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Daily Newsletter, Thursday, 01/31/2008

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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

Caught in the Vortex

Introduction

If you enjoyed trading the last two days, I've got a vacation suggestion for you and your family, the Howlin' Tornado at the Grapevine, Texas location of the Great Wolf Lodge. This ride washes rafts out into a huge funnel-shaped enclosure, swinging them from one side to the other of the funnel before slinging them into the downspout.

I'm not associated with the Great Wolf Lodges and have never visited that resort, but I think I know how the riders must feel. Trading since the FOMC announcement has felt like being caught in that ride: helplessly washed from one side of the vortex to another, trying to hang on, screaming all the way. MBIA's (MBI) earnings and a couple of economic reports provided the screams. Reassurances by MBI executives about the company's position and New York Governor Spritzer that progress was being made on a plan to help the bond insurers added the thrills. Unfortunately, no one is sure yet where that vortex is going to set us down.

Let's look at charts. Feel free to use your imagination and experience that ride vicariously whenever you feel you might be going to sleep. You just might be about to be washed out into that vortex with your positions.

Charts

I decided to show a weekly rather than a daily chart of the SPX so we could gain a more balanced outlook. This vortex has been scary so far, but what's really happened?

Annotated Weekly Chart of the SPX:

The daily Keltner chart, not shown, predicts that as long as the SPX maintains daily closes above the rising 9-ema, now at 1359.57, it sets a potential upside target at 1399.33, but it's a long way down all the way to 1359.57 and a daily close below it before we know that potential upside target is erased.

Annotated Daily Chart of the Dow:

The daily Keltner chart suggests that as long as the Dow is producing daily closes above the 9-ema, now at 12,441, it maintains a potential upside target near 12791-12846. Again, as with the SPX, it's a long way down to a daily close beneath that rising 9-ema, though, and you might want closer stops than that.

Annotated Daily Chart of the Nasdaq:

On the daily Keltner chart, not shown, the Nasdaq has met its current upside target. It would need sustained daily closes above 2400 to set a new one. For now, bulls want to see sustained daily closes above the 9-ema, now at 2366.

Annotated Daily Chart of the SOX:

Annotated Weekly Chart of the RUT:

Annotated Daily Chart of the TRAN:

Today's Developments

Today's releases proved numerous, so I'm going to cover them as briefly as possible. In some instances, I'll provide links to the government or other sites, so that subscribers who wish to delve deeper into the reports can do so.

The day's releases began with the Monster's January Employment Index. The index fell nine points, the third straight month of declines. Year over year, the index has declined nearly five percent. Twenty out of 23 occupational categories declined. Monster pegged January's decline on a combination of seasonal trends and further slowing in the U.S. economy.

Other highlights from the report detail the sectors that eased. Those included the financial, retail and sales, and leisure and hospitality sectors. Monster pointed to sharp declines in the arts, entertainment, and recreation and accommodation and food services as showing lower household spending and consumer confidence.

The healthcare sector showed the strongest growth. Among industries, the mining industry was the only category to show increases. The West South Region was the region showing the strongest year-over-year growth.

That report was followed by the Weekly Initial and Continuing Claims and the 2007 fourth-quarter's Employment Cost Index. If the Labor Department's weekly initial and continuing claims proved reassuring last week, they were anything but reassuring this week, and they slung equity futures around a bit in that vortex. Initial claims rose sharply to 375,000, jumping by 69,000. However, balancing this rise was the puzzling decline by 51,000 in initial claims that had been seen in the late December period. Also, the Labor Department pegged the jump on adjustments made due to the Martin Luther King holiday. The four-week moving average, considered a much better barometer, rose 10,250 to 325,750.

Market participants weren't interested in balance or reading details, however, particularly with the tomorrow's important Employment Report looming. Equity futures weakened as the report was released. Continuing claims rose 47,000 to 2.72 million. The four-week moving average of those claims dropped, however, by 9,500 to 2.71 million.

