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Daily Newsletter, Sunday, 02/24/2008

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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

Trapped and Confused

The markets ended mixed for the week but that was only the result of news-triggered short covering right before the close. It would have been much worse without that news. The Dow was down about 135 points at 3:30 when CNBC broadcast news that an Ambac bailout could be announced on Monday or Tuesday. Financials exploded as shorts covered and the Dow rallied +230 points to end with a 96-point gain. That end of day spike rescued the Dow from posting a losing week but even with a +35 point closing spike on the Nasdaq it still lost nearly 20-points for the week.

S&P-500 Chart - 90 Min

The economy weighed on the markets as well as the continuing bond insurer saga. The inflation monster and his cousin stagflation appear to have awakened and are prowling about like roaring lions looking for investments to devour. The Consumer Price Index last week showed headline inflation rose +0.4% in January and core inflation rose 0.3%. That does not sound like a big jump but taken in context headline inflation has risen 4.4% over the last 12-months and at an annualized 6.8% clip over the last 3-months. Core inflation rose 2.5% over 12 months and annualized at 3.1% over the last 3-months. The energy component to the CPI increased at 2.4% over December and a 19.6% rate for the last 12-months. Dallas Fed President Richard Fisher warned on Friday that the Fed must be wary about feeding inflation as it cuts rates to fight the low growth environment.

This rising fear of inflation put a damper on the expectations for the Fed to continue cutting rates. The Fed Funds Futures still show a 124% chance of a 50-point cut in March but investor sentiment about that cut is falling fast. That sentiment decline is depressing the equities markets on fears the Fed will be hesitant to cut further and even worse hike rates sooner than previously thought to counteract rising inflation. In the FOMC minutes of the January meeting that were released last week the FOMC discussed a "rapid reversal" of existing rate cuts if inflation continued to rise. The Fed is clearly between a rock and a hot place. The rock is the stagnant economy and the heat is the rising inflation. They have to change one of those factors quickly or be faced with an even worse problem down the road.

Next week has a very full economic calendar highlighted by the PPI, PMI, GDP and twin testimonies by Bernanke. The economic roadmap is going to be liberally peppered with land mines in the form of reports that spell out the slowing growth and increasing inflation. It is not going to be very market positive unless the bulls have strapped on their wall of worry climbing apparel. There should be plenty of details to worry about.

On Monday the Chicago Fed National Activity Index (CFNAI) is expected to show a further deterioration from the 12-month low posted in December. The index was already in contraction territory with a -.91 reading and it is expected to show further weakening in January. Existing Home sales are expected to show another decline as willing buyers suffer through the nearly impossible home loan torture test. With bank credit at a standstill and nearly $100 billion in secured loans currently unsold and searching for buyers it is nearly impossible to get a mortgage unless you have perfect credit, cash in the bank, spotless tax returns and a buyer for your old home with the same qualifications. Very few Americans are that lucky.

Economy.com reported on Friday that 10.3% or 8.8 million U.S. homes were now worth less than their mortgage balance. With little in the way of a rebound in values projected over the next two years many of those buyers are electing to walk away from their homes and mortgages rather than continue making the escalating mortgage payments. Many of these people are leaving well ahead of the foreclosure process and further complicating the housing picture. Realty Trac said on Friday that 1.5 million homes are still expected to foreclose in 2008. $2.1 trillion in mortgages or 19% of all mortgages outstanding were sliced and diced into mortgage backed securities (CDO/MBS) and sold all over the world. There were $625 billion in subprime loans written in 2005, four times the rate of 2001, and those loans written in 2005 are the ones resetting today and causing the mortgage problem.

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The S&P/Case-Shiller Home Price Index due out on Tuesday is expected to show another major decline in prices across the nation. The last report covering the November period saw a drop of -2.2% for the month and -8.4% for the trailing 12-month period. This is already the largest drop in the last 50-years. The New Home Sales report due out on Wednesday is expected to see annualized sales fall to the 580,000 range and a continuation of the 4.7% drop seen in December. This is down from the 1.4 million annual rate at the peak in 2005.

The Durable Goods report on Wednesday is expected to show a drop in new orders of -3.5% and a reversal of the +5.2% spike in December that was powered by a +138% jump in orders for defense aircraft. Unless the government bought another $50 billion in fighters in December the new durable goods orders are expected to plunge sharply. The next Q4 GDP revision will be out on Thursday and is expected to erode and possibly show a contraction. In the initial report growth for Q4 was seen as only +0.64% or extremely anemic. It would not take a very big revision to push it negative and increase recession fears.

The Chicago Purchasing Manager Index (PMI) for February will be announced on Friday and official expectations are for a drop to 50 and a level of zero growth. A reading under 50 would represent contraction and most whisper numbers are in the 47-49 range. Coming the day after the GDP revision it will be viewed as a more current look at Q1 economic activity. The following Monday the national Institute of Supply Management (ISM) Index will be released and expectations are also for a drop into contraction territory under 50.

Lastly Fed Chairman Ben Bernanke will give what was previously called the Humphrey Hawkins testimony on Wednesday and Thursday. This is the semiannual report to the House and Senate on the state of the economy. Whenever Bernanke has spoken in front of a microphone in recent weeks the market has paid close attention. This testimony is coming just a little over two weeks ahead of the next FOMC meeting on March 18th. The key phrases analysts will be looking for are the ones indicating the Fed's plan to cut rates again at that March meeting. Should his testimony focus more on inflation than growth the market will not react positively.

