After weeks of rallies and rebounds on good news it is time for the bad news bulls to reappear and buy this earnings dip. Will they do it? I would not hold my breath but they have been showing up in quantity just when you thought they had left for vacation. Remember the prior Tuesday when the Dow lost -150 points intraday. The bad news bulls arrived to power a +400 point rebound. Remember back on June 29th news pounded the Dow to a -208 point intraday move. The bulls returned the next day to power a +350 point move over the following week. The bad news bulls are out there but they were nowhere to be seen on Friday.
Dow Chart - Daily
Nasdaq Chart - Daily
Friday had no important economic reports with Mass Layoffs and the Weekly Leading Index the only reports on the schedule. Mass layoffs in June rose to 1,219 events from 1,190 in May. The number of workers told to expect a pink slip rose to 127,897 from 119,089 in May. Layoffs had been averaging about 127,000 so May's dip was an exception and we are right back on trend. There was nothing for traders to worry about in this report. The weekly leading index was also flat at 143.9 and it would take a 10.0 move on the Richter scale to make anybody pay attention to this weekly report.
Next week is going to be busy with a headline report due out every day. There are three regional Fed surveys, two housing reports, the Fed Beige Book and the first look at Q2 GDP. The regional Fed manufacturing surveys are not expected to show any problems with steady but slow growth. The home sales numbers could not show any more negativity than is already priced into the market so any surprise would likely to be to the upside. The big reports for the week will be the Beige Book and the GDP. The Fed Beige Book is a report from all 12 Fed banks. Each bank reports on the economic conditions and trends in their area and the report is seen as a very specific update of overall economic conditions. Last month seven of the twelve banks reported modest or moderate growth and growth no worse than the prior reporting period. The other five banks reported stronger growth with improvement from the prior period. Traders will be looking for more banks to report stronger growth as evidence the recovery is still in progress.
The Q2-GDP is where the fireworks could start. Current official estimates are for +3.2% growth in Q2 compared to 0.69% growth in Q1. Whisper numbers have been over 4.0% in prior weeks but have cooled after some of the weekly economic reports were weaker than expected. The continued housing slump is also forcing a lowering of expectations. Bernanke said in his testimony this week that the slump was continuing and the bottom is still ahead of us. A jump from less than 1% to more than 3% could also ratchet up Fed rate expectations if it appears the economy caught fire and is suddenly accelerating. Conversely if the GDP comes in below 2% we could see expectations rise for rate cuts by year-end. The Fed needs to keep the economy on a growth cycle and if the bottom in housing is still ahead they may not want to wait for it to begin easing rates. Dropping the Fed rate indirectly impacts mortgage rates and buyer interest and could soften the landing when that housing bottom eventually arrives. With the Beige book on Wednesday and the GDP on Friday and three regional reports spread through the week the Fed watchers will have a busy schedule.
Earnings will be the focus next week probably even more than last week even though the five majors, IBM, INTC, MSFT, GOOG and EBAY have already reported. The market was hammered by some very high profile earnings misses last week and there were very few earnings reports. Because of the way the July 4th holiday fell on the calendar there are nearly 1200 companies reporting earnings next week. That is the busiest week I can remember. It means there is so much happening that only a small portion of the announcements will ever make it to the airwaves. Those will likely be the ones with the biggest disasters since bad news creates more attention than a company reporting inline with estimates or beating by a penny. I added a line to the earnings table below showing the number of companies reporting each day. This is only my rough count but you get the picture.
Last week there were some spectacular earnings disasters and they put a lot of stress on the markets. Intel reported a strong quarter but missed on margins and the stock was pummeled for a -$2 loss (-7.5%). Remember I cautioned that the biggest moves were normally a reversal of the pre-report trend. If the stock was already soaring on expectations then those expectations could be reaching unrealistic levels. Any minor flaw in the earnings or guidance or maybe just missing a hypothetical whisper number can knock multiple dollars off an inflated stock price. Even spectacular earnings can fail to push a stock higher that has already seen strong gains. Prime examples of this came from Intel, Google, Caterpillar, Mattel and Juniper. This just proves that if you are going to speculate on earnings and hold over the announcement your best odds are to bet against the trend.
Intel Chart - 30 min
GOOG Chart - 60 min
CAT Chart - 30 min
MAT Chart - 30 min
JNPR Chart - 30 min
If you take the earnings calendar from last week and chart each of the 46 companies I had listed you will find 9 that traded higher (BRCM on news not earnings) one flat and 36 that traded lower, most a lot lower. That was a 75% chance of a negative reaction to earnings and many of those companies posted decent earnings. The reason is simply an overextended market and overly optimistic expectations. I strongly advise you take 10 min and look at the charts for each of these companies. It could be an eye opener.
Last week's earnings reactions
Next week will offer investors plenty of reasons to take profits. Since there are an inordinate number of earnings reports in one week, well more than twice the average, there will be twice the number of sellers. If you are bullish and playing a stock for earnings then once earnings are reported you take profits and move on. The following week also has an abnormal number of reporters as the rest of the majors try to get it done before July is over.
To say last week was volatile would be an understatement. Twice the Dow set new highs and twice there were -200 point intraday reversals. The Nasdaq equaled that with two new highs and two -50 point reversals. This is not a normal event but typical of frothiness at a market top. There are quite a few things weighing on the markets and some of them are serious. We heard from several sources last week that the subprime slime has not gone away and will likely get worse. Bear Stearns (BSC) reported that their two subprime hedge funds, worth $1.5 billion in Q1 were now worthless. They were busy hiring lawyers to defend against he various suits already headed their way. Many of the major banks and brokers who had earnings last week reported taking charges to double or triple loan loss reserves for the problems they see coming in their own portfolios. Uncle Ben reported that the housing slump would get worse before it got better but it appeared to be contained. That means the eventual damage, now expected to be in tens of billions, will be confined to deep pocket investors and no institutions are expected to fail. That is good since Fed President Poole was on the wires on Friday saying the Fed should not be planning on any subprime bailouts.
