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Daily Newsletter, Saturday, 03/15/2008

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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

The Ghost of John Pierpont Morgan Rises Again

Recently Bear Stearns (BSC) had denied persistent rumors about liquidity problems. This morning, market participants learned that some of those rumors were true. BSC said, however, that its liquidity situation had deteriorated rapidly over the past day.

Introduction

J.P. Morgan & Chase (JPM) worked together with the Federal Reserve Bank of New York to provide funding for BSC, giving rise to memories of John Pierpont Morgan's famous efforts to rescue the financial system. Some may remember those stories of how on one very bad day in 1907, financial wizard John Pierpont Morgan gathered his cronies together and engineered a bailout that prevented a financial collapse.

In 1907, faltering banks and trusts had led to a situation similar to the current one. A credit crunch had resulted when some banks were reluctant to make loans. The economy had slipped into a recession. Lending was tight, and the whole financial system threatened to freeze.

JPM has come to the rescue in other instances since, and it did again Friday. Through the Fed's discount window, JPM obtained funds to provide secured financing for BSC. That funding was for an initial period of up to 28 days.

JPM assured its shareholders that they would not incur "material risk" as a result of the efforts it was making on behalf of BSC. The Federal Reserve assured the rest of us that it "is monitoring market developments closely and will continue to provide liquidity as necessary to promote the orderly functioning of the financial system."

Some signs suggest difficulty keeping the financial system functioning in an orderly manner. Thursday, the Federal Reserve's own figures showed that outstanding commercial paper, a measure of liquidity, declined $15.1 billion in the week concluding March 12. The decline was prompted by financials, both domestic and foreign. As noted in Thursday's Wrap, we need to see financials finding ready markets for their short-term paper (30 to 180 days) before we can feel any assurance that the credit crunch is easing. Companies that can't place this paper, needed to fund operations, are forced to go to banks for more expensive loans. If they can get them.

Friday, the Libor rate (the London Interbank Offering Rate) soared to a three-month high. This is the rate banks charge to borrow money from each other. It is not the same as the official target rates set by central banks. Those are the rates at which central banks lend to each other.

The British Banking Association sets the Libor rate, meeting each morning with representatives from 16 major banks. They all decide how much they're willing to lend and the rate at which they'll lend, and a rate is then calculated.

The rising Libor rate suggests that banks are afraid to lend to each other, not knowing the risks that each holds in their portfolios. The spike in the Libor rate perhaps indicates that the Fed's surprise efforts to increase liquidity, taken in cooperation with a number of central banks across the globe, are not achieving the desired results.

It is in this context in which JPM will be fulfilling its agreement to continue working with BSC to obtain permanent financing or alternative solutions. Some believe that these alternative solutions will result in BSC being taken over by another entity.

What happened to BSC?

Some blame BSC entirely. One article called BSC a "trafficker" in highly leveraged mortgage-backed complex securities. Some are kinder, saying that BSC just didn't get out of these securities fast enough when things started going downhill, as if it were a timing issue.

If you've been reading other Wraps recently, including mine, you know that there's been a growing disparity between the book value of mortgage-backed securities and their market value. A little over a week ago, when Swiss banking giant UBS was forced to sell its entire portfolio of Alt-A securities at what were deemed fire-sale prices to Pimco, the action was indicative of the spillover of the subprime mess into other types of mortgage-backed assets. When UBS sold at fire-sale prices, it could be reasoned that other counterparties to repurchase agreements would devalue the portfolios against which they had loaned money. They would insist that more margin be put up. And they have done so.

Here's some background from a previous Wrap for the benefit of those wondering what a repurchase agreement is. Repurchase agreements are forms of short-term borrowing. For the company selling the security, it's a repurchase agreement, and they're agreeing to repurchase it at a later date for a higher price. For the company buying it, it's a reverse repurchase agreement. The repurchaser buys them with the agreement to sell them at a higher price at some specific date. Companies might use the borrowed money they receive under the repurchase agreement to finance the purchase of other securities, such as portfolios of residential-mortgage-backed securities backed by Fannie Mae and Freddie Mac. When the value of those asset-backed securities drops too far, the financial counterparties to that agreement send out a margin call.

That's happened to Thornburg and Carlyle, both in the news for the last couple of weeks. BSC holds some of those mortgage-backed securities and collateralized debt obligations: too many of them, apparently. Although BSC blamed accelerating client withdrawals, it should also be noted that banks are insisting on higher margins and imposing higher borrowing costs on BSC, hamstringing its ability to conduct business.

BSC's stock plummeted amid speculation that it would no longer exist as a separate entity by Monday morning. Although JPM had issued assurances to its investors and its leadership role suggested that it must be in sound financial shape, its stock dropped, too, with JPM closing near the 3/10 low. Some speculated that banks other than JPM are being approached to acquire BSC, with rumors surrounding Washington Mutual (WM) among others.

BSC closed at $29.91. A MarketWatch.com article noted that BSC's stock price had dropped further than its record one-day 22 percent drop in the October 1987 stock market crash, a comparison that must send shivers through any who traded through that infamous day. When announcing that it would report its latest quarterly earnings Monday, BSC noted that its book value remains above $80.00, well above its current stock value, but that claim did nothing to stem the losses.

Amid the turmoil, Standard & Poor's noted that it has lowered ratings on BSC's long-term and short-term counter-party rating to BBB and A-3, respectively. Former ratings were A and A-1. Both were placed on Credit Watch with negative implications. BSC also garnered downgrades.

Articles speculated on other financials that might suffer similar fates. Lehman (LEH) was mentioned due to a widening in its credit default swaps. Financials such as Washington Mutual (WM) and National City (NCC) joined BCS in receiving downgrades in credit ratings, by Moody's in their cases.

Other financials have been impacted. Carlyle Capital got into trouble when it borrowed money to buy a portfolio of securities issued by Fannie Mae and Freddie Mac, with those securities backed by mortgages. In the past, these have been highly liquid because most believed them to have an implied government guarantee. However, with no market for anything backed by mortgages, what was once liquid had become illiquid. The value of the fund dropped, margin calls were made, notices of default were issued when Carlyle failed to meet those calls. By yesterday Carlyle announced that it expected its lenders to seize most remaining assets.

Carlyle Group's co-founder David Rubenstein told reporters of his desires to make amends to investors in Carlyle Capital. He said he was searching for legal and other methods of compensating those investors, allowing them some reparations for their losses.

However, the developments during the pre-market period evaporated the good feelings engendered by the milder-than-anticipated CPI. Prices on indices hesitated a moment after the cash open and then dove. The rest of the day saw choppy price movements that result in a new low in the afternoon for many indices and then a soon-failed rally attempt.

Let's see how much damage was done.

Charts

For those not accustomed to reading my Thursday Wraps, I consult a number of charts--standard and nested Keltner--of different time intervals--intraday, daily and weekly--to determine possible support/resistance levels and interpret chart action. The annotations bring together information from daily and weekly standard and Keltner charts. The end of the article includes a number of intraday charts providing benchmarks to watch early Monday morning.