In a separate release, the Labor Department reported that the employment costs index (ECI) rose 0.8 percent in the fourth quarter. This was in line with expectations. The full-year 2007 increase in employment costs was 3.3 percent, equal to the 2006 increase. Wages rose 3.4 percent for the full year, more than 2005's 3.2 percent rise.

A study of the components showed wage costs increasing 0.8 percent, with that rise equal to that seen in the last three quarters. Benefit costs rose 0.9 percent.

The ECI is rumored to be important to the Fed as the FOMC seeks to balance inflation pressures against downside risks from the economy. This number did not go the way that market watchers would have preferred, increasing worry that the Fed would have difficulty continuing the rate-cutting trend.

Other departments were busy with releases today, too. The Bureau of Economic Analysis presented its reports on December's Personal Income and Personal Spending. Personal Income rose 0.5 percent while Personal Spending climbed 0.2 percent. Prior rises had been 0.4 percent and 1.0 percent, respectively. Expectations were for 0.4 percent and 0.1 percent increases.

Core personal consumption expenditures (PCE) rose 0.2 percent, with the number at 2.2 percent for the past twelve months. December's number was in line with expectations and prior numbers, but that keeps the number for the past twelve months above the Fed's perceived comfort zone. In addition, some economists feel that the real income is too low to sustain spending. Those who would like to read today's Bureau of Economic Analysis' complete reports can find them at this link.

January's National Association of Purchasing Management-New York (NAPM NY) was the next on the slate of economic events for the day. The association headlined its report with the words "Activity Down, Pessimism Up." The Current Business Conditions component dropped to 47.9, below the benchmark 50. The Six-Month outlook fell to 44.2. NAPM-NY termed this the lowest that outlook component had been since November 2005. Prices Paid and Quantity of Purchases indices fell. The association said companies participating in the survey blamed concerns about recession, drops in consumer discretionary spending and market downturns, among other causes. Those who would like to read the report in its entirety can find it at this link.

Chicago's PMI, the report on manufacturing from the NAPM-Chicago, stood at 51.5 for January. This was well below the prior 56.4 and also below the forecast 52.0-52.5. The January number sank to just above the 50 that benchmarks the difference between and expanding and contracting environment. The New Orders index plummeted to 44.7 from its prior 56.7. This dropped the index into levels not seen since the spring of 2003. The Prices Paid index jumped to 81.7 from the prior 67.4. This district's report is considered predictive of the ISM, and it wasn't predicting good things. Those who would like a more detailed view of the report can locate it at this link.

The less-watched Kansas Fed Manufacturing Survey also showed an easing in expectations for future factory output coupled with rising price indices. The report mentioned a "large jump in raw materials prices for food, chemical, and machinery producers."

The Department of Energy released natural gas inventories today. Those inventories dropped by 274 billion cubic feet, more than the 260 bcf's that were expected.

Information relating to the housing industry was also released. Freddie Mac's weekly survey on mortgages revealed that rates rose last week in concert with the rise in yields on treasuries. A 33-year fixed-rate mortgage averaged 5.68 percent, up from the previous week's 5.48 percent, but still well below the year-ago level of 6.34 percent. Freddie Mac's chief economist noted that a rate cut such as those provided last week and this week sometimes don't immediately impact long-term rates.

Today, in testimony before Congress, the FDIC's Chairman Sheila Blair warned that the mortgage industry needed to move faster to modify loans in risk of default. She also warned that credit problems were expanding beyond the subprime sector, saying that a better solution for both homeowners and lenders might be to forgive part of the debt.

The Federal Reserve released its weekly figures on outstanding commercial paper, an important gauge of whether companies are able to place commercial paper to fund their operations and development plans. If you're not familiar with the number, the current climate dictates that we want to see increases in outstanding commercial paper, suggesting that companies were successful in obtaining funds this way. Seasonally adjusted, outstanding commercial paper increased $4.1 billion last week. Seasonally adjusted, the non-financial foreign paper was flat and asset-backed paper dropped $1.1 billion, but all other categories rose. Not seasonally adjusted, it fell $0.6 billion.

