Option Investor

Daily Newsletter, Wednesday, 10/24/2007

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap

Fed to the Rescue, Maybe

After the DOW sold off more than 200 points today all it took was a rumor that the Fed was ready to lower the discount rate again and the market charged higher from its low, finishing at the flat line for the day. Whether the Fed leaked some information or it started from a "reliable source" (probably some blogger), we'll never know. But that's all it took to get a couple of buy programs to start some short covering and an hour later people were looking around asking "what decline?"

Looking at the market breadth numbers in the table above you can see that while the major indices may have recovered (except the techs and small caps), the down volume was better than 2:1 over up volume and new 52-week lows were almost 2:1 over new highs and the a-d line was almost 2:1 negative. And it wasn't just because of the techs and small caps. Looking inside the NYSE numbers shows 166 new lows vs. 74 new highs. So this afternoon's recovery rally was narrow-based.

The next Fed meeting is only a week away and there's obviously a lot of nervousness and chatter about what the Fed will or will not do and what they'll say. Since their last Fed funds rate cut on September 18th (and another cut in the discount rate) the DOW gave up the entire post-rate cut euphoric rally at its low on Monday. The market has since bounced off that low (SPX tested it today) but this is very typical--the rate cuts in 2001-2002 were typically followed by euphoric rallies as traders believed the Fed was here to save the day. That euphoria usually wore off in less than a month as the market rolled over to a new low. I suspect we'll see repeat performances on the way down this time as well.

Keep an eye on the 10-year yield as the Fed follows them (not the other way around). Here's what we've got as of today:

10-year Yield (TNX), Daily chart

The 10-year yield is now lower than where it was on September 18th and the Fed rate cut. Following that rate cut TNX bounced FFtwice) but found resistance at its longer term broken uptrend line from the June 2005 low. The move down from its most recent high looks like a completed 5-wave move which suggests another bounce is coming. Depending on the larger wave pattern the next move could be a rally above its most recent October high near 4.7% or we could see just a correction to its most recent decline before tipping back over and heading for new lows. I think key levels for TNX are 4.3%, 4.5% and 4.7%. Whichever way TNX is headed when crossing those levels should see it continue to the next level. A break below 4.3% could see an acceleration lower (that would mean buying in the Treasuries and likely bearish for stocks).

It will be interesting if TNX bounces back up within the next week and gets up to 4.5% which is where it was before the last Fed rate cut. Would that be an indication that the Fed is going to stand firm on rates for now? I wouldn't want to be long stocks if that happens. But if rates continue lower from here, below the September low then that will be telegraphing another rate cut from the Fed. Even though the buying in Treasuries in that case would be bearish for equities, I suspect bulls will at least temporarily think it's a good time to do some more buying. We still have a very active buy-the-dip crowd.

Economic reports
There were only two economic reports today--existing home sales and crude inventories--but the equity market had already been struggling before the home sales report. The crude inventory data did cause a big jump in crude prices.

Existing Home Sales
Economists had ratcheted down their estimates for September's home sales but as it turns out it wasn't quite enough. Sales of existing homes and condos dropped -8% to an annualized rate of 5.04M, the lowest level in eight years. It's probably lower than the lowest level before 1999 but that's when the NAR (National Association of Realtors) started tracking combined single-family and condo sales.

Inventories of unsold homes and condos rose to a 10.5-month supply, also the largest in eight years. For just single-family homes, sales dropped -8.6% to a seasonally adjusted annual rate of 4.38M which is the slowest pace since January 1998.

Crude Inventories
Crude supplies dropped 5.3M barrels to 316.6M last week while gasoline supplies dropped by 2.0M barrels to 193.8 and distillate stocks were down 1.8M to 134.5M. Refinery activity also declined slightly to 87.1% from 87.3%.


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Imports of crude oil dropped 1.3M barrels to an average of 9.1M bpd. The lack of demand for imports is what has many traders thinking we could be witnessing a drop in demand which should depress the price of oil. Japan's imports have dropped near 10% so far this year due to lack of demand.

The drop in inventory levels and the tensions along the Turkish/Iraqi border were credited for today's rally in the energy products.