The daily charts, especially with the weekly information included, provide an overview, but don't neglect to look at the intraday ones. Thursday, the daily chart suggested that the indices were poised to push up toward their 30-sma's, but the intraday charts provided benchmarks to watch to determine if that looked feasible. The potentially strong resistance indicated on those intraday charts held; the potentially strong support did not, and down prices went.

Annotated Daily Chart of the SPX:

Barring a weekly close above about 1340, the SPX still looks vulnerable to the bottom of the blue channel and perhaps even to 1235, a Keltner target. That vulnerability should be factored into trading decisions as should the potential bearishness of the possible triangle shape setting up on the daily and weekly charts.

Typically prices stay inside the triangle until they've moved about two-thirds of the way through toward the apex, which would give the SPX time to act on that potential reversal signal on the weekly chart and push up through the triangle one more time. That's not a given, but traders who elect to participate in a bullish trade on the hopes of a move up through that triangle should assess how much risk they're taking home with them each evening and whether they feel comfortable with that risk or should lighten it before the close of each trading day.

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Bears should do the same. Some Fed actions appear to be calculated to do as much damage as possible to short positions. This morning on CNBC, Art Cashin mentioned the "suicidal shorts" who have gotten slashed on several separate occasions by pre-market developments. We don't want our subscribers to suffer that consequence.

Even a casual glance at these charts shows how often steep declines are met by strong bounces and bounces that end on the highs of the day, erasing literally days of losses, are followed by strong declines. If the triangle interpretation proves valid, it's only going to get worse.

This week's economic developments, coupled with BSC's earnings, option expiration and the FOMC decision, provide plenty of opportunities for an upside breakout or downside breakdown out of that triangle. Although great trading opportunities can result heading into an FOMC meeting, this triangle interpretation and the more typical chop leading into the decision might combine to produce untradable conditions ahead of the FOMC decision. Those may be worsened by typical option-expiration gyrations. Decide by Monday's close how much risk you want to carry into the trading day Tuesday morning.

Annotated Daily Chart of the Dow:

Annotated Daily Chart of the Nasdaq:

Watch the wedge's defining trendlines for potential support and resistance, and look for RSI confirmation. Remain prepared to be whipsawed out of a trade as typical technical analysis tools are rendered less useful pre-FOMC and during option-expiration week. Next week will be all about positioning portfolios ahead of that FOMC decision and expiration, and not about what some oscillator says.

Annotated Daily Chart of the SOX:

This triangle has narrowed enough that the SOX must either break through it quickly or it will be useless as a technical analysis tool. Once prices move too close to the apex, any little jit or jot will constitute a seeming breakout when the SOX may just be widening the formation again. Watch the SOX, as it sometimes leads other indices and may do so by breaking out of this triangle before other indices break out of theirs, but be aware of its tendency to hit a few stops and then settle back in again.

Annotated Daily Chart of the RUT:

Annotated Weekly Chart of the TRAN:

I don't follow the Dow Jones Transportation Index (TRAN) as a trading vehicle, but rather as a sort of indicator index. Although their charts have diverged, in most times, the Dow, SPX and OEX do not travel too far in one direction if the TRAN is headed the other.

I follow another chart as an indicator of where U.S. equity prices might go: the USDJPY or the U.S. dollar valued against the Japanese yen. For several years, the SPX's chart tracked the USDJPY's with the USDJPY often leading. Both intraday and daily charts showed congruence. Then, in October 2007, the two diverged. For example, the SPX made a higher high while the USDJPY made a lower one, after which it rolled down. The SPX soon followed.

The shapes of their charts still show some congruence, although I'm attentive to the possibility that the yen carry trade might be unwound and will not soon be reinstituted. For those not familiar with the term, a simplified explanation is that because Japan's interest rate was so low compared to others, traders would borrow cheap yen. They would then use the borrowed funds to buy equities or other securities that they expected to provide higher yields than the rates they were paying on borrowed yen. For a while, those securities purchased were often U.S. and European equities. When the yen began climbing against the dollar and euro, those trades began being unwound. Quickly.

Now we see an interesting phenomenon. The USDJPY has dropped to a new low while the SPX has not. I've been taught that any difference at a market low is a bullish divergence. No bullish divergence predicts that price will climb, but equity traders should keep the USDJPY on their radar screens and bears should be alerted to keep their profit-protecting plans in place in case this bullish divergence is confirmed.

Looking at the chart now, however, nothing screams reversal.

Annotated Daily Chart of the USDJPY:

A fitted Fib bracket does not foretell a target, as Thursday's did not. For now, all we know is that there's tentative bullish divergence when comparing this chart to the SPX's, but that vulnerability to the mid 90's exists. If the USDJPY does dive to the mid 90's, equities will likely suffer, too, and the tentative bullish divergence may be reversed.

The selection of Governor Fukui's successor, if it happens next week, could change the entire character of this chart. If that governor is perceived as hawkish, likely to raise rates in Japan and unlikely to intervene in the currency markets, the USDJPY could soon drop further. If Deputy Governor Muto is selected, the USDJPY could bounce. If no one is selected, the values could wander around in some unpredictable manner, or perhaps could be reactive to rather than predictive of U.S. equity behavior. That has sometimes seemed to be the case over the last week or two.

Friday's Developments

Addresses by Federal Reserve Chairman Ben Bernanke and President Bush figured prominently in Friday's news. When speaking before the Economic Club of New York, President Bush acknowledged the difficulties facing the U.S. but asserted that this administration had reacted quickly to the crisis. He assured listeners that the U.S. economy has rebounded stronger than ever from each such challenge in the past.

He also mentioned the need for a strong dollar. As noted in Thursday's Wrap and in the chart section, the dollar's weakness signals continued weakness in U.S. equities, too. When the USDJPY began sinking beneath 100 overnight Thursday night, commentators across the globe called for intervention while other decried the effectiveness of any intervention even if it was attempted.

And who will attempt it? Intervention in the form of yen selling has typically been the tactic taken by the Bank of Japan, but the Bank of Japan is in a bit of a muddle these days. Next week marks the last work days of the Bank of Japan's Governor Fukui, with his successor not yet named, as was mentioned in the chart section.

Although it had been widely believed until recent elections unseated Governor Fukui's political party that his Deputy Governor Muto would succeed him, but Muto's nomination was rejected last week by the ruling party. That presents the specter of a central bank led by committee. This could occur at a time when concerted action by central banks across the globe is needed to keep credit markets from freezing and the financial markets functioning as smoothly as possible.

No one knows the hawkish versus dovish position of the next governor since that governor's identity is yet unknown. In this climate, Japan may be of little help in driving the yen lower against our dollar. Others have clamored instead for the Fed to stop easing or at least ease less drastically, in an effort to support the dollar. Other central banks have been staunch in their claims that their efforts must be directed toward stemming inflation, so they remain firmly against easing while our Fed continues to do so.

Chairman Bernanke spoke before the National Community Reinvestment Coalition's Annual Meeting in Washington, D.C. He said it was not appropriate for him to comment on the BSC situation when asked.

