Friday was the worst leap day of trading since records were begun back in 1896. Leap year babies have to wait for years for their birthday to roll around again. Traders would probably not mind waiting 4 more years before seeing a repeat of Friday's selling. A tsunami of economic news was flooding Wall Street with analysts and economists warning that things could get worse before they get better. At least five Fed speakers made comments, sometimes conflicting, that suggest the Fed may still be ready to cut rates again but are already preparing to remove those cuts the instant conditions show signs of improvement. There was evidence the municipal bond sector was imploding with massive amount of selling by hedge funds. The news was ugly on every front and the market reflected this sentiment. Selling in the dollar increased sharply on increased recession fears. It is now trading at all time historic lows.
Dollar Index Chart
The economics were headlined on Friday by a sharp drop in the Purchasing Manager Index or PMI. The headline number fell to 44.5 for February from 51.5 in January. This is the lowest reading since Dec-2001 and well below expectations for a drop to an even 50. This put the PMI into contraction territory and increases the likelihood that we are in a recession. As you can see in the table below the employment component fell sharply by nearly 16 points to a multi year low at 33. Shipments and order backlogs also declined sharply to settle in the 30s. This index suggests we will see an equivalent drop in the national ISM when it is reported on Monday. Some analysts are now projecting a negative GDP for both Q1 and Q2 and that is the textbook definition of a recession.
Chicago PMI Four-Month Table
Chicago PMI Chart
The economic calendar for last week was crowded but next week has the two most important reports for the month. Those are the ISM and Payroll reports. The ISM is expected to fall into contraction territory and the PMI on Friday has analysts lowering their expectations to something in the mid 40s.
The jobs report on Friday was expected to show a gain of 40,000 jobs based on reported estimates as of noon on Friday. After the close that estimate had fallen to a gain of only 25,000. If the ISM does come in at a mid 40 level that jobs estimate may fall into negative territory. The rising jobless claims in Q1 suggest that employment has fallen significantly and we could see a second month of job losses when Friday's number is revealed.
Jobless Claims Chart 2008
The other three economic reports of interest are Factory Orders, ISM Services and the Beige Book. Factory orders are expected to drop sharply and the ISM services report is expected to post its second month in contraction territory. The Fed Beige Book will be released on Wednesday and that will give investors a look by region at the current economic conditions.
The selling on Friday was triggered by the drop into contraction territory by the PMI but also by bad news in stocks. AIG reported earnings before the open and reported substantially bigger losses than previously expected. AIG posted a loss of $5 billion for the quarter due mostly to losses in the credit markets. Credit default swaps owned by AIG fell by more than double the estimates made just two weeks ago. AIG owned credit default swaps on $579 billion in debt and those swaps lost more than $11 billion in value on worries that the debt will not be repaid. AIG also lost $3 billion in its investment portfolio because of "significant, rapid declines" in the value of mortgage debt. Because of the continued high exposure to mortgage debt and various bond investments the downgrades were flying fast. AIG said it also had $42 billion in bonds insured by those insurers trying to construct a bailout and there is indecision in the market on whether that insurance will be paid. AIG said 84% of the bonds were "A" rated or higher with only 2% considered junk credits. AIG stock lost $3.29 or 6.5% on the news. As a Dow component that equates to a loss of nearly 30 Dow points. The real damage to the market was much worse since it suggests the damage is still growing and when the brokers report earnings again in mid March it is going to be ugly.
Dell lost a buck after reporting earnings on Thursday night but the ugly results knocked the support from under the tech sector. Dell reported an unexpected drop in earnings, missing estimates by a nickel and sales that were substantially below consensus estimates. All the news was not bad with overseas sales rising +16% with sales to BRIC countries rising +36%. Sales in the U.S. were disappointing and again point to sharply slowing economics. This was the equivalent of finding cancer in the tech sector. Expectations for sharply lower spending in Q1/Q2 pushed all the major techs lower.
