lasted all of a day. Now with the break below that support level it would appear this index is headed immediately lower. If so, watch for a bounce from the projection for two equal legs down from February at 487.56.
Oil chart, ETF (USO), Daily
Oil may be ready for a pullback but I don't see any reason yet that negates the likelihood that we'll see USO rally up to the $59 area. That would be two equal legs up from January and a 50% retracement of the 2006 decline. If and when we get there I think that will be the end of the rally in oil as it turns around and heads for new low (due to slowing economy). For now it remains bullish.
Oil Index chart, Daily
With the strength in oil it's not surprising to see the oil stocks continue higher as well. But watch the Fib projections near 786 and then 820 if reached. Based on the rally pattern from March I see this as close to an end. It will probably top out before the price of oil does (which is very typical--stock prices lead the commodity prices, just as it happened between gold stocks and gold).
Transportation Index chart, TRAN, Daily
I mentioned last week that the choppy corrective pullback from the mid-June high gave me the impression that we were going to see another leg up in the bounce off the June low. That bounce would now have two equal legs up at 5268 so watch for potential resistance there if tagged. There's layered resistance above by various trend lines and then the upside Fib projection, if there's to be a new high, just under 5415. My preferred wave count on the Trannies is the bearish one that's looking for the 3-wave bounce off the June low to fail at a lower high and then turn back down (dark red price path).
U.S. Dollar chart, Daily
The US dollar broke support by its uptrend line from May and dropped swiftly from there. It has dropped to support at its previous low and is either consolidating before continuing lower or it could bounce a little further before dropping to the new low (dark red). While it's possible the pullback is already finished, it will take a rally back above 82.30 to suggest that's true. In the meantime the dollar is back into a bearish pattern which should complete with a drop back down to the bottom of its descending wedge near 80.50.
With the big drop in the US dollar I would have expected metals and other commodities to do better than they did. This alone may be suggesting that the dollar's pullback will be short lived.
Gold chart, August contract (GC), Daily
While the US dollar broke its uptrend line from May, gold was not able to break its downtrend line from May. Running into its 200-dma didn't help the bulls any. If gold can get back above 660 then the gold bulls have a chance, otherwise the downtrend in gold is solidly in place.
Gold's failure to break its downtrend, if that continues to be the case, tells me the selling in gold is more a result of credit contraction than inflation. While inflation is still on the tips of central bankers' tongues (and European countries continue to ratchet up their rates to fight inflation) people are not flocking to gold as a safe haven. This is very telling and suggests inflation is not the real problem. Credit contraction will be the next buzz word out there. Just ask Bear Stearns and all the other hedge funds who hold risky junk bond portfolios.
Results of today's economic reports and tomorrow's reports include the following:
The only economic report of consequence Friday morning will be the payrolls number. With today's ADP numbers there shouldn't be any surprises.
SPX chart, Weekly
The weekly SPX chart shows what looks like a choppy pullback from the June high. Because it's been a choppy consolidation it tells us to be on the lookout for a continuation of the rally. The first Fib projection to watch for in that case is just under 1563 (two equal legs up from October 2002). The shorter term charts point to some lower resistance levels so basically it could be a tough road for bulls between 1538 and 1563.
The bears want to see price drop back below 1484, the last low because that would likely be followed by some hard selling. A consolidation pattern, as the June price action appears to be, that fails will typically fail hard. You see the same thing intraday on patterns such as bull and bear flags--when price fails (such as dropping out the bottom of a downward sloping bull flag) it fails hard. But until that happens, run with the bulls.
Tomorrow being Friday of a holiday week I suspect trading volume will become even more pathetic. Today's 4.8B shares made for a light day and Friday could be slower. First of the month buying may continue to buoy the market so don't fight it if you want to try a short play (such as I recommended on the techs). Look for crisp entries (let the market come to you) or just let it go. If nothing else, continue your holiday by making it a 3-day weekend now. One on, three off. Not a bad work schedule.
We have mixed signals between the techs and large caps and that will always make trading a little more difficult. Who's going to lead who? Will the techs pull the blue chips up or are the blue chips giving us a heads up that something worse is coming. But then I look at the charts of the blue chips and I see the possibility for more rally while I see the techs topping. So that's our dilemma this evening and why I suggest you look for very good entries or sit it out tomorrow and wait for some volume to return next week.
For the swing/position traders we don't have enough answers yet. While I see the possibility for the techs to top out before the blue chips (which could be here or very close to today's price highs), and thus create some bearish intermarket divergences, we don't have enough evidence of that yet. We could see the DOW rally another 400-500 points before it's done, which makes a short entry in the blue chips too risky.
