Option Investor

Daily Newsletter, Saturday, 11/10/2007

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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

No Lipstick For This Pig

It does not matter how much lipstick you apply to last week's market crash to dress it up. The result is still an ugly market. All the bulls have scattered and the bears are firmly in control and enjoying the barbeque. It was a perfect storm that stampeded the bulls with negative press releases pounding their backsides like summer hail. Earnings misses, weak guidance, write downs, questionable economics and weak Fed statements all worked together to sour market sentiment.

Wilshire 5000 Total Market Index Chart - Daily

There were no earth shaking economics out on Friday with the biggest news a sharp drop in Consumer Sentiment. The headline fell to 75.0 and the lowest level since Oct-2005. It was the second lowest reading since the 1990s. To say that consumer sentiment has turned sour would be an understatement. The problem with falling sentiment is its impact on GDP. Over 79% of our GDP is derived from consumer purchases. If consumer wallets tighten as they did post 9/11 the economy will drop like a rock. The internal components fell sharply with the biggest decline in the present conditions component with a drop of -6.6 points. With oil prices at record highs and well publicized by the press there has got to be a lot of apprehension about heating and transportation costs. Heating oil is already at record levels and gasoline can't be far behind. The average price of unleaded rose +10 cents this week to $3.10 but with oil at $96 the real price of gas should be much closer to $4. A dollar increase in gasoline prices represents real pain for most Americans. Most consumers are just finding out they are locked out of borrowing against their shrinking home equity. Not having that home equity ATM available will shrink the holiday purchases and cancel many home improvements, auto upgrades and even college tuition. The Michigan Consumer Sentiment survey focuses more on consumer finances rather than economics and the equity markets. As such it is the leading indicator for consumer stress.

Consumer Sentiment Table

Consumer Sentiment Chart

Friday's other economic reports included Import and Export Prices and International Trade. Import Prices spiked +1.8% in October but most of that was directly attributable to the +6.9% rise in crude over that period. International Trade was basically flat at -$56.5 billion in September compared to -$56.8 billion in August. This is a trailing number and has no impact on the markets.

Next week we will get the two major inflation reports, the Producer Price Index (PPI) and the Consumer Price Index (CPI). These reports will show how much inflation due to record oil prices has made its way into manufacturing costs and finally into consumer prices. The estimates are for a slower rise in prices in the PPI to only 0.3% growth from 1.1% rise in September. Personally I think this is wishful thinking but they did not ask me. I can't imagine that crude prices haven't caused another strong spike in manufacturing costs. However, the key is how much of that cost the producers are passing along to the retailers. If business is slow they may elect to eat some of the costs and keep prices for their products artificially lower. The CEO of DOW said on CNBC this week that they are using about one million barrels of oil or oil equivalent per day in their manufacturing processes. That annual crude cost has risen to $22 billion in 2007. They have to pass those costs along in their products.

The CPI rose +0.3% in September and I have a hard time believing we are not going to see another 0.3% rise or even higher. Fortunately some consumers will not have to pay those higher food and energy costs because the government does not take food and energy into account when calculating their "core" rate of inflation. As long as you don't eat, heat or drive your rate of inflation will be very low. These reports have a good chance of roiling the markets on Tuesday and Wednesday.

The Philly Fed survey is the next material report on Thursday and will show how economic conditions have changed in the Philadelphia region. This report has a strong correlation with the national ISM and is seen as an interim look at the next ISM, which is not due out until Dec 3rd.

EEconomic Calendar

The Bernanke testimony last week did not help the market. His sometimes-stumbling answers suggested he was either unsure of how to form his answers or trying to create his own form of Greenspeak to confuse the committee members. It was clear that inflation was still the "official" worry but it was also clear that the problems in the financial sector were growing again. This prompted a rise in the chance of an unusual December rate cut from 80% before the testimony to 115% when it was over. The next FOMC meeting is on Dec-11th, an even 30 days from today. There will be a lot of water flow under the economic bridge by then so any rate speculation today is worthless.

This was an ugly week in the markets and my "all the bad news is priced in" bullish theory from last weekend is deader than a bull in a slaughterhouse. The digital ink was barely dry on last Sunday's newsletter before Citigroup said they could see as much as another $10 billion in write-downs. The positive news that CEO Charles Prince abdicated the throne at Citi was overshadowed by the news of massive additional losses. That killed the entire finance sector on the more than one cockroach idea. If Citi was going to take another $10 billion hit only a few days after announcing the first write-down then who else was going to come back to the market with a second or even third confession? Turns out those fears were not baseless. Morgan Stanley (MS) was quick to follow suit with news it was going to take nearly $3 billion in subprime losses. That confession prompted even more financial weakness and turns out it was also justified.


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Wachovia (WB) quickly jumped into the news with a $1.1 billion charge hoping that their minor charge compared to some of those already announced and still rumored would be ignored. AIG also disclosed earnings would be damaged by subprime losses. On Friday, just as the financials were beginning to rebound from the week's events JP Morgan announced it would be taking undisclosed additional losses on its CDO and LBO portfolios. They have $6.8 billion in unsold CDO positions and $40.6B in leveraged loans and unfounded commitments. They will not write down all of it but you can bet the number will be large. They also expect to lose up to $270 million per quarter over the next several quarters on their home equity portfolio due to defaults and foreclosures. JP Morgan said that because of declining market and economic forces their "loan losses may keep rising." Adding to the negative news on Friday was an announcement from Bank America (BAC) that "continued market dislocations," including CDO mortgage securities it owns, will adversely impact Q4 results.

Also on Friday Capital One (COF) warned that its charge off rate on U.S. cards rose to 5.11% in October compared to 4.13% for all of Q3. They said the default rate, cards over 30 days past due, rose to 4.75%. COF just raised their forecast for credit losses on Tuesday. The conditions are changing much faster than expected according to Credit Suisse. There were rumors all day Friday that Barclays (BCS) would announce a $10B write-down. The rumors were so strong that the CEO had to make an announcement denying it. Even untrue the rumor had a lot to do with the negative market sentiment.