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The subprime problem may not be as contained as Uncle Ben thinks. Or maybe it is just a guilty by association factor now impacting private equity deals. With regulators trying to raise taxes on private equity firms at every turn and lenders starting to reappraise their risk appetite there are cracks starting to show in several LBO deals. The LBO firms have to sell debt to close their deals and the price of debt is rising quickly as lenders raise the stakes for these sometimes high-risk deals. One $22 billion deal in England, the largest ever done there, was reportedly in trouble on Friday as the closing date approached. Another deal, the multibillion Chrysler/Cerberus buyout, is coming to market next week and traders are expecting a less than enthusiastic reception for the debt. Reportedly Cerberus has all the necessary commitments from banks but the market is still on edge until they see the pricing next week. Reportedly $62 billion in debt will be required to complete the deal. $10 billion was supposed to fund at 3.25% over Libor is now being quoted at 3.75%. An additional $2 billion second line loan, considered more risky, is now being quoted at 7% and higher. Chrysler's finance arm will be trying to fund an additional $8 billion in loans and rates being quoted are moving higher there also. Another $40 billion in debt will come in the form of asset-backed securities. Reportedly big buyers of these loans in the past have been hedge funds but they are staying on the sidelines at present.
The problem is the sheer amount of debt being floated by the LBO firms. In the table below you will see that the deal total for 2007 has already surpassed the total for all of 2006, which was the all time record high. So far in 2007 the deal value is more than four times the total value in 2004 and three times the deals in 2005. The final total for 2007 is going to staggering. Assuming only 50% of the first half is done in the second half of the year we could be looking at $650 billion for all of 2007. By the end of 2007 we could be looking at $1.35 trillion in deals over the last 4 years. The market is drowning in LBO debt and you have heard many times about the world being awash in liquidity. How much more debt can be sold is anybody's guess. All that debt has got to come back to the market before the LBO firms can make a profit. They have to restructure the companies and then bring them back into the equity market as new IPOs to cash out on their play. That is going to be a lot of IPOs over the next 3-4 years. It also assumes the market will still be friendly to equities and to IPOs in general. Lenders were ready to dole out the cash when this trend began but they may be rethinking it today after the various subprime blowups. They are not related but we could quickly have a round of LBO blowups just as easily. What if the currently booming world economy suddenly burned out? What if Al Qaeda started setting off hundreds of improvised explosive devices (IED) in the U.S. like they are currently doing in Iraq? Don't think it can't happen. What would our markets be doing? What if Peak Oil actually occurs before 2010 as most petroleum engineers believe? Would gasoline rationing and $200 oil crush the global economy? Absolutely and it will eventually happen, it is only a matter of time. Lenders are starting to worry about all the LBO debt they have on the books. New debt is going to see a higher risk premium and stronger guarantees. Those covenant light loans are going to disappear. That could mean a substantial slowing to the LBO craze and that would negatively impact the equity markets. Equities have been climbing higher on a constant reduction in stock for sale. Massive buyouts and massive buybacks have taken more than $2.5 trillion in stock out of the market over the last four years. What if that trend suddenly ended or even worse it reversed to stock coming back into the market? This is what is weighing on lenders this weekend. The fear is growing that the end to the LBO boom is in sight.
Table of Leveraged Buyout Deals
On Friday's Citigroup conference call CFO Gary Crittenden said Citigroup was UNABLE TO SELL DEBT on four deals forcing Citigroup to hold the so-called bridge loans on their balance sheet. Citigroup took a hit to revenue in Q2 because of these loans. He also said Citigroup was likely to be stuck with more deals in Q3 and it "will impact our revenue." Citigroup said it was stuck with so-called equity bridges, in which the bank takes direct equity stakes in companies being bought out with the aim of later selling that stake to other investors. These are typically very risky positions. Citigroup said it was comfortable with its risk at around 5% of its revenue but uncomfortable with taking on future debt of this kind. JP Morgan reported last week they were also setting aside additional funds to cover debt they are having trouble selling. If these financial giants have to eat these equity loans it suggests the market is turning soft very quickly and Citigroup, JP Morgan and others will be far less likely to take any deal coming at them. They will become much more picky and that will slow the overall volume of deals. That will eventually impact the equity markets. The recent Blackstone (BX) and Fortress (FIG) IPOs are down over -25% from their IPO price on worries about the future of the LBO sector.
I believe Citigroup's admission of being unable to sell debt on the morning conference call was a big reason contributing to the market collapse. Citigroup's comments knocked others in the sector into the cellar with GS losing -5.76, MER -2.68, BSC -4.21, LEH -2.14 and MS -2.31. A nearly +$1 billion jump in profits for the quarter kept Citigroup from joining the biggest losers list but it did finish down slightly. The benchmark ABX subprime debt index hit a new record low also weighing on financials. The financial sector is the only S&P sector in the red for the year, down nearly -4%. The disaster at Caterpillar knocked another 60 points off the Dow at the open but that was halved by CAT's rebound before the close. The market did not share in that rebound.
On Tuesday the Dow passed 14,000 intraday but closed -26 points below that level. I attributed the prior week's +450 point rebound to short covering given the record short interest in the S&P and Russell futures at the prior Tuesday's close. Guess what? Last Tuesday's close was an even higher record of short interest with the Dow at 14,000. It appears the shorts forced to cover were ready to pile right back in once 14,000 was reached. The rebound at Wednesday's close and into Thursday's open was another textbook short squeeze but there was no breaking that Dow 14,000 level on Thursday. There were plenty of sellers waiting on that second attempt. At the same time we are seeing a surge of buying in bonds sending yields on the ten-year note to 4.95% and a new two-month low. Bernanke must be having Greenspan nightmares. He talked tough and tried to put the inflation scare into the bond market in his two days of testimony last week and rates went lower rather than higher. Although it seems just like yesterday that we were waiting for the post FOMC announcement the next meeting is almost upon us. The Fed meets again for a one-day meeting on August 7th and I would expect some harsher tones in the statement meant to put the fear of rate hikes back into the market.