As for the equity markets, since Monday's low we've had a choppy market with lots of whipsaws. Whenever we got this kind of price action it can be very difficult to figure out where it's going next--it's constantly looking like it's ready to fail but then some strong buy programs come in and knock the shorts out. Then the buying suddenly stops and down she goes. One thing to remember about bear markets (assuming for now we're heading back into one), especially now as compared to the time before 2000, is the fact that we will always see violent bear market rallies.

I remember talking to traders in 2000 and many didn't even understand a put option. Everyone had been so conditioned to only buying stock or call options and no one bothered to think about trading the short side. Shorting stock, or heaven forbid, futures, was a sure fire way to the poor house. Now everyone and their brother shorts stocks, futures and ETFs and buys puts like candy. But the retail trader is a very weak holder on the short side as they typically have very little ability to let the market go against them.

Therefore when the market is spiked against them they stop themselves out quickly. This causes the quick flare-ups in the market and if the bulls can then carry it a little further it will soon start reaching the stops of the bigger players and it begins to feed on itself until the majority of the shorts are stopped out.

Recently, as the market was making new highs in October, it was apparent that the bears had pretty much gone back into hibernation. The bullish sentiment has been at an extreme level while bearish sentiment was near record lows. It opened up the way for last Friday's decline since there weren't enough shorts in the market to help spark a rally. That actually hasn't changed much this week (in the number of bears) but today's rally off the bottom sure looked like a good squirt higher thanks to too many shorts jumping on this decline again.

Playing the short side is going to be very difficult so make up your mind to either play a longer downtrend and let it bounce back up in your face or else take profits quickly and try to short the flare-ups. That's a lot easier said than done since bear market rallies look so strong, until they just stop and turn on a dime and head south again. Get used to it because I think that's going to be our market environment for the next year or so.

In the meantime, let's see what the week has done to the charts since my weekend review with you:

DOW chart, Daily

When I say this week's choppy price action makes it difficult to figure out what's next, I'm not kidding. You can see by the various scenarios on the chart that we could go up, or we could go down, or we could go sideways. Any questions? And the separation of the key levels is not exactly helpful at the moment either--bullish above 13900, bearish below 13100. Monday's hammer candlestick at its 50/100-dma support was bullish and today's dragonfly doji at resistance (see 60-min chart below) is potentially bearish (a red candle tomorrow would complete a reversal candlestick pattern).

No one said trading would be easy but there are times when it's more difficult than usual because there are no good (more reliable setups). This is one of those difficult days to make a call and when it's like this I always recommend the sidelines. You've heard many times from the successful traders that one of the secrets to their success (besides proper risk management) is knowing when Not to trade.

From the daily chart I would say I'd look at a short play setup if the DOW reaches the mid line of its channel just above 13800. Or a break below today's low could usher in some strong selling down to its uptrend line from July 2006 which is where its 200-dma has been tracking along. I do not like the long side unless you can scalp plays by watching the market like a hawk. I show the possibility (in green) for the market to rally to a new high but frankly don't see it as a reasonable possibility until the DOW is able to rally above 13900 and even then I'd be more inclined to believe it's just a larger corrective bounce that's in progress.

DOW chart, 60-min

This afternoon's rally had the DOW rallying almost to its downtrend line from October 11th and its broken uptrend line from Monday's low. Those two lines cross at the 38% retracement of the October decline at 13711. Might that make for a good short entry if tagged first thing tomorrow morning? It's certainly something I'd look over very carefully, as I will be doing on the Market Monitor tomorrow, for a potential short play setup.

Notice the highlighted RSI--I'm showing how it provided a heads up that the bounce is looking a little more bullish than price action was at the time. By breaking its downtrend line we have a heads up that the same could happen to the downtrend line on price. The quick pullback in RSI early yesterday held on the retest of the broken downtrend line and it held again on today's pullback. I was watching this on the Market Monitor today and used it to warn bears about a potential bounce off this afternoon's low. Between this and bullish divergence on the 10-min chart between this morning's and afternoon's lows it was looking like the low was going to hold and then start a strong rally back up. Shortly after that, boom, along came the buyers.

SPX chart, Daily

Just like the DOW--pick a direction, any direction. It's like the person pointing both ways saying "he went thataway". Unless SPX can rally above 1544 I'm looking at this bounce as just a correction to the October decline. If it were able to get above 1544 then I'd watch for resistance at the bottom of its parallel up-channel, which could take it back to a new high. I guess I'd have to say I'll believe it when I see it. More likely in my opinion is that we'll see a little more bounce before the market rolls back over.

