I (Keene Little) am filling in for Jim this weekend as he finishes up his oil seminar. Friday was of course the 20th anniversary of Black Monday, October 19, 1987. Unless you were under a rock this past week, you've heard this mentioned countless times during the week. The October goblins came out and spooked the bulls who beat feet out of the pasture. We'll have to see if they regain their composure and come back out on Monday.
In case you were wondering if today was a bearish day, take a look at the numbers in the table above. It was a heavy volume day and down volume swamped up volume almost 14:1. Wow. Declining issues beat out advancing issues almost 5:1. New 52-week lows beat new highs better than 2:1. The techs, which have been leading the parade to the upside, had almost 3:1 new lows vs. new highs. It's always hard to discern whether the put/call ratio has much meaning during opex (may be more opex related than a true sentiment) but today's .73 reading is high and closely matches Wednesday's .75.
Those put/call readings reflect a lot of bearish sentiment and from a contrarian perspective it's potentially bullish, at least from a short term perspective. Monday could see quite a reversal of Friday (if it doesn't, look out below). Opex can exaggerate moves if the majority were caught leaning the wrong way coming into the week. So that leaves me wondering if this week's decline, especially Friday's, may have been a deeper pullback than there would have been otherwise. Basically it could be a bear trap now.
But other than the price pattern on the NDX (which has been the stronger index) I'm getting some very bearish feelings on the other charts. Combined with the plethora of bearish signals that I've been mentioning (weak breadth, non-confirmations, etc.), there is a very good possibility that the market has already put in its high. One thing to be aware of is the possibility for a gap down on Monday and a continuation of the selloff. If we do see a gap down and it doesn't get closed within the first 30 minutes then the market's in trouble. As always, I'll review the price patterns and key levels on the charts.
The selling on Friday was relentless with only a small mid-day bounce. It actually started to accelerate lower the closer we got to the closing bell (it had a bit of a waterfall look to it). It didn't have any sense of panic about it but it definitely stretched many of the sentiment indicators into deeply oversold territory. For example, the VIX closed more than 2 standard deviations from its 20-dma, something that has sparked oversold rallies in the past.
As we headed into opex week, and as I've been reporting recently, the bullish sentiment has reached an extreme (e.g., as shown in the Investors Intelligence report on Wednesday). If we had many traders expecting a bullish week for opex and were positioned for a rally then the selling could, and likely was, exacerbated by opex positions. For example, if you have a short put position on a stock and the stock price starts to drop below your strike level then you'd want to either cover (buy the puts back) or sell stock to hedge your short put position. Either action adds selling pressure to a market that's already under pressure.
The put options then expire and come Monday the trader has short stock that is unhedged. If we start a rally on Monday and there's a lot of short stock out there then we could see a large rally as those who are short the stock suddenly start buying to cover their position. I have no idea if this will happen on Monday, or how long the buying would last, but it would be very typical to see today's selling get reversed. The flip side is that panic selloffs have happened many times on the Monday following opex Friday. It's hard to know what will happen on Monday but you'll need to be very careful initially until we see what follows the open.
I mentioned market sentiment above. As technical traders, which I assume most of you are otherwise you wouldn't be reading this, one of the things we try to do is gauge the sentiment of traders. It's hard to do but we want to be contrarians and be ready to trade against the crowd when we think the time is right. That doesn't necessarily mean we will always pick the top or bottom of a move (no matter how hard I try) but it means we want to be on guard for a market reversal. Whether we play that reversal or simply go into protection mode, we still want to get a sense of what the crowd is doing and be prepared to go against them.
Examples of common sentiment indicators we all use are the VIX, put/call ratio, investors intelligence reports, bullish vs. bearish advisors, cash levels in mutual funds and the ratio of holdings in the Rydex bullish and bearish funds (their Nova vs. Ursa funds). When we see too many bulls leaning towards one side of the boat we know what's going to happen to the boat. For a hint, here's what happens:
The same thing happens when too many bears get short. A high short interest ratio and high put/call ratio shows too many people are getting ready for a market decline and that can set up some strong short-covering rallies. Another less well known sentiment indicator that many use would be called the "magazine cover theory". You'll find this mentioned in many technical analysis books in the "other" category of sentiment indicators. What this refers to is the fact that many times market tops and bottoms are found when a general magazine cover has something about the market on their cover.
The media wants (needs) to report on what people want to read about (otherwise they wouldn't be able to sell their magazines off the newsstands). Stories contrary to popular beliefs simply won't sell. But by the time a trend is realized, makes it into the publication schedule and gets printed it's likely that the trend has already matured and is peaking (or bottoming).