All the Fed members are talking low inflation, if you use the core rate, but the cost of food and energy continues to rise. The Clinton administration changed the way the CPI is calculated to produce a lower inflation rate. Using the pre-Clinton CPI inflation is now running about +11%. Which seems closer to correct for your expenses, today's CPI at 2% or the prior calculation at 11%? It probably seems closer to the 11% and that is due in part to the crash of the dollar in value. On Friday the dollar hit a new 10-year low and came within 3 cents of an all time low. With the dollar falling relative to any hard asset like gold, oil or any overseas goods bought with dollars it takes more dollars today to buy the same item you bought last week. Seems to me that is the textbook definition of inflation. The dollar index has fallen -13 cents from its 2005-Q4 high and that means everything bought with a dollar requires roughly 13% more dollars to buy today. For instance a barrel of oil cost roughly $66.50 to buy on Oct-1st 2005. Today that same barrel is $76. Oil's value did not change but the dollar did. $66.50 x 1.13% = $74.58. Funny how that works out almost exactly to today's price. Eventually this real world inflation is going to show up in the Fed numbers and there is going to be a serious impact to the equity markets.
Dollar Index - 5 years
While I am on the subject of oil I am sure everyone noticed the new contract high at $76.13 on Friday. $76 and not a hurricane in sight. $76 and gasoline has fallen from $2.38 on the 10th to $2.07 on Tuesday, a -13% drop. $76 and crude inventory levels are at a decade high. There is nothing new on the geopolitical horizon and despite all time record demand for gasoline of 9,710,000 barrels per day last week the summer driving season is about over. Makes you really wonder about the relationship between the price of oil and the value of the dollar doesn't it. I know, in reality everyone is afraid a hurricane will show soon but if it does not show in the next week or so oil is going down hard. Actually we have already seen $80 a barrel this year for light crude, just not the West Texas Intermediate (WTI) crude that is commonly quoted as the benchmark price. Nigerian Bonny Light has been over $80 since July 9th and Louisiana Light Sweet (LLS) hit $80 late last week. I know the televangelists of oil are predicting as high as $85 before the summer is over but without a hurricane it is going to be tough to hit those levels as long as gasoline continues to fall. In the chart below you can see that crude inventory levels are well in excess of the 5-year average (blue band).
Crude - Five Year Average Chart
Let's not forget our current tie to China. China's GDP was announced last week at +11.9% for Q2 and topping every estimate in the Bloomberg poll. Inflation rose +4.4% and the most since September 2004. This exceeded the central banks target of 3.0% for the 4th consecutive month. Oil imports rose +12% over the same period in 2006. The Shanghai Composite (SSEC) spiked another +3.69% even after its months of already stellar gains. The SSEC is up +95% year-to-date and was up +150% last year. This is the chart in the dictionary that defines irrational exuberance. China reacted quickly to the GDP news and hiked rates another .27% to 6.84% but that minor change is not likely to slow their economy. Let's not forget how quickly our markets reacted to previous drops in the SSEC. If that resistance holds at 4250 and a long overdue correction begins it could spread a bad layer of ugly around the globe.
Shanghai Composite Chart - Weekly
For next week the main focus is going to be earnings with an increased sideline focus on economics later in the week. Ironically even after a disastrous earnings week the estimates for some stocks continue to rise. Apple Inc (AAPL) gained +3.75 on Friday to $143.75 after a Piper Jaffray analyst raised his price target to $205 citing a robust sales forecast for the iPhone for fiscal 2009. 2009? That is looking way down the proverbial road. Unfortunately options are so dang expensive on Apple now the penalty for guessing wrong ahead of earnings would be huge. This is a stock that has every right to crater post earnings but from this side of the event I can see nothing to criticize. My only complaint is that I took profits at $120.
Texas Instruments (reports Monday) was surging into its report but the Intel sell off knocked out the props on TXN and it pulled back to support at $38. It could go either way from here now that the expectations have been dulled slightly. Amazon (Tuesday) also gave back some of its pre-earnings gains last week but is still basking in the glow of its April earnings surprise that produced a +$30 gain over the last three months. That suggests Amazon earnings could be dangerous. Expectations will be even higher this time around because of last quarter's surprise.
Cummins (CMI - Thursday) was expected to strongly beat estimates but the CAT miss may have taken some of the expectations out of CMI. After the +$50 gain over the last quarter I could easily see some serious damage if they don't beat by a mile. Again, CMI options are expensive after the CAT surprise.
Exxon reports on Thursday and they will report massive earnings once again. The key here is that all the good news is definitely priced in with the +$22 gain since March. It would be hard for Exxon to disappoint and even harder to really post an upside surprise. Exxon options are actually cheap because there is no unknown and there are 5.6 billion shares outstanding. Large sudden moves don't happen very often. Because of the potential drop in oil prices I might speculate in some Exxon puts about 90 days out.
Qualcomm (QCOM) reports on Wednesday and this could be a put candidate. QCOM suffered a setback on Thursday when Verizon pulled out of the protest against the import ban on QCOM enabled phones. Verizon signed a deal with Broadcom to pay $6 per Qualcomm phone imported into the U.S. and dropped support of Qualcomm. A court found Qualcomm in violation of several Broadcom patents and imposed an import ban on phones in violation of that patent. Verizon, Sprint and several other carriers would be hurt very badly by this ban and the inability to import phones for the coming holiday season. Qualcomm refuses to settle even though Broadcom offered them the same $6 per phone royalty deal. Qualcomm says the deal would cost them $2 billion a year and refuses to pay. Odds are good Qualcomm will have to say something negative in their earnings guidance. Puts are cheap despite the -$2.50 end of week drop.
NYSE Composite Chart - Daily
Next week is chip and energy week for earnings with dozens of companies in each sector confessing their sins. Oil companies that cannot beat estimates over the last quarter should be banished to the artic to explore for oil. Chip companies are a different story. There are plenty of mixed results expected with some going to crash and burn while others soar. It is knowing who will do which ahead of the event that poses a problem. The SOX was one of the few indexes to post a gain for the week even after Intel spoiled the party. According to most reports PC sales are booming and we already know cell phones and video games are hot as well. The problem is the large number of manufacturers. It is very tough to produce large profits with a dozen of manufacturers all trying to compete in the same market. Broadcom has an inside track here as does Nvidia. The ATI/Intel combination has yet to push Nvidia out of the market and if anything slowed down ATI's ability to move quickly. I have bought a dozen high level Nvidia video cards in the last few months after problems with multiple ATI cards. Nvidia is currently the winner in this sector. They are expanding into extreme high performance gaming products including motherboards and complete PCs along with their marketing partners. They are also releasing extreme performance computing systems for fields like geosciences, molecular biology and medical diagnostics. They are not just video cards any more. Unfortunately there is no earnings date posted and Nvidia has not responded to my emails as of yet. I am expecting their earnings the first week of August. I will keep you posted. I would buy Nvidia on any serious pullback.