The trend remains up and that's the easiest way to look at this market. If we truly are following a similar price pattern as 1929, 1967, 1977, 1987 and a few others, which so far we are, then a rally into August should be our expectation. I continue to watch for evidence that we might top out sooner and while I see hints of it (such as in the techs, maybe), I can't suggest that you look to short the market here. Continue to keep your powder dry.
Good luck tomorrow and next week and I'll be back next Wednesday. I'll see some
of you on the Market Monitor for what I hope will be a session that's a little
more exciting than watching paint dry.
Play Editor's Note: We were tempted to add a few more bullish candidates tonight. However, we are choosing to wait since volume continues to come in low due to the holiday week. Plus, those traders who are not on vacation are probably waiting for Friday's big jobs report.
Avery Dennison - AVY - cls: 67.30 chg: +0.08 stop: 64.90
AVY is still inching higher and looks bullish following its breakout past the $67.00 level. Traders were relatively quick to buy the two dips under $67 today. This looks like another entry point to buy calls but you may want to use a tighter stop loss than our suggested stop at $64.90. The recent move over $67.00 has produced a new P&F chart buy signal with an $80 target. Our target is the $69.75-70.00 range. We do not want to hold over the late July earnings report.
Picked on June 11 at $ 66.05
BP Plc. - BP - close: 72.92 change: -0.59 stop: 68.75
Shares of BP continue to look bullish over $70.00 but the stock also looks short-term overbought and the rally looks tired. Today's move is a bearish failed rally under $74 and a bearish engulfing candlestick pattern. We wouldn't be surprised to see a dip back toward $72 or the 10-dma near $71.45. The P&F chart points to a $90 target. Our target is the $74.85-75.00 range. More aggressive traders may want to aim higher.
Picked on June 22 at $ 70.25
Chevron Corp. - CVX - close: 86.57 chg: +0.24 stop: 79.90
Oil stocks have rebounded sharply in the last few days and CVX broke through resistance near $85.00. We are raising our stop loss to $81.39, which is just under technical support at the 50-dma. We remain bullish on oil but we're not suggesting new positions in CVX at this time but we'll be watching for a dip near $85 or $84 as a potential entry point. CVX's Point & Figure chart is positive with a bullish catapult breakout buy signal and a $120 price target. Our target is the $89.00-90.00 range.
Picked on June 18 at $ 83.75
Deere Co - DE - close: 123.06 change: +0.83 stop: 116.90
DE broke through short-term resistance at the $122 level on Monday. Traders continue to buy the dips so the recent action looks like a new entry point to buy calls. If you're feeling cautious then consider raising your stop loss toward the $118 level or last week's low (118.57). We have two targets. Our first target is the $129.50-130.00 range. Our second, more aggressive target is the $134.00-135.00 range.
Picked on June 20 at $123.55
Russell 2000 iShares - IWM - cls: 84.51 chg: +0.15 stop: 81.35
The market's recent strength has continued to fuel the rebound in the Russell 2000 and the short-term technicals are definitely improving. The IWM is nearing resistance in the $84.65-84.75 zone. Our target is the $86.50-87.50 range.
Picked on June 24 at $ 82.85
Manpower - MAN - cls: 93.88 change: -0.03 stop: 89.90
MAN has traded in a relatively narrow range the last three days. We don't see any real changes from our previous comments. More conservative traders may want to tighten their stops toward $91.00. Meanwhile readers may want to wait for a breakout over $95 before considering new positions. The P&F chart has a triple-top breakout buy signal with a $110 target. Currently our target is the $99.50-100.00 range.
Picked on June 20 at $ 94.15
Pacific Ethanol - PEIX - cls: 14.55 chg: +0.93 stop: 11.90
Thursday proved to be a big day for PEIX. The stock broke out past technical resistance at the 50-dma and broke out past price resistance near $14.00 to produce a 6.8% gain on very strong volume. We didn't see any specific news or event to account for PEIX's strength. The rally did stall at the $15.00 level. More conservative traders may want to exit right now with the stock up more than 13% from our suggested pick price. We are adjusting our target to the $15.40-15.60 range to account for potential resistance at the descending 200-dma. FYI: We cannot find a future earnings date for PEIX but suspect it will be in August or September.
Picked on June 24 at $ 12.83
Penn National Gaming - PENN - cls: 60.36 chg: -0.01 stop: n/a
There has been almost no movement in PENN. The consolidation has leveled off near the $60.00 level. The company has less than 30 days to solicit more bids before accepting the current cash buyout at $67 a share. We were suggesting high-risk, speculative call positions on the idea that additional companies would make a bid for PENN.