You've often heard that the public is wrong at the turns. They may have been participating in the trend but they get most bullish at the tops and most bearish at the bottoms. Looking at the COT (Commitment of Traders) reports shows commercials (informed or smart money) starts to switch sides at the end of a run while non-commercials (non-informed) usually add to their long positions at tops and sell at bottoms. When there's no one left to do the buying at tops the market then reverses. Same with the selling at the bottom. BTW, most mutual fund managers fall into the non-informed group. They are often the very last ones chasing the market into the top or bottom.
Therefore these major news magazines (such as Time, Newsweek, U.S. News & World Report, Barron's and Business Week) tend to report these major trends well after the trend has been recognized by most people. The tops of bull and bear markets in gold, housing and the stock market have been identified closely with these covers. So it came as no surprise (to me) when I received my latest copy of US News & World Report:
US News & World Report cover, October 22, 2007 issue
Most of us know that there has been a global boom in the stock markets around the world. That's because we watch the market closely every day. The rest of the public gets most of their market news from Brian Williams and whatever headlines they catch in the weekend papers. Most people don't even look at their monthly mutual fund statements. So when US News comes out with this kind of cover story, people sit up and take notice. The article then goes into what a great buying opportunity there is in the emerging growth markets overseas and even in China.
The premise of the article was that the U.S. could be headed for a slowing in its economy and that you should invest overseas to hedge yourself, especially since the dollar is down. The author, who is not a financial analyst, even predicted a further decline in the US dollar. When non-financial writers, who are supposed to just report the facts, start making market predictions based on the existing trend you can take it to the bank that the run is probably over.
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The global economy is in synch like never before. When one market sneezes the rest catch a cold. It's no longer the U.S. that controls the world's stock markets--we're all in this together now. Currencies are inextricably linked and whether it's the yen carry trade or the interest policies of the various countries, we're dependent on the entire system staying healthy. So to think that you are hedged against a downturn in the U.S. by investing in Europe or Russia or China or any of the emerging markets is incorrect.
But international stocks have outperformed U.S. stocks over the past couple of years and therefore the author of the USN&WR article was projecting the future based on the current trend. Did this cover mark the top in not just the U.S. stock market but the global stock market? Only time will tell but it's another mark against the bulls.
Friday experienced a big move in interest rates as it appeared traders fled stocks and ran to the safety of bonds (bidding up the price of bonds which dropped yields):
10-year Yield (TNX), Daily chart
This chart is getting a little busy, especially with the multiple scenarios I'm trying to show. Based on the internal wave pattern of the pullback from the initial bounce to the mid-September high I'm thinking the spike down this past week is finishing an a-b-c pullback from mid-September. If that's the correct EW (Elliott Wave) interpretation then bond yields are ready for a strong rally which could make it back up to almost 4.8% if not higher (depicted in dark red and green). That interpretation could mean money is freed up to support a rally in stocks.
The move down from the high on October 15th looks like it may have completed, or has only a minor new low to go. That would suggest at least a bounce to correct it. If the leg down from October 15th is the start of a much larger decline then we'll see just a bounce to perhaps 4.5%-4.6%, as depicted in pink, and then a new low from there. The key level for the downside is the September low.
Many are saying low interest rates is good for the economy and therefore stocks. As we've seen for quite a while now, stocks and interest rates have been more in synch than not. That wasn't always the case but until that pattern breaks, declining interest rates has been bearish for stocks (probably because bond and stock players are seeing the same thing--a slowing economy).
I had mentioned recently that a pattern during the 2001-2003 rate decrease campaign by the Fed showed the market would rally for brief periods following a rate cut and then drop like a stone from there. Typically the stock market euphoria would expire in about 30 days and the reality of a slowing economy or other problems would cause the next wave of selling to hit. The rate cut on September 18 is now 30 days behind us. Makes one wonder what's next for the stock market.
There were no economic reports today. There were several earnings reports but I think the one that had the most impact was Caterpillar's. They laid a stink bomb on the market by announcing a gloomy forecast. The market has been rallying under the assumption that the lower US dollar would help international companies be more competitive overseas. The thought being that even if the U.S. economy slows down these big companies will do well with their overseas business. CAT shot the bulls in the heart on that idea and it is forcing many to reevaluate their assessment of the world economy.