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In the weekend Wrap, December's Semiconductor Billings was listed as being due today, but that number had not been released as this report was edited and submitted and my information suggested that it was actually released January 17. December's Book-to-Bill ratio rose to 0.89 from the previous November final number of 0.82. That means that, over a three-month average, "$89 worth of orders were received for every $100 of product billed for the month," according to the North American Semiconductor Equipment Industry press release.

As numerous as the various economic reports might have been, MBIA's (MBI) earnings report perhaps proved even more important. Although much of the early morning weakness was blamed on the sharp increase in initial jobless claims, shock over MBI's headline numbers must be assigned some responsibility, too. The company will take $3.5 billion in write downs, resulting in a $2.3 billion fourth-quarter loss. That's a loss of $18.61 per share. I kept checking that number to make sure it was right, going to several sources. It seemed that it must have been off by a decimal place, but all sources listed the same thing.

The write downs mainly resulted from a devaluation of CDOs or collateralized debt obligations. Rising delinquencies and defaults led to further write downs, including $100 million placed in reserve against potential future losses. Analysts had forecast a loss of $2.97 per share.

The MBI chairman and chief executive officer and its chief financial officer attempted to clarify the company's position. The CEO pointed out that the successful conclusion to its capital plan will more than offset the effect of the write downs on the company's capital position. He reportedly has said that MBI will be able to meet all requirements to maintain its AAA rating. The CFO asserted that the company could cover its needs for a two-year period with the cash on its balance sheet.

As most market participants know by now, the company is scrambling to maintain its AAA rating, with both Moody's Investors Service and Standards & Poor's already reviewing its ratings along with those of other bond insurers and Fitch Ratings already cutting FGIC Corp's rating yesterday. As Jim Brown has detailed in other Wraps, MBI's failure to maintain that rating would result in cascading difficulties for banks and other entities, including municipalities whose bonds companies such as MBI have insured.

In the afternoon, a Reuters report reported that the Federal Reserve Bank of New York's president, Timothy Geithner, was closely watching the efforts to formulate a rescue package for bond insurers AMBAC Financial Group and MBIA Inc. His efforts should not be construed as interference with or participation in the New York Insurance Department's efforts to formulate the rescue plan, articles asserted. Those efforts are led by New York State Insurance Superintendent Eric Dinallo.

Although MBI initially dipped to a new week's low, it didn't stay there. It climbed through most of the day, closing at $15.17, just off the $15.87 high.

Other reporting companies included Bristol-Myers (BMY), MasterCard (MA) and Procter & Gamble (PG). All companies were deemed as beating expectations in various articles.

In addition to economic and earnings reports, some attention focused on the progress of the stimulus package. The Senate Finance Committee has reportedly made some changes in the House's version, changes that some economists worry will stall the progress. Those changes reportedly include raising the maximum income individuals or couples can earn and still qualify for the rebate and lowering the rebates.

After hours, Google (GOOG) reported. Fourth-quarter profit rose 17 percent and revenue climbed 51 percent, but its results were deemed disappointing. Earnings of $4.43 a share were below the expected $4.44 a share, and net revenue of $3.39 billion was below expectations of $3.45 billion. Google reported that it had hired 889 new employees in the fourth quarter, down from the 2,000 new hires in the third quarter. Although the pace slowed, some remain concerned about the hiring pace. Also of concern was a note from analysts with Stifel Nicolaus suggesting that the European Commission will file a statement of objection to Google's intended acquisition of DoubleClick. As I type, GOOG trades at 526.96, down significantly from its 564.30 close, but that can change by the next day's open.