He titled his address "Fostering Sustainable Homeownership." As he has done in other recent speeches, he first detailed the process by which the country arrived in a situation in which "more than one in five of the roughly 3.6 million outstanding subprime adjustable-rate mortgages (ARMs) were seriously delinquent." He pointed out that independent mortgage companies not regulated by the federal banking agencies originated more than 45 percent of 2006's high-cost first mortgages. Those entities typically sold all mortgages they originated. He felt that lower mortgage rates and the efforts of the Hope Now Alliance may somewhat mitigate the effect of all subprime ARMs yet to reset, about 1.5 million this year alone.

Some would argue with him about how much mortgage rates have decreased. Last week, average mortgage rates for a fixed-rate, 30-year mortgage ticked up again, as did rates for all mortgage products. At 6.13 percent last week, the mortgage rate for those fixed-rate, 30-year loans was only slightly below the year-ago level of 6.14 percent.

More disturbing because it's indicative that the problem is deeper than first anticipated, about "45 percent of foreclosures [in 2007] were on prime, near-prime or government-backed mortgages," Governor Bernanke said. The problem will not stop with subprime mortgages.

Chairman Bernanke went on to detail the efforts that the Federal Reserve had made in response. The Fed has put together a proposal that would address such issues as unfair or deceptive advertising practices by mortgage originators, the prevention of lenders from paying a broker more than the borrower agrees in advance, a ban on prepayment penalties and other such changes.

The twelve Reserve Banks across the nation attempt to anticipate and mitigate foreclosure problems, he said. They supply analysis to groups who provide emergency funds or counseling or who attempt to draft policy remedies. Some efforts are being made to protect communities from the problems arising when a large number of properties are vacated.

My general impression is that while Chairman Bernanke provided an overview of the difficulties and the efforts of the Fed to respond to current problems and anticipate future ones, the response to current problems might not have satisfied. Perhaps Friday's tenor was just so negative that nothing would have done so, but some market participants want to know what the Fed is going to do right now, and they don't want to wait until Tuesday to find out. Those who would like to read Chairman Bernanke's prepared speech can find it at this link.

By the end of the day, the Fed funds futures showed what market watchers want and expect the Fed to do. Those futures showed a 64 percent chance that the FOMC would ease by 100 basis points next week. I'm not so certain they'll get their wish, although Friday's CPI certainly pushed away barriers to the FOMC's decision.

Friday's other developments included that long-awaited February 2008 Consumer Price Indices (CPI). Produced by the U.S. Department of Labor's Bureau of Labor Statistics, CPI delighted those who had worried that inflation figures might stay the hands of the FOMC members when they meet next week.

Futures popped on the report. However, when Art Cashin stood on CBNC and questioned the portion of the report that included a 0.5 percent decrease in February's energy prices, he was giving voice to the skepticism many felt. Thursday's February Import and Export Prices had shown an even larger decrease in February's imported petroleum prices, 1.5 percent, so that same odd decrease has been showing up on many reports.

That odd decrease on the CPI, at least, appears to be due to the time period in which the data was collected. Gasoline prices had dropped for the period in February when the data was collected then spiked higher again. With the current soaring crude costs, even those who believe in a February decrease think its beneficial impact has long since been erased.

Both CPI and the core CPI (less food and energy) were unchanged if seasonally adjusted figures were checked. Year over year, however, CPI has risen 4.0 percent and core CPI, 2.3 percent. Core CPI remains above the Fed's perceived comfort level. Both were below January's annualized levels of 4.3 percent and 25 percent, however, providing a measure of good news.

Medical costs rose a seasonally adjusted 0.1 percent month over month, and 4.5 percent year over year. As mentioned, energy costs fell a seasonally adjusted 0.5 percent.

Our FOMC members have noted that they expected inflationary pressures to moderate, and this report appears to vindicate them. Other central bankers across the globe have not been so certain about inflationary pressures, and their results have been different. Friday morning, the Eurozone reported February's CPI, too. It rose an annualized 3.3 percent. That was even higher than the anticipated 3.2 percent. Although many have called for concerted actions by central banks around the globe, believing that all should lower rates in concert, the ECB's President Jean-Claude Trichet has stood firm, not changing his hawkish tenor when speaking about near-term price pressures.

Many believe that China will be forced to raise rates, too, to control inflation pressures that have been ramping up. When other central banks are keeping rates steady or ramping them higher while our central bank lowers rates, our exporters benefit but we pay more for imported goods.

That's because something else happens: our currency tends to weaken against others. This week, something monumental happened, something shown on the USDJPY chart in the chart section. The USDJPY (the U.S. dollar compared to the Japanese yen) dropped to sub 100. It took fewer than 100 yen to exchange for one U.S. dollar. The dollar also hit a record low against the euro.

Because of the importance of the yen carry trade over previous years, our equity performance has tended to track the direction of the USDJPY, as noted earlier. Those who want a steadying or a bounce in U.S. equity markets have a quandary when looking forward to next week's FOMC decision. That quandary may complicate the reaction to the FOMC's decision. Should equity bulls pull for more easing, hoping that will improve the subprime and credit crunch situations? Or should equity hope for a smaller easing, perhaps 25 basis points, to keep the U.S. dollar from weakening even further than it has?

Those who would like to peruse the CPI report in its entirety can find it at this link.

March's University of Michigan/Reuters Consumer Sentiment had been expected to drop 69.0. In a better-than-expected result, the sentiment number dropped only to 70.5 from February's 70.8. The March number still proves to be the lowest result in 16 years.

Breaking the number into its components showed the current conditions index gaining to 84.6 from 83.8. The expectations index fell to 61.4 from 62.4. That also marked the lowest number in 16 years.

Other developments on Friday included new records on retail gasoline prices and diesel and heating oil futures. Those followed crude's record prices earlier in the week. Crude retreated ahead of next week's futures' expiration. Jim Brown detailed his expectations for crude in Tuesday's Wrap and will update those expectations in this weekend's Leaps column and next Tuesday's Wrap.

Next Week's Economic and Earnings Releases

Next Week's big event is the FOMC decision to be announced at 2:15 Tuesday, March 18. Other events are as follows:

Monday, March 17
8:30 am March NY Empire State Index
9:00 am January Net Foreign Purchases
9:15 am February Capacity Utilization
9:15 am February Industrial Production
After Market Close: Bear Stearns's Quarterly Report

Tuesday, March 18
8:30 am February Building Permits and Housing Starts
8:30 am February PPI and Core PPI
2:15 FOMC Policy Statement

Wednesday, March 19
10:30 am Crude Inventories

Thursday, March 20
Before the Open: Stein Mart (SMRT) Earnings
8:30 am Initial Claims
10:00 am February Leading Indicators
10:00 am March Philadelphia Fed

Friday, March 21
Market Holiday

Both Monday's March NY Empire State Index and Thursday's Philly Fed are sometimes predictive of the ISM's take on manufacturing, and both can prove market moving. Monday's number occurs before the market open, but Thursday, traders should be aware when making any early morning trading decisions of that approaching report at 10:00 am.