While CAT's selloff on Friday (-4.26, -5.5%) took a big bite out of the DOW, GM (-2.29, -5.7%) and MMM (-8.11, -8.56%) did even more damage. All 30 components were in the red with PG (-0.10, -0.1%) the best performer. There was clearly some rotation into consumer staples as a recession hedge.
DOW chart, Daily
Friday's decline took the DOW below its 50-dma and 100-dma. The bulls want to see this as just a throw-under support and see it bounce right back up on Monday. The bears will want to see a gap down on Monday and just keep on selling. I'm still showing the possibility for a bullish wave count (green) with the drop down here as finishing up a wave-4 correction. A part of EW (Elliott Wave) analysis is subjective and a count needs to pass the "smell test". This part of EW analysis takes years of practice to get a feel for it. When I look at the bullish wave count on this chart it does not pass the smell test. It hasn't violated any EW rules (needs to drop below the high of wave-1 to do that) but 4th wave corrections are rarely this strong. This looks more bearish.
Assuming for now that the bearish wave count is correct, we could see a continuation lower on Monday, a small bounce first or even a larger bounce back up towards the 13700 area and then a continuation lower or any combination of the above. The key level for the bearish count is 13913--any move back above that level would negate the bearish wave count (shown more clearly on the 60-min chart). Therefore if you shorted the top of the market and want to give it lots of breathing room, I'd use that level as my stop. If you're long the market and not quite ready to pull the plug I would use a break below 13400 as my stop level--any lower than that and it would completely negate the bullish wave count.
DOW chart, 60-min
Whenever you see a move bust out of a parallel channel, up or down, recognize that you've got a very strong move in progress and it's not likely to reverse soon. That interpretation will often save you from looking for reverses since it says we've now got a strong trend. This is another reason I don't like the 4th wave correction idea that I mentioned for the daily chart.
But let's assume this past week's selloff was more opex related than a true market sentiment. In that case keep your eye on the downtrend line from October 11th--if it breaks then the bears will have lost their advantage. As long as that downtrend line holds (and the bearish wave count says it will likely not even be tested until the DOW first gets much lower) I would look to short the bounces. In fact, keep an eye on the bottom of the down-channel as this is very often resistance (if you remember the decline in housing, it kept finding resistance at the bottom of the channel once it broke below it).
SPX chart, Daily
SPX is marginally stronger than the DOW if only because it hasn't quite reached its 50-dma at 1496. The same analysis on SPX as I mentioned for the DOW holds here--while it's possible this past week's pullback is finishing a 4th wave correction which will lead to another rally leg back up to its high, that interpretation is looking much less likely than it did even on Wednesday when I last reviewed these charts with you. At that time price was finding some support at the bottom of its parallel up-channel. By strongly breaking below the 1540 area the wave pattern has turned much more bearish. Look for bounces off layered support below (50-dma at 1496 and 200-dma at 1477) but those should be good shorting opportunities.
The key level for the bearish count is 1479, the top of wave-1. If that level is broken then the bullish count is dead in the water. To the upside the bulls want to get this back above 1543 to negate the bearish wave count. At this point this market is in the bears' hands and it's theirs to lose.
SPX chart, 60-min
Price has only broken marginally below the bottom of a parallel down-channel and could easily be a throw-under that is opex related. While a rally above 1543 would negate the bearish wave count I would think the bears are in trouble with a rally back above 1526 (the end of wave-i and likely a break of its downtrend line). Keep an eye on the downtrend line on RSI also--it will often give you short entries as it hits its downtrend line. Conversely, a break of the RSI downtrend line will give you a heads up that at least a larger bounce is on its way.
Of all the charts I've reviewed for this weekend the NDX still maintains the best bullish possibility. Starting with a monthly chart shows why I've been mentioning recently we could see a rally to just above 2200 to end its rally:
Nasdaq-100 (NDX) chart, Monthly
The parallel up-channel for price action since the October 2002 low shows price came very close to touching the top of it. At the same location is a Fib projection at 2210.99 for two equal legs up in its A-B-C bounce pattern off the 2002 low. The high for NDX on October 11th was 2194.14. Was it close enough or is there one more rally leg coming?
Nasdaq-100 (NDX) chart, Daily
This chart tells me to watch out for a bear trap. What appears to be a sideways consolidation near the high could easily be considered bullish. It looks like a nice little a-b-c correction for wave-4 (green) to be followed by a final 5th wave to a new high. If I looked at nothing else I would definitely be looking for another rally leg to a new high for the techs.