Currently, Google is believed to be bidding in a government auction for the "C block" of the nationwide wireless spectrum. Today, the bidding reached a $4.6 billion minimum needed for open-access rules to be applied to that chunk, a move Google wanted. All bidding is anonymous, so it's not known for certain that Google is involved in the bidding, but the size of the block and its cost make it likely that only large corporations such as Google, Verizon or AT&T would be bidding.

Tomorrow's Economic and Earnings Releases

Tomorrow's January Employment report, also variously known as the Unemployment report and the NonFarm Payrolls report, will prove important. It will be released at 8:30 am ET. Wednesday's ADP report suggested that the current estimate of 57,500 will be too low, but the ADP number has proven wrong in the past and today's initial claims number questioned the strength shown in the ADP report.

Some presume that the FOMC had this NonFarm Payrolls information at hand when making its decision on Wednesday. However, I caught a discussion on television this week in which a former FOMC member avowed that only the chairman was given prior information, and only at 4:00 pm ET the day previous to the announcement. He suggested that the Fed would not have had tomorrow's numbers but would have the ADP's Wednesday release, of course.

December's Construction Spending, January's Consumer Sentiment and January's ISM will all be released at 10:00 am ET. January's ISM may be the most watched of the three, although I still believe consumer sentiment and spending figures will gain prominence as we worry about recession.

The expectation for the ISM is for an easing to 47.0 from the previous 47.7. A big surprise either direction could impact markets, so plan your early trades accordingly.

The ECRI Weekly Leading Index should be released at 10:30 am ET.

What about Tomorrow?

Annotated 15-Minute Chart of the SPX:

If the SPX should gap higher tomorrow morning, know in advance how you'll treat a test of the upper channel resistance. As should be obvious by now to anyone not rendered unconscious over recent weeks, pullbacks can be sharp and can come out of nowhere. If you don't have a plan in mind, you may be too late.

Annotated 15-Minute Chart of the Dow:

Annotated 15-Minute Chart of the Nasdaq:

Annotated 15-Minute Chart of the RUT:

When you're drawn into a vortex or hop on a ride like that Howlin' Tornado in Grapevine, it's silly to predict the last direction you'll take before you're deposited on the ground again. Similarly, it's silly to make too many predictions about what's going to happen next in the markets. That's what's being sorted out, and these volatility-powered swings indicate that everyone is trying to figure it out with a lot of emotion-based trading going on while they do. For now, I would always remain aware that another big swing might come at any time, particularly another big swing to the downside. I absolutely would not go into the weekend this weekend with more risk in my portfolio than I was able to comfortably endure, either to the upside or the downside. Study charts and determine likely support or resistance levels and have a plan in place before those levels are touched. Sometimes you have seconds to exit or enter a position before the move begins and begins sharply.

My opinion? I believe that markets are trying to chop their way a bit higher before they roll over again, but I do believe they will roll down again. I'll be waiting if they do, to see how far they go and whether the downside momentum has waned. I felt fairly confident today that the SPX was perhaps just undergoing a 10-sma test and that it might close back above it by the day's end, but I have no confidence at all that there won't eventually be a deeper thrust down. When will it come? That's the thing about bear flags and amusement park rides. You just never know.
 


New Plays

New Option Plays

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

Play Editor's Note: It was an extremely volatile day on Thursday. We are not adding any new positions ahead of tomorrow's job report.


New Calls

None today.
 

New Puts

None today.
 

New Strangles

None today.
 


Play Updates

In Play Updates and Reviews

Call Updates

United States Oil Fund - USO - cls: 72.35 chg: -0.73 stop: 68.59

Very short-term we're seeing some signs that USO might dip again. Look for a pull back into the $71.00-70.00 zone as a new entry point to buy calls. Our short-term target is the $74.50-75.00 range. More aggressive traders could easily aim for the $77.50-79.00 region.