There were numerous events in the financial sector other than the AIG implosion. Three hedge funds, Duration Capital, 1861 Capital and Blue River were forced to dump billions in municipal bonds due to margin calls. As the bond insurer bailout continues to drag on with no signs of a solution the value of those bonds has fallen. Friday was the day the rating agencies had originally given as the deadline to do a deal or be downgraded. That deadline may have been unofficially extended after the Ambac consortium actually provided a deal framework to the agencies. Those agencies said no deal to the proposed plan without a substantial increase in the capital portion and kicked it back to the consortium with some additional demands. That may have given the consortium another week before the hatchet falls but the market did not wait around for the conclusion. With the value of bonds dropping like a rock there were plenty of bonds for sale. Pimco was reportedly in the market making ridiculous offers simply because they are the biggest buyer and nobody else was willing to jump into the alligator pit. On a normal day reportedly there are portfolios of $20-$30 million seeking bids. On Friday there were portfolios of $500 million to more than $1 billion being offered. There was definitely blood in the streets in the bond market and the flight to quality was huge. The yield on the ten-year treasury fell to 3.534% at the close as buying in treasuries exploded. That was more than .400 points below the 3.932% yield we saw as recently as Tuesday. That may not sound like much but in the bond market it is huge.
Ten-Year Yield Chart
UBS announced early Friday there could be at much as $600 billion in write-downs by financial firms. Goldman Sachs said write-down exposure could be in excess of $400 billion. According to Bloomberg total write-downs to date are $181 billion. If the Ambac bailout never comes those numbers could be worse. The news of the deal refusal by the rating agencies caused all the financials to be sold hard and this could continue next week. With financials 21% of the S&P this was very bad news for the overall market. The bond margin selling on Friday could be a sign of what is ahead. Volume dumping depresses values and that could trigger margin selling in other portfolios next week. Hedge funds had been loading up on depressed muni bonds in anticipation of an eventual insurer deal that would send the value of those bonds back to normal. Instead of rising in value those bonds have continued to decline. With $2.4 trillion of those bonds in the market there is plenty of pain to go around. Friday's margin selling was not even a drop in the bucket compared to the amount of bonds outstanding.
In another hedge fund development six banks seized the assets of hedge fund Peloton Partners. The firm announced on Thursday it was shutting down its ABS Master Fund. The fund made 87% on accurate subprime bets in 2007 but got into trouble in 2008 when their bets on highly rated securities went wrong and the value of those securities plunged in the current credit crunch. Apparently the banks decided to take action to protect their investments in a rapidly declining bond market. Funds typically raise money and then borrow against that money to produce leverage of 600% to 1000%. Get a billion, borrow $7 billion against it and go buy leveraged assets on margin to push your risk/returns even higher. According to various hedge fund managers this leverage is being removed from the markets as more banks revise their risk exposure in the face of declining asset values. Several managers have said in private that the quickness of the leverage removal (loans from banks) is making it nearly impossible to make an orderly withdrawal from the hedge funds investments. You get a notice that says we are calling your loan and you have only days to exit investments, sometimes illiquid investments, before the loan has to be paid. This forces dumping of other assets and that dumping forces other funds into a similar problem as the value of the asset class diminishes. If this turns into a self-replicating feedback loop within the industry then declines like we saw on Friday could become worse.
There was a major financial conference in New York and there was a report making the rounds analyzing the expected damage of the subprime crisis. The report claimed there would be $2 trillion less lending as the credit crunch continued. $900 billion of that reduced lending would be to homeowners and small business. This would subtract up to 1.5% from GDP in 2008 and possibly 2009. This is just more reinforcement that the markets could be under pressure for many months to come.
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The parade of Fed speakers to the podium on Friday seemed to indicate the Fed was open to cutting rates again at the March 18th meeting. Unfortunately there were several references to the need for a rapid reversal of any rate cuts the instant the economy appeared to finding traction. The prospect of a rapid reversal lessens the implied impact of any rate cut. It is like telling your kid they can have a hot fudge sundae and then taking it away after the 3rd bite. This should invoke tantrum images if you are a parent. They are diluting the potential impact of future cuts before they even happen.