After the close E*Trade (ETFC) withdrew its earnings guidance for 2007 citing significant pending write-downs on its fixed income holdings. E*Trade is holding $3 billion in asset backed securities and $450 million of CDOs. E*Trade said in a regulatory filing on Friday that its portfolio of the highest possible credit rated debt had now been downgraded to below investment grade and would force a significant write-down of its assets. In September ETFC slashed its outlook and said it was getting out of the mortgage business. In October ETFC wrote down $200 million in mortgage-backed securities and slashed its earnings guidance to 75-90 cents. On Friday they said they were removing that guidance and investors should not expect those earnings to be achieved. ETFC fell -15% in after hours trading.

Table of Announced Charges

There are many indications the corporate credit market is locking up again. With the potential for tens of billions more in write-downs nobody wants to buy paper or loan money. The August debt wreck is returning just as a new tech wreck has wiped out the last bullish sector. The mortgage market has almost completely locked up with 79% of loans being declined for various reasons and almost no home purchases actually being funded. Funded loans have fallen nearly 80% from October 2006 levels.

The financial stocks were trying to put in a bottom until Wednesday's confessional series knocked the floor from under the sector. It was not enough that the financials fell off the cliff again but GM had to tank the market with its $39 billion loss for Q3. The non-cash loss was mainly related to accumulated tax credits but that did not help GM stock or market sentiment. Just as announcements of big buyouts and acquisitions gives the market a bullish boost the announcement of major losses rekindles fear in the hearts of bulls and emboldens the bears. There was a lot of hope destroyed last week and the bears must be feeling as indestructible as Superman.

I have been telling everyone since the tech rebound began in September that fund managers were storing their money in big cap techs where it could be easily withdrawn in case the economy took a turn for the worse. I cautioned for the last week that the Russell was not following the techs higher and that meant fund managers had no conviction about the market rally. Last week I mentioned that Cisco had the potential to push the markets over resistance as long as John Chambers continued his "best business conditions" mantra when they discussed guidance. Cisco turned out to be the Achilles heel for the tech sector. Earnings rose +37% but that tidbit of information was forgotten when the guidance comments hit the wires. Orders from large U.S. corporations were down -20% over the comparison quarter. Tough to say "best business conditions" when the U.S. is spiraling downward in tech orders. U.S. service providers spending makes up 25% of Cisco's earnings and that order growth pulled back from low 20% range to high teens. Analysts said that was a bigger problem than the slowdown in enterprise spending. Over the last two days since reporting earnings Cisco stock has lost more than 16% and over $30 billion in market cap. Bernanke accelerated the tech sell off when he said on Wednesday that the Fed saw growth slowing in Q4 and remaining sluggish through the first part of next year. Investors heard "sharp drop in orders" from Cisco and slowing growth for 2-3 quarters from Bernanke and put 2+2 together and got "sell" as the answer.

Those big cap techs deflated faster than a popped balloon at a birthday party. IBM lost 12% from the week's highs but it was the earnings contrast that mattered. IBM also reported better than expected earnings back on Oct-16th but saw weakness in both hardware and software orders. Trading at $120 before their earnings they only lost $5 on the news and had been trading sideways at $115 for the last three weeks. When Cisco reported the same drop in hardware orders the bottom fell out. IBM lost nearly $15 for the week on the Cisco news. The point here is that Cisco is seen as a leading edge provider. Companies can't build out data centers and add lots of computing power without Cisco network switches to connect it all together. Those networks are planned well in advance and are put in place before the banks of servers that will eventually run on them. It could take years to fully populate the server farms but the Cisco gear has to be in place first. If Cisco is seeing a sharp drop in U.S. orders then everyone else will see a corresponding drop for new equipment. You may remember SunMicro (JAVA) reported earnings on Monday that disappointed due to sluggish server sales. Sun's server unit growth has been negative for three consecutive quarters. That was largely seen as a SunMicro specific problem until you combine it with the same comments from other vendors. Add all the puzzle pieces together, IBM, Cisco, SunMicro and others and you get an ugly forecast for tech spending and economic growth in North America. That picture did not become really clear until the Cisco guidance connected all the pieces together. You should notice in the table below that the stocks with the largest recent gains were also the ones with the biggest losses. Fund managers finally saw the picture and took their funds out of what had been seen as a safe deposit box up until last week. The big cap Nasdaq-100 or NDX gave up -8.1% for the week.

Big Cap Tech Losses Last Week

NDX Chart - 90 min

Also causing market stress and confirming the sharp drop in consumer confidence was a terrible Chain Store Sales report on Thursday. It was the worst October sales since 1995. Warmer weather was blamed but the weather is always blamed for any disruptions. Since furniture stores were the biggest losers with a -4.4% drop that tells me that it was not entirely a warm weather problem. 67% of the chains reporting missed sales estimates. Wholesale clubs, SAMS and Costco, reported a 5.8% jump in sales but it was mostly in gasoline sales as consumers hunted for the cheapest gas possible. The extra volume and the nearly 35-cent per gallon jump in gas prices during the month produced the sharp jump in wholesale club sales. It was not clothes, napkins, monster bottles of ketchup or cheap electronics powering those gains.

S&P Retail Index Chart - Daily

Dow Transport Index

The Transportation Index collapsed on high oil prices and fears of lower shipments over the holiday season. UBS cut AMR to a sell saying the 30% increase in fuel costs could not be absorbed by the small rise in ticket prices. A survey of business travel plans showed that large companies were cutting back heavily on travel with plans for even more cutbacks ahead. As oil prices continue to rise over the coming years the era of video conferencing is finally going to arrive. You may have seen the Cisco videophones in dozens of movies over the last year as Cisco tries to imprint the video phone/conference image on the civilian population. Hewlett Packard is also pushing their videoconference rooms where conferees sit on one side of a large conference table with the other side a video wall giving the appearance of everyone else at the other side of the table. I have seen one of these setups and it is very nice. It is a lot cheaper than flying five people across the country for a group meeting. I suspect in the not too distant future nearly every mid to upper scale home office will have a videoconference setup other than a videophone. A friend moved across the country and his valued secretary of many years refused to move due to family. Instead of losing her he created an office in her home and paid to wall mount a 52 inch LCD TV and camera in her home office and an identical arrangement in his office. Now thanks to broadband Internet costing only a couple hundred dollars a month they "work" in the same office all day long despite being thousands of miles apart.