Picked on January 24 at $ 70.93
Change since picked: 1.42
Earnings Date 00/00/00 (unconfirmed)
Average Daily Volume = 3.2 million
 

Put Updates

Ambac Fincl. - ABK - cls: 11.64 change: 0.79 stop: n/a

Yesterday afternoon and today was all about the bond insurers. S&P came out and reaffirmed their AAA rating on ABK yet shares of ABK only added 6.4% and produced another lower high in a string of lower highs. Given the S&P comments we would have expected a bigger bounce. Overall there was a lot of talk today about the potential bailout for this industry. We remain bearish but would probably hesitate to open new positions at this time. Our suggestion was for the May puts. We are labeling this a speculative, higher-risk, lottery-ticket style of play. Basically we'll either win big or lose the entire bet. We will have to play it by ear when it comes to exiting but we're looking for a decline to $5.00 or less.

Picked on January 27 at $ 11.54
Change since picked: 0.10
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 10.9 million

---

MBIA Inc. - MBI - close: 15.50 change: 1.54 stop: n/a

The daily double-digit percentage moves in MBI must be heaven (or hell) for the day traders of the world. This morning the company reported earnings and the results were worse than expected. No surprise there. During their four-hour conference call the company claims that they are positioned to endure any downturn and can endure a credit downgrade and do not see any chances of a bankruptcy. Yet after MBI's earnings report S&P reiterated that they have MBI on their negative creditwatch placing the company at risk for a downgrade. We remain bearish on MBI but this remains a very speculative play. There was a lot of news about a potential bailout but it could be a long time coming and at this point looks like it could be company specific. Reporters on CNBC today suggested that if something doesn't change in the next two weeks that the rating agencies will downgrade MBI's AAA rating. We're not listing a stop loss. This is a lottery ticket play. We'll win big or it's going to go bust. This is one of the few times that we will hold over earnings. MBI reports earnings on Thursday morning before the bell. We will have to play it by ear when it comes to exiting but we're looking for a decline to $5.00 or less.

Picked on January 27 at $ 14.20
Change since picked: 1.30
Earnings Date 01/31/08 (confirmed)
Average Daily Volume = 15.2 million

---

Perrigo Co - PRGO - close: 30.84 change: 0.04 stop: 32.11

The morning weakness pushed PRGO under support at $30 but it didn't stay down very long. We remain bearish. We're not suggesting new puts until we see a failed rally at $32 or a new relative low under $29.70. Our target is the $25.50-25.00 zone. The P&F chart has turned bearish with a $23 target.

Picked on January 28 at $ 29.85 *triggered
Change since picked: 0.99
Earnings Date 02/05/08 (confirmed)
Average Daily Volume = 1.3 million

---

Polo Ralph Lauren - RL - cls: 60.73 chg: -0.81 stop: 63.75

Shares of RL were double teamed this morning as two different analyst firms downgraded the stock. Shares gapped down at $56.79 and dipped to $56.40 before bouncing back thanks to a strong market session. Volume was 4.7 million shares versus the normal 1.7 million shares. Look for a failed rally under the 50-dma as a new bearish entry point to buy puts. We're listing two targets. Our first target is the $55.50-55.00 range. Our second, more aggressive target is the $52.00-50.00 zone.

Picked on January 27 at $ 59.19
Change since picked: 1.54
Earnings Date 02/06/08 (confirmed)
Average Daily Volume = 1.7 million

---

Teleflex Inc. - TFX - close: 59.12 chg: 1.47 stop: 60.01

It was not a good day for the bears. TFX dipped to $56.47 and then rebounded sharply this morning. The stock ended with a 2.5% gain and a bullish engulfing candlestick pattern. The rally did stall near overhead resistance at the 50-dma. We would wait for a new decline under $58.00 or $57.50 as an entry point to consider buying puts again. Our target is the $54.00-52.50 zone.

Picked on January 30 at $ 57.65
Change since picked: 1.47
Earnings Date 02/28/08 (unconfirmed)
Average Daily Volume = 408 thousand
 

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.)