Of all the price depictions on the chart right now I'm leaning toward the pink one that has an upside target in the 1525-1530 area. SPX 1490-1500 has been resistance in the past and now 1490 is support--it found support there on Monday and again today. A break below that level should see a quick move down to its 200-dma (although that hasn't provided much support/resistance in the past) and then probably down to the 1430-1440 area. But like the DOW, the daily chart is not showing any clear setups at the moment.

SPX chart, 60-min

RSI did exactly the same thing that I pointed out on the DOW. Between the successful retest of the broken downtrend line and the bullish divergences on this chart when comparing to Monday's low, along with the bullish divergences on the 10-min chart at today's two lows, it was a good setup for the long side. Also like the DOW, SPX has now rallied up to its downtrend line from October 11th (closed marginally above it) and its broken uptrend line from Monday. It left a bearish looking hanging man doji at resistance and a red candle from the first hour of trading tomorrow morning would make for a reversal pattern.

But assuming the bulls can keep this alive, the next upside resistance would be the 38% retracement just above 1523 and then 50% just above 1533. The previous low at 1526 (labeled wave-A) would also be a typical resistance level. It takes a rally above 1544 to say something more bullish is happening.

In the weekend Wrap I showed a monthly chart for NDX that showed price nearing the top of its parallel up-channel for price action since the October 2002 low. I also showed the EW (Elliott Wave) projection for two equal legs up at 2211. This weekly chart also shows how price has reached the top of a parallel up-channel for price action since the July 2006 low:

Nasdaq-100 (NDX) chart, Weekly

The tops of both channels intersect just above the 2211 price projection. So the question here is whether this morning's 2205 high was close enough or whether we've still got a little more work to do to the upside. Before getting the steep selloff today I thought we'd push a little higher. Now I'm not so sure, or if it does whether it will happen in a choppy rising wedge kind of way. The daily chart shows that possibility along with a couple of other ideas:

Nasdaq-100 (NDX) chart, Daily

The NDX chart looks a little busy but I'm trying to show a couple of ideas. The more bearish idea is that the current bounce will fail at a lower high and head south at a high rate of speed. The more bullish idea says we'll get a choppy rise in a rising wedge (I'm basing that idea on some evidence from the short term wave structure). In the middle, literally, is the pink price depiction that forms the right side of a diamond top pattern. The choppy price action we're getting makes this idea currently very plausible. If it happens this way then you'll want to be very careful about the chop and whipsaws over the next couple of weeks.

Nasdaq-100 (NDX) chart, 60-min

The last 60-min candle is another hanging man close to the trend line along the first two highs on the 11th and 18th. At this point I would suggest a short against the 2205 high since risk is relatively small. An even tighter stop could be placed just above the trend line near 2190. A break back below 2117 would be bearish and anything in between has a lot of chop potential. I find it more than a little interesting that yesterday's and this morning's high stopped at the broken uptrend line from August.

Looking at RSI, notice the relative weakness of NDX as compared to the DOW and SPX 60-min charts I showed above. RSI broke back below its broken downtrend line so now watch to see if it can get back above it or turns lower right away tomorrow.

The whole time the techs (NDX and the COMP) were rallying from the August low the semiconductors were not participating and it has been bearish non-confirmation of the tech rally. And now the semis look like they're in breakdown mode:

Semiconductor Holders (SMH), Daily

The H&S top that has developed since May of this year broke the first neckline last Friday and broke the 2nd neckline today. Then it the bounce off today's low brought it right back up and parked on the neckline. Was that a save? Right now it looks like bullish hammer on support and I wouldn't be surprised to see a rally back up to at least the 1st neckline before rolling back over. But any continuation lower would have the lower price objectives near 30 and then 28 in play.

Russell-2000 (RUT) chart, Daily

Since last Friday's low the RUT has been bouncing around its 50, 100 and 200-dma's and its uptrend line from August. Anyone who has been using those levels for trade entries and/or stops has been whipped severely and beat about the head and shoulders this week. The RUT closed right on its 200-dma as if to dare you to pick a direction and trade that way.