Picked on June 17 at $ 62.12
SanDisk - SNDK - cls: 48.09 change: +0.49 stop: 44.85
SNDK hasn't moved much this week. Traders are buying the dip after Monday's analyst downgrade. The rebound looks like a potential entry point but you may want to use a tighter stop loss. SNDK has already hit our conservative target in the $49.50-50.00 range. We're currently aiming for our aggressive target in the $52.50-55.00 range. We don't want to hold over the mid July earnings report, which doesn't give us a lot of time so you may want to avoid launching new positions.
Picked on June 17 at $ 46.40
Allegheny Tech - ATI - cls: 108.74 chg: +0.03 stop: 110.15
Shares of ATI continue to be very volatile. Several steel and metal stocks have continued to rebound the last few days and ATI got a boost on Monday after some positive analyst comments. The stock appears to have broken its bearish trendline of lower highs and is currently flirting with a bullish breakout over resistance at the $110 level. More conservative traders may want to exit early right here. Currently we're aiming for our aggressive target in the $95.50-95.00 range.
Picked on June 12 at $106.70
Gilead Sciences - GILD - cls: 38.98 chg: -0.07 stop: 40.85
GILD continues to trade in a bearish trend of lower highs. The stock recently broke down under technical support at its 100-dma. We're not suggesting new positions at this time but GILD might be vulnerable to a pull back near the 200-dma around $36.00. Our post-split target is $37.62-36.25. Aggressive traders may want to aim lower. More conservative traders may want to lower their stop closer to the $40 level.
Picked on June 07 at $ 39.95 *split adjusted
Mettler Toledo - MTD - cls: 95.94 chg: -0.62 stop: 99.11
MTD is still trying to bounce but has been struggling with the $97 level. We remain bearish given the larger pattern but the two-week week rebound is about to turn the daily chart's MACD indicator into a new buy signal. More conservative traders may want to tighten their stops toward the 50-dma around $98.00. Readers can choose to buy puts on today's failed rally or wait for a new decline under $95.00. We're still keeping a wary eye on the 100-dma, which is where shares bounced in June. Our target is the $90.50-90.00 range. FYI: The P&F chart has reversed into a new triple-bottom breakdown sell signal with an $87 target (was $91).
Picked on June 19 at $ 96.75
QUALCOMM - QCOM - cls: 43.54 change: -0.32 stop: 44.05
We are still defensive with QCOM. The stock continues to find resistance at the $44.00 level but we don't know how long it will last. Shares have developed a bullish trend of higher lows suggesting a bullish breakout is imminent. We are not suggesting new positions at this time and more conservative traders may just want to cut their losses right here.
Picked on June 10 at $ 41.87
Global SantaFe - GSF - cls: 74.35 chg: -0.27 stop: 68.86
Target achieved (and exceeded). Shares of GSF actually hit our target in the $74.50-75.00 range on Tuesday, July 3rd with an intraday high of $74.70. The stock rose again this morning with an intraday high of $75.44. GSF continues to rise in its bullish channel but we'd wait for a significant dip before considering new positions. The $70-71 zone should offer some support as would the rising 50-dma.
Picked on June 03 at $ 68.86
Las Vegas Sands - LVS - cls: 78.60 chg: +1.96 stop: 78.05
LVS surged 2.5% on Thursday and broke out over the $78.00 level to hit our stop loss at $78.05. Market pundits were suggesting the merger/buyout news for Hilton Hotels today fueled a rally in casino stocks with big hotels attached. LVS almost hit our target back on June 27th and we're not completely convinced the stock is turning around. Watch for a failed rally under $80 as a potential entry point for puts or a breakout over $80 as a potential entry point for calls. However, if you're buying calls be aware that the 100-dma and 200-dma will be overhead resistance.
Picked on June 17 at $ 76.78
I started on the topic of seven, as in 'lucky' seven or unlucky seven in this case, option trading mistakes to avoid in my last week's Trader's Corner article (Wed., June 27th.); this was in answer to a subscriber question who I gathered was relatively new to options trading. I got through 3 of those 7 rules last week, which were my interpretations of 7 such rules given in the 'Trader's Notebook' section of my latest issue (July) of Technical Analysis of Stocks and Commodities magazine. Hey, my favorite magazine on trading.
Before I launch into completing this topic from last week, I would also make a quick detour into what I make of the technical action of THIS WEEK. I had been leaning to a bearish interpretation of the fact that a possible double top was in place in the S&P and Dow, but without the double top 'confirmation' that comes (only) when the major market indices ALSO pierce, on a closing basis, the last significant downswing low that occurred before there was a top twice in the same area.
