On Wednesday, the last day of the year for mutual funds, we saw a strong window dressing session where all the leaders were bought so the funds would be fully invested in winning stocks for their year-end statements. Thursday's market looked like a stag party in comparison with the massive undressing taking place. As market voyeurs we had a ringside seat to the various strip acts and we did not even have to pay for admission unless of course you were invested on the long side and then the admission price was heavy. Thursday was a perfect storm where the various events came together to sink the bulls. The first day of the new fund year allowed them to take profits on those leaders who had extended their gains into uncharted territory. The post Fed letdown added to the selling as traders began to realize the Fed had just said goodbye in a "dear investor" letter cleverly disguised as the FOMC announcement. Adding to the already heavy selling pressures were new earnings disappointments and downgrades in the financial sector headlined by Dow component Citigroup. It was a textbook perfect storm that capsized the bulls and sent the indexes plunging back to support.
Dow Chart - Daily
Wilshire 5000 Composite Index Chart - Daily
The beautiful thing about major storms is their relatively short duration followed by clear skies and rainbows of hope. Friday's market action more closely resembled the turmoil of diminishing winds and thunder receding into to the distance than a fresh new day but in the end the sun was breaking through the clouds and suggesting that Monday could be the beginning of a bright new week for the markets.
The economics on Friday were very positive led by a strong gain in the Jobs report. The economy added +166,000 jobs in October and the strongest month since May. This was double the expectations for a gain of only +85,000. The momentary downtick in August has been completely forgotten, erased by the strong gains and revisions. The strong jobs gain makes it even more evident the Fed really had to stretch to cut rates on Wednesday. They knew the big jobs gains were coming but they also knew the markets were going to implode if they did not cut rates as expected. They considered the various options and cut rates one last time but corrected the statement to a neutral bias eliminating the chance of any future cuts. The strong jobs probably gave them a feeling of reassurance that the cut would be the last needed. The jobs report did have some components causing concern. Retail jobs were down -21,000 year over year and October is normally the beginning of a strong hiring cycle for the holidays. It appears retailers are not expecting a strong holiday season and therefore not hiring as many workers or at least putting off the task and expense until the last minute. That suggests consumer spending is truly slowing despite the minor gains in the shorter-term reports. Manufacturing employment fell -21,000 continuing the jobs losses seen over the last several years. The unemployment rate remained at September's 4.7% level and a level not seen since August 2006. This also suggests the economy is showing signs of slowing but not falling apart. This was a bullish report and should have been comforting to investors after the Fed pause statement.
Factory orders also rose unexpectedly in September after a monster -3.5% drop in August. Non-durable orders rose +2.1% and offset a -1.7% drop in durable goods orders. I know this is brain numbing economic trivia but I will try to hit the high points. Basically a surge in petroleum and coal orders caused purely by the spike in prices was the biggest cause for the headline gain. With oil spiking 10% over the period the routine orders for anything petroleum related will show a 10% increase based entirely on price. This makes the headline gain in factory orders a number to ignore. We want to see orders increasing in quantity not in crude price.
This was a monster week for economic events including the Fed meeting. Next week is a sleeper for economics without any material reports to shake up the market. We have already seen the ISM Mfg, Jobs, PMI, PPI, etc. The reports next week are either filler or confirmation of previous reports. The lack of economic news means traders will be focused on earnings as the market news for the week.
Even though there are over 300 companies reporting next week it was a struggle to pick out stocks for the calendar that you would recognize. This is small cap and energy week on the calendar and while there are a lot of earnings reports the market will be reacting to only a few names.
Leading that list of names will be Cisco (CSCO) on Wednesday. CEO John Chambers has been steadfast in his claims that business is great everywhere but in the U.S. market. Cisco is expected to post strong earnings and continue to confirm their global view.
SunMicro (JAVA) changed their ticker from SUNW to JAVA back in August and it appeared investors thought it was an IPO. The stock promptly rose over 20% in value after the change. About half of that gain has been erased but strong earnings on Monday could help. After a long string of quarters where SunMicro posted disappointing results they have actually turned the corner to the upside according to analysts and recent press from SunMicro itself. If SunMicro can continue to show gains in their sales this stock could actually catch fire. SunMicro has been depressed for so long that it is under owned by institutions and could see some heavy buying if the sales trend is confirmed. As SUNW the stock traded over $64 back in August of 2000 but began a steep decline when the tech bubble burst. It slipped under $7 in June 2002 and has not traded over that level since. The ticker change to JAVA produced a spike to $6.25 but the post change decline put it right back in the mid $5 range where it has spent the last five years. It would be nice to see them return to their former glory but it will have to start with a positive earnings report on Monday.
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GM and Ford will report on Wed/Thr but I doubt any readers are pegging their financial future on positive earnings from either carmaker. Toyota (TM) will also report on Wednesday and they have been very bullish about their current sales trends.