Given the increasing negativity in the recent economic reports I would say there was a greater potential for a negative result next week than a positive surprise. However, since everyone is so bearish ANY positive economic news could be followed by a short covering rally. Any positive news would have to be balanced with the likelihood of that "rapid reversal" of the Fed rate cuts so a rally is not a sure thing on positive news. It depends on what the news was and how it was presented.

Economic Calendar

The news rescuing the markets from a multi-week closing low on Friday was the announcement by Charlie Gasparino on CNBC at 3:30 that a deal was being finalized on Ambac. Gasparino said "significant progress" had been made and a bailout could be announced on Monday or Tuesday. The bailout would be a recapitalization of Ambac by a consortium of banks and would save the AAA rating for the bond insurer. The consortium of banks includes Dredsner, WB, UBS, RBS, C, SocGen, BNP and Barclay's. Reportedly the banks would provide a credit line and actual investment into Ambac. However, Gasparino stressed that the deal could blowup at any time. It was enough to move the market given the stress the bond insurer problem has been. Gasparino also reported that Channel RE, the reinsurance company for MBIA, had been downgraded by Moody's to less than AAA status. That puts more pressure on MBIA and its battle with the rating agencies. Reportedly the rating agencies have given regulators until Feb-29th to produce a solution or ratings on MBIA and Ambac will be sharply lowered. It may be this deadline that finally got everyone to get serious. However, it was only about an hour later that news began to break from Ambac that a deal was not imminent. Ambac said they were in talks with numerous parties and exploring all options including capital raises. An Ambac spokesman said we have no comment on a deal or the timing of a deal. They also said they did not see any deal as a bailout. The New York Times reported in its early Saturday editions that Ambac plans to split itself in two and hopes to raise $3 billion to bolster its finances according to a person who saw the plans on Friday. That does not sound like a bailout by a consortium of banks. Late Friday Citigroup said it had $4.02 billion in exposure to the monoline bond insurers. That would be a significant incentive for Citigroup to get a deal done.

The bond market has begun to freeze on another level according to recent reports. There are numerous instruments that banks, funds and institutions use to park money or guarantee yields. Some are called auction rate preferred securities and others are called variable rate notes. These securities are normally traded like cash and required only a phone call to liquidate. Reportedly there are over $100 billion of these securities that have gone off the grid. Dealers are refusing to buy them back and owners are being told to contact the tender agent to discuss repurchase. This has severely crimped liquidity in the marketplace and dealers have begun serving notice that transactions will be on a "best efforts" basis. For trading notes previously considered as liquid as cash this is a stark change. Yields have fallen from 2.5% to less than 1% while rates have spiked to 6% or even higher for debt backed by faltering insurers. American's typically take cash out of money market funds to pay taxes by April 15th. Same with corporations who file by March 15th and analysts claim there is an increasing liquidity problem in these notes used by money market funds to park money. If they can't resell them the money markets are going to be in trouble. Morgan Stanley said on Thursday there was $60 billion in failed auction rate debt that needed to be liquidated quickly but there were no takers. Northern Trust (NTRS) said it would provide $229 million in support to money market funds it advises that have exposure to notes issued by firms that have been downgraded. This is going to be a continuing pattern if something does not change soon.

We also heard on Friday that over the last 48 hours the major money center banks had suddenly begun calling buyers of debt and trying to unload tens of billions in leveraged debt at a loss. These banks had been reluctant to take a loss on the debt over the past couple months and preferred instead to keep it on the books rather than get killed in the frozen market. Something happened in the last 48 hours that changed that scenario. Now it appears they are in dump mode and it is not just one or two but all the major players suddenly are trying to unload failed debt. An example of this debt would be the $20 billion leveraged buyout of Clear Channel (CCU). Nearly all of the LBO debt incurred over the last six months is still on the books of the originating banks because there were no buyers once the credit markets locked up. If the banks are suddenly calling debt buyers and offering it at a substantial discount of as much as 60-75 cents on the dollar then what changed? Why the sudden rush by the majors to take additional losses. 99% of the debts will eventually payout so why rush to take a monster loss unless the liquidity crisis is deepening.

Merrill Lynch cut Fannie Mae (FNM) and Freddie Mac (FRE) to a "sell" on Friday saying the mortgage entities still did not reflect the severity or duration of the financial headwinds facing the companies. "Specifically, we think further deterioration in financial market conditions and worsening credit performance will undermine fundamentals and likely leading to further valuation compression." "We think Fannie and Freddie could retest 2007 lows and possibly incur new troughs as the cyclical downturn appears more acute." Both stocks were knocked for steep losses on the downgrade. Oppenheimer banking analyst Meredith Whitney said Citigroup had insufficient reserves and would be forced to cut its dividend again. Whitney also warned that financial stocks could fall as much as 15% to 50% in 2008. Bernstein cut estimates for BSC, LEH, GS and MS saying the brokers had significant exposure to depreciating asset classes.

Fannie Mae Chart - Daily

The cold front sweeping from the Midwest to the Northeast has been responsible for huge draws of natural gas from storage. That pushed prices on gas to $9.15 and a new 9-month high. With winter quickly drawing to a close this commodity may be running on borrowed time. Options on natural gas futures expire next week so expect continued volatility in those prices. Crude prices closed the week at $99 after a record run. You have probably heard the Boone Pickens quotes from Wednesday suggesting crude will decline to the mid $80 range as we approach the second quarter. High gasoline prices and slowing demand are contributing to the expected decline in crude prices. Pickens is a noted energy bull but he admitted he was currently shorting both natural gas and crude. OPEC meets on March 5th to discuss production quotas but no changes are expected. Once that event occurs the support for crude should evaporate. Several prominent analysts including Pickens are expecting $107-$120 by year end so this is just a temporary decline if it appears at all.