Friday's trading was the worst leap day trading since records began in 1896. The Dow lost -315 points on Friday but only -115 for the week. The low on the prior Friday was 12155 and the high on Wednesday was 12756 or a +601 points. Even at the low this Friday of 12224 we have not yet retraced that 601-point move. Yes, it was a bad day in the markets but it did not change the recent market trend. I cautioned on Tuesday night that the +600 point move was the result of anticipating of an Ambac bailout, hopes that Bernanke would make some market moving statement and the guidance upgrade by IBM. Basically all the expectations had been priced into the market in advance of the events. The Ambac deal died, Bernanke disappointed the markets and Dell killed the outlook on techs. The AIG earnings after an $11 billion write-down and forced margin selling by hedge funds was icing on the cake for the bears.
Despite Friday's drop the Dow continues to trade in its recent range. I agree that it looked ugly but volume was still relatively light at only 7.7 billion shares. It was far from a washout even though the A/D line was negative 10:1 over advancers. The decline was predominantly in financials although all sectors saw profit taking. All 30 Dow components were down but only AIG was down significantly. On the Nasdaq 100 only six stocks finished in the green. Only 62 of the Russell 3000 were up more than 50 cents. It was an ugly day but it was just a day with several news events providing the motive power.
For next week the Dow still has support in the 12100-12200 range and the January intraday lows are well below at 11634. The Dow can continue to wander for hundreds of points without any serious damage. Many analysts this weekend are renewing their calls for a retest of the January lows. If it did happen I believe it would be good for the markets since there has been plenty of advance warning. Traders have already been beaten senseless and are far less likely to hold long positions in a falling market. Any retest could easily clean house and have an entirely new set of holders rush into the dip to establish new positions. This is what is needed to provide a firm bottom.
The qualification here is the margin selling by hedge funds. If this increases we could see a really high volume market event that could endanger the prior lows. I view it as a slim chance but still a chance. The Fed is watching the bond insurer saga and they will be forced to consider what a cascade of bond selling would mean to the broader market. Over the weekend the Fed could lean on the parties involved and press for a resolution. They could also throw a surprise rate cut into the mix next week if it appears the markets are about to fall off a cliff. I still believe the key is Ambac. If a deal appears that will allow them to maintain their AAA rating then sellers will evaporate and a real rally begin.
Everyone believes we are in a recession. We should not get any news next week that can increase that possibility other than maybe a big job loss. The CPI on Friday was a preview to the ISM so without a bigger implosion in the ISM it should not be a major market mover. All the smaller economic reports have shown falling employment so a minor job loss on Friday should not be a major news event. It would just be confirmation of the current recession. A major job loss approaching 100,000 jobs or more could prompt fears of a deeper recession and possibly cause another sell cycle. It would also provide the Fed with another reason to cut rates.
Because of the Dell shortfall the Nasdaq looks a little worse than the Dow but is still within its 6-week trading range. Friday's close was a new 17-month closing low but there were four days over the prior six weeks where the Nasdaq traded lower but recovered to close higher. Currently 2260 is initial support and 2365 initial resistance. 2202 was the intraday low back on Jan-23rd and theoretically the point we could test before a new rally appears. Nothing says we need to go there but it is always a possibility.
The S&P-500 also made a complete round trip from the bottom to the top and back to the bottom of its range. The bounce on last week's expectations was erased and the S&P returned to retest initial support at 1320-1325. We could easily return to the January lows at 1285 but there would need to be a buyer boycott to do it. Plenty of buyers still remain at the bottom of the range as evidenced by the prior rebounds. It may take another bloody nose and a dip back to 1285 to bring in the really big money and that possibility always exists. The Dow and S&P have declined for four consecutive months and that has not happened since the last bear market bottom in 2002. The Russell-2000 chart mimics the S&P so I will skip it today.
One negative point I have not yet discussed was the news from Thomson Financial. They calculated that the final earnings tally for Q4 showed a drop in earnings of -25% and a number that we have not seen since they began keeping records in the mid-90s. With profits in Q1 expected to be worse we could be nearing a bottom in the cycle. Q1 only has a month to go and then estimates for the rest of the year begin to explode higher. This is of course due to the meager comparisons with Q3/Q4 of 2007. It would not be hard for Q4-2008 earnings to be better than Q4-2007 at -25%. When does an earnings bottom begin to produce speculation in stock prices? Normally when investors actually see those earnings start to improve. We are not there yet we can probably see it from here. When companies begin to give guidance for Q2 we will quickly know if the bottom is behind us or still in our future. That early guidance is about six-weeks away. Odds are good that institutions will begin to speculate on that guidance being positive sometime over the next 2-4 weeks. Assuming an Ambac deal is finally announced that would be the all clear signal and investors would come back to the market. Those stocks with the best outlooks would be the first to be bought. The caution here is that the next couple of weeks could be rocky and volatility will likely increase as we try to find a bottom in this market. If more hedge funds find their leverage cut and are forced to liquidate the odds are very good the January lows will be tested. I would be a cautious buyer of any dip to that range. Until then I am an observer rather than a participant. Trying to pick a trend in a range bound market is a fool's game. You can scalp the reversals if you are quick and nimble but a position older than two days is a huge risk.