The ethanol story or "deathanol" as it is currently being called in many circles will be the topic of discussion when Archer Daniels (ADM) reports on Monday and Pacific Ethanol (PEIX) reports on Friday. For all practical purposes corn ethanol as a growth sector has died. The number of plants coming online has far exceeded the demand for the fuel and the costs currently outweigh the selling price. As the tax credits come to an end so will the viability of corn-based ethanol. The cost in energy to produce it was never conducive to extensive long-term use. According to generally accepted costs after a couple years of process refinement it takes about one gallon of fuel to produce 1.2 gallons of ethanol. Since ethanol has about 20% less power than gasoline and E85 cars get about 20% less gas mileage per gallon the future is grim for corn-based ethanol. The only way it will ever work is when peak oil is finally apparent and crude rises to $150 a barrel or more and becomes scarce. The target for permanent scarcity to begin is 2009-2011.
The ethanol story will improve when cellulosic ethanol becomes a reality. Cellulosic ethanol is made from waste products like corn stalks, switch grass, woodchips and similar waste. There are several pilot plants running around the globe but nobody has yet been able to perfect the process to make it in commercial quantities. It is a slow process and input intensive. Until cellulosic becomes a reality most analysts expect significant consolidation in the sector with many ethanol startups going out of business. Archer Daniels stands to gain from this consolidation since ethanol is only a fraction of its business and they have a strong balance sheet that would allow them to be the acquirer at the top of the consolidation food chain. IPOs for ethanol companies are being pulled on almost a weekly basis as the price of ethanol continues to decline. Agassiz Energy delayed (translation = cancelled) its $58 million IPO and plans to build a Minnesota plant due to the drop in ethanol prices to $1.50 over the summer. ASAlliance Biofuels formerly pulled its $300 million IPO last week and was sold to VeraSun Energy (VSE) instead. Other listed companies AVR, USBE and PEIX are all trading at or near 52-week lows. Another problem for ethanol use is the lack of pipelines. Since ethanol contains some water the pipeline companies won't allow it in their pipelines. Petroleum products expel water and prevent pipelines from rusting. Ethanol is highly corrosive and the water promotes rust. The cost to construct an ethanol pipeline is about $2 million a mile. Pipeline companies are refusing to put out that kind of money until the production and use of E85 ethanol becomes more prevalent.
This is small cap energy week but we do have a couple larger companies that bear watching. Peabody Energy (BTU) and Valero (VLO) both report on Tuesday. Valero is the largest independent refiner in North America. We saw horrible earnings from Exxon and Chevron because of shrinking crack spreads. A crack spread is the amount of profit between the cost of the crude oil and the value of the refined products. Even though oil is nearing $100 the price of gasoline has stubbornly refused to move over $2.20 until just last week. This puts pressure on refiner profits as seen in the dismal earnings. Valero is different than Exxon and Chevron. Valero can refine the heavy sour crude that is currently plentiful and significantly cheaper than the light sweet crude needed by the other refiners. Valero is not completely insulated from the higher cost of crude but they should report relatively better earnings than we saw last week.
Peabody Energy (BTU) is the worlds largest independent coal company. 10% of the electricity in the U.S. is generated with Peabody coal. Peabody spun off Patriot Coal (PCX) on Wednesday to existing shareholders with one share of PCX for every 10 of BTU owned. By spinning off its low margin coal mining and processing segments in Patriot, Peabody is going to concentrate on the high margin areas and continue to expand globally. PCX had a big day on Thursday but dropped -$2 on Friday. Peabody should report earnings both with and without the Patriot spin off but the guidance should be on a standalone basis. This could either ignite Peabody or crash it back to earth if the guidance is not suitably positive now that they dumped their scraps. Another factor in Peabody's favor is the expiration of some long-term contracts. The older cheaper contracts are expiring and Peabody is rewriting them at current market rates. This should help their future profits. There is also a long list of new coal fired plants in various stages of planning and construction so the future is bright for Peabody even if coal emissions are not. Most utilities can't afford the $3 billion+ and 10-12 years to build a nuclear plant but they can afford the $750 million to build a coal plant.