Another evidence of cooling consumer spending even at very high levels was the failure of the Sotheby's art auction. Paintings by Van Gogh, Picasso, Renoir and Gauguin failed to garner even the minimum bid. The sale was expected to bring in $400-$557 million but instead found bids on only $269 million in paintings. Sotheby's filed a notice with the SEC on Friday saying they lost $14.6 million in the auction because they have to guarantee a certain price for some paintings to secure them for the auction. Auctions attract a better crowd if they have a lot of high value and hard to get art to draw in the collectors. The auction house secures the key pieces by guaranteeing a certain minimum bid. 26% of the paintings did not even get a bid and bidding on those that did sell was lackluster according to JMP Securities analyst Kristine Koerber. A Bank of America analyst Dana Cohen said this was clearly evidence of the credit crunch and mortgage market playing out in America. She said the various data points they track are suddenly showing heightened risk of consumer weakness. Sotheby's (BID) fell -35% to $33 after the auction.

You would think with crude oil still over $96 that oil stocks would be strong. That is not the case with stocks like Exxon, the largest U.S. oil stock, down -2.57 on Friday. Refiners were still declining even though the retail price of gasoline had risen to $3.10 by Friday. The price of oil should actually have been higher than it was on Friday. The North Sea is experiencing a once a decade type of storm and there are some huge crude flows being halted. Statoil shut in 320,000 bpd, Conoco 140,000 bpd and BP 80,000. They only expect the impact to be 5-days or less but that is as lot of oil out of the market. OPEC is meeting next weekend but there are no production discussions on the schedule. The OPEC president said any changes in output would not be discussed again until the December meeting. That suggests there will be no output changes until January at the earliest. Venezuela tried to get them to discuss using a basket of currencies for payment instead of dollars but OPEC officials said it was not on the schedule. Iran and Venezuela have been trying to switch payment to some other currency than dollars more as a irritant against the U.S. than a real change in the process. With the dollar at 40-year lows that kind of discussion becomes even more relative as a real way to increase income. With the dollar shrinking in value every day the value they receive for every barrel is also shrinking. Crude options expire on Tuesday and the December crude futures expire on Friday. To say "expect volatility in crude next week" would be an understatement.

Next week is also regular option expiration and the volatility we saw last week could have been in part to those expiring options positions being rolled forward or just closed instead. One major options analyst said there was a good chance the holders of the S&P options would try to move prices higher before Friday morning's expiration and then dump the index again on Friday. With earnings basically over and a 3% to 8% drop in the various indexes over the last week there are going to be a lot of options trading next week and $billions in calls expiring worthless.

In the market internals table below it would appear that we had a capitulation day on Wednesday with volume 10:1 in favor of decliners. Unfortunately the selling continued on Thursday with the end of day rally sold hard at the open on Friday. The volume does not show it at 3:1 declining on Friday but the actual index losses were much worse than the internals. Note there were only 79 new highs on Friday and when you look at the charts all the indexes closed at the lows. Normally you would have an end of day short covering spike on the Friday of a losing week. Instead we had a strong end of day crush of selling. That was prompted by the late afternoon news of the new JP Morgan write-downs and rumors of several others. It was an ugly finish to an ugly week.

Market Internals Snapshot

Dow Chart - 5 min

The Dow was led lower on Friday by IBM, MMM, XOM, BA, CAT and GM. The big losers offset gains in AIG and MRK and losses accelerated into the close. In the two charts below I have highlighted the various major support levels for the Dow and they are not pretty. Friday's close was right at major support at 13000 and I would like to think the damage was over and we will rebound from here but nothing in the analysis supports this possibility other than a possible oversold bounce or option expiration games. If the Dow breaks 13000 it could get really ugly very quickly.

Dow Chart - Weekly

Dow Chart With Averages - Daily

The biggest challenge for the Dow and several other indexes is the violation of the 200-day average. For the Dow it is 13218 and Friday's close was 13042. There is no ambiguity there. It is definitely broken and that suggests there could be a lot more fund selling next week. There is no klaxon that will be blaring when traders walk in on Monday morning with the head trader yelling "sell, sell, sell" like the captain of a submarine yelling dive, dive. It is however a strong indicator funds do watch. If the market somehow rebounds back above that level next week then the tensions will ease and traders back away from the sell button. If it appears we are going to break 13000 to the downside I believe we could easily see a lot of funds lighten up into year-end. They do not want to lose their profits and their bonuses by holding tight with white knuckles and try to hope their positions back into the green. It will be a case of simple self-preservation. Take profits and wait until 2008 to make a new investment decision. A fund manager long techs since January would have been up +25% or so at last week's highs. They gave back 8% or one-third of their profits in only three days. Do you think that has caused more than one Maalox moment this weekend? I would bet on it.

The Dow, S&P and Wilshire 5000 have all violated the 200-day average. The Russell has been fighting it for two months and finally gave up on Nov-1st and has seen nothing but selling since then. The Nasdaq and NDX are still well above the 200 with the NDX resting on the 100-day at Friday's close. The 100-day has not been critical support but more or less a warning track that the 200 was just ahead. There is no reason to expect the NDX-100 to hold next week based on the history for the last year. The 200-day is historically considered strong support for tech stocks. The last time it was broken other than the single day dip in August was May of 2006 and the NDX spent four months trying to recover before moving back above the average. Again, it is not an immediate sell signal and the average can remain in play for weeks just as long as a major break does not occur. The Nasdaq Composite is less precise and can wander all around the 200 without any material damage.