NII Holdings - NIHD - close: 39.73 change: -0.74 stop: 41.26
Why We Like It:
BUY PUT APR 40.00 QHQ-PH open interest=1002 current ask $3.40
Picked on March xx at $ xx.xx <-- see TRIGGER
Precision Castparts - PCP - cls: 110.39 chg: -5.09 stop: 112.65
Why We Like It:
BUY PUT APR 110 PCP-PB open interest= 41 current ask $6.60
Picked on February xx at $ xx.xx <-- see TRIGGER
Sears Holding - SHLD - close: 95.62 change: -5.78 stop: 100.51
Why We Like It:
BUY PUT APR 100.0 KTQ-PT open interest=12602 current ask $9.70
Picked on February xx at $ xx.xx <-- see TRIGGER
CNOOC - CEO - cls: 165.77 chg: -5.53 stop: 159.49
As traders we have a decision to make with CEO. The U.S. markets pulled back sharply on Friday. Normally overseas markets react negatively to any bid decline here in the states. So do we buy the dip in CEO near $165? Or do you try and exit early or tighten your stop closer to $165 to reduce your risk? We also need to take into account that shares of CEO are likely to gap open on Monday (for us) as they adjust to trading on the Chinese exchanges. Will it gap higher or lower? We still believe that the oil stocks present some bullish opportunities. Although Jim might discuss his views in the wrap this weekend on how crude oil is temporarily too high (we are still very bullish on oil long-term). At this point in the game we are going to suggest that readers look for a bounce in the $165-160 zone as a new entry point to buy calls. We are listing two targets. Our first target is the $188.00-190.00 zone. Our second target is the $208-210 zone. We would expect some resistance and a pull back on CEO's initial test of the $185 region and the $200 region. Our $208 price target is pretty aggressive given our three to four week time frame. We do not want to hold over earnings. Plan on exiting the majority of the position at the first target.
Picked on February 26 at $170.73
CF Industries - CF - close: 122.08 change: -4.14 stop: 117.45
As the market's losses began to mount on Friday afternoon so did the declines for CF. The stock lost 3.2% and produced a bearish engulfing candlestick pattern. This is typically seen as a bearish reversal pattern and the ominous roll over in some of the technical oscillators doesn't bode well for the bulls either. If the market sees any sort of sharp sell-off lower on Monday then CF could break support at $120 and stop us out. If we do get stopped out we'll be looking for a new bullish entry point on a dip near $115 and its rising 50-dma (or very worst-case near the 100-dma). If you're feeling conservative then consider a tighter stop near $120. Our target is the $138.00-140.00 zone. The Point & Figure chart is bullish with an updated $143 target. FYI: The most recent data puts short interest at 6.8% of the 53.4 million-share float.
Picked on February 19 at $121.03 *triggered/gap higher
iShares China 25 - FXI - cls: 145.23 chg: -5.26 stop: 149.45
The Chinese FXI never confirmed its bullish breakout from Wednesday. The index has lost about ten points since then. It looks like traders were buying the dip near $145.00 late this afternoon. Aggressive traders may be tempted to follow their lead and jump in here. However, we will repeat our comments from the CEO update. Normally overseas markets react negatively to big down days here in the states. That should put more pressure on the FXI come Monday - at least Monday morning. Patient investors might get a shot to buy a dip or a bounce around $143 or even $140-137 in the FXI. If we see a clear bounce around the $140 area we might adjust our suggested entry point. Currently we're waiting for a move over $160. Our official plan suggests that readers buy calls at $161.01. If we are triggered our target is the $178.00-180.00 zone although we'll have to keep a wary eye on potential resistance at the 100-dma.