Last but not least Toll Brothers (TOL) reports earnings, or the lack thereof, on Thursday. The homebuilders are not out of the woods yet and continued economic reports about the sector suggest still worse times ahead. Countrywide's CEO Mozilo said last week "I don't think the worst is behind us" in reference to the housing market. KB Home's Jeff Mezger said, "We anticipate things are going to stay tough for quite some time." The S&P/Case-Shiller report released last week showed home prices fell again for the eighth straight month. On Friday after the close Foreclosure.com reported the totals for the pre-foreclosure listings in October and they rose from 30,000 in September to 128,000 in October. Those are the homes that will be going into foreclosure over the next 60-90 days depending on the requirements in each state. This is a massive jump and it will be mentioned many times over the coming weeks. Coupled with the spike in foreclosures we just saw housing starts hit a 14-year low. Toll Brothers has repeatedly been called a potential turn around candidate and we have seen numerous swings between $20-$24 since it first bottomed there back in July. I don't expect them to be very positive with their earnings next week and I would wait for a breakout over that $24 level before investing any serious money. I might nibble for a trade on a new touch of $20. We still have not seen a bankruptcy of a major builder because most are sitting on a pile of cash from the prior boom. That cash is burning at an accelerated rate as prices come down and inventories go up. Toll should not be in any danger but until it moves back over $24 it is just a trade.
After the bell on Friday news broke that Citigroup CEO Charles Prince or Prince Charles as he is called on the street would be losing his crown. News broke first that there would be an emergency board meeting at Citigroup and that sent shockwaves through the after hours markets. Later the Wall Street Journal reported that Prince would tender his resignation at the emergency board meeting on Sunday. Prince will walk with $31 million in vested stock options from his tenure at Citigroup. Citigroup is losing money on all fronts and the SEC is reviewing how it accounted for those off balance sheet transactions or Structured Investment Vehicles (SIV). Citigroup manages seven SIVs holding $80 billion, much of it in mortgage backed securities and those SIVs are taking heavy losses. Citigroup is the largest player in the $350 billion SIV market. Citigroup is backing a rescue plan where a group of banks would form a "superconduit" to buy assets from these SIVs. Basically a SIV bailout and a way to prevent them from blowing up in their face. Former Treasury Secretary Robert Rubin is rumored to be the temporary successor. Rubin was formerly Chairman of Goldman Sachs. NYSE CEO John Thain is also rumored as a possibility. The emergency meeting is also expected to discuss some additional write-downs on billions in securities continuing to drop in value. This rumor had been making the rounds all week.
Citigroup CEO Charles Prince
Also after the close AIG was rocked by news that ousted CEO Hank Greenberg is considering "strategic alternatives" to increase the value of his remaining shares in AIG. Greenberg was forced out of the company in 2005 amid allegations of fraudulent business practices brought by AG Eliot Spitzer. Greenberg is still fighting the charges and denies any accounting wrongdoing. In Friday's 13D letter to the SEC he said a group of shareholders and other third parties plan to discuss the possible disposition of certain operations and investment opportunities. They also expressed concern over the current management of the company and a possible proxy campaign. Greenberg owns 13.6% of AIG stock. AIG jumped +$2 on the news in after hours trading. AIG had fallen -$12 over the last month on concerns they had undisclosed subprime exposure. AIG reports earnings on Wednesday.
Crude futures rose again to touch $96 after the cash close before easing back to $95.65 at the close of extended trading. Pushing oil back to its highs was news that the U.N. agreed to draft some new sanctions against Iran to be passed in November if Iranian cooperation with the International Atomic Energy Agency did not improve. Investors fear we are creeping towards an armed conflict with Iran that will seriously disrupt oil supplies. Additionally we heard that hurricane Noel may have disrupted some tanker deliveries as it churned around east of Cuba and through the Bahamas. Other analysts think that the new OPEC production scheduled to start on November 1st was hampered by maintenance at some OPEC oilfields. Strange that OPEC would be doing maintenance now when they knew for the last two months that the increased production would begin on Nov-1st. My conspiratorial mind is wondering if this is just another ploy to keep prices high or are they really having trouble increasing production due to accelerating decline rates? It looks very likely that we will see $100 oil next week. These daily $4 moves in crude have put it within striking distance any day now. If Noel really caused a delay in tanker traffic and we have another week of inventory declines we could easily see $110 on the hype. This is a monster bubble with no fundamental basis. Eventually it is going to end very badly.
December Crude Oil Chart - Weekly
U.S. Dollar Index Chart
The US Dollar continued to fall with the dollar index hitting another new low at 76.22. The bears continue to forecast lower lows but there are many claiming we are approaching another oversold bounce like we saw at the beginning of October. Until then gold and other commodities will continue to rise.
Wednesday I warned that there was a strong potential for mutual funds to exit positions now that their fiscal year was over. That came true in spades and was accelerated by the Citigroup downgrade. Volume was very strong and was 10:1 in favor of declining stocks. Had this day come at the end of a multi-day drop it would have been considered a capitulation day. Instead it came after a week and a half of gains. Under normal conditions a major drop like this would be seen as a climax top but I doubt this was the case. It was simply fund dumping day as I explained earlier. The Citigroup news along with several other earnings problems just accelerated the selling. In the table below you can see the sharp drop in advancing volume on Thursday. If it were a capitulation day we would have seen a reversal of those numbers on Friday. Unfortunately the advancers and decliners were almost even as was the volume on Friday. Even more confusing was the new highs and lows. Friday was officially an up day with the major indexes finishing in the green. Those are not the internals you would expect to see on an up day. However, it did not start out as an up day and the Dow made two attempts to push below 13500 and was down -121 points intraday. The rebound into the close may have had a strong short covering component but it was still a COMEBACK day. The Dow recovered from a -121 point drop and two separate tests of 13500 to rebound into positive territory at the close. The two dips under 13500 produced the high volume of 52-week lows shown below. The high volume over 7.7 billion shares also represents buyers stepping in as the funds continued dumping shares they no longer wanted to own.