So far this earnings cycle about 25% of the S&P has reported with 59% beating estimates, 20% reporting inline and 21% missing estimates. The average earnings growth so far is coming in at about +10.4% on an earnings per share basis but only +4.1% on a total profit basis. Everyone expects those numbers to slide significantly before the cycle is over even with strong earnings from the energy sector. Remember, earnings per share is skewed significantly higher by share buybacks and you can see that difference in those two numbers. Buying back shares makes you look like a big winner while actual profits are just creeping along.
Forgetting earnings gyrations and potential economic minefields next week we are still faced with what appears to be a solid top at Dow 14000, SPX 1555 and Russell 855. The Nasdaq is not showing a clear line of resistance but is showing a critical line of support. Here is the problem we are facing. Short interest was at record highs on Tuesday. Thursday's rebound was stopped cold at 14000. Friday's volume was nearly 7 billion shares and was 6:1 in favor of decliners. After a retest of the historic highs, volume that imbalanced to the downside looks an lot like a top. Of course we had the option expiration to skew the volume and cloud the issue but bear with me here.
Depending on how you compare data August and September are typically the two worst months for the stock market. Since 1950 September has the record for being the worst month for all the major averages. In the shorter term August has been the worst month for the averages for the last 16 years. Together they are the valley of death bull markets must cross. In theory it is the end of summer back to school mentality that causes problems. Traders and investors are trying to cram vacations into the few weeks left for summer. Retail investors are taking money out for those back to school expenses, college tuition and to pay for those vacations. As the third quarter progresses money managers tend to prune portfolios to get rid if under performers and take profits on those that have run ahead of their values. Managers want to stock up on cash for the typical October bottom to capitalize on bargains as the Q4 rally begins. Of course this is a typical scenario as seen over dozens of years. How this year will react is yet to be seen. If you had bailed last August you would have missed out on some very nice gains since the market rallied out of the July dip and never looked back until February of this year. That July dip came on the second week of earnings season, which just happens to be next week. There was no September/October crash and we saw days on end with no selling whatsoever. In 2005 the last week of July was the summer high and the markets hit a low in October just like they were supposed to.
Since we can't see the future we have to react to the little road signs along the way. Once of those road signs was a double top at 14000 last week. Another was the extremely high volume on Friday. Another would be a break of support on the Nasdaq at 2675. Critical Dow support is well below at 13450 so there is plenty of room for profit taking before the Dow is in danger. Retail margin loans hit a new record this week. Short interest on individual stocks hit a new record and that is also a pair of road signs but which way are they pointing?
Nasdaq Chart - 90 min
SPX Chart - Daily
Russell-2000 Chart - Daily
Don't you wish you could see how the professionals are trading so you would know which way to lean? Fortunately to some extent we can. The Commitment of traders report as of July 17th shows us the hands held by the commercial traders, those who trade big dollars, and by individuals and smaller accounts called non-commercials. Typically the commercials are in the right trade and the non-commercials, the little guys, are wrong. It sometimes goes the other way but generally those with billions of dollars at stake are playing a winning hand. In the table below there are plenty of contradictions, enough to make your head spin. The big guys are heavily long the S&P and Russell futures while the little guys are extremely short. In theory that means the S&P/RUT have a better chance of moving higher than lower if the big guys decide to jab the index with a sharp stick. They can do it if they want to simply because of the amount of money they control. Knowing the little guys are extremely short allows the big guys to cause them pain any time they want. A quick buy program when it is not expected and those little guys will be running to cover. However, it is not that simple this week. On the Nasdaq futures the positions are reversed with the commercials on the short side. That would make me think the Nasdaq could be heavy next week but not materially since the S&P/RUT would have to confirm for the Nasdaq to dive. That leaves us with some good information but still lacking in a firm direction for the indexes. It will be interesting to see how this plays out. Technically it suggests another rebound but conditions can change in an instant in the futures market. For the commercials to shift to a short bias in the S&P/RUT would require a huge amount of selling and Friday could have been the beginning. Over 2.2 million S&P contracts traded on Friday. We won't know for sure if they changed sides until the next report is published on July 27th.
Commitment of Traders Report
I added another line to that table and that is crude futures. Note that the little guys are long nearly 2:1 over the shorts while the big guys are nearly even with only a 10% edge to the short side. I would read that as an impending move lower since any additions to the short side on the commercials would come at the expense of the overly long little guys. However, I am biased to an impending top in oil prices so that may not be an arms length analysis.
When I started writing this commentary after the market closed I was bearish.
After several hours of research I have moved back to neutral. I can see all the
road signs pointing to the downside but every dip for months and months has been
bought almost immediately. Logically I would expect some weakness into
August/September but using logic on the market rarely works. The technicals have
not yet broken down even with the high volume. I am afraid of the Citigroup/JP
about not being able to sell debt but that is a big picture item
not a day-to-day problem. It may have hastened Friday's decline but we do not
know if it will carry over into Monday. The expectations for earnings took a
huge hit last week and that may be positive for next week. Lowered expectations
means smaller drops on missed earnings. Whichever way you play these earnings
don't bet the farm on any one position and prepare to exit quickly if your
position goes against you.