Picked on February xx at $ xx.xx <-- see TRIGGER
Humana Inc. - HUM - close: 68.33 change: -2.92 stop: 67.75
Thursday HUM provided us what looked like the perfect entry point with a dip to $70.50. We had been suggesting that readers buy calls in the $71.00-70.00 zone. Sadly, Friday's market weakness pushed HUM right through technical support near $70.00 and its 200-dma. The intraday low was $68.12. Honestly, we're surprised that we were not stopped out. If the market sees any follow through lower on Monday we do expect to be stopped out at $67.75. However, readers may want to keep an eye on the $67-66 zone and look for a rebound there as a new entry point to consider buying calls. We have two targets. Our first target is the $74.75-75.00 range. Our second target is the $78.00-80.00 zone but HUM will have to power through technical resistance near $75.00, its 100-dma and 50-dma to reach our second target. The P&F chart is bullish. It recently produced a new triple-top breakout buy signal with an $83 target.
Editor's note: HUM and healthcare may be a great long-term investment considering the future of the U.S. and the aging baby-boomer population. Unfortunately, this short-term reversal in HUM is pretty ugly. If it breaks down under the February low (65.89) we would strongly consider shorts/puts and aim for the $60 level.
Picked on February 28 at $ 71.00 *triggered
Monsanto - MON - cls: 115.68 change: -2.84 stop: 113.99
Traders are facing another tough decision with MON. The stock has pulled back to what should be support near its short-term trend of higher lows, support near $115, and its rising 50-dma. All three should combine to be a tough spot for the bears to break through and thus a buying opportunity for the bulls. However, the recent weakness is casting a bearish tint across the short-term oscillators. I remain bullish on the fertilizer stocks. However, if we get stopped out on market volatility this coming week I suggest we watch the $110 level or the 100-dma as potential entry points to jump back in. We have two targets. Our first target is the $127.00 level. Our second target is the $137.00-140.00 range. We are adjusting our stop loss to $113.99. The fertilizer and agriculture stocks have been very volatile so readers should consider them aggressive, higher-risk plays.
Picked on February 12 at $118.09 *gap higher entry
Potash - POT - close: 158.90 change: -3.39 stop: 147.75
It is always painful to see gains get stripped away like today's 2% drop in POT. However, the stock has actually been showing relative strength and remains above its 10-dma. The question is can it hold above this level next week? POT has already surpassed our early target in the $158-160 zone so readers should have already booked some profits. At this point a correction back to the $155.00-152.50-150.00 zone would still be normal and a dip near its 50-dma would definitely look like a new bullish entry point to jump in again. We're not suggesting new positions today but we'll be looking for new entries next week if POT provides one. 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.
Picked on February 12 at $147.50 *triggered
Shaw Group - SGR - close: 64.38 change: -3.91 stop: 59.85
Ouch! The market-wide profit taking on Friday hit shares of SGR pretty hard. The stock, which had been up two weeks in a row and most of last week, plunged 5.7% to its rising 10-dma on Friday. This wiped out all of our unrealized gains in one session. We are still bullish on SGR but we need to see some sort of bounce first before considering new call positions. A rebound anywhere in the $60-62.50 region should work. We have two targets. Our first target is the $69.50-70.00 zone. Our second, more aggressive target is the $74.00-75.00 zone. The Point & Figure chart is very bullish with an $81 target.
Picked on February 24 at $ 64.53
Smith Intl - SII - close: 63.03 change: -2.72 stop: 59.90
Oil service stocks had been leaders most of the week but traders sold them hard on Friday in a rush to lock in a gain. Shares of SII spiked lower and ended the session with a 4.1% loss. The stock is now trading back under its 50 and 200-dma. While it looks like SII was starting to rebound on Friday afternoon we would be cautious here. There may be another surge lower on Monday. A bounce anywhere above $60 could be used as a new bullish entry point. The stock has already hit our first target in the $64 zone. Our second target is the $68.00-70.00 zone. The P&F chart for SII is very bullish with an $80 target (it was a $77 target last week).