Because the rest of the market looks a lot more bearish than the techs I have to wonder about the bullish setup. Or do I have to worry about the bearish setup because of the techs? It's never easy and I'd say the difference between the techs and the rest of the market is what is creating some hesitation on my part in declaring an outright bearish call this weekend. But there is a way to consider the pattern in the techs bearish as well:
Nasdaq-100 (NDX) chart, 60-min
Because the bounce to the high on October 18th was a lower high, below October 11th, I can count the move down to the low on October 11th as a 1st wave, followed by a 2nd wave correction to the high on October 18th and now we're in the middle of the 3rd wave down. While I show 2127 as a key level for the bears, in reality it takes a break below 2088, as shown on the daily chart, to say the bulls are in trouble on the techs. But bears beware here--this one has the potential to bite you.
Russell-2000 (RUT) chart, Daily
A key level for the RUT was violated on Friday. By breaking below 802.57, the high on August 23rd and labeled as the top of wave-1, the bullish wave count was negated. Wave-4 (green) can't overlap the top of wave-1 (an important EW rule). The only exception to that rule is when you have a rising or descending wedge. For you sharp-eyed observers, you'll see that the bearish (dark red) wave count does in fact have wave-4 dipping below wave-1 and that's because of the ending diagonal (rising wedge) from the August low for the larger degree 5th wave.
I'm still showing the possibility for the current pullback to be wave-4 (green) in the bullish wave count. This is a stretch and I don't like it (it definitely does not pass the smell test). It would mean the 5th wave from the August low is forming a larger ending diagonal and the final move higher will be another 3-wave move as depicted on the chart. This is a count that is forced to fit a bullish bias and right now I see no justification for it. I think the best the bulls could hope for on this one is a bounce to a lower high as the NDX presses up to one final high.
Russell-2000 (RUT) chart, 60-min
Like the DOW and SPX, I think the downtrend line from October 11th will be an important trend line. It might not get tested for a while but any bounce in the next several days that manages to break that downtrend line would tell me the bearish wave count is suspect. Until that happens I expect to see price stair-step lower from here.
BIX banking index, Daily chart
After bouncing off its long term uptrend line from October 2002 twice in August the banking index has now handily broken below this key support level. It should now become resistance on any bounces. I show a bounce back up to it soon but the banks have an equal chance of selling off a lot harder before they bounce in which case that long term uptrend line might not be retested for a while, if ever. The bears own this index until the bulls manage to rally it back above 357, the bottom of wave-1.
U.S. Home Construction Index chart, DJUSHB, Daily
The housing index is testing the September low and continues to show bullish divergences at its new lows. One of them is going to lead to a larger bounce. But so far each bottom call (the most recent one by Citigroup at the end of September--which they probably sold into) has lead to another selling opportunity. I expect soon we'll see at least a sideways or sideways/up correction to relieve some of the oversold conditions. This index is not done selling off but it does need a little larger correction for its pattern.
Oil chart, December contract (CL07Z), Daily
I had pointed out the Fib target at 88.15 (for the December contract) and on the 60-min chart pointed to a Fib projection at 88.42. Based on the EW count, Fibs and trend lines I had recommended trying a short if oil reached this 88.15-88.42 area (it was a trade recommendation on the Market Monitor). Zooming in closer to the leg up from early October, here was the setup:
Oil chart, December contract (CL07Z), 60-min
The December contract touched 88.49 (the e-mini contract for December traded one contract at 88.475) in overnight trading and I'm thinking that was the end of the run for oil. You can see the negative divergence at its last high. For those who may have shorted oil, I placed a stop just above the Friday bounce to 87.55. As long as that level holds now I see oil beginning a large drop back down now. The first support level in that case would be its uptrend line from August.
Oil Index chart, Daily
After breaking its first uptrend line from August, the oil stocks drove back up to a higher to high and found it to be resistance. It has now broken the 2nd uptrend line drawn through its last pullback. I show the possibility for another push back up to retest the 2nd uptrend line. At this point I don't think that will happen and I believe the high for oil stocks is in and the next large move should be below the August low.
Transportation Index chart, TRAN, Daily
The Transports have been hanging back the whole time the DOW has pushed to new highs. That's been bearish non-confirmation but obviously not a good timing tool. It just means you should take any broader market selling seriously since you never know which one will be the big one. You should not be assuming at this point that it will always work to buy the dips.
Having said that, if the Trannies are going to get another bounce this is the time and place for it. The index has dropped to the long term uptrend line from March 2003 where price has been cycling around since August. The overlapping pattern of the decline from the October high leaves me wondering if it's going to lead to one more leg up within its consolidation pattern (pink). It takes a break below the August low (4486) to confirm the next large decline is already in progress. A break below 4650 would be a heads up that the bears are in fact control.