Bear Stearns - BSC - cls: 134.72 chg: -4.21 stop: 142.55
Why We Like It:
BUY PUT AUG 140 BSC-TH open interest=3754 current ask $8.30
Picked on July 22 at $134.72
Harley Davidson - HOG - cls: 58.21 change: -1.16 stop: 60.26
Why We Like It:
BUY PUT AUG 60.00 HOG-TL open interest=6826 current ask $2.50
Picked on July xx at $ xx.xx <-- see TRIGGER
Ryanair Holdings - RYAAY - cls: 38.13 change: -0.62 stop: 40.15
Why We Like It:
BUY PUT AUG 40.00 QRX-TH open interest= 97 current ask $2.55
Picked on July 22 at $ 38.13
Amazon.com - AMZN - cls: 71.63 chg: -1.72 stop: n/a
Why We Like It:
BUY CALL AUG 75.00 ZQN-HO open interest=10110 current ask $3.00
FYI: There is an August $67.50 put (ZQN-TC) available if you prefer it. Just try and keep your dollar amounts relatively equal on both sides of the trade.
Picked on July 22 at $ 71.63
DaimlerChrysler - DCX - cls: 89.75 chg: -2.34 stop: n/a
Why We Like It:
BUY CALL AUG 95.00 DCX-HS open interest=1400 current ask $1.90
Picked on July 22 at $ 89.75
Lexmark - LXK - cls: 45.43 change: -0.71 stop: n/a
Why We Like It:
BUY CALL AUG 50.00 LXK-HJ open interest=1548 current ask $0.45
Picked on July 22 at $ 45.43
Boeing Co - BA - cls: 103.86 change: +1.38 stop: 99.75
BA displayed relative strength on Friday. Shares broke out higher to a new all-time high and did so on above average volume, which is usually a bullish signal. Unfortunately, we're almost out of time. We are planning to exit on Tuesday at the closing bell to avoid holding over BA's earnings report on Wednesday morning (July 25th). We are not suggesting new positions. More conservative traders may want to exit early now given the market's weakness. Our target is the $109.00-110.00 range. FYI: Readers might want to tighten their stop toward $100.75 or $101, just under the 10-dma.
Picked on July 13 at $101.55
FedEx - FDX - cls: 115.67 change: -1.53 stop: 114.42 *new*
The transportation stocks took a tumble on Friday. Honestly, we're surprised at the strength this sector did show last week given the rising price of crude oil. FDX dipped back toward its 10-dma and looks poised to retest support near $115.00. We are raising our stop loss to $114.42. Normally we would look for a bounce near $115 as a new entry point but we hesitate to suggest new bullish plays at this time. Our target was the $119.50-120.00 range.
Picked on July 12 at $114.42
GulfMark - GLF - cls: 55.75 change: +0.42 stop: 53.74 *new*
GMRK began trading under its new (NYSE) symbol of "GLF" on Friday. The company also announced that it will report earnings after the closing bell on August 1st. That gives us a little more time to play the bullish trend in GLF. We remain bullish and would still consider new positions here. However, we are inching up our stop loss to $53.74. Our target is the $59.50-60.00 range. If GLF doesn't hit our target we plan to exit on Wednesday, August 1st, before the closing bell.
BUY CALL AUG 55.00 GLF-HK open interest= 0 current ask $3.80
Picked on July 09 at $ 55.05
GlobalSantaFe - GSF - cls: 74.74 change: +1.46 stop: 69.90
Bulls quickly bought the dip near $72.00 on Friday morning. GSF eventually powered past short-term resistance near $74.00 and hit new two-week highs. More conservative traders may want to inch their stops up toward $71.00. We're leaving our stop at $69.90 for now. The next hurdle for GSF is the old high near $76. Our target is the $78.00-80.00 range. We do not want to hold over the early August earnings report. The P&F chart is bullish with an $87 target.
Picked on July 15 at $ 73.05
Helmerich Payne - HP - cls: 35.59 chg: -0.12 stop: 33.95
We remain bullish on HP. The company makes high-end drilling equipment and we're shocked that someone else in the industry hasn't acquired them. Given the pace of M&A in the market we think HP remains a high-odds takeover target. The question is when? Meanwhile the stock is doing just fine with a bullish trend of higher lows and technical support near its 40 and 50-dma. Technicals are a mixed bag and while we are suggesting positions now more conservative traders may want to wait for HP to clear resistance near $36.50 first. We plan to exit ahead of the August 1st earnings report. Our target is the $39.85-40.00 range, just under long-term resistance near $40.00. FYI: Readers might be tempted to adjust their stop loss toward the 50-dma around $34.40.
BUY CALL AUG 35.00 HP-HG open interest=270 current ask $1.80
Picked on July 15 at $ 36.30
Joy Global - JOYG - cls: 63.03 chg: -1.35 stop: 59.75
JOYG is still inside a multi-month bullish trend but short-term technicals are starting to look bearish. You could argue that JOYG, like several stocks and sectors this week, has created a bearish double-top pattern, albeit a short-term one. JOYG has pulled back toward support near $62.00. More conservative traders may want to raise their stop loss toward the $62.00 region. If you're feeling more optimistic then a rebound from the $62 zone could be used as a new bullish entry point. Our target is the $68.00-70.00 range. The Point & Figure chart is forecasting an $81 target.
Picked on July 11 at $ 62.05
PACCAR - PCAR - close: 94.90 change: -2.66 stop: 91.95
Warning! We are also considering an early exit in PCAR. The stock lost 2.7% on Friday and gave back a big chunk of last week's gains. Shares slid lower on big volume this Friday, which is usually a bad sign. Furthermore PCAR has produced a very clear three-day bearish reversal pattern. We do suggest more conservative traders exit now! We're going to stick it out for another day and see if shares bounce near the rising 10-dma. FYI: We still can't find a confirmed earnings date and we're not suggesting new positions.
Picked on July 15 at $ 93.77
Penn National Gaming - PENN - cls: 58.77 chg: -0.52 stop: n/a
This play seems to be getting more and more speculative as each day passes. We're down to the last ten days before time runs out for PENN to find another bidder. We're not suggesting new positions. If you're willing to gamble on a new offer coming in over the next several days we would stick to the August strikes.