I've left the key level of 802 showing only because it's a reminder why I no longer show a bullish wave count since the 4th wave, which would be the pullback to Friday's low, overlapped wave-1 which is a big no-no in EW counts. Therefore the most I'm expecting is a bounce to a lower high (which could have already finished) before heading lower again. If the bounce manages to get two equal legs up from Monday's low that would give us 824.50 for an upside target, as shown on the 60-min chart:

Russell-2000 (RUT) chart, 60-min

While the correction to the October decline might have finished at Tuesday's high, I'm leaning towards the need for another push higher to complete a larger A-B-C bounce off Monday's low before setting up the next leg down. The projection to 824.50 places it between a 50% and 62% retracement of the October decline.

BIX banking index, Daily chart

After breaking below its long term uptrend line from 2002 I'm expecting to see a bounce back up to it for a retest. If it happens from here then it should make for a very good shorting opportunity.

One thing I haven't pointed out on the other charts but will on this one--the price pattern suggests we could see a longer lasting bounce into next week. Next Wednesday is the FOMC rate decision and what's interesting about this price depiction is that it calls for a selloff following the FOMC announcement. That's all speculation from here since I have no idea where price will be by next Wednesday. But if it sets up this way I'm thinking the market is going to be disappointed with the Fed.

U.S. Home Construction Index chart, DJUSHB, Daily

There was more bad news about home sales today but the home builders index didn't crater. After tomorrow's new home sales data, if the home builders hold up then we could see a further bounce under the assumption that all the bad news is priced in. It's not but it could be good for the bounce that I'm expecting for a 4th wave correction before tipping back over into the end of the year.

Oil chart, December contract (CL07Z), Daily

I was short oil from 88.40, near the high but had lowered my stop to 87 and got stopped out today, thanks to the crude supplies data. Now it appears we could either be headed higher from here or back down. The only question in my mind, and the reason I'm staying flat for now, is whether we'll chop lower/sideways or head up to the Fib projection near 92. Watching and waiting for now.

Oil Index chart, Daily

Oil stocks bounced with the rest of the market but not nearly as strongly as oil itself. Keep an eye on oil stocks if you like trading oil since oil stocks tend to lead the commodity (for gold as well). Linda's article on the fan principal is at work here. Watch for retest of its middle broken uptrend line, near 830 currently, as a shorting opportunity. A break below the lower uptrend line, the 3rd one, is usually the signal that the top is in.

Transportation Index chart, TRAN, Daily

The transports could bounce back up to the top of its consolidation pattern near 5080 but there's layered resistance between here and there and I'm not confident it will make it that high. A break below 4755, Monday's low, would be a heads up that it's heading much lower sooner rather than later.

U.S. Dollar chart, Daily

The US dollar is holding above its low and looks like it could finally bounce but it needs to get up and go now that it tagged its Fib projection at 77.20. It's getting pinched now between its downtrend line from August, currently near today's high of 77.83, and the bottom of its down-channel near 76.78.

Gold chart, December contract (GC07Z), Daily

Gold has bounced off its low near 751 but it looks choppy and corrective. It continues to support the idea that we've seen the high for gold. There is another Fib projection at 784.50 if it pushes to a new high but as you can see by the negative divergence at the last high, it's not looking bullish here. The wave pattern suggests the next big move will be back below 650 in less time than it took to rally from that level (retracement of the rising wedge).

Results of today's economic reports and tomorrow's reports include the following:

Tomorrow's economic reports could move the market if the durable goods number is much different than expected. I think home sales data is pretty much priced in for now and probably won't move the market.

SPX chart, Weekly

The weekly chart shows how small the bounce is so far against last week's decline. MACD hasn't crossed down yet but is getting close and will leave an obvious negative divergence if it crosses back down from here. I expect we'll see a test of its longer term uptrend line near 1400 before the end of the year.

As discussed with the charts, the direction of the market is up for grabs tomorrow. This week's choppy price action makes for a higher probability to get whipsawed. My best guess on the price pattern is that we're going to get further upside tomorrow but a sharp rally off today's low could get reversed quickly and unless you're able to scalp the move I just don't see enough upside potential to make it worthwhile.