Each day other than Wednesday features possible minefields for either bulls or bears, and market craziness will already be impacted by the FOMC decision and option expiration.

One note about option expiration: This month's expiration occurs during shortened week. We have a market holiday Friday. Check with your broker for complete information, but that will change the expiration schedule. Wednesday, March 19, will be the last trading day for March index options such as the SPX's. Settlement values will be determined at the open on Thursday, March 20, rather than Friday, since no trading occurs Friday. March 20 will be the last trading day for March equity options and for indices such as the OEX.

Don't let the altered expiration schedule take you by surprise. If you're trading something other than index or equity options, check the schedules because the times when they stop trading or are settled vary.

What about Monday?

I've eliminated some Keltner channel lines on my intraday Keltenr charts for clarity. What remains notable on these charts, however, is how little the Keltner support or resistance has mattered as prices chop back and forth. Usually black-channel support and resistance are strong enough to stall prices or bounce them, as they did on occasion last week, but mostly prices have just chopped back and forth willy-nilly.

It's not that the Keltner channels are failing: in fact, they're illustrating what we know from our own impressions as we wake each morning. With worried glances, we study television or computer screens to determine direction the markets are going to gap. Markets are disorganized, pushed around by each new announcement. The failure to adhere to any kind of typical behavior around Keltner channels illustrates that there is very little pattern or predictability about what might happen next.

Annotated 15-Minute Chart of the SPX:

Ordinarily, sustained values below the channel line now at 1276.24 would set a potential downside target of 1257.70, but Thursday's break did not move anywhere close to the potential target. Also, ordinarily, sustained 15-minute closes above the line now at 1320.82 would set a potential upside target near 1343.53, but the SPX hasn't traded closer to the red price channel's boundary than the Keltner setup.

Annotated 15-Minute Chart of the Dow:

Annotated 15-Minute Chart of the Nasdaq:

Annotated 30-Minute Chart of the RUT:

For now, prices churn within price channels or formations on both these intraday and daily charts. The price behavior within those channels on intraday charts appears somewhat unpredictable, as indicated by their atypical responses to Keltner channel support and resistance, as well as they way they chop back and forth across the 9-ema's on those charts. They neither trend along those 30-minute 9-ema's nor have they flattened them, as is typical in range-bound trading. The good news is that there are more than enough potential developments next week to break the stalemate and perhaps even get at least a short-term trending market going. Watch for breakouts out of the price channels, confirmed by breakouts out of black-channel Keltner resistance levels. For those who don't have Keltner channel capabilities (black channels are defined by a central 45-ema with a multiplier of 3), watch those price channels for guidance.

When making decisions to either go long support or short (or go long puts) at resistance or else wait for breakout trades, cast these charts intraday charts in the context of weekly and daily charts. The weekly charts show potential reversal signals. To best support the case for those reversal signals, prices should not push below last week's lows. It would instead be preferable if they opened near or above last week's open and then stayed above it other than for quickly reversed spikes lower. That open was 1293.16 for the SPX. Those conditions do not have to be completely met for a potential reversal to be possible, but those are the optimal conditions.

Where might indices go if they do reverse? If they bounce and if your trading the long side, prepare profit-protecting plans for tests of the 30-sma and the other benchmark levels indicated on the daily charts. If those levels haven't been reached in the course of the trading day in which you entered the trade, ask yourself if you want to carry those long positions overnight or if you want to just lock in your profits, considering the market environment and the potentially bearish setups on some charts.

The charts show me that possibility of a reveral signal being confirmed on the weekly charts. When looking at the weekly chart, it even looks like the most probable setup. However, if indices do rise, they'll be rising within consolidation zones of various shapes on intraday and daily charts, whether they're the possible bearish right triangle for the SPX on its daily chart or the less bearish versions on other indices. All such formations on the daily charts are forming at the bottom of steep declines, mostly within the descending price channels that began to form late last year.

And there's this other thing. For those of you who celebrate Christmas, can you remember that feeling of letdown that occurred sometime about midday Christmas Day, when you'd finished opening all presents, when you realized that the gifts you'd gotten didn't really change your lives?

I'm afraid that market participants have pinned too many hopes on the FOMC's March decision. Whatever that decision is--the dollar-saving lower easing or the market-hope-building greater one--it's not going to prevent further upheavals such as the one created by BSC's situation on Friday. Other BSC-type situations still might arise. Market participants hailed the recent steps that the Fed took to increase liquidity, but the euphoria didn't last, and when that after-Christmas disappointment sets in, the possibility of a real capitulation day exists. That's a fear, though, and not something yet showing up on the weekly charts, with their potential reversal signals.

If that letdown occurs, it could precipitate failures from support rather than any attempted push up through consolidation zones. If so, follow with account appropriate stops and ask yourself each evening if you want to lock in profits or carry that risk overnight of one of those wild gaps higher.

Trade lightly if at all ahead of the FOMC decision as well as in the immediate aftermath, when volatility arises and true direction is not usually predictable. Realize that you don't have prime trade setups right now. If your trades aren't working, it may not be your fault. If they worked before, it may only be that the market conditions have changed so drastically. Realize what's happening and scale back trading in response. You may not be responsible for the market conditions but you are responsible for protecting your trading capital.

The consolidation formations on many daily charts prove that setups aren't prime, as does the squirrelly reactions to typical Keltner support and resistance levels. So does the fact that your blood pressure escalates each morning when you turn on the television to find out that the nice cushion you had at the close of the previous trading day has evaporated. Unless you're one of those "traffickers" mentioned in that report on BSC, you're not responsible for market direction. You can't control it. In many cases these days, you can't even predict it.

What you can control is your own reaction. You can do this. Scale back or refrain from trading if the setups aren't working out. Use the time to listen to webinars and practice new trades on paper or with your broker or trading platform's simulator. While your long-term portfolio deserves consideration, too, remember that we are options traders and we can benefit from moves both directions. Wait for the optimal setups because they will occur. Not right away, however, if markets continue to churn within those price formations on the daily charts.

Make a practice of evaluating the risk you're carrying home each night before the market close. If that risk is more than you can afford to lose, lighten it. If you're balanced too heavily toward the long side in too many stocks or LEAPs or even long calls, and you can't or don't want to close those, consider buying protective puts or collaring some of your long stocks or LEAPs by selling an OTM call and using the proceeds to buy an OTM put. (Consult your broker about the pros and cons of such positions.) If you're too heavily short, consider locking in some profits by stepping out of at least a portion of your positions.

Consult your broker if you want to hedge positions and remove some of the delta, vega or theta risk that way. Take profits too early rather than too late.

And good luck.
 


New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
CLB None None
FCX    
FTI    
JOYG    

Play Editor's Note: A few stocks we're watching...GME and XTO look like potential bullish candidates. A move over 62.50 for XTO could be an entry point. The FXI has broken down and could sink toward the $115-110 zone but we didn't want to chase it here. SLG also looks like a short if it breaks $79.00 but be wary of the above average short interest! We're also watching LFC and ATK, which look weak.