If your electricity is costing more this winter you can expect it to go up even more next summer. Coal accounts for 49% of the electricity generated in the U.S. and coal prices are exploding. In an interview with a coal executive on Friday who also agreed with comments from Boone Pickens the demand for electricity and coal was going to continue. It appears to be a consistent fact that we need to add 15% additional electrical generating capacity by 2020 and much of that capacity will be coal whether we like it or not. There are a number of nuclear plants being discussed but extremely high costs, long lead time and availability of fuel for those plants is a serious problem. Coal continues to get a bad wrap for pollution but when the rolling blackouts begin because of insufficient generation capacity it is always coal that jumps to the front of the discussion. Coal plants can be built from scratch in about 2 years and even at the 80% increase in prices per ton it is still cheaper per watt. Coal companies you might consider include Peabody (BTU), Foundation (FCL) and Walter (WLT). Peabody would be my choice for a long-term hold because of their dominance and global footprint.

Coal Prices

By 2:PM on Friday afternoon I had already started to think about how I was going to explain my bearish bias. The Dow had declined to 12155 and appeared right on the verge of a collapse below critical support at 12100. A retest of the January lows at 11650 appeared to be all but guaranteed. Suddenly the long awaited news about a bond insurer bailout hit the wires and a nearly 250-point rebound appeared. Hardly an hour had passed before denials began to flow and had the markets been open the odds are good we would have retested the lows for the day.

That leaves us with a really confused market for Monday. If a real Ambac bailout appears then we could continue to see the financials rally depending how the bailout was structured. If no bailout appears over the weekend or on Monday then the market will return to its funk and hunker down in an attempt to survive the week's heavy economic calendar. In fact, not having a bailout after getting its hopes up could cause an even deeper swoon.

For the week the Dow continued to be trapped in a range from 12500 to 12150. We did see a series of lower highs and lower lows over the last ten days. To me the Dow was setting up for a breakdown below 12100 and a retest of the January lows at 11650. Friday's spike failed to reverse that trend and based on the Friday evening comments on the wires it could be just one more lower high on what could be negative news on Monday. I would be hesitant to buy a dip to 12100 and I would look to short any break of that level.

DDow Chart - Daily

Nasdaq Chart - Daily

The Nasdaq was equally as bearish as the Dow and the big cap techs were getting crushed intraday on Friday. Apple set a new relative low at $116 to cap a week of declines. Microsoft set a new 10-month low at $27.20. Resistance is very strong at 2350 and the Nasdaq would have closed at two week low without the Ambac news.

The S&P has been the calmest of the three major indexes with a much tighter range from 1340-1365. That range was broken on Friday with a drop to 1327 and technicians were holding their breath that critical support at 1320 would hold. The closing spike put the index back at 1350 and dead center in the middle of the range. It is clear that 1320 is the critical level that must hold or the sentiment of the last four weeks is going to change. A break there could easily retest the January lows of 1275. The Russell-2000 uptrend broke and the index returned to initial support at 685 on Friday and was holding its own until the news broke. Unfortunately I think sentiment is turning against the small caps and I am switching to the S&P as the market indicator for this week.

S&P-500 Chart - Daily

Russell-2000 Chart - Daily

A key point here is still the lack of volume. For the last two weeks the total volume has been in the mid 6 billion range and very anemic. This is a buyer boycott rather than a crush of sellers. In reality there has not even been an imbalance of sellers. The internals are very choppy and change directions almost daily. This would suggest neither side has any conviction and everyone is just waiting to see if a recession appears. Traders don't know which way to trade although we were just starting to see an imbalance to the downside when the news broke.

Market sentiment is more neutral than bearish and we have every reason to be headed for the cellar. You could make the case that the lack of serious selling in the face of all the current problems is actually bullish but that would require a leap of faith greater than I have today. The lower highs and lower lows of last week have me worried. I said on Tuesday I was losing any enthusiasm for buying the dips. If we get a bond bailout on Monday the key market indicator will be how aggressively the bears sell the rally and if the S&P can break resistance at 1365 and again at 1395. If we don't get a bailout and news suggests nothing is imminent then the key will be S&P 1320. Between 1320-1360 is the Twilight Zone of confused sentiment and a good place to waste money trying to force a trade. Wait for a breakout or a breakdown and go with the trend.

Jim Brown
 


 


New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
SGR None None
WFR    

Play Editor's Note: We are not adding a lot of new plays to the newsletter tonight. The Friday late-afternoon spike on the potential bailout of ABK is a real wildcard. No one knows if a deal will get done or not. The market looked ready to breakdown from its consolidation and now it might see a short-covering rally higher. I suggest readers step back and take a wait and see approach. One idea that readers may want to consider is some sort of straddle or strangle on the market itself. We'll be looking at the DJX, DIA, QQQQ, and the SPY on Monday to see if there is any opportunity there.


New Calls

Shaw Group - SGR - close: 64.53 change: +1.48 stop: 58.45

Company Description:
The Shaw Group Inc. is a leading global provider of technology, engineering, procurement, construction, maintenance, fabrication, manufacturing, consulting, remediation and facilities management services for government and private sector clients in the energy, chemicals, environmental, infrastructure and emergency response markets. (source: company press release or website)

Why We Like It:
In addition to having pretty sound fundamentals and a strong business outlook, shares of SGR are breaking out. Traders bought the intraday dip near $60.00 on Friday. If we get another dip in the $61-60 zone we want to jump on it but we're not going to wait. Shares have cleared their 100-dma and look poised to rally toward $70. We are listing two targets. Our first target is the $69.50-70.00 zone. We suggest closing most of your position there. Our second, more aggressive target is the $74.00-75.00 range. The Point & Figure chart is very bullish with an $81 target. FYI: More conservative traders may want to use a stop loss closer to $60.00.