---

DJIA 1/100 Index - $DJX - cls: 126.50 chg: 2.07 stop: n/a

It was another very volatile day for the markets and the DJIA index. The $DJX (or djx.x) hit an intraday low of $122.50 and a high of $127.02. We are not suggesting new strangle positions at this time. The options we suggested were the February $127 calls (DJW-BW) and the February $122 puts (DJW-NR). Our estimated cost was $3.36. We want to sell if either option hits $4.85 or more. FYI: The intraday high for the call was $2.10 and the intraday high for the put was $2.40.

Picked on January 29 at $124.80
Change since picked: 1.70
Earnings Date 00/00/00
Average Daily Volume = million

---

Google - GOOG - close: 564.30 chg: 16.03 stop: n/a

Shares of GOOG traded in another wide range ($534-573) and produced what appeared to be a potential failed rally under its 10 and 200-dma. However, the real fireworks didn't start until after the closing bell and GOOG's earnings report. Wall Street estimates were for an EPS of $4.45. GOOG missed by 2 cents and missed the revenue numbers as well. The stock hit an after hours low of $507.45 but was bouncing at the time of this update trading at $525. We are not suggesting new strangle positions at this time. The options we suggested were the February $600 calls (GOO-BT) and the February $500 puts (GOP-NO). Our estimated cost is $17.00. We want to sell if either option hits $27.00 or more.

Picked on January 30 at $548.277
Change since picked: 16.03
Earnings Date 01/31/08 (confirmed)
Average Daily Volume = 5.6 million
 

Dropped Calls

None
 

Dropped Puts

Hartford Fincl. - HIG - cls: 80.50 chg: 1.95 stop: 81.75

It was a crazy day in the markets with a 450 point swing in the DJIA. Shares of HIG also witnessed a lot of volatility with an intraday low of $76.42 and a rally all the way back to $82.00. We have been whipsawed out of it as shares hit our suggested top at $81.75.

Picked on January 30 at $ 78.55
Change since picked: 1.95
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 2.6 million

---

Harley-Davidson - HOG - cls: 40.64 chg: 2.13 stop: 42.51

We are giving up on HOG as a bearish play - at least for now. With the U.S. economy in or near a recession sales of Harley Davidson motorcycles have been suffering and should continue to suffer. Unfortunately, a rising tide lifts all boats and HOG is bouncing. Today's session produced a bullish reversal pattern although the stock continues to have resistance near $42.00, near the 50-dma and near the $45.00 level. We'll watch for a failed rally near $45 as a potential entry point for bearish plays.

Picked on January 27 at $ 37.96
Change since picked: 2.68
Earnings Date 01/25/08 (confirmed)
Average Daily Volume = 2.4 million
 

Dropped Strangles

None
 


Trader's Corner

Computing Current Upside Possibilities

It seems my 'regular' Wednesday Trader's Corner article has been slipping to Thursday the last couple of weeks. Last week (1/24/08) I wrote about the technical reasons that I thought the market had reached a bottom on the 23rd. This was my conclusion based on how the Dow 30 (INDU) held its long-term weekly support trendline, at least on a closing basis (the only way Charles Dow ever looked at it), and especially based on the long-term Nasdaq 100 (NDX) weekly chart; NDX had led the market up in recent weeks and months and if a major index was going to rebound from its major up trendline, it had to be NDX and that's what happened, so far at least.

The other reason I thought there had been a substantial upside reversal was another technical pattern, that of a key upside reversal, which was especially apparent in the S&P indexes. I don't need to go into all this again. If you want to look at or review my prior article you can click here if online or go back to your 1/24 OI Daily.

Assuming we have good reasons technically at least, to think that the market has found bottom, we've bought calls, sold puts or done some other bullish strategies in indexes or stocks. What is then going to be our first, second and third upside objectives? Watching the market and seeing how it 'looks' from day to day? A lot of traders do this and some or many lose money because they don't have a game plan and end up reacting to the market rather than to the market AND to reasonable expectations.