New Calls

Core Labs - CLB - close: 122.40 chg: -0.74 stop: 117.99

Company Description:
Core Laboratories N.V. is a leading provider of proprietary and patented reservoir description, production enhancement, and reservoir management services used to optimize petroleum reservoir performance. The Company has over 70 offices in more than 50 countries and is located in every major oil-producing province in the world. (source: company press release or website)

Why We Like It:
Crude oil at triple digit highs should mean big business for the oil service companies. Shares of CLB have out performed the market this past week and look poised to move higher. Traders bought the dip near $120 on Friday afternoon. More aggressive traders could buy calls now. Since we are more than a little cautious on the market right now we'd rather see some confirmation higher. Thus, we're suggesting readers use a trigger to buy calls at $125.25. There is potential resistance near $130 so we're setting our first target at $129.85-130.00. We do think CLB will breakout past $130 sooner rather than later so we're setting a second target in the $137.50-140.00 zone.

Suggested Options:
Our suggested entry point is $125.25. We are suggesting the April calls.

BUY CALL APR 120 CLB-DD open interest=22 current ask $7.40
BUY CALL APR 125 CLB-DE open interest=47 current ask $4.80
BUY CALL APR 130 CLB-DF open interest=38 current ask $3.40
BUY CALL APR 135 CLB-DG open interest=27 current ask $2.30

Picked on March xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/23/08 (unconfirmed)
Average Daily Volume = 295 thousand

---

Freeport-Mcmoran - FCX - cls: 101.61 chg: -1.78 stop: 98.99

Company Description:
FCX is a leading international mining company with headquarters in Phoenix, Arizona. FCX operates large, long-lived, geographically diverse assets with significant proven and probable reserves of copper, gold and molybdenum. FCX has a dynamic portfolio of operating, expansion and growth projects in the copper industry and is the worlds largest producer of molybdenum. (source: company press release or website)

Why We Like It:
Commodities will continue to be market leaders so why not play one of the largest commodity producers in the world? FCX has been out performing the S&P 500 and looks like it's on the verge of breaking out from a bull flag pattern. The intraday high on Friday was $105.44. We are suggesting a trigger to buy calls at $105.51. There is potential resistance at $110. We're setting a minor target to take some profits at $109.85-110.00. However, our main target is the $117.50-120.00 zone. Normally we suggest taking the lion's share of the position off at the first target. This time aim higher.

Suggested Options:
Our suggested trigger to buy calls is at $105.51. If triggered we would use the April calls.

BUY CALL APR 100 FCX-DT open interest=11319 current ask $8.05
BUY CALL APR 105 FCX-DA open interest= 5164 current ask $5.45
BUY CALL APR 110 FCX-DB open interest=11204 current ask $3.65

Picked on March xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 13.7 million

---

FMC Tech. - FTI - close: 58.18 chg: +0.79 stop: 54.45

Company Description:
FMC Technologies, Inc. is a leading global provider of technology solutions for the energy industry and other industrial markets. The Company designs, manufactures and services technologically sophisticated systems and products such as subsea production and processing systems, surface wellhead systems, high pressure fluid control equipment, measurement solutions, and marine loading systems for the oil and gas industry. (source: company press release or website)

Why We Like It:
FTI is another oil service stock that looks set to run. Shares just broke through a bull flag pattern. There is potential resistance near $60 but given the sky-high oil and gas prices we expect FTI to push past the $60 mark. Shares have additional resistance near $65.00. We are aiming for the $64.00-65.00 range.

Suggested Options:
We are suggesting the April calls.

BUY CALL APR 55.00 FTI-DK open interest= 658 current ask $5.80
BUY CALL APR 60.00 FTI-DL open interest=2065 current ask $2.90
BUY CALL APR 65.00 FTI-DM open interest= 684 current ask $1.35

Picked on March 16 at $ 58.18
Change since picked: + 0.00
Earnings Date 05/08/08 (unconfirmed)
Average Daily Volume = 2.2 million

---

Joy Global - JOYG - close: 68.80 chg: -1.75 stop: 67.45

Company Description:
Joy Global Inc. is a worldwide leader in manufacturing, servicing and distributing equipment for surface mining through P&H Mining Equipment and underground mining through Joy Mining Machinery. Joy Global, Inc. (source: company press release or website)

Why We Like It:
JOYG is in the mining equipment industry and given the world's rising demand for commodities business appears to be doing very well. The stock is trading near all-time highs around $72.00. If this momentum keeps up JOYG will be in blue-sky territory. We are suggesting that readers buy calls at $72.50, which would be a new all-time high. If triggered our target is the $78.00-80.00 zone. Currently the Point & Figure chart is bullish with an $86 target. Now we do want to warn readers that early this month JOYG's CFO quit. No reason was given for his departure. Normally when the CFO resigns it's not a good sign but investors don't appear to be worried and the next earnings date isn't until late May.

Suggested Options:
Our suggested entry point to buy calls is $72.50. If triggered we would use the April calls.

BUY CALL APR 70.00 JQY-DN open interest=4316 current ask $4.40
BUY CALL APR 75.00 JQY-DO open interest=2011 current ask $2.40

Picked on March xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 05/29/08 (unconfirmed)
Average Daily Volume = 2.4 million
 

New Puts

None today.
 

New Strangles

None today.
 


Play Updates

In Play Updates and Reviews

Call Updates

General Dynamic - GD - close: 84.39 chg: -1.71 stop: 82.99

Ouch! A very uncooperative market on Friday has hammered shares of GD back into its trading range. The stock spiked to $86.90, near its 100-dma and reversed as the market turned south. Friday's reversal now makes the breakout look like a bull trap. Technically the failure to hold broken resistance at $85.00 as support is good enough for more conservative readers to just abandon ship right here. On the other hand GD did manage to bounce near $83.50 and its 200-dma. We would look for a new rise past $85.25 as an entry point to buy calls. You might want to consider adjusting your stop loss toward $83.50. We are setting two targets. Our first, short-term target is the $89.75-90.00 range since the $90 mark would be natural, round-number resistance. Our second target is the $93.00-94.00 zone near its highs. We do not want to hold over the late April earnings report.

Suggested Options:
If GD provides a new entry point above $85.25 we would consider the April calls.

Picked on March 13 at $ 86.10
Change since picked: - 1.71
Earnings Date 04/23/08 (unconfirmed)
Average Daily Volume = 2.1 million

---

Ingersoll Rand - IR - close: 43.15 change: -1.13 stop: 40.85*new*

IR ended the week with a small gain but the upward momentum is struggling a bit. Shares have tried multiple times to try and breakout past its 100-dma near $44.75. On the bullish side of things the stock continues to have a positive pattern of higher lows. However, if the market does breakdown to new relative lows we would expect IR to roll over. The $40 level should be decent support but we're going to try and reduce our risk by adjusting the stop loss to $40.85. The $41.00 level is another level of support. We would hesitate to open new bullish positions at this time. Our target is the 47.00-47.50 zone.