Suggested Options:
We are suggesting the March or April calls. Our preference would be Aprils but Marchs still have four weeks left.

BUY CALL MAR 60.00 SGR-CL open interest=1107 current ask $6.30
BUY CALL MAR 65.00 SGR-CM open interest=2697 current ask $3.20
BUY CALL MAR 70.00 SGR-CN open interest= 746 current ask $1.30

BUY CALL APR 65.00 SGR-DM open interest=1034 current ask $5.30
BUY CALL APR 70.00 SGR-DN open interest= 680 current ask $3.20

Picked on February 24 at $ 64.53
Change since picked: + 0.00
Earnings Date 04/08/08 (unconfirmed)
Average Daily Volume = 1.8 million

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MEMC Electr. - WFR - cls: 81.55 chg: +1.30 stop: 77.45

Company Description:
MEMC is a global leader in the manufacture and sale of wafers and related intermediate products to the semiconductor and solar industries. (source: company press release or website)

Why We Like It:
Shares of WFR are flirting with a bullish breakout over resistance in the $82.00-82.50 zone. The stock has been strong the last few days and the technical picture has definitely improved. The P&F chart is bullish with a $107 target. Unfortunately, anything solar energy-related has been pretty volatile lately. That makes placing our stop loss somewhat of a challenge. We would put it under last week's low around $73.50. However, that is a bit too aggressive. We are suggesting a stop loss at $77.45. Our suggested entry point to buy calls is $82.55, which would be a breakout higher. We have two targets. Our first target is the $89.00-90.00 range and we suggest readers close out the majority of their position here. Our second, more aggressive target is the $94.00-95.00 range near its December highs.

Suggested Options:
We are suggesting the March or April calls. Our preference would be Aprils but Marchs still have four weeks left.

BUY CALL MAR 80.00 WFR-CP open interest=4132 current ask $5.70
BUY CALL MAR 85.00 WFR-CQ open interest=4089 current ask $3.20
BUY CALL MAR 90.00 WFR-CR open interest=2337 current ask $1.60

BUY CALL APR 85.00 WFR-DQ open interest=1439 current ask $5.50
BUY CALL APR 90.00 WFR-DR open interest=10258 current ask $3.60

Picked on February xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 5.9 million
 

New Puts

None today.
 

New Strangles

None today.
 


Play Updates

In Play Updates and Reviews

Call Updates

Atwood Oceanics - ATW - cls: 93.11 change: +0.84 stop: 87.45

The OSX oil service index managed a decent bounce near its rising 10-dma, which is normally a positive sign. Meanwhile ATW, which did dip under short-term support near $90.00 intraday, managed to bounce back. We remain bullish on ATW and would use the rebound as a new entry point to buy calls. If you're skeptical of the market's late day bounce then consider a tighter stop loss near $89.00 or Friday's low near $89.25. Our target is the $99.00-100.00 zone. FYI: ATW has a moderate amount of short interest, about 7.4% of the 27.6 million-share float. That is about 4 days worth of short interest.

Suggested Options:
We would suggest the March or April calls.

Picked on February 17 at $ 90.37
Change since picked: + 2.74
Earnings Date 05/08/08 (unconfirmed)
Average Daily Volume = 654 thousand

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CF Industries - CF - close: 125.86 change: +2.90 stop: 113.45*new*

Shares of CF hit some rough profit taking on Thursday but the stock found support near $120 on Friday. Shares bounced near $120 twice on Friday and were already on the way up before the last hour market rally occurred. This looks like a new bullish entry point but if you are launching positions now then consider a tighter stop under its 10-dma (near 118.00). We are adjusting our stop loss to $113.45. Our target is the $138.00-140.00 zone. The Point & Figure chart is bullish with a $141 target. FYI: The most recent data puts short interest at 6.8% of the 53.4 million-share float.

Suggested Options:
We would suggest the March or April calls.

Picked on February 19 at $121.03 *triggered/gap higher
Change since picked: + 4.83
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 2.8 million

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Monsanto - MON - cls: 116.67 change: +0.24 stop: 111.90 *new*

It looks like MON is offering bulls another entry point. Shares pulled back toward $114.24 and hovered there most of the day before rebounding into the close. If you don't trust the late day bounce then wait for a breakout over $120.00 (or better yet $120.50) before buying calls. We have two targets. Our first target is the $127.00 level. Our second target is the $137.00-140.00 range. As we discussed earlier a move over $118 triggered a new P&F chart buy signal, which now forecasts a $157 price target. The fertilizer and agriculture stocks have been very volatile so readers should consider them aggressive, higher-risk plays. Please note that we are adjusting our stop loss to $111.90.

Suggested Options:
We would suggest the March or April calls.

Picked on February 12 at $118.09 *gap higher entry
Change since picked: - 1.42
Earnings Date 04/03/08 (unconfirmed)
Average Daily Volume = 7.1 million

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Mosaic - MOS - close: 108.96 change: -2.79 stop: 99.45

Friday's pull back in MOS and its mini, intraday, double-bottom near $106.50 looks like a new bullish entry point. However, if you want to launch new call positions here we would suggest a tighter stop, maybe in the $104-105 zone. The problem with that is MOS and its peers have been very volatile equities the last several weeks and you could easily get stopped out on an intraday dip. We are leaving our stop at $99.45 for now. MOS has already hit our initial target near $110. Our second target is the $118.00-120.00 zone. Again, these are very volatile stocks with a lot of intraday spikes. We would consider this a more aggressive, higher-risk play.

Suggested Options:
We would suggest the March or April calls.