Nasdaq Composite Chart - Daily

NYSE Composite Chart - Daily

S&P-500 Chart - Daily

The NYSE Composite touched the 200-day on Friday at 9683 but managed to hold the high ground. The NYSE Composite does not have a strong track record of respecting the 200 but it does seem to acknowledge it. In reality it is millions of traders watching individual stocks that force any index to respect support. It is not a group of fund traders waiting for any specific index other than the S&P-500 to decide to sell or hold. The NYSE may be showing less selling than the other indexes because of the diverse nature of the stocks on the NYSE. I would like to attribute some bullish sentiment to the market from the strength in the NYSE but that does not work this week.

Last week I told you I was bullish and to buy the dips above 13500 and Nasdaq 2780. That lasted until about 11:AM on Wednesday when the bottom fell out due to GM's monster loss and new revelations on loan losses. In theory everyone would have switched to a bearish bias by noon on Wednesday. Unfortunately, theory never works in real life unless it is being used against you. This week is going to start out with a bearish bias and I can't think of any reason today to switch back to bullish unless there was a sudden and miraculous turn around in the markets that demanded to be bought. I can't conceive of that possibility today. We are at support on the Dow but there are simply too many negative economic factors to just assume traders will buy the dip. With the credit markets locked up again and daily confessions of new loan losses it is not a buying opportunity.

The exception here could be a trading opportunity. Remember, this is expiration week and those funds long S&P options may try to game the index as the week progresses. That game ends at Thursday's close. Unfortunately I am not clairvoyant enough to see even a glimmer of that trade in my crystal ball. With negativity this strong it would take some monster buy programs to push the S&P back into a positive trend. This is going to be one of those weeks where we just follow the intraday trend and be fully aware that trend can change several times a day as the VIX approaches 30 again. About the only thing I can promise you for next week is at least one attempt at an oversold bounce and increased volatility as options expire. If you are trading energy stocks remember crude options expire on Tuesday and futures expire on Friday. Crude inventories will be reported on Thursday instead of Wednesday due to the Veterans Day holiday on Monday. If inventories actually show a build this week that last day of trading on the December contract could be extremely volatile.

I said last Sunday that the last week would be crucial to year-end market direction. I believe that again for next week. What happens next week will determine if it was just a normal bout of post earnings profit taking accelerated by news events or the beginning of a new trend. This week could clarify that question. This is not the week to be bold in the market regardless of what you are buying. Be patient and let's see if Dow 13000 will hold and I will update my views on Tuesday evening.

New Plays

New Option Plays

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

Play Editor's Note: I seriously considered not adding any new plays to the newsletter this weekend. Everything looks bearish. Yet how can any trader confidently add new bearish positions after a 200-point drop in the NASDAQ and a 600-point drop in the DJIA in just the last three days. Stocks are very short-term oversold and due for a bounce. Adding bearish positions now is just asking to get stopped out on an oversold bounce. However, the major averages closed near their lows for the session and the only thing that stopped them from hitting new lows for the day was the closing bell. Without a doubt the market's trend and attitude has changed and any fourth quarter rally is in serious jeopardy right now. We are adding a couple of plays this weekend but I am urging an extra level of caution on entering and exiting anything at the moment. FYI: A few stocks we're keeping an eye on as potential plays are ATI, AZO, BHP, FCX, FDX, MO, PCAR, and RIG.

P.S. I want to remind readers that November options expire this week after Friday, November 16th.

New Calls

None today.

New Puts

Chipotle Mexican Grill- CMG - cls: 121.60 chg: -5.83 stop: 125.55

Company Description:
Chipotle Mexican Grill offers a focused menu of burritos, tacos, burrito bowls (a burrito without the tortilla) and salads made from fresh, high-quality raw ingredients, prepared using classic cooking methods and served in a distinctive atmosphere. Chipotle opened its first restaurant in 1993 and operates more than 670 restaurants today. (source: company press release or website)

Why We Like It:
CMG reported earnings in late October. The results were better than expected. Following the report two different analyst firms raised their price target on CMG to $150. Shares of CMG quickly shot up to $141 but that proved to be the peak. The bullish trend is now in jeopardy as CMG has pulled back toward support near $120 and its rising 50-dma. Odds are pretty good that the market will see an oversold bounce soon and we wouldn't be surprised to see CMG bounce near $120. However, if the market continues to sell-off then CMG is likely to breakdown. We're suggesting a trigger to buy puts at $119.45. If triggered our target is the $112.00-110.00 range. One of the biggest risks for us is that CMG might dip under $120 on an intraday basis and then rebound again. More conservative traders may want to play with tighter stops.

Suggested Options:
If CMG hits our trigger at $119.45 then we would suggest the December puts.

BUY PUT DEC 120 CMG-XD open interest=770 current ask $8.00
BUY PUT DEC 115 CMG-XC open interest=301 current ask $6.00
BUY PUT DEC 110 CMG-XB open interest=514 current ask $4.40

Picked on November xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/30/07 (confirmed)
Average Daily Volume = 697 thousand


Dryships - DRYS - cls: 97.13 change: -4.07 stop: 108.75

Company Description:
DryShips Inc. is an international provider of drybulk cargo marine transportation services. Headquartered in Athens, Greece, DryShips owns and operates a fleet of 44 drybulk carriers comprising 5 Capesize, 29 Panamax, 1 Supramax, 1 Handymax and 8 newbuilding drybulk vessels, with a combined capacity of approximately 4.0 million deadweight tons. (source: company press release or website)

Why We Like It:
If we have any adrenaline junkies and thrill seekers then this play is for you. DRYS has produced some truly amazing gains in the last twelve months. Now that bullish trend appears to have finally run out of fuel and those gains are clearly being targeted for profit taking. As we all know, it's not a gain until we collect it. The challenge is that DRYS can be a very volatile stock and the options are expensive because of it. Furthermore, we can't find what the current level of short-interest is but it wouldn't surprise us if the short-interest was above average. Given DRYS' small 18.6-million share float that raises the risk of a short squeeze. Now toss into the mix a market that is short-term oversold and due for a bounce and you see some of our risk! Looking at the chart the trend has clearly rolled over and DRYS' breakdown under support at $100 and its 50-dma is our entry point for puts. We have a fairly wide stop loss but our target is the $80.50-80.00 range near the rising 100-dma.