Because of where the DOW and SPX stopped this afternoon, it looks like a good opportunity to test the short side first thing tomorrow morning. A quick pop higher that fails could be the setup. But I see the possibility for a pullback followed by a continuation of the rally so again, choppy whipsaw price action could play havoc with traders. There just isn't a good enough setup this evening and therefore flat is a good position.

Keep an eye on the key levels on the charts for setups or confirmation of breakdowns. I don't like the upside since I think the market has topped. The new trend should be down and therefore watching these bounces for opportunities to get short should be the higher odds play. Good luck in your trading. See you next Wednesday on the Market Monitor each day.

New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
None None None

New Calls

None today.

New Puts

None today.

New Strangles

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Sina Corp. - SINA - cls: 53.22 change: -0.28 stop: 49.99

SINA avoided most of the market's volatility on Wednesday. The stock traded sideways in a $1.70 range. Traders bought the dip twice near $52.00, which is a bullish signal. We would still consider new positions now although more conservative traders could wait for a rise past $54.00 before initiating positions. Our target is the $59.50-60.00 range. SINA is due to report earnings somewhere in the October 29th-November 8th range. Hopefully the closer we get to the end of October we'll find a confirmed date since we do not want to hold over SINA's earnings report. Speaking of earnings Baidu's (BIDU) earnings report is due out this week on October 25th. Reaction to BIDU's earnings could strongly influence shares of SINA.

Picked on October 23 at $ 53.40
Change since picked: - 0.28
Earnings Date 11/08/07 (unconfirmed)
Average Daily Volume = 1.0 million

Put Updates

BEA Systems - BEAS - cls: 17.55 change: -0.32 stop: 19.01

Steam continues to build behind the idea that this ORCL acquisition of BEAS will not happen. The BEAS board of directors rejected the offer again and no one else seems to be stepping up as an alternative bidder. Shares of BEAS lost 1.79% on strong volume. ORCL will cancel its $17 a share offer this Sunday at 5:00 p.m. Our target is the $15.25-14.75 range. We're suggesting a stop loss at $19.01 but readers could try and play with a stop above yesterday's high ($18.67).

Picked on October 23 at $ 17.87
Change since picked: - 0.32
Earnings Date 10/27/07 (unconfirmed)
Average Daily Volume = 19.6 million


Tsakos Energy - TNP - cls: 68.34 change: -0.10 stop: 72.16

The action in TNP could just be the sort of failed rally under resistance that we've been looking for as another entry point for puts. The stock reversed course under the 50-dma and was trading lower into the afternoon instead of rebounding with the market. Meanwhile in the news TNP announced that they would report earnings on Monday, November 5th. That means we will plan to exit on Friday, November 2nd unless shares hit our target first. Our target is the $65.10-63.65 zone. Almost all of its technical indicators on both the daily and weekly charts are bearish or they are turning bearish.

Picked on October 22 at $ 67.67 *gap down
Change since picked: + 0.67
Earnings Date 11/05/07 (confirmed)
Average Daily Volume = 114 thousand


Sepracor Inc. - SEPR - cls: 23.32 change: -0.71 stop: 25.05

Bears can take some comfort in the fact that there was no follow through on SEPR's big rebound yesterday. The stock slipped 2.9% and did not rebound this afternoon with the same gusto the broader market did. We're not suggesting new positions at this time. Our target is the $20.25-20.00 zone. We do not want to hold over the October 30th earnings report.

Picked on October 21 at $ 22.91 *gap down
Change since picked: + 0.41
Earnings Date 10/30/07 (confirmed)
Average Daily Volume = 1.5 million

Strangle Updates

(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.)


Borg Warner - BWA - cls: 95.49 change: -0.18 stop: n/a

BWA ignored most of the market's volatility and continued to trade sideways as investors wait for the company's earnings report due out tomorrow morning. We are not suggesting new positions any longer. The options we suggested for a strangle were the November $100 calls (BWA-KT) and the November $90 puts (BWA-WR). Our estimated cost was $4.50. We want to sell if either option hits $7.25 or more.