Picked on February 17 at $ 60.52
Yahoo! Inc. - YHOO - close: 27.78 change: -0.37 stop: n/a
YHOO continues to drift down as investors wait on the next development in the MSFT-YHOO drama. Last week the biggest news was a rumor that YHOO was finally in "talks" with MSFT about the takeover bid. We have three weeks before March options expire. Right now we're speculating that MSFT will raise its bid before expiration. This remains a very risky, aggressive bet. Our suggested calls were the March $30 or March $32.50 strikes.
Picked on February 17 at $ 29.66
Ambac Fincl. - ABK - cls: 11.14 change: -0.66 stop: n/a
Here we are. It's the end of February and still no bailout deal and no ratings agency downgrade in spite of all the dire warnings a few weeks ago. That doesn't mean the agencies won't still downgrade ABK and MBI. A couple of the rating agencies did reaffirm their triple-A rating on ABK and MBI while keeping them on negative creditwatch. Seems like a contradiction and a worthless action at this point. There was some news floating around on Friday that the ABK rescue plan had run into some hurdles with how much money the company needs to raise in order to get the deal approved. Meanwhile in the news ABK cut its dividend from 7 cents to 1 cent and have suspended all structured finance deals for the next six months. Anything and everything could happen in the next week or two but we're still betting with the bears. This remains a very speculative play. We will definitely hold over the April earnings if we get the chance. If you are considering new positions here then think about an out of the money April call as a potential hedge against a deal getting done. 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.
Picked on January 27 at $ 11.54
MBIA Inc. - MBI - close: 12.97 change: -1.09 stop: n/a
Shares of MBI lost 7.7% on Friday. The stock under performed its peer ABK most likely due to its 10-K filing. An AP article on the company's regulatory filing was interesting. MBI claims that "demand for our product is the lowest it has been and we are writing very little new business." They stated that they (MBI) expect more write downs due to a very bad January. The picture still looks very murky for MBI and ABK. While a rescue plan might get done the bond insurers could get downgraded by the ratings agencies at any time. If you're thinking about opening new plays then consider an out of the money April call as a hedge against a bailout coming to pass. 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. We will definitely hold over the April earnings if we get the chance.
Picked on January 27 at $ 14.20
Everest Re Group - RE - close: 96.88 change: -1.05 stop: 102.01
Weakness in insurance giant AIG and the market weighed on shares of RE. Yet honestly we were expecting a bigger decline. Shares of RE only lost 1%. The pattern still looks very bearish but the lack of real movement makes us cautious. We are setting two quick targets. Our first, conservative target is $93.50. Our second, more aggressive target is the $91.00-90.00 zone. We're suggesting a stop loss at $102.01 but more conservative traders might be able to get away with a stop around $100.51. FYI: The P&F chart is bearish with a $74 target.
Picked on February 28 at $ 97.93
(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.)
CROCS Inc. - CROX - close: 24.32 chg: -0.81 stop: n/a
CROX slipped 3.2% on Friday, under performing the S&P 500 (-2.7%) but the stock bounced near $24.00 for the second time this week. The trend is obviously bearish but CROX is very oversold and due for a bounce. We only have three weeks left until March expiration. Any bounce in CROX would wipe out any premium still left in the March $25 puts. More conservative traders need to strongly consider an early exit now to cut your losses. On the positive side the market could see another big drop on Monday and further push the puts into the money. We are not suggesting new strangles at this time and we are adjusting our exit target. 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. We were previously suggesting an exit if either option hit $4.25. We're adjusting our target to $3.75.
Picked on February 17 at $ 33.43
Genentech - DNA - close: 75.75 change: -0.11 stop: n/a
DNA did post a gain for the week but the stock gave back a big chunk of it with profit taking Tuesday through Friday. Shares did start to bounce when they tagged the $75 level and its rising 10-dma on Friday. We are not suggesting new positions at this time. 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.
Picked on February 20 at $ 72.37
MEMC Electr. - WFR - cls: 76.28 chg: -2.40 stop: 77.45
It's been a rough three days for solar-energy bulls. WFR hit our trigger to buy calls on an intraday spike Tuesday and has been sliding lower ever since. Friday's market weakness helped send WFR through the $78.00 level and quickly hit our stop loss at $77.45.
Picked on February 26 at $ 82.55 *triggered
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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