U.S. Dollar chart, Daily
The US dollar is as hated as ever (and the euro is loved--at a bullish extreme). Now that the dollar has pressed lower it's approaching the bottom of a parallel down-channel from October 2006, currently near 77. That should provide support and at this point it won't take much of a rally to break its downtrend line from August. Bullish divergences at the new lows continues.
Gold chart, December contract (GC07Z), Daily
Like oil, I had recommended a short on gold because of the Fib projection being tagged and the bearish divergences I was seeing. The high was 776.90 and I had recommended a short at 773.50 on Thursday and have the stop at breakeven now which is just above Friday afternoon's bounce high. As with the oil trade, this an attempt to catch the top of its move and I like to pull my stop down as quickly as possible as soon as I get a lower high. Once I can get it to breakeven then it's a free trade. This is a position trade as I expect both oil and gold to start heading south. I just need the US dollar to find a bottom and help out the trade.
There is one more higher Fib projection for gold based on the EW count in the move up from October 4th where its 5th wave would equal the 1st wave. So if you're looking to trade gold (YG is the e-mini), that would be the next I'll be watching to try a short again if stopped out. A break below 758.20 would suggest we've seen the high for gold so if you're long the shiny metal and want to protect profits, that's the level I'd use as a protective stop.
There were no economic reports on Friday. Next week's reports include the following:
It's going to be a relatively quiet week for economic reports. Company earnings could have a greater impact, particularly guidance for the 4th quarter (this is what depressed the market after CAT reported, even after good third quarter results). Housing is so depressed that any sign of relief will likely get some more bottom calls so if anything I would expect the housing numbers to prompt a rally. The durable goods number shouldn't move the market much unless it comes in even worse than last month's negative number.
SPX chart, Weekly
This past week's big red one is not bull-friendly. The only way it could have been worse would have been to see a higher high since then that would have created a key reversal week. As it is it's bearish enough as a bearish engulfing pattern. But see that little shooting star from last week followed by the big red candle this week? That should send shivers through the bulls. Seeing this at Fib resistance, double-top resistance and leaving a bearish divergence on the weekly oscillators is simply not bullish. You can put some lipstick on this and call it a pretty pig but she ain't gonna fly.
There's another potential bearish signal that popped up this past week. I've mentioned the Hindenburg Omen signal before and since we got 3 of them this past week (Tuesday, Wednesday and Thursday) I thought it worth mentioning again. As a review, a Hindenburg Omen is a market crash signal and is triggered under the following conditions:
1) The daily number of new 52-week highs and the new number of new 52-week lows
each must exceed 2.2% of all stocks traded on the NYSE that day.
For Friday, 2.2% of the total number of issues traded (3348) is 74 and that means another Hindenburg Omen was missed on Friday because that number fell short of the required 79. But you can see how close we came to getting four signals this week which is an amazing event.
The first day these conditions are satisfied creates an unconfirmed Hindenburg
Omen. A confirmed signal occurs if a second (or more) Hindenburg Omen occurs
during a 36-day period. The probabilities of a selloff following a confirmed HO
Having a confirmed Hindenburg Omen does not guarantee a market decline (it failed a year ago) but every NYSE crash since 1985 has been preceded by this signal. A confirmed signal may result in just a short term selloff such as we saw in July after the July 23rd signal. We've got a heads up again so be prepared for the possibility for a significant market decline. The current confirmed signal is following many other signals we've been getting in this market during the August-October rally, primarily the weak market breadth and lack of confirmation from the banks, transports and semiconductors (not confirming the tech rally).
So was Friday the start of an even larger selloff? That will only be known in hindsight. There are enough oversold indicators after a week of selling that says there's a good chance for a bounce. The flip side is that market crashes come out of oversold conditions. Very rarely will the market experience a panic selloff from an overbought condition. So we wait to see how Monday goes.
As I mentioned for the techs, there's a good possibility that they haven't put in their final high yet. A final rally in the techs, with a reluctant broader market making a lower high would be the final nail in the bull's coffin but that's purely speculation at this point. I think at this point there's a greater likelihood that the rest of the market will start to drag the techs lower and once the tech bulls get a whiff of broader market weakness they'll start bailing in a hurry and lead the southbound parade.
Like Pavlov's dogs, the bulls have been conditioned to look at mini panic declines as golden opportunities to pick up stocks cheaper than has they been forced to chase the market higher. This has worked so well, especially in the past year which has experienced a couple of quick strong selloffs, that many will keep trying until it doesn't work anymore.