Picked on June 17 at $ 62.12
Toro Co. - TTC - cls: 60.04 change: -1.62 stop: 57.95
TTC's lack of follow through on Thursday's bounce is bad news. The stock lost 2.6% and plunged back toward round-number support near $60.00. Odds are good that TTC may have been influenced by investor react to CAT's earnings report. The technical indicators for TTC are turning bearish. More conservative traders may want to exit early right here! We're not suggesting new positions at this time even though normally a bounce from here would look like a bullish entry point. If you don't want to exit but you're feeling cautious then consider a tighter stop loss. Our target was the $64.95-65.00 range. The P&F chart points to a $77 target.
Picked on July 11 at $ 60.75
XTO Energy - XTO - close: 60.77 change: -1.06 stop: 59.95 *new*
Time is almost up. Monday is our last day for XTO. We plan to exit at the closing bell on Monday to avoid holding over the company's earnings report on Tuesday morning. We will re-evaluate new positions after we see investor reaction to the earnings announcement. Please note we're inching up our stop loss to $59.95. Our short-term target is the $64.85-65.00 range.
Picked on July 15 at $ 60.56
(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)
Advanced Micro - AMD - cls: 15.50 chg: -0.28 stop: n/a
We do not see any changes from our previous comments. AMD produced what appears to be a bearish failed rally pattern on Friday in addition to a bearish engulfing candlestick pattern. We're not suggesting new strangle plays at this time. The August options we suggested were the August $16 call (AMD-HQ) and the August $15 put (AMD-TC). Our estimated cost was $1.18. We want to sell if either option hits $1.85 or higher. Aggressive traders could aim for $2.40.
Picked on July 15 at $ 15.43
Intel - INTC - cls: 24.55 change: -0.71 stop: n/a
INTC's post-earnings sell-off is picking up speed. Shares produced what looks like a failed rally under the 10-dma and broke down under new short-term support. The MACD on the daily chart has produced a new sell signal. We are no longer suggesting new strangle positions. The August options we suggested were the August $27.50 call (INQ-HY) and the August $25.00 put (INQ-TE). Our estimated cost was $0.96. We want to sell if either option hits $1.65 or higher. FYI: The August $25 put is already up to a $1.00.
Picked on July 15 at $ 25.97
Manpower - MAN - close: 90.87 chg: +0.09 stop: n/a
Shares of MAN were upgraded on Friday morning, which accounted for the stock gapping higher at the open. Fortunately, for the bears the move turned into another failed rally pattern. We are no longer suggesting new strangle positions. We were suggesting the August $100 call (MAN-HT) and the August $90 put (MAN-TR). Our estimated cost was $3.35. We want to sell if either option hits $5.75 or higher.
Picked on July 15 at $ 94.60
MGIC Invest. - MTG - close: 53.49 change: -2.32 stop: n/a
It looks like there was a bit of a delayed reaction in MTG to its earnings news out on Thursday morning. The stock broke down on Friday and closed with a 4.1% loss and a new relative low on big volume. This looks very bearish and the next level of support appears to be the $50-49 range. We are not suggesting new positions. We were suggesting the August $60 call (MTG-HL) and the August $55.00 put (MTG-TK). Our estimated cost was $3.10. We want to sell if either option hits $5.95 or higher.
Picked on July 15 at $ 56.98
Avery Dennison - AVY - cls: 67.72 chg: -0.77 stop: 66.85
We are suggesting an early exit in AVY. The plan was to exit on Monday at the close to avoid earnings on Tuesday. However, the market weakness and AVY's pull back on Friday is our cue to bail out now.
Picked on June 11 at $ 66.05
Deere Co - DE - close: 129.07 change: -4.61 stop: 127.45
We are calling for an early exit in DE. Rival Caterpillar (CAT) missed earnings estimates. Shares of CAT plunged on the news and it pulled DE down with it. DE lost 3.4% on Friday. What is unfortunate is that DE hit an intraday high of $133.96 on Thursday. Our secondary (aggressive) target was the $134.00-135.00 range. DE had already hit our first target at $129.50 days ago. It's time to abandon ship. We'll definitely keep an eye on DE for future entry points.
Picked on June 20 at $123.55
Russell 2000 iShares - IWM - cls: 83.25 chg: -1.38 stop: 81.35
We suspect the market has put in a top. The Russell 2000 was never able to breakout past resistance even though the other major indices were hitting new relative highs. Now stocks are rolling over and short interest is at record highs. We're dropping the IWM as a bullish play.
Picked on June 24 at $ 82.85
L-3 Comm. - LLL - cls: 99.91 change: -0.64 stop: 97.45
We are suggesting an early exit on LLL. The stock is not cooperating with us. Shares have been stuck in a trading range around the $100 level. We believe investors are just waiting for the company's upcoming earnings report. We're going to wait a day, maybe two, before considering a new strangle position on LLL to try and capture any post-earnings volatility.
Picked on July 12 at $100.15
MAGNA Intl. - MGA - close: 94.21 chg: -0.99 stop: 91.89
We are giving up on MGA too and suggesting an early exit. Now we might just be too cautious here. MGA does still have what appears to be support near the $94.00 level and a bounce near $94.00 would look like a new bullish entry point. Unfortunately, given the market's weakness and combined with MGA's bearish failed rally near $96 on Friday (not to mention the bearish engulfing candlestick pattern), we would rather exit MGA now.
Picked on July 15 at $ 95.40
Pacific Ethanol - PEIX - cls: 13.38 chg: -0.05 stop: 12.83
We are also dropping PEIX. The stock has been slowly withering lower over the past two weeks and broke down under multiple levels of support. Friday did see a bounce from the $13.00 level but part of that was due to an analyst upgrade. Even an upgrade couldn't break the bearish pattern of lower highs. Readers may want to keep an eye on PEIX for a new rise past $14.00 down the road.
Picked on June 24 at $ 12.83
Goldman Sachs - GS - cls: 205.94 chg: -5.75 stop: 224.05
Target achieved and exceeded. Investors continue to fear how much unknown exposure the big broker-dealers may have to the sub-prime meltdown. The XBD broker-dealer index lost 2.3% on Friday. GS helped lead the way down with a 2.7% decline and a big bearish breakdown under technical support at the 200-dma, all of which occurred on big volume! Our target was the $208.50-207.00 range. More aggressive traders may want to aim toward the $200 region.