Picked on February 12 at $101.83 *gap higher entry
Change since picked: + 7.13
Earnings Date 04/09/08 (unconfirmed)
Average Daily Volume = 5.8 million

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Nucor - NUE - close: 65.85 change: +1.70 stop: 59.95

Shares of NUE continue to look strong. The stock was already on the rebound Friday afternoon before the market's spike higher. The stock is arguably overbought after five weeks of gains in a row. However, in this case all we can do is play the trend. The stock has broken through multiple levels of resistance in the last several days. Our target is the $68.00-70.00 zone since the $70.00 level is likely to be significant resistance. The P&F chart is bullish with a $76 target.

Suggested Options:
We are not suggesting new positions at this time. However, after NUE hits our target we'll probably start looking for a new entry point.

Picked on February 17 at $ 62.01
Change since picked: + 3.84
Earnings Date 04/17/08 (unconfirmed)
Average Daily Volume = 5.0 million

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Petroleo Brasileiro - PBR - cls: 118.55 chg: +0.35 stop: 111.90*new*

Bulls bought the dip in PBR near its rising 10-dma again and the stock maintained its pattern of higher lows. Friday's bounce looks like a new bullish entry point to buy calls although readers could certainly wait for another rally past prior resistance near $120 again. We are adjusting our stop loss to $111.90. Currently, our target is the $128.00-130.00 range. The move over $116 has produced a new Point & Figure chart buy signal. Actually it is a quadruple-top bullish breakout buy signal with a $150 target (it was a $138 target two weeks ago). FYI: Another risk is PBR's earnings report. We can't find an earnings date and they normally report in mid February. That is a risk because we do not like to hold over an earnings report.

Suggested Options:
We would suggest the March or April calls.

Picked on February 12 at $116.00 *triggered
Change since picked: + 2.55
Earnings Date 02/12/08 (unconfirmed)
Average Daily Volume = 7.6 million

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Potash - POT - close: 157.00 change: +0.13 stop: 144.75

Shares of POT continue to march higher. This past week was definitely bullish with a breakout to new all-time highs. The stock has already hit our first target in the $158-160 zone. Right now if you're looking for a new entry point we would look for a bounce in the $150-152 zone or a new high over $160. POT should have some short-term support near $150 and its 10-dma. More conservative traders might want to think about adjusting their stop toward $150. Our second, more aggressive target is the $168.00-170.00 zone. More aggressive traders may want to aim significantly higher. The Point & Figure chart is forecasting a $222 target. Again, this is a very volatile stock. Readers should consider it an aggressive, higher-risk trade.

Suggested Options:
We would suggest the March or April calls.

Picked on February 12 at $147.50 *triggered
Change since picked: + 9.50
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 5.9 million

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Smith Intl - SII - close: 62.33 change: +0.87 stop: 58.45

Business is good for many of the oil service plays but unfortunately the group can be influenced by the day-to-day fluctuations in crude oil prices. The sector definitely saw some volatility this week. Traders bought the dip in SII near round-number support at $60.00 before the late day market spike higher. We remain bullish on SII but the stock does have some hurdles ahead of it. First and foremost is potential resistance near $65.00 and its 50 and 100-dma. Plus, we see a lack of volume behind the rally. Normally, to be truly bullish, we want to see rising volume on the rally. Friday's bounce could be used as a new entry point to buy calls but consider raising your stop closer to the $60.00 level. Our first target is the $64.25-65.00 range. Our second target is the $68.00-70.00 zone. We would expect SII to pull back initially when it hits $65.00. The P&F chart for SII is very bullish with an $80 target (it was a $77 target last week).

Suggested Options:
We would suggest the March or April calls.

Picked on February 17 at $ 60.52
Change since picked: + 1.81
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 3.5 million

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Yahoo! Inc. - YHOO - close: 28.42 change: -0.00 stop: n/a

Gosh! It only took three weeks for the lawsuits to start flying. Two pension funds have filed suit against YHOO for its rejection of the MSFT bid. The current consensus on the street, if there is a consensus, is that YHOO will eventually accept MSFT's bid. The real question is will they accept the $31/share bid or will they negotiate MSFT higher, say in the $33-34-35 zone. Some have speculated that MSFT is pursuing a proxy fight with YHOO's board because it is cheaper than raising their bid for the company. Our directional call play is a very speculative gamble that MSFT will raise its bid and that this news will come out in the next four weeks. There is plenty of risk and MSFT could decide to walk away or YHOO could do something stupid and poison any deal that kills the share price.

Suggested Options:
We were suggesting the March $30.00 or March $32.50 calls. They are cheaper today than they were a week ago. This is probably a "better" entry point given the speculative nature of the play.

Picked on February 17 at $ 29.66
Change since picked: - 1.24
Earnings Date 04/17/08 (unconfirmed)
Average Daily Volume = 54 million
 

Put Updates

Ambac Fincl. - ABK - cls: 10.71 change: +1.48 stop: n/a

ABK was the big story on Friday. It was a late story that came out in the last hour of trading but it was still THE story that moved the market. A CNBC commentator reported that ABK and a group of banks were close to a bailout plan for the troubled bond insurer. This news sent shares of ABK to a 16% gain and the market spiking higher. The story suggests that a deal could be reached as early as Monday or Tuesday this week. CNBC plans on airing a live interview with ABK management on Monday morning before the opening bell. It is unclear if this plan involves splitting up the company or not but it sounds like a group of banks is planning to add $2 or $3 billion to stabilize ABK and save it from losing its triple-A credit rating. While we have been bearish on the bond insurers I'm surprised this hasn't happened sooner. If you're a bunch of banks at risk of write downs in the tens of billions should ABK lose its credit rating would you "invest" a few billion to save the company and save yourself from these massive write downs? Odds are you would even though it is a conflict of interest and probably only prolongs the market's financial duress since we still won't know what these CDOs are worth or what's inside them and how much is at risk. Will the market pop on news of a real plan? Yes, it will. Will we suddenly revert to a bull market? I can't say but stocks could rebound for several days on the move. There is still no guarantee that a deal will get done or if it will meet approval with the credit rating agencies. However, we are not suggesting new positions at this time. Previously we had been suggesting the May out-of-the money puts and a speculative out-of-the money March ($20) call as a hedge should a bailout plan come to pass.