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

Picked on March 09 at $ 42.87
Change since picked: + 0.28
Earnings Date 04/20/08 (unconfirmed)
Average Daily Volume = 5.5 million

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Mosaic - MOS - close: 107.23 change: -1.70 stop: 99.89

Friday was a rough day for the bulls and we may be seeing one of our worst case scenarios with MOS, which is being filled on an intraday spike higher only to see it immediately reverse lower on us. Shares actually gapped open at $111.25. Our suggested entry point was $111.00. The stock hit $112.40 and then turned tail and fled. At this point we have a couple of choices. If you're really worried about where the market is headed following Friday's performance then consider an early exit now and just cut your losses. We are going to suggest that readers wait for a new rally over $110.50 or a bounce in the $100.00-102.50 zone as potential entry points to buy calls on MOS. Remember, this is an aggressive, higher-risk play and the stock can be very volatile. We have two targets. Our first target is the $119.50-120.00 zone. Our second target is the $135.00-140.00 zone. Please note that we do not want to hold over the early April (unconfirmed) earnings report.

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

Picked on March 14 at $111.25 *triggered/gap open
Change since picked: - 3.77
Earnings Date 04/03/08 (unconfirmed)
Average Daily Volume = 7.0 million

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Potash Corp. - POT - cls: 160.46 chg: +0.06 stop: 149.00

The action in POT is similar to the trading in MOS. The stock did trade higher on Friday morning and POT did hit our suggested entry point to buy calls at $162.75. POT traded to an intraday high of $165.00 before succumbing to profit taking. The trend in POT continues to be bullish but if the market sees any sort of washout event then we do expect the stock to suffer. Such an event will probably be another entry point to buy calls. We would be watching POT's 100-dma if and when the market finally sees any capitulation. In the mean time we would look for a dip into the $157-155 zone or a new rise into or past the $163-165 range as potential entries points. Our target is the $178.00-180.00 zone. We will consider adding a second, more aggressive target as the play progresses. Remember, these stocks can be very volatile and see some huge intraday swings. We have to label this an aggressive, higher-risk play.

Suggested Options:
If POT provides a new entry point we would suggest the April calls.

Picked on March 14 at $162.75 *triggered
Change since picked: - 2.29
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 7.5 million

---

Research In Motion - RIMM - cls: 101.69 chg: -3.96 stop: 94.49

RIMM gave back the majority of its Thursday gains with a 3.7% decline on Friday. Traders did buy the dip at $100 on Friday afternoon but we would remain cautious here. The market's recent performance concerns us and we would hesitate to open new bullish positions in RIMM. However, if you're bullishly inclined then the dip to $100 would be a new entry point. Readers could try using a tight stop under $100 but if the market sees any follow through lower on Monday you would probably be stopped out. We're going to leave our stop loss at $94.49 for now and see if RIMM can hold in the $95-105 region. Our short-term target is the $110.00-112.00 zone.

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

Picked on March 11 at $100.74
Change since picked: + 0.95
Earnings Date 04/02/08 (confirmed)
Average Daily Volume = 25 million

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Yahoo! Inc. - YHOO - close: 26.71 change: -0.79 stop: n/a

What in the world is going on with YHOO? Friday's move lower almost makes sense because MSFT, who's trying to acquire YHOO, saw it's own stock slip 2.3%. YHOO plunged 2.8% and is nearing its own 200-dma. Unfortunately, technicals don't matter much for YHOO since we're trying to play the merger. We already reported that Thursday's drop in YHOO was due to rumors of a hedge fund needing to (or wanting to) unload a large block of shares. This week's drop has murdered the March calls and with just four days left before March calls expire odds are looking bleak for the bulls. You could speculate on MSFT raising its bid with the April calls but we're growing less enthusiastic by the day with this play so we're not suggesting new positions.

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

Picked on February 17 at $ 29.66
Change since picked: - 2.95
Earnings Date 04/17/08 (unconfirmed)
Average Daily Volume = 54 million
 

Put Updates

Ambac Fincl. - ABK - cls: 6.22 change: -0.41 stop: n/a

ABK continues to sink and shares lost another 6% on Friday. The path of least resistance continues to be down. ABK management tried to soothe investor fears on Friday. The CEO of the company issued a letter to shareholders saying that ABK has over $15 billion available to pay for claims should the need arise. It doesn't look like the letter worked. The market is still very fearful of the financial sector. We are not suggesting new ABK positions at this time. This remains a very speculative play. We will definitely hold over the April earnings if we get the chance. Previously we had been suggesting the May out-of-the money puts ($5.00 and $2.50 strikes) and an optional 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 in ABK.

Picked on January 27 at $ 11.54
Change since picked: - 5.34
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 10.9 million

---

Cytec Ind. - CYT - close: 54.32 chg: -1.18 stop: 57.15

The action in CYT continues to look bearish. The stock produced a bearish engulfing candlestick pattern on Friday. We would still consider new put positions here or on another drop below $54.00. More conservative traders might want to move their stop closer to the $56 region. The $50.00 level looks like nearest support so we are targeting a drop into the $50.25-50.00 zone.

Suggested Options:
We would suggest the April puts.

Picked on March 09 at $ 54.72
Change since picked: - 0.40
Earnings Date 04/17/08 (unconfirmed)
Average Daily Volume = 601 million

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Express Scripts - ESRX - cls: 56.43 chg: -1.46 stop: 60.55*new*

ESRX slipped to new four-month lows this past week. The stock has found new short-term support near $56.30 but shares look poised to plunge lower again. While ESRX is nearing our first target in the $55.50-55.00 zone we would still consider new positions. The second target is the $51.50-50.00 range. Our biggest concern with ESRX would be more of an oversold bounce in the healthcare sector. HUM and WLP were just pummeled senseless this past week and if the market sees any sort of bounce this group could find bargain hunters. Buying in these healthcare stocks could translate into strength for ESRX. Please note that we are adjusting the stop loss on ESRX to $60.55. FYI: The most recent data listed short interest at 3.8% of the 251 million-share float, which is about 3.4 days worth of short interest.

Suggested Options:
We would suggest the April puts.

Picked on March 09 at $ 58.51
Change since picked: - 2.08
Earnings Date 04/23/08 (unconfirmed)
Average Daily Volume = 3.7 million

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FedEx - FDX - close: 84.80 change: -2.27 stop: 89.05 *new*

We are finally starting to see some movement in FDX. The stock lost about 2.6% on Friday and did so on above average volume. It's a good thing too. We're running out of time. FDX is due to report earnings on Thursday morning, March 20th. We do not want to hold over the report. If FDX doesn't hit our target first we'll plan to exit on Wednesday at the closing bell. Please note we are moving the stop loss to $89.05. Our target is the $80.50-80.00 zone. FYI: The most recent data lists short interest at 3% of the 289 million-share float.

Suggested Options:
We only have three days left so we're not suggesting new positions.