Market Internals Table
My outlook for next week is bullish. I believe the funds have already dumped anything they did not want to hold or they are going to wait for a higher rebound to make another sales pass. Either way I think the support test on the major indexes was successful and we should move higher from here. That is my opinion and not a guarantee. The Russell returned as a thorn in my side on Friday. There was very little rebound and the Russell remains just above critical support. Since the Russell is my fund manager sentiment indicator it is not yet confirming my bullish outlook. One reason is the probable trend by funds to store money in highly liquid large caps for the rest of the year. This suggests the Russell may continue to languish while the big cap techs power the market higher.
Another thorn in my bullish argument is the financials. They refuse to form a bottom and we have seen many make new lows over the last week. Until that sector recovers any rebound will be limited. The Citigroup and AIG news after the bell on Friday should be beneficial to the Dow at Monday's open. Whether that will be enough to make any difference remains to be seen. We discussed going long a couple financials this weekend but after looking at dozens of charts we could not get comfortable with the plan. The rumor that the Citigroup board would be discussing further write-downs kept cropping up in the discussions.
Here is my dilemma. I want to be bullish and this is historically a bullish period on the calendar. Oil is nearing $100 and has somehow failed to dampen the broader market yet energy stocks are not following suit. Energy is the second largest component of the S&P with financials the largest. Without support from energy and financials it is tough to construct a bullish scenario. Tech stocks are leading and they have been known to drag the broader markets higher but the Semiconductor index is mired in quicksand just over 450. Tech stocks have a tough time maintaining a rally without SOX support. So how do I construct a bullish bias without banks, energy and chips?
I believe all the bad news is priced into the market. Everyone knows the various problems in banking. The tentacles of the subprime slime continue to be found in almost every portfolio but the damage is manageable. Mortgages are foreclosing in record numbers. The major investment banks have confessed billions in write-downs. What other skeletons are lurking in their closet? Wednesday was Halloween and I believe all the skeletons are out of the closet. We all know a scary costume at midnight on Halloween is much less frightening at noon the following day. It is a pile of rags and vinyl waiting to be put away for another year. All those subprime mortgage problems are history and the bright light of a new day is making them a lot less frightening.
In the oil sector we should be seeing new 52-week highs on every oil stock every day of the week. That is not happening because the news of $100 oil is already priced in and it created shrinking crack spreads and falling profits rather than soaring profits and even higher stock prices. Expenses are rising faster than oil prices and production is slowing. The story is already priced into the market and Chevron's 26% drop in profits barely dented the stock price with a whopping 56-cent drop. It was the sharpest drop in profits in five-years but crude is at an all time high. The divergence is not going to last. Profits are going to rise even if crude takes a 10% dive to, are you ready for this, to $87. Yes, a 10% correction would only be to $87. Profits are going to rise and investors are going to pile back into energy stocks on any dip in crude. That dip is likely to come after it tags the $100 mark next week. Valero earnings on Tuesday should reenergize the refining sector if they are as good as expected.
The semiconductor index looks like it is trying to form a bottom at 450. This is strong support and a positive earnings report by Cisco on Wednesday could start a rebound. Almost every major tech including Intel, Microsoft, Dell and Apple has been bullish on current PC demand. Is the worst over for chips? On a side note I noticed Silicon Graphics and Intel are building a supercomputer for the State of New Mexico. The computer will be capable of 172 teraflops (172 trillion) instructions per second. It will have over 14,000 Intel Xeon processors and 28,000 gigabytes of memory. Ok, it is very fast but I wonder if it could actually run Qcharts without the recent 10-second delay? Obviously that is a personal frustration about the overhead on the new 6.0 version but I could not resist the opportunity. If you know of a better alternative send me an email.