There are two things that could happen with this attitude of being rewarded by buying the strong dips. The first of course is that the market will be driven back to new highs. Many believe October is the bear killer month so they look to buy October selloffs and enjoy the run into the end of the year and January. They could certainly be correct in their thinking and it'll work again.
The second possibility, especially if the market has in fact topped out, is that those buying the dips will be the ones fueling the declines. Think of it as long covering, the opposite of short covering in the rallies. If the dipsters panic and sell out at new lows that will just drive the market lower at a faster pace since they'll be adding to the selling pressure with those who are simply selling to protect profits from longer term trades they've been in.
With the slew of ETF funds, no uptick rule and excessive bullish sentiment (meaning just about everyone is long), indiscriminate selling could hit the market hard at any time. That's the downside risk. But the market is still in a longer term uptrend so longer term bulls are not in trouble yet. There have been a couple of shots across the bow of the USS Bullship by the USS Bearpaw so now we'll see if the captain of the USS Bullship takes notice or attempts to keep steaming straight ahead. It'll take a torpedo to the stern to disable the Bullship and then one amidships below the waterline to sink her. So far we've just got the warning shot. Put your life jackets on just in case the leaders (the tech generals) abandon ship late at night.
Speaking of the tech bulls, I've leave you with one more chart of Google:
Google (GOOG), Daily
I mentioned lat week that I thought GOOG would be a good short if it tagged its Fib target at 661.36. It did tag that level after its Thursday earnings report but did not do so during regular trading hours on Friday. Therefore there is still the possibility it will press marginally higher than its 658.28 high early Friday this coming week (probably Monday if it does). The wave count, Fibs and negative divergence point to a good setup here if you'd like to try it. It's trying to catch rising knives and for GOOG they're especially sharp. But keep an eye on this one--if it breaks below 612 then the fat lady will have sung the blues on GOOG and in turn probably on NDX. If the tech generals start leading to the downside I suggest we follow. If they continue to hold up well then don't get aggressive on the short side.
Good luck in the coming week. I'll be back here on Wednesday and daily on the
Market Monitor. Trade carefully as we could see volatility return with a
vengeance. I didn't show the VIX chart but it's on a buy signal. That of course
would not be good for stock bulls.
Play Editor's Note: We are facing a dilemma. This past week was bearish and culminated into a frenzied sell-off on Friday. The recent weakness has produced a bumper crop of sell signals among equities. We need to juggle our bullish bias for the fourth quarter with the short-term downtrend. Plus, to make the waters even more muddy many stocks are now looking short-term oversold. I would expect an oversold bounce soon although probably not Monday morning. Do traders buy the bounce or look for it to roll over and use it as a new entry point for bearish positions? One of the hardest things traders have to do is trade what we see or what the market is giving us and to avoid trading our bias. It's been said before - the market is always right whether we agree with it or not.
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Our estimated cost is $1.95. We want to sell if either option hits $3.50 or higher.
Picked on October 21 at $ 59.65
(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.)
Google Inc. - GOOG - cls: 644.71 chg: + 5.09 stop: n/a
In spite of all the hype ahead of GOOG's earnings announcement there was no sell-the-news reaction that the stock typically sees following its report. Instead the stock gapped higher above resistance at the $640 level. Shares hit $658 before paring its gains. Boosting shares were a couple of new analyst price targets. One firm raised their price target on GOOG to $775 and another over $800. Nothing goes up in a straight line forever and we're going to stay with this bearish play a few more days to see if the rally will fade or not. More conservative traders will want to strongly consider just exiting early right here to avoid further losses. We're not suggesting new positions.
Our second strategy was the speculative put spread. We suggested buying the November $580 put (GOO-WP) and selling the November $530 put (GOP-WW).
*This isn't a strangle play but given the spread in strategy number two we decided to stick it in the strangles section of the newsletter.
Picked on October 16 at $616.00
Intl. Bus. Mach. - IBM - cls: 112.28 chg: -2.52 stop: n/a
IBM continued to sell-off and shares broke down under support near $115 and its 50-dma. However, the post-earnings weakness was not big enough to help our aggressive, October strangle which has now expired. Our estimated cost on the October play was $1.20. We still have a November strangle. Our November strangle suggested the November $125 call (IBM-KE) and the November $110 put (IBM-WB). Our estimated cost was $3.00. We wanted to sell if either option hits $6.00.