I'll demonstrate a tried and true method of setting some upside objectives or expectations. These are not always going to be right of course but it is a good way to gauge potential targets on a recovery rally. The other part of your trade plan is determining your risk or exit point if the trade goes against you, which is another story but as or more important.

MY FIRST OBJECTIVE:
Because the major market indexes had exceeded their prior major summer lows, I took the prior August lows as my initial or FIRST objective, which I also figured would be an initial key resistance. This idea is based on the idea that 'prior support (a bottom), once penetrated, 'becomes' resistance later on'. A prior low like this is both a first upside target and a first key resistance.

At or approaching a prior major low, there were many traders and investors who did some buying and once the upside reversal was seen then 'chased' prices up from there. This price area for many is their 'cry uncle' point weeks or months later on where they will exit if the benchmark indexes don't find support again in the same area.

There are many more holders of stock that did not exit when prices fell through this prior support. Some if not many are wishing that they could at least get out in this area if prices rebound to it. The market outlook has soured with high bearish sentiment so there are many just looking to sell a rally and the prior 'floor' becomes one target of selling. This is how a floor 'becomes' a ceiling.

In the example below provided by the S&P 500 (SPX) chart, the first level of resistance I had noted as key to overcome to suggest a next, higher, upside target was 1370, at the August intraday low which got exceeded today on the Close. Obviously, the August-October (and for the most part in December) closing lows were more in the 1400 area, so this is another overhanging resistance and probably the most potent. Today's close at the 21-day moving average is another potential near SPX resistance (and target).

The Nasdaq 100 (NDX), another key index to watch for the reasons noted initially, also of course cleared its prior 1805 low on the close and by a comfortable margin. Another resistance and potential next upside target is for a move up to the 21-day average.

The series of potential upside objectives and potential resistance levels implied by the so-called 'fibonacci' retracements are what I want to touch on next.

FIBONACCI RETRACEMENTS:
I'll explain what the fibonacci retracements of a prior move ARE, after showing these levels on the same two (SPX and NDX) daily charts. Those who want to review or need an explanation of the hows and wherefores of fibonacci (fib) levels can jump to this last section and peruse it.

There first is a question of whether we measure the 'fib' lines from the recent lows to the highs of December or the retracement amounts of the SECOND LEG down only, OR the entire decline from the late-October peak to the recent low. The answer I apply is to measure the fibonacci retracements of the last LEG down. In a bear market environment like the one I believe we'll be in for awhile, I wouldn't expect much more than a 'minimal' retracement which would be either, 38% (already done) a 50%, possibly a 62% retracement, of the last major downswing. These last two retracement levels are the ones I take as my next potential upside objectives (and resistance levels).

Repeating a different view of the SPX daily chart below, you may wonder if the retracements from the 1270 low should be measured to the 1523 high or the 1499 high that came later. Since a typical intermediate to major decline (or down leg) will have two parts or segments, I begin at the top of the first segment, which would imply measuring the 38, 50 and 62 percent upside retracements of the 1523 to 1270 decline.

I didn't mention the 38 percent fibonacci retracement level as it has already been reached and falls in the same area of resistance as implied by the prior 1370 low. The 50% retracement level intersects in the 1400 area discussed already as resistance measured by a different means. These things fall in clusters sometimes. 1426 is a possible third upside target and potential resistance implied by the fibonacci 62% retracement; slippage to a little bit more than 62% is seen at the 66% (2/3rds) retracement, which is also often a key resistance, but not a fibonacci level.

The next chart is again one we've seen of the Nas 100 (NDX), but one next just focusing on the fib lines. Here, the second, third and forth upside targets/resistance points on a rebound (beyond a recovery to the prior low), that could be hit and would also be potential resistance areas, are highlighted at NDX 1868, 1922 and 1976.