Suggested Options:
We are suggesting the December puts.

BUY PUT DEC 100 DQR-XT open interest=1049 current ask $13.60
BUY PUT DEC 95 DQR-XS open interest=1760 current ask $10.80
BUY PUT DEC 90 DQR-XR open interest=1570 current ask $ 8.40
BUY PUT DEC 85 DQR-XQ open interest= 932 current ask $ 6.30

Picked on November 11 at $ 97.13
Change since picked: + 0.00
Earnings Date 10/27/07 (unconfirmed)
Average Daily Volume = 3.5 million

New Strangles

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Anadarko Petrol. - APC - cls: 57.61 change: -1.96 stop: 55.99

Crude oil may be trading near record highs but it is not translating into strength for oil stocks, at least not on Friday. APC did happen to hit new highs on Wednesday and Thursday this past week but hit profit taking on Friday with a 3.29% loss. Both APC and the OIX oil index have pulled back toward what should be support at its trendline of higher lows. Unfortunately, given the market's bearishness we would hesitate to open new bullish positions at this time. More conservative traders might want to tighten their stops toward $57.00 or the $56.50 levels. Our target is the $64.85-65.00 range. The P&F chart points to an $86 target.

Suggested Options:
We are not suggesting new call positions in APC at this time but if the stock does rebound and provide a new entry point we would suggest the December or January calls.

Picked on November 07 at $ 60.55
Change since picked: - 2.94
Earnings Date 11/05/07 (confirmed)
Average Daily Volume = 3.9 million


Deere Co. - DE - close: 153.03 change: -4.88 stop: 152.75

Shares of DE lost just over 3% on Friday's market sell-off. The stock looks poised to drop toward the $150.00 level and odds are good that DE will hit our stop loss at $152.75 on Monday morning. The only reason we do not drop the stock as a play right now is that there is still a chance that markets will see a sharp oversold bounce on Monday. Otherwise, we do expect to be stopped out. We would watch the $150 level or the 50-dma as a potentially bullish entry point for new positions. DE already hit our first target near $160. Our second target is the $164.00-165.00 zone.

Suggested Options:
We are not suggesting new bullish positions in DE at this time.

Picked on November 04 at $152.73
Change since picked: + 0.30
Earnings Date 11/21/07 (unconfirmed)
Average Daily Volume = 2.4 million


ITT Educational Ser. - ESI - cls: 126.48 chg: -3.99 stop: 122.49

Correction: On Thursday we added ITT Educational Services as a new call play. The symbol for the stock is "ESI". We put "ITT" as the symbol, which is for ITT corp. The option symbols we listed below were for "ESI".

Shares of ESI had displayed some very impressive relative strength during the market's weakness on Wednesday and Thursday last week. Unfortunately, the stock finally gave in to profit taking during Friday's decline. We suspected that broken resistance near $127.50 would act as support for ESI but shares slipped through that level and look headed for the $125 zone. More conservative traders might want to raise their stops toward the $125 level to reduce their risk. We would wait for a bounce near $125 or a new relative high over $130 again before considering new call positions. Our target is the $139.75-140.00 range.

Suggested Options:
Wait for a new entry point. We are suggesting the December or January calls. It is up to each individual investor to decide which month and which strike price best suits their trading style and risk.

BUY CALL DEC 130 ESI-LF open interest= 67 current ask $5.60
BUY CALL DEC 135 ESI-LG open interest= 83 current ask $3.60
BUY CALL DEC 140 ESI-LH open interest=154 current ask $2.20

BUY CALL JAN 130 ESI-AF open interest=554 current ask $ 8.00
BUY CALL JAN 135 ESI-AG open interest=190 current ask $ 6.10
BUY CALL JAN 140 ESI-AH open interest=887 current ask $ 4.20

Picked on November 08 at $130.47
Change since picked: - 3.99
Earnings Date 01/24/08 (unconfirmed)
Average Daily Volume = 426 thousand


Goodrich Corp. - GR - close: 70.74 change: -1.16 stop: 66.90

Shares of GR have been holding up pretty in the face of such widespread market weakness. The stock hit new highs midweek and the profit taking has been minor. Shares are holding above broken resistance and what should be support near $70.00. Look for a dip to and a bounce near $70.00 as a new bullish entry point. More conservative traders may want to raise their stop loss closer to the rising 50-dma near $67.90. Our conservative target is the $74.90-75.00 range. Our more aggressive target is the $78.00-80.00 range. The P&F chart is bullish and points to a $99 target. FYI: The last candlestick on the weekly chart does look like a short-term top. Traders need to play defensively.

Suggested Options:
If GR provides a new bullish entry point we would suggest the December calls.

Picked on November 05 at $ 71.05
Change since picked: - 0.31
Earnings Date 10/25/07 (confirmed)
Average Daily Volume = 1.0 million


Icon Pub. Ltd. - ICLR - close: 59.75 chg: +0.16 stop: 55.90

ICLR continues to show a lot of strength. Shares hit a new two-week high on Friday while the rest of the market was falling. Volume on the current rally has been improving and Friday's volume was more than double the norm. We remain bullish here. However, if you're looking for a new entry point consider waiting for a dip back toward $58.50-58.00. More conservative traders could adjust their stop higher toward $57.00. Our target is the $63.50-65.00 range. We would consider this a higher-risk play for the simple reason that volume is so low on both the stock and the options. FYI: More aggressive traders may want to aim higher.

Suggested Options:
If ICLR provides a new entry point we would suggest the December calls.