Picked on July 10 at $217.08
In the past, I occasionally wrote for the educational market. "Number sense" was a term sometimes bandied about when I was writing for mathematics programs.
Today, let's develop a little number sense or perhaps option sense that will help make decisions about buying and selling options. The article is intended to encourage subscribers to develop an innate feeling for "if the underlying's price does this, the option's price will do that."
That innate sense is an important tool for traders to develop. Too many times, traders can doom a play by having the right idea and choosing the wrong option or the wrong time to sell that option.
We're going to perform some calculations on the option price calculator found on the left-hand sidebar on the www.ivolatility.com site. Click on "Basic Calculator" and you'll see the free version.
After you've agreed to ivolatility.com's terms, here's what you'll see:
iVolatility.com has grouped the inputs for an option's price on the left-hand side. After the inputs are keyed in and "Calculate" is punched, the calculator churns out call and put values and the Greeks on the right-hand side. For the purposes of this article, we're going to be concerned with the price of the option only. We're getting a feel for where the option's price will go if the underlying's price changes in certain ways and over certain periods of time.
That agreement iVolatility.com makes you sign affirms that although the calculations are as accurate as possible, the calculator can't be counted upon to churn out the exact value for an option's price. I found that to be true when I ran through dozens of calculations when I was thinking about a hedging procedure I wanted to try on a spread play. The pricing wasn't what I anticipated when it came time to hedge.
However, the options calculator did provide some idea of where prices might be, and it's great for something else: getting a feel for how pricing changes as conditions change. That's the feeling, the sense, that I want subscribers to develop.
Let's try it. This article was first written on Friday, July 13, with the calculations below made at that time. Periodically, I'll update with some actual prices that I captured this week, so we'll see how the action and the anticipated prices matched.
Imagine that on Friday, July 13, 2007 of the week before option expiration, you bought an ATM SPX JUL call about 1:00 in the afternoon, anticipating an afternoon run higher. You spent 11.70 (estimated cost when splitting the bid/ask a conservative 70/30 in the favor of the seller) for a 1550 call with the SPX then at 1549.24.
That afternoon run occurred. Yippee! You were right. By 3:51 in the afternoon, the call you'd bought earlier was quoted at 13.10 bid and 13.90 ask. You should be able to sell it for at least $13.30, collecting a handsome profit for your afternoon's work. That's conservative. You probably could have gotten more.
Should you take that profit Friday afternoon or should you hold that option into the next week? The SPX is on a run, you reason, but what if it settles into a typical pattern for the SPX and consolidates a few days before a brief dip to the 10-sma, only then initiating another strong rise?
On that Friday, the 10-sma was at 1526.34, but it was rising and you anticipated that it might have risen to about 1528 within two or three trading days. Would you be stopped before the next run higher, if the SPX indeed dipped to that 10-sma before surging higher again into the end of opex week?
I think we intuitively know the answer to that question, but let's use the calculator to make that determination. I first ran the calculation for Friday, July 13, to see if I came up with a figure near the 11.00 bid x 12.00 ask that the 1550 was quoted at about 1:00 that afternoon. I did that to determine an estimate for the volatility that would be used for all further calculations, just to keep everything but price and days to expiration steady. That's not a real-world happening, of course, because volatility will change as price does, but we don't know how it might change.
SPX JUL 1550 Call Price on 7/13/07
The figures may be somewhat difficult to read because of the newsletter's requirement that charts and tables are kept at a certain width, but I input the then-SPX price, the 6 days to expiration, and a volatility of 14.48. iVolatility.com input the 5.32 for me. I'll explain some of those inputs.
We all know that expiration for the SPX options is Saturday, July 21, but the options chains I consult actually figure it from the last day it trades, which would be Thursday, July 19. Those options chains showed 6 days to expiration on Friday, July 13, 2007.
When using a volatility rate of 14.48 percent, iVolatility.com's calculated call price of 11.78 was between the actual 11.00 bid and 12.00 ask of that option at 1:00 that Friday. It was close to the estimated 11.70 at which I thought a trader might be expected to get a fill. So, the inputs chosen worked well, and the 14.48 volatility figure appeared valid.
How did I get the figure for the volatility percentage? Easy. Sometimes I estimate until I come up with the known option price. If you don't have a clue as to where you'd start that estimation, iVolatility provides that information, too, in two different ways.
Notice the bold words "Implied Volatility" on the bottom right-hand side of that chart? You can fill in some of the parameters for the underlying and then put in a known price for an option, and iVolatility.com will return a volatility figure for you. You can then use that figure for further calculations with the same option.
This returns a volatility figure of 14.38, a little lower than the figure I ended up using. I'll explain why later, after I've introduced the second way that ivolatility.com helps you determine volatility figures. In addition to the calculation we just performed, you can find "Basic Options" on the left-hand sidebar on iVolatility.com's main page. Clicking on that brings up a page that provides all the information you would ever want to know about historical and implied volatility on near-term options. iVolatility calculates volatility figures as of the close of the previous day, as well as providing historical information about the SPX's options' volatility. As of the close on 7/12/07, ivolatility.com pegged the July 1550's volatility at 13.02 percent.
After I had found these two estimates, I ran the figures through the calculator again to verify. Both that figure and the calculated 14.38 delivered call prices that were too low when compared to the actual price I thought someone would pay for the option, so I edged the volatility higher by trial and error until I came up with a figure that delivered the right price for buying an option.
Update: It's important to note that this volatility we're using now returns a price that would be paid to buy an option and not one that you'd necessarily receive to sell one. That would typically be a bit lower than the figure the calculator will now be churning out. Using hindsight, I probably should have also figured out a volatility estimate that would produce a call price that approximated the one at which the option could be sold, but that's hindsight.
If you do not feel comfortable fiddling around with this number, iVolatility will input the closing value from the day before as the volatility percentage default. You'll still be able to see how an option moves.
Now we can use these same inputs to determine what might happen to that call price if the SPX trades sideways into Wednesday of opex week and dips down momentarily to test the 10-sma before another hoped-for strong climb on Thursday. (Update: this several days of consolidation and subsequent dip to the 10-sma on Wednesday is actually what did happen.) Would you be stopped that Wednesday if the SPX traded sideways then dipped to 1528?