Picked on October 15 at $118.03
Cummins Inc. - CMI - cls: 137.78 change: -0.16 stop: 135.85
It looks like shares of CMI were influenced by the earnings miss in Caterpillar (CAT). The combination of CAT's negative earnings news and a weak market pushed traders to lock in profits for CMI. The stock broke down under support and did so on rising volume. Shares hit our stop loss at $135.85 pretty early in the session.
Picked on October 11 at $140.85
NASDAQ 100 trust - QQQQ - cls: 52.44 chg: -1.34 stop: n/a
It turned out to be a volatile week for the markets but the QQQQ did not move enough for our strangle to become profitable. Our aggressive October strangle using the $54 calls and $53 puts would have expired. Our estimated cost was $0.76.
Picked on October 14 at $ 53.53
Here's a sentence taken from an anecdote told by a former floor trader (Sheridan, CBOE Webinar): "I buy 500 with a 50 delta. That's 25,000 deltas long. I have to immediately sell 25,000 shares of the stock to hedge my position."
Can you interpret what he was saying? If not, you will be able to do so by the end of this article. You'll also understand a little more about what delta has to do with managing risk.
About once a year, I cover delta in these Trader's Corner articles, thinking each time that it will likely be the last time I do so. Delta, along with gamma, vega or tau, theta and rho comprise the Greeks, components of options pricing. Inevitably, questions from subscribers prompt a review or, in this case, a different twist on the discussion. Usually those questions have to do with why their purchased options aren't profitable when the underlying moved in the right direction. However, I believe that this discussion of delta also ought to concern how it can be used to monitor risk.
The reason those options aren't as profitable as readers expect them to be often involves an explanation of delta. In OPTIONS AS A STRATEGIC INVESTMENT, Lawrence G. McMillan summarizes delta by saying that it measures "how much current exposure" an option trader's "option position has as the underlying security moves." Perhaps, if you haven't studied the Greeks of options, that summarization doesn't make any more sense than the anecdote that began the article, but hang on. It will.
Another explanation of delta is one that perhaps both McMillan and the floor trader reference: delta's prediction of the option's probability of being in the money at expiration. A delta of 0.55 suggests that the option is estimated to have a 0.55 or 55 percent chance of being in the money at expiration.
Another definition exists, and this one typically makes the most sense. Delta provides a measurement of how much an option's price is likely to move as the underlying such as KO, MSFT or the SPX moves. Delta ranges in value from 0.0 to 1.0 for calls and -1.0 to 0.0 for puts, but for most options on most quoting sources, it's expressed as a decimal such as 0.32 or -0.25. On a few sources, such as ivolatility.com's free service, the delta is expressed as a percentage, such as 58.53 percent or -41.87 percent. The differences in quoting conventions relates to the delta's two purposes: showing how much an option will change in price for each point change in the underlying or giving a percentage chance that the option will be in the money at expiration.
When a call option has a delta of 0.32 or 32 percent, the option's price will increase approximately 0.32 for each point the underlying moves higher and has an estimated 32 percent chance of being in the money at expiration. If you have a call on KO with a delta of 0.55, and KO moves up a point, your call should be worth about $0.55 more if all other inputs such as volatility remain the same. If you have a put on KO with a delta of -0.78, and KO's value falls two points, your option should be worth about $1.56 more, with a caveat that will be discussed later.
Many brokers offer quotes that include the deltas for the options you're considering. If your broker's site doesn't include information on delta, ivolatility.com does. At the top of the front page, you'll find a slot for typing in the symbol of the underlying. Type in KO, for example, and click through to find out that with KO closing at $57.80 on 10/15, KO's OCT 55.00 strike call had a delta of 82.92 percent (or 0.83) and the OCT 55 strike put had a delta of -18.51 (or -0.19).
Why are deltas positive for calls and negative for puts? That's because calls increase in price when the underlying moves up, but puts decrease in price when the underlying moves higher. The negative sign shows that for each point the underlying moves higher in price, the put option decreases by the delta.
Conversely, calls lose money when the underlying drops; puts gain in that circumstance. For each drop of a point in the underlying, the put will gain by the delta. For those for whom the concept isn't intuitive, an example might be easier to understand.
XYZ @ $15.00
Two hours later, the following is true:
The increase or decrease in options prices in the example isn't exact because delta changes as the price of the underlying moves closer or further away from the strike of the option. For our purposes, we'll consider it steady at 0.50 or -0.50 throughout the two-point price change, but that wouldn't strictly be true.