Picked on November 06 at $ 58.79
Change since picked: + 0.94
Earnings Date 10/23/07 (confirmed)
Average Daily Volume = 107 thousand


L-3 Comm. - LLL - cls: 111.70 chg: -1.69 stop: 107.99

LLL held up very well. Shares only gave back 1.49% during the carnage on Friday. We would expect further declines but LLL might find support near its 10-dma and the $110 level. A bounce near $110 could be used as a new bullish entry point for calls. More conservative traders might want to think about raising their stops toward $109 or $110. LLL has already hit our first target in the $114-115 range. Our second, more aggressive target is the $118.00-120.00 range. FYI: The P&F chart's bullish target has risen from $133 to $139.

Suggested Options:
We are not suggesting new positions at this time but if LLL does provide a new entry point (like a bounce near $110) then we would suggest the December or January calls.

Picked on October 29 at $108.10
Change since picked: + 3.60
Earnings Date 10/25/07 (confirmed)
Average Daily Volume = 627 thousand


Las Vegas Sands - LVS - cls: 115.91 chg: +4.31 stop: 107.45*new*

Target achieved. LVS produced a sold rebound on Friday. The stock dipped to $108 early Friday morning and shot higher. Shares hit $118.75 before paring its gains. Our initial target was the $116.90-117.50 range. We're not suggesting new positions at this time. It looks like LVS will pull back on Monday. Wait and watch for a bounce in the $112.00-110.00 zone. We're going to raise our stop loss to $107.45. Our secondary, aggressive target is the $121.00-122.50 zone.

Suggested Options:
If LVS provides us another entry point we would suggest the December or January calls.

Picked on November 08 at $111.60
Change since picked: + 4.31
Earnings Date 11/02/07 (confirmed)
Average Daily Volume = 4.0 million


Northrop Gruman - NOC - cls: 82.47 chg: -1.43 stop: 79.99

We have been suggesting that readers look for a pull back into the $82-83 zone as a potential entry point in NOC. The stock has complied. The intraday low on Friday was $82.11. A bounce from here can be used as a new bullish entry point to buy calls. However, we would be very cautious. It might pay off to just wait a day, may be two, to see where the market bounces and if any further weakness pulls NOC toward support near $80 and its rising 50-dma. Our target is the $89.00-90.00 range. The P&F chart shows a bullish catapult pattern with a $92 target.

Suggested Options:
If NOC provides a new bullish entry point we'd suggest the December or January calls.

Picked on November 06 at $ 84.48
Change since picked: - 2.01
Earnings Date 10/24/07 (confirmed)
Average Daily Volume = 1.4 million


Petro Canada - PCZ - close: 57.71 change: -1.97 stop: 54.90

Until Friday shares of PCZ had been relatively resistant to the market's weakness. The stock succumbed to market weakness and lost 3.3% on Friday. At this point we would look for a bounce near $57.00 or $56.00 as a new bullish entry point to buy calls. Readers might want to consider a tighter, more conservative stop loss. Our target is the $64.50-65.00 range. FYI: We are going to point out that the daily chart's RSI indicator has a bearish divergence of lower highs versus the stock's price.

Suggested Options:
If PCZ provides a new bullish entry point we would suggest the December calls.

Picked on November 06 at $ 59.25
Change since picked: - 1.54
Earnings Date 10/25/07 (confirmed)
Average Daily Volume = 742 thousand


PetroChina - PTR - close: 201.89 chg: + 1.64 stop: 189.49

PTR had produced a decent bounce by late Friday afternoon, up to $207.95. Unfortunately, the very late day wave of selling erased most of PTR's gains. We can probably expect more weakness on Monday. Asian markets will most likely turn lower in reaction to our weakness on Friday. Thus when trading in New York opens on Monday shares of PTR might gap lower. The stock "should" find some technical support near the 50-dma around $196 but that might be too optimistic. If PTR can bounce from here or anywhere in the $195-205 zone we would use it as a new bullish entry point to buy calls. Remember, this is a high-risk, aggressive play. PTR can make huge intraday moves and the options are expensive because of it. We have two targets. Our first target is the $219.00-220.00 range. Our second target is the $229.00-230.00 range.

Suggested Options:
If PTR bounces again we would suggest the December or January calls.

Picked on November 08 at $200.25
Change since picked: + 1.64
Earnings Date 03/08/08 (unconfirmed)
Average Daily Volume = 1.5 million


Steel Dynamics - STLD - close: 49.58 chg: -2.31 stop: 49.25

Investors decided to sell STLD in spite of its tempting bounce on Thursday. The stock spiked lower at the open on Friday and eventually closed under what should have been round-number support at the $50.00 mark. STLD is very close to our stop loss at $49.25 and odds are very high that we will be stopped out on Monday morning. The only reason we don't drop STLD from the newsletter now is the chance that stocks might see an oversold rebound on Monday morning. We're not suggesting new positions. FYI: If you look at the chart more aggressive traders might be tempted to widen their stop under $48 or the bottom of its rising channel.

Suggested Options:
We are not suggesting new bullish plays in STLD at this time.

Picked on November 06 at $ 52.93
Change since picked: - 3.35
Earnings Date 01/23/08 (unconfirmed)
Average Daily Volume = 1.7 million


Tesoro - TSO - close: 56.02 change: -0.28 stop: 54.59

Bulls bought the dip in TSO near $54.60 for the third time in one week. While this is encouraging we are not suggesting new positions at this time. A rally past $57.50 or its 10-dma might change our mind and could be used as a new bullish entry point. We are going to adjust our stop loss slightly to $54.49 just to give us a little bit more room. Our target is the $64.00-65.00 range.

Suggested Options:
If TSO provides a new bullish entry point we would suggest the December or January calls.