Picked on March 10 at $ 85.95 *triggered
Change since picked: - 1.15
Earnings Date 03/20/08 (confirmed)
Average Daily Volume = 3.1 million

---

Harley-Davidson - HOG - close: 35.41 chg: -1.39 stop: 40.26

HOG reversed again on Friday. The stock produced yet another failed rally near $37.50 and closed down with a 3.7% loss. This decline followed some positive news for HOG. One Wall Street analyst actually removed HOG from its top list of stocks to "sell". The analyst suggested HOG may be nearing a bottom and the falling U.S. dollar should help HOG's international business. We remain bearish on HOG. Our more conservative traders may want to tighten their stop loss closer to the 50-dma (38.57) or the $38.00 level. We do have a very wide and aggressive stop at $40.26. Our target is the $30.50-30.00 zone although it wouldn't surprise me to see a drop closer to $25. The P&F chart is bearish with a bearish triangle breakdown sell signal. FYI: The most recent data lists short interest at 9.6% of the 236 million-share float. That is an above average amount of short interest and raises our risk of a short squeeze.

Suggested Options:
We would suggest the April puts.

Picked on March 10 at $ 34.69 *triggered
Change since picked: + 0.72
Earnings Date 04/17/08 (unconfirmed)
Average Daily Volume = 3.1 million

---

MBIA Inc. - MBI - close: 10.94 change: -0.63 stop: n/a

Let's see, another day, another decline for MBI. Shares lost more than 5% on Friday as investors fled the financials (yet again). We're not suggesting new bearish positions at this time. We had been suggesting the out-of-the-money May puts (7.50, 5.00 and 2.50 strikes) and an optional 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.

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

Picked on January 27 at $ 14.20
Change since picked: - 3.26
Earnings Date 01/31/08 (confirmed)
Average Daily Volume = 15.2 million

---

3M Co. - MMM - close: 77.53 change: -1.55 stop: 80.25

MMM performed as expected. The stock failed near resistance around $80 and headed lower. We would still consider new put positions right here. We have set two targets. The first target is the $72.25 level, just above the January 2008 lows. Our second target is the $68.00 level, which should be closer to the bottom edge of MMM's bearish channel. The P&F chart is currently bearish with a $62 target. FYI: The most recent data lists short interest at just 1.5% of the 707 million-share float.

Suggested Options:
We are suggesting the April puts.

Picked on March 09 at $ 76.51
Change since picked: + 1.02
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 4.3 million

---

NII Holdings - NIHD - close: 32.66 change: -1.44 stop: 38.25*new*

NIHD lost more than 4% on Friday and sank to new multi-year lows. Shares are quickly nearing our second, more aggressive target in the $31.00-30.00 range. Readers can choose to start taking profits at any time now. We're lowering our stop loss to $38.25. NIHD is very short-term oversold and way overdue for a bounce. Truly nimble traders could trying playing calls on a bounce near $30. The Point & Figure chart is bearish with a $19 target. FYI: The latest data lists short interest at 3.8% of the 171.7 million-share float, which is only about 1.5 days worth of short interest.

Suggested Options:
We are not suggesting new positions on NIHD.

Picked on March 04 at $ 38.95 *triggered
Change since picked: - 6.29
Earnings Date 02/27/08 (confirmed)
Average Daily Volume = 3.3 million

---

Sears Holding - SHLD - close: 95.07 change: +0.49 stop: 100.51

Relative strength in shares of SHLD on Friday was a mystery. The stock actually appeared to be moving higher on Friday afternoon. We would take a step back and wait for this bounce to fail before considering new put positions. Our target is the $85.50-85.00 zone. There are a lot of investors who believe SHLD is going lower. The most recent data puts short interest at more than 19% of the 65 million-share float. That is almost 7 days worth of short interest. Naturally that raises our risk of a short squeeze.

Suggested Options:
If SHLD provides a new entry point we would suggest the April puts.

Picked on March 06 at $ 94.00 *triggered
Change since picked: + 1.07
Earnings Date 02/28/08 (confirmed)
Average Daily Volume = 2.8 million

---

Wynn Resorts - WYNN - close: 96.67 chg: -0.59 stop: 100.51

It has been a rocky week for WYNN. Friday marked the third day in a row that the stock bounced around the $92.50-98.00 zone. Lack of any follow through lower in spite of the market's apparent weakness on Friday is a real warning signal for the bears in WYNN. Fundamentally WYNN's stock should be struggling if we're facing a consumer-lead recession in the U.S. Why someone would be buying it in the $91-93 level is a surprise. WYNN doesn't appear to have any real support until $85. The overall trend remains bearish so we're going to stick with the plan. However, more conservative traders might want to consider a stop loss near $98.50 to reduce their risk. We'd rather give WYNN room to maneuver with our stop at $100.51. We're not suggesting new put plays at this time. Our target was the $86.50-85.00 zone. The P&F chart is bearish with a $64 target.

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

Picked on March 04 at $ 94.27 *gap down
Change since picked: + 2.40
Earnings Date 02/26/08 (unconfirmed)
Average Daily Volume = 2.2 million
 

Strangle Updates

None
 

Dropped Calls

Goldman Sachs - GS - close: 156.86 chg: -8.58 stop: 154.99

The Bear Stearns (BSC) fiasco has seriously undermined any confidence in the broker-dealers and the rest of the financial services industry. Shares of GS reacted with another volatile session (almost a $13 intraday range) and a bearish engulfing candlestick pattern. The intraday low was $155.00. While there is a chance that GS will bounce on Monday we are suggesting an early exit. GS is due to report earnings on Tuesday morning.

We considered playing some sort of neutral strategy on GS to hold over earnings. Unfortunately, the volatility is so high right now that the options are very expensive. A straddle at the $155 strike would cost about $25.00 for April options. A strangle, using options $20 out, would still cost more than $10. These seem too expensive.

If you really want to speculative on a big move in GS then consider some deep out of the money puts or calls in March. They're cheap because there are only four days left. Friday, March 21st is a market holiday. This type of bet is essentially gambling. If GS doesn't move $20 or more on Tuesday your option will probably expire worthless!

Picked on March 11 at $163.07 /exiting early $156.86
Change since picked: - 6.21
Earnings Date 03/18/08 (confirmed)
Average Daily Volume = 12.5 million
 

Dropped Puts

Everest Re Group - RE - close: 89.83 chg: -3.54 stop: 98.26

Target surpassed. Actually RE has surpassed our second, more aggressive target in the $91.00-90.00 zone. Fear in the financial sector on Friday sent RE to an intraday low of $89.36. The $90 level looks like potential support so if you have not exited yet we would suggest extra caution here. Our first target was at $93.50.

Picked on February 28 at $ 97.93 /2nd target surpassed 89.36
Change since picked: - 8.10
Earnings Date 04/23/08 (unconfirmed)
Average Daily Volume = 487 thousand
 

Dropped Strangles

None
 


Trader's Corner

Not an Odd Couple at All

Let's set the stage. It's early Thursday, February 21 and the weekly jobless claims showed a week-over-week drop of 9,000. At least that's what the headlines on financial newswires said. The supposed drop was actually from a revised-higher figure from the previous week.