Since the S&P has again rebounded from the low end of the recent 1490-1540 trading range in the S&P 500 (SPX) and popped back above its 21-day moving average along WITH the Nasdaq surging to a new high for the current advance, neutral to bullish chart interpretations are intact.
BENEFIT OF THE DOUBT
When there is an advance, especially a strong advance, followed by a lengthily sideways trading range (lateral trend or 'line' formation) or what is called a price 'consolidation' phase, the outlook ahead is 'assumed' to be for an eventual bullish breakout and a new up leg. In other words, technical analysis would give the 'benefit of the doubt' to the dominant trend.
The consolidation/sideways/lateral trend after a big leg up calls for a wait and see attitude, which makes for a difficult situation for those holding long options. It is a great situation for those with trading strategies that involved prices remaining in a range and anticipating the erosion of time premiums. The WAIT in terms of trading an outright position is that it's necessary to see either a breakout move ABOVE or a breakdown BELOW the trading range; e.g., to above 1540 or below 1490 in the case of SPX.
Tech is another story as I-phone mania and other factors have finally caused an INDEPENDENT move and strength in Nasdaq.
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CURRENT TECHNICAL CONSIDERATIONS:
S&P 500 (SPX)
TIME duration is a factor however. The LONGER the duration of the sideways trend the greater is the probability that a lateral move is a consolidation of an intact bullish trend. A top building process can take a long time sometimes, as in 2000, when the market did hang up around its highs for a lengthily period, but more often when a top forms there will be a break sooner rather than later. But, again, the key is the direction of the breakout. Gee and I find it hard to wait!
As I mentioned with the Nasdaq Composite (COMP), the move to a new high for the advance off the last low now suggests upside potential to the high end of the uptrend channel in the 2700 area and a bit above as outlined on the chart below.
OPTION TRADING MISTAKES TO AVOID CONTINUING FROM LAST WEEK
FIRST, WHAT TO DO:
SEVEN OPTION TRADING MISTAKES TO AVOID
The first 3 are brief summaries from last week:
1.) Not understanding the independent effects of time and volatility on your option(s)
An option's price relies on MULTIPLE variables. Options are sensitive to the passage of time (theta) and changes in implied volatility (vega). These variables are independent of each OTHER, the stock price movement and the option's sensitivity to it (delta). Don't get fixed on just 1-2 of these variables.
TIP: Buy an in-the-money (ITM) option with a delta around 80-85 when you want to use an option in place of buying the underlying stock, for a directional play. The option then will mimic the stock closely. ITM options are much less sensitive to the adverse effects of time and volatility.
2.) Forcing a pre-selected strategy on every opportunity
An example is a strategy of 'selling high volatility and buying low volatility'. Sometimes the reverse will occur and a top is associated with low volatility and you could profit from buying puts. A strategy involving volatility is only one element in a complex ever-changing set of factors that make up the trend of a stock or the market. Therefore, don't get stuck in using the same strategy all the time.
Instead of looking at a chart or situation to see what the market is offering, with fresh eyes, it's easy to force a strategy onto the chart in the way of trying to force a square peg into a round hole.
3.) Not understanding the proper way to use leverage in trading options; comparing apples to oranges
This tends to especially be a mistake made by those new to options trading. They are bullish on a certain stock (e.g., Apple). They were willing to put $10,000 into buying AAPL. Instead they put $10,000 into AAPL calls. Putting the same money into purchasing calls has enormously increased their leverage and at the same time enormously increased their risk of losing most or all invested in options, assuming they hang on to or until close to expiration, even if the stock only drops modestly. Losing all you invested in option happens quickly and commonly, whereas, losing more than 30 percent in the value of stock you own is not that common.
The lesson here is to figure out how much you are willing to risk in owning the stock and make an equivalent bet on the options, where your strategy is to exit an equivalent options stake at the same dollar risk point.
4.) Not fully understanding the building blocks of option theory.
Everyone it seems wants to make a million in the markets, easily and fast even. Many learn one strategy and then they are off trading without understanding how the individual options work. Many courses or tutors overlook three of the most important concepts of option theory: the greeks, synthetic positions and the option pricing model. By the way, I mostly give advice on what I think the market trend or direction will be ahead, but this column today is dedicated to general advice on what should be studied to successfully trade options.