Picked on November 06 at $ 59.13
Change since picked: - 3.11
Earnings Date 01/29/08 (unconfirmed)
Average Daily Volume = 5.4 million

Put Updates


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: 98.32 change: -3.24 stop: n/a

It looks like it's game over for our BWA strangle play. As of October 31st it looked like the call side of our strangle would hit our target but the momentum ran out of steam. Now shares have broken down under $100. We have five days left before November strikes expire. 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.

Suggested Options:
We are not suggesting new positions in BWA.

Picked on October 23 at $ 95.67
Change since picked: + 2.65
Earnings Date 10/25/07 (confirmed)
Average Daily Volume = 392 thousand


Express Scripts - ESRX - cls: 62.22 chg: -1.82 stop: n/a

ESRX lost almost 3% on Friday and shares have broken below its 10-dma. However, in spite of the pull back the trend is still bullish. Unfortunately, we do not have positive expectations that this play is going to reach profitability. There are five days left for November options. 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.

Suggested Options:
We are not suggesting positions in ESRX.

Picked on October 21 at $ 59.65
Change since picked: + 2.57
Earnings Date 10/24/07 (confirmed)
Average Daily Volume = 2.1 million


Monster Worldwide - MNST - cls: 35.78 chg: -1.88 stop: n/a

If the stock market continues to sell-off then the put-side of our strangle might have a chance but we're not counting on it. MNST would need to drop toward $32.00 and break down under support near $35.00. We only have five days left on November strikes. 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.

Suggested Options:
We are not suggesting new positions.

Picked on October 23 at $ 37.22
Change since picked: - 1.44
Earnings Date 10/24/07 (confirmed)
Average Daily Volume = 2.0 million

Dropped Calls

Boeing - BA - close: 94.21 change: -2.07 stop: 94.85

The market's sell-off finally pushed shares of BA down through support near $95.00 and its 200-dma. The stock hit our stop loss at $94.85 and shares now look poised to test the October lows near $92.50. The MACD on the daily chart is very close to a new sell signal. We would keep an eye on BA for a bounce near support around $90.00 as a potentially bullish entry point.

Picked on October 29 at $ 97.25
Change since picked: - 3.04
Earnings Date 10/24/07 (confirmed)
Average Daily Volume = 6.3 million


Kennametal - KMT - close: 87.72 change: -1.78 stop: 87.49

We are suggesting an early exit in KMT. The stock has done a decent job of holding on to support near $87.50-88.00 but the technicals are turning negative and shares have a bearish trend of lower highs over the past couple of weeks. Odds are good that KMT will dip toward support near $85.00 and its 50-dma or even fill the gap near $82.50. We would rather exit now and just wait to see where it bounces down the road. FYI: Don't forget that KMT has a 2-for-1 split coming in December.

Picked on October 31 at $ 91.21
Change since picked: - 3.49
Earnings Date 10/24/07 (confirmed)
Average Daily Volume = 404 million


Research In Motion - RIMM - cls: 113.22 chg: -11.26 stop: 115.49

Ouch! Shares of RIMM just got crushed two days in a row. Thursday's intraday bounce from its lows looked like an aggressive entry point to buy the dip. Evidently the tech-sector selling wasn't over yet. RIMM gapped down on Friday at $118.44 and plunged to $111.76, hitting our stop loss at $115.49.

Picked on November 08 at $124.48
Change since picked: -11.26
Earnings Date 12/20/07 (unconfirmed)
Average Daily Volume = 21.5 million

Dropped Puts


Dropped Strangles


Trader's Corner

Teacher, Why Do We Have to Learn This Stuff?

By this point in the series on Greeks, some of you might have something in common with students asking their teachers why they have to learn the quadratic equation. Those students can't imagine a reason they'll use that equation once they graduate. I can imagine some of you wondering why you should spend a boring few minutes each week learning about the Greeks. You've been trading, choosing your own calls and puts, doing pretty well without even knowing that Greeks existed, or caring, if you did know.

It's fairly obvious why we might want to know about delta since it tells us the probability that an option will be in the money at expiration and how much the option's price will change for each one-point move in the underlying. The Greeks can give us more information, however.

Why do we need to know about them? Risk.

Greeks tell us how much risk we're incurring. For example, let's imagine that October 29, two days before the FOMC's decision, a newbie trader held covered calls on MSFT in her portfolio. For those among you who are also newbies, a covered call is established when a trader or investor owns stock and sells one call contract for each 100 shares of stock owned, with the strike of that call higher than the current price of the stock. The trader collects a small credit for the call that is sold, and that offers a small cushion in case the stock's price drops. However, if the stock rises above the strike of the sold call, the stock can be called away. The trader doesn't participate in any further gains.

We know that stocks and indices can move quite a bit around the time of an FOMC meeting, but perhaps this newbie trader reasoned that if MSFT climbed, she would still benefit up to the price of her sold call. If MSFT dropped, the credit she'd collected from her sold call would cushion the loss. We know that her primary risk from price movement would come if MSFT dropped heavily. How much risk from price movement was she incurring?

Here's the position:

Long 500 Shares MSFT
Short 5 Contracts NOV 37.50 Calls

We learned from an earlier article that long stock positions always have a delta of 1.00/share. What about gamma for stock positions? Gamma, most will remember, tells us how much delta will change for each one-point move in the underlying, MSFT in this case. Since delta doesn't change, ever, for a long stock position, gamma must be zero.

The MSFT shares are then long 500 deltas, and they have a gamma of zero.

What about the 5 contracts of NOV 37.50 calls that were sold? A brokerage reports the following data:

MSFT 37.50 Calls
Delta: 0.09
Gamma: 0.08

Total delta for the 5 sold contracts will then equal -45.00 (-0.09 x 5 x 100). It might make sense that, although delta is positive for calls, it's negative when those calls are sold. Total gamma for those 5 contracts will be -40.00 (-0.08 x 5 x 100). You might remember that although gamma is always positive for both calls and puts, it's negative when those calls or puts are sold.

What are the position delta and gamma for the stock plus short call position?