So, my bullish outlook assumes (ass-u-me) all the bad news is priced in on financials. Oil, even if it corrects, will still attract new money. Chips have fallen about as far as they are going to go without a massive tech wreck. The Fed is behind us, jobs were very strong and the Q3 GDP was almost 4%. After last week's economic reports the recession bears are heading into hibernation. Interest rates are cheap, China is growing at 11% and every major multinational company reporting earnings has said how strong the global economy is currently. What is wrong with this picture? Housing is the only continuing problem that could still get worse. I reported earlier about the sharp increase in pre-foreclosures for October and that number will continue to grow through March according to most sources. We know this and the bears have been using it as a club against the bulls for months. I believe investors are tired of this story. They know it is bad and going to get worse but we are nearing the turning point. Rather than being afraid of the next real estate report they are looking for a bottom as a buying opportunity. If Toll Brothers actually said something positive on Thursday we could see a surge of buying in the housing sector. I seriously doubt it will happen but I will be eagerly sifting through the report looking for clues.
They say buy when there is blood in the streets. We may not be anywhere near that event but Thursday's decline and Friday's open were about as close as we may get in November. Obviously there could be more fund selling but those who have already sold may be looking to add new positions so the impact will be lessened. The risk we have from now until year-end is tax loss selling but I don't think it will be a major factor this year and I am not going to fret over it. I want to be bullish through Thanksgiving. Of course the market may have other ideas and I will have to adjust my outlook accordingly. I will be bullish until proven otherwise and I hope I don't have to eat these pages in my Tuesday night update.
The Dow returned to retest support at 13500 that dates all the way back to July and was successfully tested a week ago. Obviously a failure at that 13500 level would be catastrophic to my bullish bias. The next major support level is well below around 13000.
Dow Chart - 60 min
Nasdaq Composite Chart - 60 min
Nasdaq-100 Chart - 180 min
The Nasdaq broke out on Monday and ran to a new multiyear high at 2860 before being crushed by nearly 85 points to a low of 2773 at Friday's open. The long-term uptrend is still intact and the Nasdaq closed back over the prior resistance at 2800. I believe this is a bullish sign that big cap techs are still in charge. The chart of the Nasdaq-100 (NDX) is much more bullish and proves the theory on the big cap techs. Last week's decline is barely a blip and was exactly to uptrend support.
The SPX is a charting challenge. The decline to 1492 was a nearly perfect retest of long-term support but the rebound was lackluster thanks to weakness in financials and energy. We also had a lower high on Wednesday and a technically bearish configuration if it is confirmed with another lower high. Until then I am going with the glass half full outlook and the rebound from 1490 as bullish. The NYSE composite is a much better picture of the overall market and the post Fed decline did not come anywhere close to the corresponding level (9700) to the S&P retest at 1490. The 100-day average is well below the current level and rising. This chart suggests a much more bullish view than the S&P.
NYSE Composite Chart - Daily
Russell 2000 Chart - Daily
The Russell 2000 is by far the most bearish chart of the group. We have two
lower highs and a lower low on Friday with a close under resistance. This is
clear evidence fund managers are afraid of the small caps and are parking money
in highly liquid big caps until a confirmed market direction appears. Normally I
would believe the small caps rather than the other indexes but based on the
current calendar timing, economics and market environment I am choosing not to
trust what the Russell
is telling us. Fund managers are looking at the coming 40
days until year-end and seeing some rocky economics and some questionable
earnings. Where normally they would buy small caps in October we saw that trend
begin in late September. As the index returned to near its highs the earnings
warnings and recession fears began to appear in earnest. Funds took profits and
ran to the safety of big caps. With only 40 trading days left in 2007 they are
choosing not to return to the more
risky small caps. It is just a timing problem
ahead of year-end and not necessarily a value call. If they have profits to
protect it makes sense to be cautious. The next 15 days are likely to be the
majority of the Q4 rally. It only makes sense to ride the more stable horses to
the finish line. I look for the Russell to wander for the rest of 2007 and not
be indicative of the overall market. Keep your fingers crossed as we enter the
new week. This week will be crucial to year-end direction.
Deere Co. - DE - close: 152.73 change: +2.18 stop: 144.45
Why We Like It:
BUY CALL DEC 150 DE-LJ open interest=2346 current ask $11.80
*Note - normally a December $60 or $160 call would end with -LL but the CBOE is listing the Dec. $160 call at DE-LV. Double check with your broker.