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

Picked on January 27 at $ 11.54
Change since picked: - 0.83
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 10.9 million

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W.W.Grainger - GWW - close: 74.77 chg: +0.07 stop: 78.26

GWW was hitting new relative lows near $72.75 before reversing higher on Friday afternoon. Friday's candlestick is technically a bullish reversal pattern. Traders need to be on the defensive here. More conservative traders might want to tighten their stop toward $77.00 or even $76.00. We are not suggesting new puts at this time. Our target is the $70.75-70.00 zone.

Suggested Options:
We are not suggesting new puts at this time.

Picked on February 10 at $ 76.65
Change since picked: - 1.88
Earnings Date 04/16/08 (unconfirmed)
Average Daily Volume = 1.0 million

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iShares DJ Financial - IYF - cls: 87.92 chg: +1.14 stop: 91.85

The IYF financials ETF was trading near its low for the day and its low for the week on Friday afternoon before the ABK news came out. The news sent shorts scrambling to cover. If a bailout plan does get announced on Monday then we would expect the IYF to breakout over resistance near $90.00 and probably its 50-dma near $90.70. We're going to adjust our stop loss to $90.75. We are not suggesting new puts at this time. Our official target is the $81.00-80.00 zone.

Suggested Options:
We are not suggesting new puts at this time.

Picked on February 06 at $ 88.62
Change since picked: - 0.70
Earnings Date 00/00/00
Average Daily Volume = 1.1 million

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MBIA Inc. - MBI - close: 12.18 change: +0.28 stop: n/a

Shares of MBI were trading near new lows for the day, week and month just before the ABK bailout news hit the wires on Friday afternoon. MBI ended up 2% by the closing bell but the stock might shoot a lot higher if a feasible plan for ABK does get announced. It is worth noting that Moody's did downgrade a reinsurer for MBI, which puts more pressure on the company. Given the news on Friday for ABK we're not suggesting new put positions for MBI at this time. We had been suggesting the out-of-the-money May puts and a March $22.50 (or $20.00) call as a hedge in case a bailout plan for the bond insurers does get done.

Suggested Options:
We are not suggesting new positions.

Picked on January 27 at $ 14.20
Change since picked: - 2.02
Earnings Date 01/31/08 (confirmed)
Average Daily Volume = 15.2 million

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Mohawk Ind. - MHK - cls: 74.68 chg: +1.58 stop: 78.05

There is no real reason for MHK to be spiking higher on Friday afternoon other than shorts covering into the weekend afraid the ABK news will spark a market stampede. MHK is nearing resistance at $75.00 again. If the market does rally we would expect MHK to trade up into the $76-78 range. Wait and watch for a failed rally before considering new put plays. There is potential support at $70.00 but we're aiming for the $66.50-65.00 zone near its January 2008 bottom.

Suggested Options:
Wait and watch for a new failed rally before considering new put positions.

Picked on February 14 at $ 73.70
Change since picked: + 0.98
Earnings Date 02/13/08 (confirmed)
Average Daily Volume = 907 thousand

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Sears Holding - SHLD - cls: 96.54 chg: +0.54 stop: 100.55

We were quickly running out of time but SHLD finally hit our suggested trigger to buy puts - and then it bounced! The market's late afternoon spike on Friday lifted SHLD from its lows of the month to a gain for the day. Our suggested trigger was $94.75. The play is now open. If you missed the entry point look for a failed rally anywhere in the $98-100 zone as a new entry point to buy puts. We only have three days and plan to exit on Wednesday afternoon at the closing bell to avoid holding over the Thursday morning earnings report. Currently our target is the $86.00-85.00 range but we could face a challenging week. It would not be out of the question to see SHLD trade sideways as investors wait on the earnings report.

Suggested Options:
If you can handle the three-day time span we would suggest the March puts.

Picked on February 22 at $ 94.75 *triggered
Change since picked: + 1.79
Earnings Date 02/28/08 (confirmed)
Average Daily Volume = 3.0 million

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Legacy Vulcan - VMC - cls: 68.26 chg: +0.14 stop: 70.86

VMC spent the week trading sideways. At this time we would watch for a failed rally under $70.00 or a new decline under $65.00 before considering new put positions. Our target is the $60.50-60.00 zone. The stop loss is a little bit wider than we would like but VMC can see some big $3-$4 swings intraday so readers should consider this an aggressive, higher-risk play.

Suggested Options:
If VMC provides us a new entry point we would suggest the March or April puts.

Picked on February 17 at $ 66.64
Change since picked: + 1.62
Earnings Date 04/30/08 (unconfirmed)
Average Daily Volume = 2.1 million
 

Strangle Updates

(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)

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CROCS Inc. - CROX - close: 25.43 chg: -0.69 stop: n/a

CROX slid again on Friday. The stock broke support near $25.00 on an intraday basis and hit new multi-month lows. Even the market's spike higher in the last 30 minutes failed to really move shares of CROX. We are not suggesting new strangles at this time. The options we had suggested were the March $40 calls (CQJ-CH) and the March $25 puts (CQJ-OE). Our estimated cost was $2.50 and we wanted to sell if either option hits $4.25 or higher.