Picked on October 23 at $ 95.67
Change since picked: - 0.18
Earnings Date 10/25/07 (confirmed)
Average Daily Volume = 392 thousand


Express Scripts - ESRX - cls: 57.37 chg: -1.03 stop: n/a

ESRX continued to see profit taking ahead of its earnings report tonight. Wall Street was expecting a profit of $0.57 a share. The company reported 60 cents a share and raised their earnings guidance. The stock is trading up in after hours and it looks like shares could gap above the $60 level tomorrow morning. We are no longer suggesting new positions in the stock. The options we suggested for a strangle were the November $65 calls (XTQ-KM) and the November $55 puts (XTQ-WK). Our estimated cost was $1.95. We want to sell if either option hits $3.50 or higher.

Picked on October 21 at $ 59.65
Change since picked: - 2.28
Earnings Date 10/24/07 (confirmed)
Average Daily Volume = 2.1 million


Intl. Bus. Mach. - IBM - cls: 112.95 chg: -1.73 stop: n/a

Technology stocks were the under performers today and IBM lost 1.5%. We are not suggesting new strangle positions at this time. 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
Change since picked: - 5.08
Earnings Date 10/16/07 (confirmed)
Average Daily Volume = 7.5 million


Monster Worldwide - MNST - cls: 36.02 chg: -1.15 stop: n/a

Shares of MNST lost 3% ahead of its earnings report today and the stock failed to rebound like most of the market this afternoon. Wall Street was expecting a profit of 33-cents a share. MNST reported after the closing bell with 35-cents and management guided earnings higher. The stock was trading higher after hours and looks like it could gap up above resistance near $38.00. We are no longer suggesting new positions. The options we suggested for our strangle were the November $40 calls (BSQ-KH) and the November $35 puts (BSQ-WG). Our estimated cost is $1.75. We want to sell if either option hits $2.95 or higher.

Picked on October 23 at $ 37.22
Change since picked: - 1.15
Earnings Date 10/24/07 (confirmed)
Average Daily Volume = 2.0 million


Microsoft - MSFT - cls: 31.25 change: +0.35 stop: n/a

Traders bought the dip in MSFT at $30.50 this morning and the market's rebound actually lifted MSFT (or MSFT leaded) with a new relative high over short-term resistance near $31.25. The big news for MSFT today was its win over rival GOOG for a minority stake in Facebook. MSFT made a $240 million investment, which is pocket change for the software titan. Tomorrow is the big day. MSFT reports earnings after the closing bell. Tomorrow is also our last day to open strangle positions ahead of the report. We would suggest positions in the $30.50-31.50 zone. The options we suggested for our strangle were the November $32.50 calls (MSQ-KZ) and the November $30.00 puts (MSQ-WK). Our estimated cost is $1.07. We want to sell if either option hits $1.85 or higher.

Picked on October 23 at $ 30.90
Change since picked: + 0.35
Earnings Date 10/25/07 (confirmed)
Average Daily Volume = 53.0 million

Dropped Calls


Dropped Puts

Autozone - AZO - cls: 122.01 change: +2.35 stop: 122.26

Shares of AZO completely ignored the market's weakness this morning. The stock began to climb and displayed impressive relative strength with a 1.9% gain and a breakout over its 10-dma on above average volume. AZO hit our tight stop loss at $122.26 ending the play. Keep an eye on the $125 level and its 100-dma overhead as additional levels of resistance.

Picked on October 21 at $118.67
Change since picked: + 3.34
Earnings Date 12/05/07 (unconfirmed)
Average Daily Volume = 800 thousand


Chipotle Mexican Grill - CMG - cls: 123.55 chg: -3.58 stop: 128.26

Shares of CMG experienced some profit taking today with a 2.8% decline. The stock did bounce from its intraday lows but not to the same degree as the rest of the market. It was beginning to look like the bears might have a chance here. Unfortunately, any bearish dreams of a breakdown below $120 are likely over following some news out after the closing bell. Standard & Poors has announced it will add CMG to the S&P midcap 400 index on October 26th. That means all the funds that track the midcap index will have to buy shares of CMG. The stock was up 2.8% in after hours trading. We are issuing the retreat order. All hands abandon ship. If you want to take advantage of this news then consider buying calls on a breakout over $128.50 or the $130.00 level.