Picked on November 04 at $152.73
DST Systems - DST - close: 86.58 change: +0.77 stop: 83.45
Why We Like It:
BUY CALL DEC 85.00 DST-LQ open interest= 10 current ask $4.60
BUY CALL JAN 85.00 DST-AQ open interest=2664 current ask $5.60
Picked on November xx at $ xx.xx <-- see TRIGGER
Goodrich Corp. - GR - close: 70.29 change: +1.78 stop: 66.90
Why We Like It:
BUY CALL DEC 70.00 GR-LN open interest=160 current ask $3.20
BUY CALL FEB 70.00 GR-BN open interest=5295 current ask $4.90
Picked on November xx at $ xx.xx <-- see TRIGGER
S&P 100 Index - OEX - close: 704.95 chg: -0.51 stop: 694.99
Why We Like It:
BUY CALL DEC 705 OEZ-LA open interest= 122 current ask $23.60
BUY CALL JAN 710 OEZ-AB open interest= 259 current ask $26.70
Picked on November 04 at $704.95
Petro Canada - PCZ - close: 58.17 change: +2.01 stop: 54.90
Why We Like It:
BUY CALL DEC 60.00 PCZ-LL open interest=820 current ask $1.90
Picked on November xx at $ xx.xx <-- see TRIGGER
PowerShares NDX ETF - QQQQ - cls: 54.42 chg: +0.42 stop: 52.49
Why We Like It:
BUY CALL DEC 54 UQQ-LB open interest=8672 current ask $2.53
BUY CALL JAN 55 QQQ-AC open interest=111163 current ask $2.27
Picked on November 04 at $ 54.42
Research In Motion - RIMM - cls: 126.95 chg: +4.87 stop: 117.49
Why We Like It:
BUY CALL DEC 130 RUL-LV open interest=5725 current ask $11.05
BUY CALL JAN 130 RUL-AV open interest=4386 current ask $13.90
Picked on November 04 at $126.95
Aracruz Celulose - ARA - cls: 76.17 chg: +1.73 stop: 72.49
The $74 region held as support as traders bought the dip in ARA. Friday's rebound is a new bullish entry point to buy calls. Short-term technicals are improving and the P&F chart is still bullish with a $93 target. We are leaving our stop loss at $72.49 but more conservative traders could inch their stop closer to the $73.75 area (near Friday's low). We have two targets. Our short-term target is the $79.90-80.00 range. Our more aggressive target is the $82.50-85.00 range.
BUY CALL DEC 75.00 ARA-LO open interest=13 current ask $5.20
Picked on October 31 at $ 76.89
Boeing - BA - close: 97.76 change: +1.16 stop: 94.85
Bulls bought the dip in BA near its 10-dma. It was an encouraging move following the failed rally under its 50-dma earlier in the week. We had suggested that readers look for a bounce near $96 and the low on Friday was 96.34. Another positive from last week was the new buy signal on BA's Point & Figure chart that now points to a $108 target. We remain bullish here and would use Friday's rebound as a new entry point to buy calls. Our target is the $104-105 zone. More aggressive traders could aim for the highs near $107.
BUY CALL 95.00 BA-LS open interest=1794 current ask $5.50
Picked on October 29 at $ 97.25
BHP Billiton - BHP - cls: 83.73 chg: +1.30 stop: 78.49 *new*
We are changing our entry point on BHP. Instead of waiting for a breakout to a new high we're suggesting that readers buy the bounce on Friday. The big intraday rebound from $80.88 on above average volume looks like an attractive entry to buy calls. We're going to put our stop loss at $78.49 but more conservative traders may want to consider a higher stop closer to $80.00. We're adjusting our targets too. We will have a more conservative target in the $89.00-90.00 range. Plus, a more aggressive target in the $97.50-100.00 range. The P&F chart points to a $104 target.
BUY CALL DEC 80.00 BHP-LP open interest=694 current ask $8.10
BUY CALL JAN 85.00 BHP-AQ open interest=3447 current ask $6.80
Picked on November 4 at $ 83.73
Haynes Intl. - HAYN - cls: 84.12 change: -0.04 stop: 81.49*new*
We are somewhat concerned by the action in HAYN on Friday. The stock did manage to bounce intraday from technical support near the 50-dma. Unfortunately, the bounce failed and the stock closed in the red. This sort of relative weakness is a warning sign. We're reluctant to do it but we're adjusting our stop loss lower to $81.49. You can see on the chart below that HAYN could dip back toward its trendline of support near $82.00. A bounce from that trendline could be used as a new bullish entry point to buy calls. We're not suggesting new positions at this time. Our conservative target is the $89.90-90.00 range. Our more aggressive target is the $94.50-95.00 range. The Point & Figure chart has broken through resistance and points to a $104 target.
Picked on October 28 at $ 86.49
Kennametal - KMT - close: 89.41 change: +0.57 stop: 86.90
Not much has changed since we added KMT on Wednesday night. The stock has been holding support near $88.00 and Friday's rebound from the $88 level is a potential buying opportunity. However, KMT was paring its gains on Friday afternoon. Readers may want to just wait for a new relative high over $91.21 again before initiating positions. Our target is the $99.00-100.00 range. The P&F chart has a triple-top breakout buy signal with a $102 target. We're suggesting a stop at $86.90 but more conservative traders might try a tighter stop near $87.50 or near $88.00. FYI: KMT has a 2-for-1 stock split set for December 19th.