Suggested Options:
We are not suggesting new strangle positions on CROX.

Picked on February 17 at $ 33.43
Change since picked: - 8.00
Earnings Date 02/19/08 (confirmed)
Average Daily Volume = 5.2 million

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Genentech - DNA - close: 71.60 change: -0.15 stop: n/a

Shares of DNA were halted for trading around 3:40 p.m. on Friday afternoon (just as the market was spiking higher on the ABK story). A few minutes after the closing bell it was announced that the FDA advisory panel had approved for DNA's Avastin drug as a treatment for breast cancer. Now remember, this is not a "cure" for breast cancer but it has been shown that Avastin prolongs the life of those suffering from advanced breast cancer. It is certainly a positive step for patients and shares of DNA soared after hours. DNA was trading in the $77.50-78.00 range in after hours markets. At $78.00 the March $75 calls could easily spike to $5.00 or more. More aggressive traders may want to raise their exit target from $5.00 to something in the $7.00 or $8.00 range. We are no longer suggesting new strangle positions on DNA. The options we had suggested were the March $75 calls (DWN-CO) and the March $70 puts (DWN-ON). Our estimated cost was $2.80. We want to sell if either option hits $5.00 or higher.

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

Picked on February 20 at $ 72.37
Change since picked: - 0.77
Earnings Date 04/10/08 (unconfirmed)
Average Daily Volume = 3.5 million
 

Dropped Calls

Apple Inc. - AAPL - close: 119.46 change: -2.08 stop: see details

Our bullish triple-play on AAPL has been a big disappointment. The explosive rebound never materialized and shares slowly withered back toward support near $120. The final blow came on Friday. The stock dipped to a new low under the early February bottom after new concerns arose over AAPL's iPhone. It appears that analysts are concerned that iPhone sales are not meeting expectations. Plus, the high-number of iPhones that have been "unlocked" impact AAPL's profitability for this product line. Shares eventually hit our suggested stop loss at $116.99.

AAPL play #1 - directional calls

AAPL hit our suggested stop loss at $116.99 closing this directional play.

AAPL play #2 - Credit put spread

The drop to a new relative low is our cue to exit. That means we need to buy back the $120 put we sold. In the mean time it might pay off to keep the March $110 put we bought.

AAPL play #3 - Sell Naked Puts

AAPL hit our suggested stop to close this play so we needed to buy back the naked put we sold. We had suggested selling the March $150 put.

Picked on February 10 at $125.48 *stopped out 116.99
Change since picked: - 6.02
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 44.4 million
 

Dropped Puts

Myriad Genetics - MYGN - cls: 36.88 chg: +0.05 stop: 40.51

Target achieved. MYGN ended Friday up five cents but midday the stock broke down under the $36.00 level hitting $35.93. Our target had been the $36.00-35.00 range. The stock is now down three weeks in a row and down five out of the last six weeks. It is probably time for an oversold bounce soon. We can be watching for a failed rally near resistance at a potential entry point for new bearish plays.

Picked on February 07 at $ 39.75 *triggered
Change since picked: - 2.87
Earnings Date 02/05/08 (confirmed)
Average Daily Volume = 801 thousand

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Simon Properties - SPG - cls: 85.88 chg: +2.15 stop: 90.15

We are losing patience with the REIT put play in SPG. The stock can be very volatile, as are many stocks in the industry, and if you can catch a move it's great. Shares have been going nowhere for days and now it looks like SPG might be poised to move higher. We're closing the play now and will reconsider bearish positions on a failed rally near its 100 or 200-dma or a new low under $82.00.

Picked on February 07 at $ 84.39 *triggered
Change since picked: + 1.49
Earnings Date 02/01/08 (confirmed)
Average Daily Volume = 2.7 million
 

Dropped Strangles

None
 


Trader's Corner

Exhaustion Gaps

Gaps, gaps, and now more gaps: the last couple of Trader's Corner articles have discussed a couple of types of gaps. When more than a couple appears on a chart, however, you may be seeing exhaustion gaps.

Annotated Daily Chart of CME:

In TECHNICAL ANALYSIS EXPLAINED, Martin J. Pring warns that "the presence of a second or third [runaway] gap should . . . alert the technician to the fact that the move is likely to run out of steam soon." Pring cautions traders who have too much risk on the table that an exhaustion gap might be a warning that they should lower that risk.

Pring offers clues to the presence of an exhaustion gap, but not all those clues were present on CME's chart. Pring says that prices will often move back toward the gap (down if prices gapped up and up if prices gapped down) by the end of the day. In addition, exhaustion gaps are often accompanied by large volume when compared to the price movement.

Volume was large the day of the gap, but CME's price movement was also large. Obviously, prices also closed near their high and not near the gap.

However, that information about identifying exhaustion gaps piqued my interest because of my study of Tom Williams' volume/price-spread analysis. In MASTER THE MARKETS, Williams warns that market tops are often accompanied by high-volume days. He says if the markets have been rallying and high volume suddenly appears but is accompanied by prices that close nearer the low of the day than the high of the day, you must consider the negative result (price action) of all that effort (volume). "[A] wide spread up-bar, closing on the lows, on increased volume, is bearish, and represents effort to go down" when coming after a rally. Although this section of his book does not specifically address gaps, the chart he supplied to illustrate the point did include a gap and the information corroborated some of Pring's points.