Picked on October 21 at $123.40
Change since picked: + 0.15
Earnings Date 10/30/07 (confirmed)
Average Daily Volume = 446 thousand

Dropped Strangles

Google Inc. - GOOG - cls: 675.82 chg: + 0.05 stop: n/a

We are throwing in the towel with GOOG. Traders had a chance to take it down today with the market down sharply this morning. The worst the sellers could do was the $660 region. Buyers stepped in twice to buy the dip in GOOG near $660. We didn't hear anything earth-shattering come out of the GOOG analyst day. It seems the big headline was MSFT winning a stake in Facebook over rival GOOG but shares of GOOG are not reacting to the news. Our failed, high-risk put strategies involved the November $550 put and a put spread with the November $580 put and $530 put. Normally we play a regular strangle on GOOG's earnings report with both an out of the money call and an out of the money put. This time we tried to play our bias, which was bearish, and it failed.

*This wasn'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
Change since picked: +59.82
Earnings Date 10/18/07 (confirmed)
Average Daily Volume = 4.3 million

Trader's Corner

Constructing Trendlines and Trend Channels

I've written recently, in both this column on Wednesdays and in my recent weekend Index Trader's column, about the tip off supplied by constructing trend 'channel' lines as they highlighted technical 'resistance'. Resistance is usually thought of as where a stock or an index hits approaches or touches a PRIOR high. Support/potential buying interest is implied by the opposite; i.e., an area where the price of a stock or stock index approaches a prior low.

However, there is also technical support implied by a pullback to an up trendline or resistance (potential selling interest) implied by an rebound to a down trendline. Up trends are 'defined' not by a series of higher highs so much as by pullbacks in a series of higher (reaction) LOWS; an up trendline of course slopes up. The more steep the slope, the stronger the uptrend.

Downtrends are defined by a series of lower relative lows made on rallies. Constructing a straight line connecting 2-3 or more reaction lows, makes a trendline when that line is extended out, into the future as it were. A down trendline connects 2-3 or more rally highs and the trendline slopes down.

There is another aspect of trends in technical analysis, which is that of trend CHANNELS. In recent weeks and months the trend has been higher and the DOMINANT trend and trendline has been up. There is no way to measure RESISTANCE using an up trendline; its usefulness, whether on a short-term (e.g., hourly), intermediate-term (e.g., a daily chart) or long-term (e.g., a weekly chart), is to suggest areas of support on pullbacks.

However, construction of a line drawn parallel to the rising up trendline will often highlight a rising level of technical resistance. This is true also for a line that is constructed parallel to a falling down trendline, as that lower line will often highlight support. There are always downside reversals and pullbacks along the way in a bull market trend and upside reversals and rallies in a bear market trend.

Since we're interested in TRADING, there are times when the next best trade is one that is contrary to the direction of the dominant trend. Hence the usefulness of any drawing or charting tool such as the construction of trend channels, that might define resistance where it can't otherwise be guessed at; e.g., in a move to new highs and with no prior peak that suggests potential resistance.

I haven't said specifically yet how an upper or lower channel line is constructed. Better is to show it step by step. Keep in mind also that the same constructions may be applied to any stock and it just happens that my chart examples use stock indexes. The same methods can be also used in intraday charts (e.g., hourly), daily or weekly charts. I'll start with weekly chart examples of the Dow 30 (INDU), then move to hourly examples.


At least two reaction lows, with the second being higher than the first, is needed to began construction of an up trendline, as can be seen above in chart #1, where the tentative up trendline in the INDU weekly chart is from late-2002/early-2003. Extending this line up to the right (into a future time frame) may prove to highlight a future area of support and give us a THIRD point later on that falls at the up trendline. 3 or more points from which to construct a trendline makes for a 'superior' or more 'reliable' support/up trendline.

The other point to make here is that there are two TYPES of trendlines: 1.) The conventional way is to draw a straight line that touches only the LOWEST lows in order to construct an up trendline and only the HIGHEST highs to construct a down trendline. 2.) An 'INTERNAL' or 'best-fit' trendline is a line that touches the MOST number of lows in an up trendline, or the MOST number of highs in an internal down trendline. I tend to call both types, simply trendlines. However, when you see a trendline cutting THROUGH one of more lows or highs, it is a best-fit or internal trendline.

The third reaction low in the weekly INDU chart came years later than the first two lows that initially established a tentative up trendline for the weekly INDU chart as seen below. After low #3 occurred, the most number of weekly lows establishing this up trendline was to construct an internal up trendline cutting through one low occurring just after the number 2 weekly low noted on the up trendline below.