Picked on October 31 at $ 91.21
L-3 Comm. - LLL - cls: 110.06 chg: +2.26 stop: 103.90
The defense sector continues to show strength and the DFI index hit another new all-time high on Friday. LLL contributed to that move with a 2% gain and a new all-time high over resistance at the $110 mark. If you prefer to buy momentum then this is another new entry point. Currently we have a target in the $114.00-115.00 range. We are adding an aggressive target in the $118.00-120.00 zone. More conservative traders may want to tighten their stops. FYI: The P&F chart's bullish target has risen from $133 to $139. Plus, LLL will webcast its upcoming investor conference on Tuesday, November 6th, 2007 at 8:00 a.m. ET.
BUY CALL DEC 110 LLL-LB open interest=148 current ask $4.20
BUY CALL JAN 110 LLL-AB open interest=3151 current ask $5.50
Picked on October 29 at $108.10
Siemens - SI - close: 135.40 change: +4.25 stop: 129.75
Investors applauded news that SI was about to go on a diet. The CEO has decided to cut jobs and tie the management's compensation toward their performance. The share price reacted with a decent bounce on Friday that almost recovered Thursday's losses. We remain bullish and Friday's bounce looks like a new entry point. Currently our target is the $139.85-140.00 range but we're thinking about adding a more aggressive target in the $144-145 zone. The P&F chart is pretty bullish with a $182 target. FYI: SI trades as an ADR here in the U.S. and will most likely gap open one way or the other every session as the ADR adjusts to trading in Europe.
Picked on October 29 at $135.54 *gap higher entry
Sina Corp. - SINA - cls: 57.83 change: +2.33 stop: 53.45
Traders quickly bought the dip in SINA on Friday and the stock added more than 4% on strong volume. Our target is the $59.50-60.00 range but given SINA's relative strength readers may want to be more aggressive. We're going to add a second, more aggressive target in the $63.00-65.00 range. The Point & Figure chart is bullish with an $81 target. More conservative traders may want to tighten their stops toward $55.00. Meanwhile it looks like SINA will report earnings in the November 8th - 22nd range but we still don't have a confirmed date yet. We do not want to hold over the report.
Note: We would suggest selling half or more of your position at our first target. More conservative traders may want to take some money off the table right now!
Picked on October 23 at $ 53.40
(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: 103.67 change: -1.04 stop: n/a
BWA suffered some profit taking on Friday but traders bought the dip twice in the $102.50-102.00 zone. The stock continues to look poised for more gains. We are not suggesting new strangle positions. At this time we have two weeks left on November options. 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
Express Scripts - ESRX - cls: 65.05 chg: +1.06 stop: n/a
ESRX continues to rally and shares closed at a new all-time high. If the stock can add another two or three points it should push the call side of our strangle to our target. We are no longer suggesting new strangle positions on ESRX. 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
Intl. Bus. Mach. - IBM - cls: 114.59 chg: +0.94 stop: n/a
IBM has continued to creep higher the last several days. The lack of a big move on earnings has doomed this strangle play. Unless IBM sees some really big swings in the next couple of weeks this is a bust. 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
Monster Worldwide - MNST - cls: 38.87 chg: -0.03 stop: n/a
MNST failed to move much on the jobs report this Friday. The stock traded sideways in a $1.00 range with a meager bounce from technical support at the 10-dma. At this point our best bet for a profit is to see a strong move to a new relative high toward the 200-dma. We have two weeks left on the November options. 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
Let's face it. Almost everything about options pricing sounds complicated: Black-Scholes model, Greeks, and up and down delta. If I had concentrated on delta's mathematical definition--the partial derivative of the Black-Scholes model with respect to the underlying's price--in my introduction of the Greeks two weeks ago, all but the most mathematically inclined might have stopped reading.
Concepts about option pricing don't have to be complicated. They certainly aren't where it concerns gamma. Delta tells us how much an option's price might change for each one-point move in the underlying; gamma tells us how much delta itself will change when that one-point move is made. Almost everything about gamma seems intuitive when we think about how options' prices change.
We already know that the delta of an option doesn't remain constant as the underlying moves. It can't if delta is near 1.0 for deep in-the-money calls, near 0.50 for at-the-money calls and near 0.00 for far out-of-the-money calls. It can't if the delta of puts changes from 0 to -1.0. Delta must be changing as the price of the underlying moves.
Gamma tells us how much it's changing.
Let's look at an example. At the close of trading on October 26, GOOG closed at 674.60. A NOV 680 call was quoted as follows:
Imagine that GOOG had risen in the last few minutes of trading that day. How would the value of that NOV 680 call have changed?
If we ignore the up-delta effect that was explained in last week's article and all other inputs such as volatility were to stay the same, we could expect value of that NOV 680 to escalate by 0.48 if GOOG were to rise by a single point. But what if GOOG had risen two points? Gamma tells us that for every point GOOG rises, delta will increase by 0.01, so after GOOG had risen that first point, delta would no longer be 0.48. Instead, it would be 0.49. So, still ignoring that up-delta effect, we could expect that NOV 680 call to escalate by $0.97 ($0.48 + 0.49) if GOOG had risen two points, rather than $0.96 ($0.48 x 2).