Annotated Daily Chart of Computer Sciences:

Should one load up on options if an exhaustion gap occurs? It certainly seems so if that CSC chart is used as an example. However, CME's chart showed a different pattern: consolidation over several months, a sharp but short pullback just below the gap and then another charge higher.

Pring warns that an exhaustion gap "indicates only temporary exhaustion," not necessarily a sign of a major market turn. As has already been noted, both Pring and William mention price spread and volume patterns in connection with exhaustion gaps. Might it be possible to use volume/price-spread patterns to distinguish between an exhaustion gap that signals a potential market turn and one that signals consolidation?

That's an intriguing thought. It's especially intriguing when one considers that CSC's exhaustion gap met William's volume/price spread conditions for a possible market top and was in fact topping while CME did not meet Williams' parameters. It did meet some but not all of Pring's for an exhaustion gap.

With the warning that anything examined in this article will be anecdotal evidence only, let's look at other charts, seeing what we find.

Annotated Daily Chart of PCLN:

Some might even argue that PCLN's action after the third gap was a continuation of the rally since PCLN climbed another hefty percentage, but the head-and-shoulders formation contributes to a different interpretation. Our point, though, is to decide whether anything on the chart might have foretold that this third gap, a candidate as an exhaustion gap, was not signaling an immediate market turn?

Did this chart show characteristics that met Pring's parameters for an exhaustion top? It did meet some. The gap was the third in that particular rally. The volume was high relative to previous days and weeks. Prices, however, did not drop back toward the gap by the close, and the spread or price range was relatively wide that day, so not all parameters were met.

This meant that the candle produced the day of the gap would not have met the most important of Williams' parameters for a market top. Williams looks for signs of weakness when prices are climbing. Volume much bigger than previous days' volume signals to him that there was some institutional involvement in the action, so he would have urged traders to pay particular attention to the price spread that day as well as to where the prices closed that day. What was the result of all that effort that the higher volume signified?

In this case, prices pulled back only slightly from the day's high, and in fact closed rather near that day's high. The day's range was wide. All that effort in fact produced a lot of results, verified when Priceline's stock climbed again the next day. When looking at effort (volume) versus results (price action), we don't see anything on that candle to lead us to the impression that big money was using that day to distribute stock. It didn't look like a market top, at least from that evidence alone.

If I'd been combining what Pring has to say about identifying exhaustion gaps with what Williams has to say about identifying market tops, I would have had to have voted in the "probably consolidation will follow" camp. Of course, that's easy enough to say in hindsight, isn't it?

So, let's test the idea by finding a stock that looks as if it might be meeting both Pring's parameters for an exhaustion gap and William's for a potential market top or bottom. If both sets of conditions are met, we might conclude that a trend reversal, at least over the short-term, would look more probable than mere consolidation.

Since the chart I located showed a possible exhaustion gap at the bottom of a steep decline, it's important to consider what signs Williams looks for at a market bottom. The previous discussion involved market tops. When looking for a market bottom, Williams also searches for signs of institutional involvement (high volume relative to previous days) and then looks at the result of that involvement. While some would consider any large volume on a decline as validation of the bearishness, Williams cautions that traders should be more attentive.

If the volume signaled that big money was involved, what was big money doing? What was the result of their effort? Did prices bounce by the end of the day? If so, wasn't big money likely accumulating?

Annotated Daily Chart of ARRS:

Note: When I scroll back on a chart, my charting program outlines the scroll bar in red, as it did with CME's chart, the first shown in this article. You can check then, that I didn't just roll back a chart so I could make it fit the discussion about what it predicts. This chart was snapped after the close February 15, my annotations made then, and the scroll bar shows that.

Large volume was present, a sign of big-money involvement according to Williams. Big money must have been accumulating, Williams might have concluded, although he certainly would have warned that big-money accumulation doesn't promise that prices will always and immediately go higher. If they'd been doing all the dumping and little of the buying, it would have been nearly impossible for mom-and-pop retail trader to absorb that heavy volume and send prices that far off the low by the end of the day.

As of February 15, then, it looked possible that an exhaustion gap was forming that might signal at least a short-term turning point for ARRS. Williams cautions in his book that even when we see signs of accumulation, a turnaround might not be immediate. Big or smart money can afford to begin accumulating while a stock is still going down if they think a turn may be approaching. Mom-and-pop retail trader can't always afford to do that. He offers suggestions about retests, for example.

Perhaps the combination of Pring's information and Williams' conditions points to a turning point in ARRS. Perhaps not. Three or four charts don't prove a theory, as intriguing as the information they contain might be.

Whether AARS bounces or not, the chart's picture is not a pretty one, and that gap's upper boundary may serve as strong resistance, so this was not meant as a trade suggestion. As I edit this article midmorning on February 22 in preparation for submitting it, ARRS trades at $5.97, an 8.5 percent gain from the value shown on that chart. The candles produced over the last few days have been small-bodied candles rising like wisps of smoke on lower volume, so it's been consolidating sideways up. It's possible that prices may need to come back and retest, so again, I'm not offering this as a trade suggestion, but only as an illustration of what you might look at with an exhaustion gap.

However, bearish traders have been forewarned by the presence of the possible exhaustion gap to consider lightening up on positions and to plan for a possible bounce.

That's what an exhaustion gap does: it warns traders that a trend may be changing. A prolonged consolidation or even a trend reversal may be at hand. While price action should guide the choices that are made from that point, the presence of a third or fourth gap alerts traders to make a plan. Those who are too highly leveraged in a trend-related move can plan how they'll hedge or reduce their risks. Perhaps you'll decide that Pring's and Williams' information helps you differentiate those times when exhaustion gaps are likely to be followed by consolidation from those when it signals a reversal, but that's something to be discovered only after much experimentation.
 

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

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