Once you have learned an options strategy, you may of course wonder why knowing the 'greeks' has value. The greeks being a group of statistical reverences that describe and quantify an options position risk relative to the variables that can affect the price of your options. If you don't know what will happen to the value and nature of your options position as movements occur in the stock or index price, volatility and time, you can't accurately assess your risk. As I noted initially, knowing your risk is as important, or in a way MORE important, then knowing how much you could make if a stock or index reached particular objectives.
Synthetic positions are constructed using a tandem of components that mimic another position identically. Synthetic positions show you how options relate to each other mathematically, which in turn tells a trader how to morph from one position from one strategy to another in the most cost efficient way. Add this subject to what you could gain from a studying options.
The option pricing model is to understand the origins of options, which is to understand the instrument itself and is fundamental knowledge and not to be overlooked.
TIP: Avoid courses that rush you into option strategies as they only give you enough knowledge to be dangerous to yourself. Learn from the bottom up if you have determined that you really want to understand and profit from trading options.
5.) Assuming that if an option is cheap or expensive is determined by dollar cost.
However, the strike price is key here. Options with different strike prices have different values. These different option strikes have different deltas associated with them. One of the definitions of delta is that of a percentage chance. Since all of these options have an associated percentage chance of being in-the-money at expiration, they will have different values. This means that options that are already in-the-money have a better chance of finishing in-the-money and are more expensive because of it.
Out-of-the money options are less likely to finish in-the-money by expiration, so they are less expensive. This establishes that dollar cost does NOT dictate how expensive or how cheap an option is; strike price dictates this. The question is how to relate the cost difference between options of different strikes to determine relative cheapness or expensiveness. This is done through implied volatility, which is the only way to determine whether an option is expensive on a relative basis. Although options are separated by different months and strike prices, they are similar under implied volatility.
A higher level of implied volatility means a more expensive option and vice versa. Implied volatility is the unifying factor necessary to use to determine whether any option is truly cheap or expensive.
6.) Overcomplicating otherwise simple strategies.
There are many different strategies in use in options trading. Most are relatively easy. However, some or many traders wind up choosing a strategy that is much more complicated than necessary to take advantage of a given opportunity. Of course, the flexibility of options allows more than one way of doing something, which in and of itself is an advantage of options.
We all know what 'sexy' stocks are; e.g. currently, a stock already mentioned, Apple is one, due to its very 'sexy' cutting edge I-phone product. There are also 'sexy' strategies that get employed just due to being complex and new. I find that this tendency to complicate things is also one of the biggest downfalls in technical analysis methods. You see analysis that is so complex you can't hardly follow it, let along understand WHY this analysis works. Nevertheless, the complexity tends to make us think that there must be something to it. I've followed the advice of others just because I thought that more factors considered made it better. 'Quantity equals quality' is one of the pitfalls of dialectical reasoning.
KISS: 'Keep it Simple, Stupid' is what I try to keep coming back to. Maybe it's just because I am stupid. But I've also been influenced by very successful traders who use fairly simple and straightforward trading strategies and entry and exit rules. This is not to say that there are not complex trading models that ALSO work. But if a simple method works as well, I find it more efficient of my time and energies to use that. Mainly stick to what you really know and can understand.
7.) Not knowing how to pick the correct option for the selected strategy.
When a trader decides to select a strategy to apply to given opportunity, there are several choices to make. Selecting the proper generic strategy is just the first step. Once a strategy is selected, it's necessary to choose the proper month and strike price that will optimize that strategy for the identified opportunity.
Every strategy has certain features that are applicable to different perceived opportunities. The two basic choices are month and strike price. Month selection deals with market timing especially (and what I concentrate on in my Index Trader columns each weekend). Further, a longer-term option of course will not decay as fast as a shorter-term option. This nonlinear rate of premium decay is an important consideration in whether we are best to buy or sell an option in our selected strategy.
Regarding strike price, depending on the strategy and what it needs, we must select an in-the-money, at-the-money (ATM) or out-of-the-money option. An ATM option contains the most extrinsic value of any option in the month. It is also the most sensitive to movements of time and volatility. Consider all such factors when deciding which option will fit best in a given strategy.
As I deem my forte to be market timing or having a reasonably good feel for knowing when a trend may be about to change, I tend to favor ATM or only slightly out-of-the-money index options. But what I do won't work for anyone who is not prescient in timing trend changes. It was also a long hard road to learn market timing, so is probably not the best way to start in options trading. In fact I started by trading the futures markets for a number of years before trading options.
GOOD TRADING SUCCESS!
Today's Newsletter Notes: Market Wrap by Keene H. Little, Trader's Corner by
Leigh Stevens, and all other plays and content by the Option Investor staff.
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