Again, I think we know the answer to this question intuitively, but let's run the numbers. I'll input "1" for days to expiration because that's the number of days the option will still trade on Wednesday, July 18, as explained earlier.
Estimated SPX JUL 1550 Call Price on 7/18/07
Yikes! That's obviously not something you want to do, to let an $11.70 option sink to $0.14, the call price ivolatility.com calculated. We knew intuitively that we wouldn't want to hold on through that test without running this calculation, but it goes against human nature sometimes to sell at a loss on a Friday when a bounce and higher prices are anticipated by the end of the next week. If traders aren't practiced at running these calculations, at developing this intuitive feeling for what will happen with option prices over time and with certain movement of the underlying, those traders might translate "higher prices" into "higher option prices," not realizing what will happen in between.
To me, this holding on no matter what seems to have increased since the early 2000's, when the SEC changed the rules for active traders with accounts smaller than $25,000. Those rules now limit the number of round-trip options trades to three a week, I believe, so if a trader has already bought and sold options twice that week, that trader may be averse to selling a call at a loss when a bounce is anticipated later.
Okay, so let's imagine on this Friday, July 13 that someone held on all the way through an imagined 10-sma test on Wednesday and then the anticipated bounce did occur from the 10-sma. (Update: The SPX did bounce from its 10-sma, although the 10-sma was higher by Wednesday than I had anticipated.) Imagine that bounce brought the SPX all the way from a test of the 10-sma on Wednesday morning up to 1556 by Thursday afternoon. (Update: the high Thursday was actually 1554.31.)
As you can guess, the calculator delivered a price of $6.00 if the SPX closed at 1556 on Thursday of opex week, the last day it traded. This was the amount by which that 1550 strike would have been in the money. Someone who bought the option for $11.70 on Friday, July 13 and held on when the SPX was just below 1550 would have lost a hefty amount, even though the SPX closed expiration week in this example more than six points higher than the point at which the call had been purchased and high enough that the option was in the money. (Update: Traders would have lost even more if they hadn't sold at the close on Thursday and had held on through Friday morning's settlement. The Friday-morning settlement figure for the SPX was 1553.69, so that the cash-settled JUL 1550 call would have delivered 3.69 into a trader's account for an option purchased for 11.70.)
I deliberately chose an easy example, one that worked intuitively, but I'm still often surprised by the number of traders who accurately predict what will happen in the markets but not with their option's price. That's why building up number sense by playing around with an option calculator can be so important.
Updating this example, by Wednesday, the 10-sma had risen to 1533.32, higher than I had anticipated. The SPX did exactly what I thought it might do (and warned it might do in my Thursday, July 12 Wrap). It consolidated sideways to sideways up for a few days and by Wednesday, the third day of consolidation, it dipped toward that 10-sma, achieving a low of 1533.67 that day. Having just moved to a new town a few days earlier, I was in and out of my study all day, so I didn't capture the option price at the exact test of the 10-sma. However, I did catch it at 12:22 EST, with the SPX at 1535.08, and the JUL 1550 call was 2.00 bid by 2.60 ask at that moment. Presumably, it was lower when the SPX dipped lower to that final 10-sma test. Although this 2.00 x 2.60 price was far higher than the calculated 0.15 price when I had estimated that the 10-sma might have risen only to 1528 by Wednesday, most traders still would have been stopped long before the decline of their 11.70 option to somewhere between the 2.00 bid and the 2.60 ask.
What if you predicted a different scenario on Friday, July 13 as this article was first roughed out? What if you thought the SPX was going to make a run toward 1560 Monday before dropping back and eventually hitting the 10-sma sometime during opex week? What if you bought that 1550 call at 1:00 EST Friday, July 13 and decided Friday near the close that you wanted to hold out for that anticipated 1560 test on Monday, hoping you could safely exit for even more profit than offered to you Friday near the close? How would the option price compare to Friday's closing price?
Estimated Price If the SPX Hits 1560 on Monday, July 16, Calculated on Friday,
Remember that we set up this calculator so that it's giving us the price at which we'd likely buy an option, not sell it. The person selling to close that 1550 call would likely receive less money, perhaps around $14.20. Still, the holder of that option would likely profit if the SPX were to reach 1560 on Monday, as long as the volatility stayed the same. (Update: the SPX high on Monday was 1555.90, but I didn't capture the call price that day.)
What if volatility didn't stay the same? What if volatility had dropped as the SPX edged slowly higher all day Monday? What if it dropped to 13.00, certainly not impossible? The calculator returns a price of $13.86, so that a profit could likely be found.
That's not too bad. It might be worth a try, you reason. But how certain are you that the SPX will climb to 1560 on Monday? What if the SPX doesn't climb on the subsequent Monday, but sinks just a few cents at the open, say back to 1552.00, sits there while the volatility declines to 13.00? What would your option be worth? You shouldn't lose too much by taking that chance, should you?
Depends on what you call "too much."
Estimated Price if the SPX Consolidates at 1552 on Monday, July 16, While
Volatility Sinks to 13.00:
Yikes again! The option's price fell to $8.71, and, the way we set it up, that's the price to buy the option. A seller would likely collect less, perhaps $8.50 or so.
Do you want to risk a decline of $3.20 (11.70 - 8.50) from the price you paid for the option and $4.80 (13.30 - 8.70) from the price you could have received selling it Friday afternoon, just to potentially make $2.50 (14.20 - 11.70) above your original purchase price if the SPX climbs to 1560? Some would, and some wouldn't. Unless traders develop some number sense about options, though, they might not know what they're risking.
The point is that running the numbers through the calculators gives you a feel
for the way the options price might react under certain conditions. These prices
might not be completely accurate, as iVolatility wants you to acknowledge before
it allows you to even view the free calculator, but developing this kind of
number sense can prove invaluable as you make decisions. I've seen too many
people make too many wrong decisions just for lack of this kind of number sense.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda
Piazza, and all other plays and content by the Option Investor staff.
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