Option Investor

Daily Newsletter, Wednesday, 03/26/2008

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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

Market Wrap

Wednesday, March 26, 2008

Market Takes a Breather (Another One)

1.0 The Big Picture

1.1 Markets at a Glance--One Confused Market
1.2 Bank Credit Spread Update
1.3 Economic Reports

2.0 Equities

2.1 S&P 500 Index (SPX)
2.2 Dow Jones Industrial Average (DOW)
2.3 Nasdaq-100 Index (NDX)
2.4 Semiconductor Holder (SMH)
2.5 Russell 2000 Index (RUT)

3.0 Featured Industry Groups

3.1 Banking Index (BIX)
3.2 U.S. Home Construction Index (DJUSHB)
3.3 Transportation Index chart (TRAN)

4.0 Currencies

4.1 U.S. Dollar (DXY)

5.0 Commodities

5.1 Oil Fund and Index (USO and OIX)
5.2 Gold Fund (GLD)

6.0 Bonds
6.1 10-year Yield (TNX)

7.0 Summary


1.0 Overview

Today's Numbers

1.1 Markets at a Glance--One Confused Market

Before I started writing tonight's newsletter I was thinking I really don't want to. I'm tired of this market, I'm tired of saying "it's a choppy market full of whipsaws and there are much better days to trade." I've backed off on my trading because frankly I'm having a hard time making sense of it. I like to see some impulsive moves to indicate at least a short term trend is in place. We are getting none of that.

This market has done more reversals of reversals of reversals and it gets my head spinning. There's nothing more I'd love to be able to do than tell you to get long for a great buying opportunity that should last at least a couple of weeks. There are now many who play the short side and I'd love to be able to say get short since we should see a big move down into April.

The trouble is we're getting what used to be big moves on a daily basis now (remember the days when the DOW moved 100 points it was a big day?). And it's happening multiple times on an intraday basis. Catch those moves right and you're putting some serious change in your pocket. Hang around too long in a trade and you're giving it back. Have your stop too close (this market requires wide stops right now) and you're bleeding to death from a thousand paper cuts.

I like to keep ideas on my charts for where I think the market could be headed (all the arrows and wave counts that I place on my charts). The difficulty lately has been keeping track of the multiple possibilities and not cluttering the charts. I know many of you already find the charts too cluttered. But this market requires all of us to stay on our toes and be ready for anything.

So it's a frustrating market to trade and I don't see anything yet that tells me it's about to become less frustrating. Unless you're selling credit spreads each month (in which case you love the fact that it's trapped in a trading range) you are likely finding this to be one of the more challenging markets you've traded in quite a while. This too shall pass of course and the trick is to not get yourself to point where you're forcing trades just to trade. That's often what leads to larger losses so stay patient.

1.2 Bank Credit Spread Update

As hard as central banks try to increase the liquidity in this market, in an attempt to free up the frozen credit market, the more it seems to be going the other way. The U.S. Federal Reserve has been the most aggressive in that they've aggressively lowered rates and injected massive amounts of money into the monetary system. Other central banks have kept rates steady but they've also injected enormous sums of money into the banking system. But rates like the LIBOR (London Interbank Offered Rate) are not ticking lower. They're lower than they were last summer but they're stubbornly remaining higher than the Fed rate and Treasury rates and even ticking back up. It's the spread between these banks' lending rates and the Fed funds rate and Treasury rates that's frustrating the central bankers.

In last weekend's newsletter I showed the credit spread between the Moody's BAA-rated bonds and the 10-year yield and how it continues to widen. This is very telling and as the credit spread continues to widen it indicates a further reluctance to accept anything but higher and higher rates on loans (and only highly-rated loans). Banks don't trust each other and consequently they are not nearly as willing to lend money. This is reflected in the higher interbank rates and higher bond rates for even low-risk loans. This is of course making it much more expensive to borrow money even if you're able to get it.


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The difference between the rate banks charge for three-month dollar loans relative to the overnight indexed swap rate is showing a decline in the availability of cash. The so-called LIBOR-OIS spread widened 7 basis points to 64 basis points. It averaged 8 basis points in the first half of 2007.

This lack of trust is the key issue. It's not a liquidity problem--there's plenty of money in the system (after all it's nothing for the printing machine to simply print more money, except for that annoying inflationary problem). The problem is trust. Without trust the whole system breaks down because everyone becomes afraid of the risk of not getting their money back. No one trusts the current rating system. And without trust the Fed and other central banks are powerless. The unintended consequences (inflation) could become a bigger problem (although it could be argued that deflation is a far bigger and more difficult to solve problem that's coming our way).

When credit spreads continue to widen, as they are, while the stock market rallies, it's bearish non-confirmation and it's a warning that the bounce is very likely just a correction to the decline. Don't trust it. Use it to lighten up your holdings or put some collars in place (gave a good example over the weekend). Don't be a deer in the headlights and do nothing. As readers of this newsletter you have already shown you are far more knowledgeable about the stock than the majority of investors. Use that knowledge and protect yourselves. There's absolutely nothing wrong with cash in an uncertain market. Just make sure you're confident about the banking institution you're with.

1.3 Economic reports

Durable Goods Orders
Orders for machinery and other capital equipment dropped again in February, down -1.7%. This was a disappointing number against expectations for a rise of 0.5% but at least a little better than January's -5.3% (revised to -4.7%). Capital equipment orders, a measure of how much businesses are investing in their modernization efforts, dropped -2.6% which exceeded January's -1.8% decline. This is an indication that businesses are pulling in their spending as they see a slowdown ahead. Machinery orders dropped -13.3% while civilian aircraft orders increased +5.4% (this one is volatile month to month). Excluding the transportation goods, orders were down -2.6%, the most in a year.