Gamma is always positive but ranges down to 0.0. That's intuitive, too. We know already that if a call is deep in the money, for example, its value is going to change nearly point for point with any price change in the underlying. It's going to keep changing nearly point for point unless there's a big move. Since delta won't change much unless there's a big change in price, gamma must be zero or nearly zero when options are deep in the money, we reason, and we'd be right.
Gamma is also zero or nearly zero when an option is far out of the money. In this case, delta is also approaching zero. The far OTM option's price isn't going to change much when the price of the underlying changes, and it isn't going to change much until the underlying makes a big move. If gamma measures how much delta is going to change for each one-point change in the underlying, then it's reasonable to expect that it's zero or near zero for an option that's far out of the money. That reasonable assumption turns out to be right, too.
GOOG's option chain on October 26 shows us that our intuitive guesses were right. With GOOG at 674.60, the follow data was found for one ITM and OTM put:
(ITM) GOOG NOV 740 Put:
(OTM) GOOG NOV 600 Put:
With the far OTM 600 put, a value of 0.00 for gamma shows us that GOOG would have to make a big move before that OTM's delta started changing, and, therefore, before the put's price started changing much for each point move in GOOG. With the deep in the money 740 put, the put's value will escalate about $0.87 for each point drop in GOOG until GOOG makes a big enough move to change that value.
If gamma moves closer toward zero the further an option is in the money or out of the money, logic tells us that it would be highest for at-the-money options. We know from the previous study of delta that delta changes the most rapidly for ATM options, once the underlying's price moves. Again logic would be right. In our GOOG example, with GOOG at 674.60, the NOV 670 put and call revealed the following gamma values:
NOV 670 Put
NOV 670 Call
That's not a big value, is it? It might not be, but it's a common gamma value for ATM options that day, still 19 days from option expiration. For example, with the OEX at 717.18, gamma for NOV 715 calls and puts was 0.01.
We learned previously that delta began to change more rapidly for ATM options once option expiration approached. It's possible to compare gamma for OEX NOV 715 calls and puts to the weekly 715's, which were only a week away from expiration on October 26. The weeklies had a gamma of 0.02. That's still not a big gamma, although it's double the gamma of the 715's that had 19 days until expiration.
If you've ever bought an ATM OEX call on expiration Friday and the OEX has risen two points, you know that the call is by then moving almost point-for-point for each gain the OEX makes. Delta has quickly risen to 1.00 or nearly 1.00. While gamma might be only 0.01-0.02 for an ATM option weeks before expiration, it might have risen to 0.20-0.25 the last day an option trades before expiration.
It's obvious that gamma for ATM options increases as expiration approaches. However, the opposite is true of OTM options. Gamma more quickly approaches zero as expiration approaches. Think about delta again as the prediction that the option will be in the money at expiration. As the time to expiration decreases, the probability that the OTM option will be in the money at expiration grows smaller, and its not going to change much unless the underlying makes a big move. Similarly, gamma more quickly approaches zero for in-the-money options as the time for expiration approaches.
Gamma is also impacted by volatility. The lower the volatility of an underlying, the higher the gamma will be for the ATM options. Does this make sense logically? Sure it does. Again, go back to the concept of delta as a prediction of whether the option will be in the money at expiration. If a stock or index isn't volatile and is sitting at the money as expiration approaches, any small movement is likely to move it permanently into or out of the money, so delta will change at a greater rate for any small movement in the price of the underlying. A higher gamma for these low-volatility ATM options predicts that delta will change more rapidly for ATM strikes in a less volatile underlying.
However, if the underlying is volatile, a move of a point or two might quickly be reversed, so doesn't greatly change the prediction of whether the option will be in the money by expiration. Delta isn't going to change much for small moves of the underlying, so gamma should be smaller for the more volatile ATM stock. Two examples show this effect.
DLX @ 40.09 on October 26
OMI @ 40.12 on October 26
The less volatile stock's ATM call had a higher gamma.
The opposite effect is seen with OTM options, however. There, the more volatile stock has the highest gamma.
McMillan notes that when an underlying is extremely volatile, gamma values should remain stable across all strikes when there are at least three months remaining until expiration. He explains that this indicates that the delta of all options could change quite a bit for even a small move in the underlying. I admit finding this concept not as intuitive. In fact, when I took a look at JUN GOOG options, my charting service showed gamma values of 0.00 for nearly all options. I guess that is stable, right?
Perhaps my brain has just had enough logical thinking for one setting, and
perhaps yours has, too. Next week, it will be time to discover how people use
gamma in setting up their options positions, so give your brain a rest.
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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