That doesn't matter. What matters is that traders were cheered by the lower jobless claims. Futures were higher. All was right in the financial world.

When the cash markets opened, the SPX gapped higher and ran right up into the 1367-1370 resistance. The climb was corroborated by a soaring advance/decline line. All was still right in the equities world.

Not quite all, though. Even ahead of the 10:00 am ET release of the February Philadelphia Fed Business Index, something in the climbing advance/decline line signaled potential trouble ahead.

What was that signal? It was found when viewing the advance/decline line charted on a graph with Keltner channels. For clarity, the chart below includes only one set of the three nested Keltner channels that I typically watch.

Annotated 15-Minute Chart of the Adv/Dec Line:

The way the advance/decline line looked on this chart told me that although the day opened with a strong advance/decline line, that strength didn't tell the whole story. The advance/decline line was about to slam into potentially strong resistance. Although in this case, historical resistance corroborated that impression, that historical support and/or resistance is not always present. Sometimes only the Keltner channels show the approaching support and/or resistance.

That resistance did hold. Most attributed the pullback that began about 30 minutes after the open that day to the release of the Philly Fed number, but I propose that the advance/decline line was already showing some possibility of a pop-and-drop day. The Philly Fed was only the catalyst for what was already setting up on the charts.

By late morning that day, the SPX had stabilized after an early decline and was bouncing, but the advance/decline was already signaling more trouble ahead, as my 11:26 post on the live portion of our site indicated. The advance/decline line had fallen beneath the central basis line of the Keltner channel shown here. My post alerted subscribers on the live portion of the site that I thought the advance/decline line was going to rise up to retest that broken support, perhaps bringing the SPX up with it, but then that the advance/decline line was likely to roll down. It did roll down, and so did the SPX.

Annotated 15-Minute Chart of the SPX:

Some of you might be thinking that it's easy to pick some instance that showed what I want it to show, but those who have read my commentary on the live portion of the site know that February 21 didn't comprise an isolated instance.

Several questions arise as a result of these two charts and the anecdotal information: What is the advance/decline line; is it amenable to technical analysis; and, if it is, how can it be used with Keltner channels? A single article can't address all those questions, but let's start with what the advance/decline is and whether it's amendable to technical analysis.

Investopedia.com defines the advance/decline (AD) line as the "(# of Advancing Stocks - # of Declining Stocks) + Previous Period's A/D Line Value." Some feed sources provide an advance/decline for both the NYSE-listed and Nasdaq-listed stocks. A moving average of the advance/decline is sometimes used to smooth the fluctuations.

Some sources calculate the advance/decline differently. They calculate a ratio. I, like some other technical analysts, prefer the ratio form, but my current feed source does not provide a ratio.

Why would a ratio be better? Consider what happens during the lunchtime lull on a strong rally day, for example. The advance/decline line might have been soaring, but then traders head off for lunch and volume dries up. When everyone trots off for lunch, it's possible to imagine that the advance/decline line calculated by the subtraction method might drop just because there are fewer traders around and fewer stocks being traded.

However, the same distortions don't exist for the ratio variation. Unless disproportionate amounts of buyers and sellers head off to lunch, something that's difficult to imagine happening with regularity, the ratio should not be impacted by a drop in volume during the lunchtime lull. Any drop in the ratio form of the advance/decline line should reflect a change in the proportionate amount of advancing and declining stocks.

Whatever form of advance/decline line feed services provide or traders follow, an advance/decline line offers a view of what's happening in the markets that is independent of price. Many other indicators are derived from a study of the prices. For example, calculating the stochastic indicator requires the following inputs: the closing price, the lowest low over the desired period of time, and the highest high over that same period of time. While I believe that the stochastic indicator can be a useful indicator, it's not independent of price action.

However, the advance/decline line is independent of price action. Traders trading a downtrend in prices want to see that independent source corroborate their trades. If they're trading a rally, they want to see the advance/decline line climbing. If they're trading a downtrend, they want to see the advance/decline line dropping.

New traders might be surprised to note that it doesn't always happen that way. Prices can head higher while the advance/decline line heads lower, no matter which variation of the advance/decline line is employed.

For example, imagine that prices are going higher, but beneath the markets, traders are actually worried, with many buyers standing back. A few issues, maybe some of the big caps, are performing well enough, as they often do in a defensive market, but worried traders are beginning to step out of some of their long positions.

An experienced trader might glance at the advance/decline line while the stocks are still climbing and note that the advance/decline line is headed lower. There's a divergence. Divergences are important in many types of indicators, even in those such as the stochastic indicator that is derived from price. Perhaps they've even more important when seen on an independent indicator, signaling that prices might be nearing a reversal. Many experienced traders believe that volume patterns sometimes lead price patterns, and I'm one of them.

I believe it so strongly that I not only want to see those times when divergences already exist: I want to see times when the advance/decline line might be about to reverse. If that advance/decline leads price, as I believe it can do, then I want to know when it's about to lead the opposite direction.

How does one determine that? I use the same technical analysis tools I use when looking at price charts. Some market participants feel that such tools are useless when applied to the advance/decline line, the VIX and other beneath-the-markets measurements, but I believe that most can be studied using standard technical analysis tool.

The TRIN can be an exception. While I sometimes find that the TRIN reverses exactly where my chart setups would suggest it should, I haven't always been able to find much useful information about the TRIN using those standard technical analysis tools.

Unlike the TRIN, studying the advance/decline with standard technical analysis tools was so helpful that for a while I experimented with entering and exiting scalps or day trades based only one what I was seeing on the advance/decline line. The number of profitable versus losing trades was phenomenal, but when entering based on the advance/decline line, setting account-appropriate stops was difficult. The advance/decline line was great at predicting when a profitable trade should be exited, but in the case of a trade going wrong, the advance/decline setup let the price loss get too big in some instances. Too many small profits were wiped out by one bigger loss. As you can imagine, that situation doesn't prove profitable in the long run, but that doesn't mean that studying the advance/decline line isn't helpful. Just don't let it be your only guide to entering and exiting trades.

Here's another instance when standard technical analysis tools, simple trendlines in this case, proved helpful in predicting when the advance/decline line might reverse.

Annotated 15-Minute Chart of the Advance/Decline Line:

The first chart in this article had predicted horizontal trendline resistance, too, but trendlines may not be as common on the advance/decline line as on price charts.

My preferred method of finding likely reversal spots and making if/then kinds of predictions about the advance/decline line is by following it on a chart with Keltner channels. Subsequent articles in this series will talk about how I use Keltner channels in this manner, setting likely upside or downside targets for the advance/decline line.

Before you read those articles, spend some time this week using your own preferred methods of technical analysis, deciding whether you agree with the premise that the advance/decline can be followed by using standard technical analysis tools.

Don't try trading based on what you're seeing but do notice any divergences that might show up, any trendlines, or any responsiveness to RSI values above 70 or below 30. You'll have to check your charting service's symbology for the advance/decline line if you're not used to watching it. The symbols can be different to ascertain logically. For example, my charting service uses JINT.Z for some reason.
 

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

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