Notice that the call in our example had a delta of 0.50 and the put, -0.50? That's because these calls and puts are at the money, with the underlying at 15.00 and the strikes at 15.00, too. At-the-money (ATM) options have deltas of approximately 0.50 or 50 percent.
On October 15, with KO closing at $57.80, ivolatility pegged the OCT 57.50 call's delta at 58.50 percent (or 0.59) and the OCT 57.50 put's delta at -42.69 percent (-0.43). KO had moved away from that 57.50 strike, moving higher, so the call's delta had increased a little above .50 or 50 percent and the put's had decreased a little below .50 or 50 percent. The deeper an option is in the money (ITM), the closer the delta's absolute value will be to 1.00 and the further it is out of the money, the closer the delta will be to 0.00.
That means, for example that a deep-in-the-money put will move almost a point for every point the underlying drops. A far out-of-the-money one won't move much at all unless the underlying drops precipitously.
That leads directly into the problem that prompts subscribers to write me. A subscriber might have bought an SPX put, for example, and the SPX moved down 4 points, but the put didn't change much in value. That's usually because the option was so far out of the money that the delta was low.
For example, at the close on October 17, with the OEX at 719.70, an OCT 700 put had a delta of 0.06 or 6 percent. The bid/ask spread was 0.15 for that option. That means that, all other things held constant, the OEX would have to drop almost three points just to cover the distance between the bid/ask spread, and even further to cover the costs of the commission, and that would just get you to breakeven, not even to a profit. When I was daytrading the OEX, I would buy options as deep in the money as I could afford, but I wanted a delta of at least 0.70. That usually allowed me to make a profit, albeit sometimes a small one, on a three-point move in the OEX. McMillan goes further. He says if you're going to be daytrading, buy the stock, not an option. This whole delta problem is one of the reasons--along with the wide bid/ask spreads--that some former options traders switched to futures.
Did you notice that in our hypothetical XZY stock at $15.00, the deltas of the ATM call and strike added up to zero (-0.50 + 0.50 = 0.00)? The position is called delta neutral. What does that mean? It means that, theoretically, the position will not suffer from price movement. If XZY moves up, the call's price would theoretically increase as much as the put would decrease, at least at first. Of course, it's not always quite that easy and this ignores other risks.
Risks to options positions come mainly from price movement, volatility changes and time decay. Either the price moves against you, volatility drops or escalates or time passes without enough movement. A delta-neutral position temporarily wipes out the price risk, but depending on how it's structured, it may suffer from other risks. For example, what if you bought that XYZ straddle at with a strike of $15.00 (i.e., one 15.00 call and one 15.00 put) and the price of XYZ stays near $15.00 right into expiration? Time decay eats away at the value of the options you bought. In addition, volatility will likely decrease and that also will decrease the value of both the call and the put you purchased.
It's not always possible to wipe out all risks, but the former floor trader who bought "500 with a 50 delta" and turned around and sold "25,000 shares of the stock to hedge" was trying to create a delta-neutral position, one that wouldn't suffer from adverse movements in the stock. Stock is considered to have a delta of 1.00. Why? For each point a stock moves, the stock gains or loses that same value. When a stock is sold, you're short the stock and so the delta is now -1.00. For every point the stock moves down, your position gains a point.
That floor trader who bought the 500 contracts with a delta of +.50 was at risk if the stock dropped. For every point the stock dropped, the floor trader would theoretically have lost $25,000 (500 contracts x 100 multiplier/contract x .50 delta = 25,000 deltas). Yikes. That's a tremendous risk. No wonder that trader wanted to "immediately" sell 25,000 contracts.
What happens then if the stock drops a point after the floor trader had hedged? The value of the options position theoretically drops $25,000, but he's offset that by gaining $25,000 in his short stock position. Floor traders don't last long if they don't control both price and volatility risks, say former floor traders, and you can see why.
Delta-neutral positions don't always stay neutral. Imagine the floor trader's case. If the stock were to drop five points, for example, the call he bought is further out of the money and the delta has dropped. Imagine that it had dropped to 0.41, for example. The trader is then long 20,500 deltas (0.41 delta x 100 multiplier/contract x 500 contracts), but he's short 25,000 due to the stock he shorted. What does he do? He could buy-to-cover 4,500 of those shares of stock he shorted if his only goal was to keep a delta-neutral position.
He might have other goals. He might be also be trying to keep his entire
portfolio gamma/delta-neutral. What's gamma? That's the topic of next week's
Today's Newsletter Notes: Market Wrap by Keene H. Little, Trader's Corner by
Linda Piazza, and all other plays and content by the Option Investor staff.
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