My next chart (3) adds an upper trend channel line by constructing a parallel line to the lower up trendline; one that touches the highest high(s) preceding the last low used in constructing the trendline. The upper parallel channel line seen below, extended to the right, is the assumed future high or pause point for the rising trend. After recent weekly highs, the last of which is highlighted with a red down arrow, came up to the area of the upper trend channel boundary, counter-trend declines have followed. Even if a trader failed to go into puts, much could be gained by exiting calls with most of the gains intact.


What I consider an important addition to any trend channel that I construct and use is the Relative Strength Indicator or RSI. In the case of a weekly chart I set 'length' to 8 or 13. With such a powerhouse trend as the one we've been in, I use the longer fibonacci 'length' setting of 13; i.e., using the last 13 closes to calculate the RSI level. What I am looking for is the confirmation of a possible top NOT ONLY by a move to potential resistance at the top end of the uptrend channel, but ALSO, either an overbought reading (e.g., at or above 70) OR a high not 'CONFIRMED' by a similar new high in the RSI indicator.

An example of price/RSI 'non-confirmation' is highlighted in my next INDU weekly chart (step 4). Such price/RSI divergences are usually suggesting that the stock or index in question is at or near at least an interim top. The question of any high being a 'final' top is not something that can be determined by these techniques or methods. We're just looking for high probabilities of enough of a downside trend reversal to make it advisable to exit call and/or also make it worthwhile to get into puts.

A similar uptrend channel pattern has been traced out by the Nasdaq Composite (COMP) as seen in my next weekly chart. The differences are that the high noted at point 1 was not in the immediate area of the top end of the price channel, rather was only approaching it. The 13-week RSI WAS registering the kind of high reading often associated with a top as noted by the first down red arrow on the RSI portion of the chart.

However, when the next rally carried to potential resistance implied by the top end of the broad uptrend channel (2nd red down arrow) and the RSI again was at a typical peak reading, this pattern had two reversal elements; e.g., that of resistance implied by the chart pattern and as implied by an "overbought" RSI.

As could be seen from today's rebound from intraday lows and is fairly typical of long-standing strong bull market moves, this market is not going to just collapse. What is more common is to see prices stall for a while, then start moving lower over time in a definite decline. Bull market trends, as well as bull markets die hard, as buying on pullbacks is the habitual reaction. Stay tuned on that!

To show how trend channels can be useful on the shorter-term hourly charts, and using the RSI also (length setting here equal to '21'), the following hourly Dow charts and their comments are presented:

The next chart of the hourly Dow is just a more recent view of the same trend channel construction as above, allowing a more detailed examination of the trend channel. Not everyone has the capability to see so much data for an hourly chart. Most charting applications that reside on your computer, will allow quite a lot of hourly 'bars' or periods to be seen, whether you pull in the data from your chart service or if that data is stored (locally) in your PC's hard drive. The longer the better is my suggestion in terms of how much data to keep or look at in terms of hourly charts.

Note how a rebound to the previously broken up trendline seen below, formed an apparent 'line' of resistance subsequently; if INDU had managed to pierce that lower trend channel line and get back into its prior uptrend channel, it would have suggested exiting DJX puts. The recent rally occurred from the 13400 area which I had pegged as a next key INDU support. Stay tuned as to whether this recent low is just a way station to further declines late on or not! So far, I think 'way station' only.

The upper end of price channels are not always of course so useful in highlighting potential reversal points or key areas of technical resistance and areas where price reversals may occur. Sometimes reversals come out of the blue so to speak, at least in terms of technical/chart patterns. The DIVERGING price/RSI pattern seen below in my last chart, that of the hourly Nasdaq Composite (COMP), did suggest formation of a possible top. The projected channel drawn below was not really a key aid in seeing this last COMP top develop by a reversal around the upper end.

The most recent rebound did however also come back to, and reverse AT, the hourly COMP uptrend line at the red down arrow, suggesting that this index was still running into selling on rallies and a lack of enough buying interest to propel prices back into its uptrend channel; back into its prior trajectory so to speak, that had been defining the degree or strength of its upside momentum.


Today's Newsletter Notes: Market Wrap by Keene H. Little, Trader's Corner by Leigh Stevens, and all other plays and content by the Option Investor staff.


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