FIBONACCI:
The origins of one of the most useful retracement theories for stocks, stock indexes and other markets came from someone who lived in the middle ages and was studying the population growth of rabbits. Leonardo Fibonacci was an Italian mathematician who was doing such work in the early 1200s. The number sequence that is named after Fibonacci is where each successive number is the sum of the two previous numbers; i.e., 1, 2, 3, 5, 8, 13, 21, 34, 55, 144, etc. Any given number is 1.618 times the preceding number and .618 times the following number.

There are some technical indicators whose formulas rely on the Fibonacci number sequence, but the main application is to look at price moves in stocks or index and use the fibonacci retracements of .382 or 38 percent, .50 or 50 percent and .618 or 62%.

Looking at the number progression of 1, 2, 3, 5, 8, 13, 21, etc. where each succeeding number is the sum of the two before it, there are certain arithmetic relationships that exist: .618 is the percent that each number is OF the next higher number; .382 is the inverse of .618 (100 61.8 = 38.2). Well stick to a shorthand and round off .382 and .618 to an even 38 and 62 percent %.

Imagine a stock that in 12 months goes from 10 to 20, for a gain of 10. The stock has had a fantastic double but you think it could go yet substantially higher. You wished you had owned it at 10 and but still would like to buy it, but cheaper than 20. The stock starts to trade lower. At what level could you hope to buy the stock?

Considering what would constitute the 38, 50 and 62% retracements of the 10 to 20 dollar advance would suggest the following:

1. If the demand is really strong for the stock, you might not be able to buy it cheaper than 16.25 (.38 of the 10 gain subtracted from the 20 high point)
2. If the demand was average, you could hope to buy the stock at 15, which is a give-back of .5 or one-half of the 10 point run-up.
3. If demand turned out to be weak on the way back down from the high point of $20 (e.g., after some news stories about the company die down or change), you might anticipate or wait to see if you could buy the stock at 13.75 (.62 of 10, subtracted from the high point 20).

Also useful in trading index and stock options, is to track what would constitute the 38, 50 and 62% retracements, after a minor, intermediate or major price swing.

There is a simple pragmatic reason for this popularity; buying or selling in these retracement areas often results in coming close to buying at the low and selling at the top. Maybe the saying of "buy low/sell high" owes something to the common retracements.

You can set most charting applications to calculate retracements ranging from .33 to .38, .50, .62 to .66, In an correction (fall in price), to see what would be the retracement levels in a recovery rally, use of the retracement "tool" is by first pointing at the high, then the low.

The reverse of this method is used within an uptrend, where prices begin a counter-trend decline: first point at the low, then at the high to see what the retracements levels could be of the prior advance.

SOME GENERAL GUIDELINES ON FIBONACCI RETRACEMENTS:

A strong trend will usually see only a 'minimum' price retracement -- around 1/3 to 38%. If prices start to hold around this area, trade entry may be warranted.

In a normal trend (not powered by something extraordinary), a retracement will often be about half or 50% of the prior move. A common level to buy or sell by some will be at this point. After about this much of a return move has occurred; with an exit if it continues on much beyond 50%; e.g., 5% more.

Within the range of normal, but evidence of a weaker trend, will be a retracement of 62% or perhaps 2/3rds (66%). If prices hold this area, it can suggest initiating a trade, with an exit if the retracement exceeds 66%.

If a retracement exceeds one level, look for it to go to the next; e.g., if a retracement goes beyond 38%, look for it to go on and approach 50%. If it exceeds 50%, look for 62%. If a retracement exceeds 62% (or a maximum of 66%), then I look for what I call a "round trip" or a return all to the way to the area of the prior low or high this type action suggests a retest of the low or high and is the ultimate "retracement" so to speak, of 100%.

Retracements are done from the low to the high, high to the low, of the trading period being looked at; e.g., hourly, daily, weekly charts. If daily, measure from intraday high to intraday low; not usually based on the highest close to the lowest close, but this is another method also. I use retracements based on closing levels some and this way can show sometimes where prices might be headed.

QUESTIONS/COMMENTS:
Please e-mail Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

GOOD TRADING SUCCESS!
 

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

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