Position Delta: 500 - 45 = 455 deltas
Position Gamma: 0 - 40 = -40

As of the close on October 29, two days before the FOMC meeting, the covered call position was long 455 deltas, still quite long. For the first one-point drop in MSFT's price, the trader risked a $455.00 loss.

What about gamma, though? What does it mean that gamma is negative? In the words of Lawrence McMillan in OPTIONS AS A STRATEGIC INVESTMENT, it "means that as the underlying security moves, the position will acquire traits opposite to that movement." In other words, if MSFT were to climb, the position becomes long fewer delta. If MSFT were to drop, however, the position becomes longer more delta. It begins to incur even more risk from price movement, because a trader doesn't want to be long more delta as price is dropping. That means that trader loses more for each point MSFT loses.

If you've heard that covered call positions are not the conservative trade that some consider them but are instead quite risky, that negative gamma tells you why. If MSFT were to drop, and the position becomes long more delta, each point loss hurts more. Soon, as the calls drop further out of the money, the gamma of the calls will drop to zero, of course, and the delta of the out-of-the-money sold calls will drop to zero, too. The position delta will then be 500 deltas, the delta of the stock position.

Intuitively, this makes sense. What it means is that the credit that the newbie trader collected for those sold calls is small, and can only cushion a little of the loss. After that cushion is used up, the position loses point for point what the stock position does.

Some calculations might make the covered-call position's risk clearer. We of course don't have to go through these delta and gamma calculations to figure out the risk in a covered call position, but it's an uncomplicated position that most can understand and many have tackled, and the calculations here can be applied to more complicated positions.

The first point that MSFT drops, the loss is the position delta or $455. How did I figure that? The 500 shares of stock lost $500, of course. That's easy. During this one-point loss, the value of the sold call has theoretically dropped by its delta. That benefits the seller of the call, cushioning her loss in the stock's value by 45 deltas. The trader with the covered call position has theoretically lost $455.00. So, for the first point drop, the trader has lost the position delta that was calculated earlier.

The second point that MSFT drops, the stock position loses another $500, of course. What about the option? Since it's a call, it drops in value again for the second point, but this time when we figure out how much it drops, we have to consider how gamma impacts delta.

For each one-point drop in MSFT, gamma tells us that delta will change by 0.08. The negative gamma tells us that for each one-point change, delta reduces by 0.08 since the gamma is negative. Delta will then be 0.01 (original 0.9 - 0.08). Since there are 5 contracts, the option position loses another $5.00 (5 x 100 x $0.01). Since the holder of the covered-call position sold that call, it benefits the holder for the call to lose that $5.00, so that helps cushion the loss from the stock position. The total loss for that second point drop in MSFT is then $495.00.

Another way of thinking about it is that for the second one-point drop, the position loses the position delta we calculated earlier plus the gamma or $455.00 + $40.00.

The total loss for the two-point drop has been $455 + $495, so the position has lost $950.00. For those who prefer formulas, the total loss for a 2-point drop in MSFT = 2 x $455 (position delta) + $40.00 (gamma) = $950.00.

As should be obvious, the downside protection offered by the sold call is soon depleted as the delta of that sold call approaches zero. The call is moving far enough out of the money that the position is left long 500 deltas, which means it will lose $500 for each one-point drop in MSFT.

Other positions can get into even more trouble. Studying delta and gamma exposure can help traders determine their risk from price movement. We didn't need all the complicated calculations to tell us that the covered-call position wouldn't provide much of a cushion if MSFT should drop severely, but in other cases, performing such calculations can be eye opening.

Some traders attempt to neutralize the risk from price movement. In some cases, they attempt to do so by establishing delta-neutral positions. Remember the anecdote that started this series of articles, when the former market maker talked about the time he had shorted 25,000 shares of stock to neutralize the 25,000 deltas he was long when he bought 500 contracts of a call with a delta of 0.50? What would happen as the stock moved? The fact that the delta was 0.50 tells us that the option was an at-the-money one. Gamma is largest for at-the-money positions. That means that delta will be changing most rapidly as the position moves away from the at-the-money position.

The position that was delta-neutral will soon be anything but. If the market maker hadn't already closed the position, adjustments would be needed. Depending on which way the stock price moved, the market maker would be required to either short more stock or buy-to-cover some he already owned.

Some experienced traders go further and establish gamma/delta neutral positions. Such positions can be complicated and varied, of course, but are always started by first neutralizing the gamma and then the delta. For example, McMillan details a position that included hypothetical OCT 60 calls with a gamma of 0.05 and OCT 70 calls with a gamma of 0.025. To neutralize gamma, two OCT 70 calls would be sold for each OCT 60 call purchased.

With gammas neutralized, the trader can then neutralize deltas. The deltas of the two options are 0.60 for the OCT 60 call and 0.25 for the OCT 70 call. McMillan set up the comparison to show 200 OCT 70's have been sold and 100 OCT 60 purchased. The delta of this position would be +1000 (100 x 0.60 x 100 + 200 x -0.25 x 100 = 1000). The holder of this position would then need to short 1000 shares of this stock to neutralize the delta. This would not impact gamma since the gamma of a stock position is always zero. The position would be neutralized with respect to both delta and gamma.

Of course, gamma would change as the position moved and an adjustment would be needed, but for small movements, the position is neutralized with respect to price movements. Such positions may not be neutralized against other risks, however. That position might either benefit from or suffer from a change in volatility or the passage of time, for example.

An Internet search for gamma/delta neutral positions turns up potential trades that neutralize gamma and delta with the intention of benefiting from either time decay or a change in volatility. Many, as in the example from McMillan's book, require the selling of naked options, sometimes establishing some kind of ratio spread. Being somewhat squeamish about naked short options positions, I have not personally attempted such positions, and perhaps some of you won't, either. However, that doesn't mean that we can't all benefit from understanding what position delta and gamma tell us about the risk we're incurring from price movement.

Market makers seek to neutralize as much risk as possible in their positions. Next week, we'll hear from a former market maker who talks about risk as well as answering other questions about what market makers do.

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.


Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.

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