You can see by the chart of durable goods orders that the trend has been down for about two years now:

New Home Sales
The news on home sales continues to sound depressing. With all the stories in the evening news and other news programs about how hard it is to sell homes and how much prices have dropped, it's no wonder consumer confidence is taking a nose dive.

Today's report showed sales of new homes fell to a 13-year low in February to a seasonally adjusted annual rate of 590K, down -1.3% from January. Sales are down four months straight now and -30% over the past year. The good news is that new home inventory dropped -2.1% to 471K which is the lowest since July 2005 (when the housing market peaked). But as sales slow and foreclosures add to the supply of homes the unsold inventory held at a 9.8-month supply in February. As in January, this is the highest level since 1981. The median sales price fell -7% from March 2007 to $244K. The sales volume and price are not pictures of health in the following chart:

Crude Inventories
Crude supplies were unchanged for the past week at 311.8M barrels vs. expectations for a increase of 1.5M barrels. This was blamed for the surge in oil prices today (up almost +5%). Gasoline supplies fell -3.3M barrels and distillate stocks were down by -2.2M.


2.0 Equities

2.1 S&P 500 Index (SPX)

SPX chart, Daily

The way price is behaving (lots of chop and whipsaws with very little follow through in either direction) I'm getting a stronger feeling about the potential for a large sideways consolidation pattern to play out into April, maybe even May. That pattern is depicted with the dark red price path. If SPX can rally above the top of the pattern near 1380 and especially above the February 1st high near 1396, the more bullish price pattern could play out (first resistance in that case would likely be the downtrend line from October, up near 1430.

It's possible the current bounce off the March 17th low will simply lead to a strong decline as the next move but that's looking less likely at this point. The large sideways consolidation calls for a lot more of what we've seen since January--lots of chop and whipsaw price action that beats both sides severely about the head and shoulders. Selling credit spreads above and below would be the winning trades in this environment. For now I'd sell resistance and buy support (including your spread trades) but when either support or resistance gives way it could be a big move.

Key Levels for SPX:
- cautiously bullish above 1396
- bearish below 1257

SPX chart, 60-min

You can see today's candles on the 60-min chart were very small candles. It was one choppy boring market today and it told us nothing about what will likely happen tomorrow. SPX is dancing on top of the broken downtrend line from December so that's potentially bullish and is the way I'm leaning. But a break of today's low (1336) that stays there would have me quickly switching to the bear camp. Just don't overstay your welcome whichever camp you decide to drop into.

2.2 Dow Jones Industrial Average (DOW)

DOW chart, Daily

I've got the same sideways pattern potential for the DOW. A rally above 12800 should see a quick trip up to at least 13K. But a break below today's low should see another test of the long term uptrend lines from 2002/2003 (12300 area)

Key Levels for DOW:
- cautiously bullish above 12768
- bearish below 11630

DOW chart, 60-min

Like the SPX, the DOW found support at its broken downtrend line from December so there's some bullish potential here. Today's price pattern just didn't give me warm and fuzzies about what the bulls will be able to do here. A break lower could pick up some speed but from a pattern standpoint, the March 19th low near 12097 (SPX 1295) is the important low for the bulls to defend.

2.3 Nasdaq-100 Index (NDX)

Nasdaq-100 (NDX) chart, Daily

The price pattern for NDX, similar in some ways to the semiconductors (next chart), suggests the current bounce will be followed by another leg down to complete a 5-wave decline from October (dark red). For that scenario to play out we should see an end to the current bounce any day now (possibly yesterday's) and drop down towards 1600. That move could set up a much larger corrective rally into May/June. If NDX instead pushes higher to the downtrend line from October (pink) then it opens up the possibility for actually being more bearish since the next leg down after that could be very strong and deep.

Rather than either a continuation higher or lower from here the other possibility of course is just like the one I showed for SPX and the DOW--a continuation in a sideways trading range into May.

Key Levels for NDX:
- bullish above 1865 (target 1945 by mid April)
- bearish below 1668 (target 1580 by mid April)

2.4 Semiconductor Holder (SMH)

Semiconductor Holder (SMH) chart, Daily

Nothing has changed in the SMH pattern from what I showed last weekend--the sideways triangle is still the most likely pattern. The semis did not follow the techs in this week's rally. SHM poked its head above the top of the pattern on Monday and Tuesday and quickly ducked back down for cover. If those little shadows sticking up are left that way it's going to look like a throw-over finish to the triangle pattern (a common occurrence). The next move should be down (dark red) if this pattern plays out like it should.

2.5 Russell 2000 Index (RUT)

Russell-2000 (RUT) chart, Daily

The RUT's pattern looks to be in between the NDX and SPX. I could easily argue for a continuation higher, at least up to its October downtrend line near 737, as well as a decline from here to a new low, potentially targeting the 550 area by the end of April. Of course it could go sideways as shown on the DOW and SPX charts. The price pattern just isn't providing enough clues as to which scenario gets top billing. If forced to choose I believe we'll see either the big sideways consolidation or lower from here. It's possible we'll see one more quick stab higher before the bounce finishes, shown on the 60-min chart.

Key Levels for RUT:
- bullish above 737
- bearish below 643

Russell-2000 (RUT) chart, 60-min

If the bounce off the March 17th low is forming a rising wedge it needs one more leg higher (pink) which should be accompanied by bearish divergences. If it sets up that way it will make for a very good short play since the rising wedge pattern is typically retraced very quickly (so back to 646 in less time than it took for the rally). Like the other indices, the bulls are not in trouble until the March 19th low, 665 for the RUT), is taken out.


3.0 Featured Industry Groups

3.1 Banking Index (BIX), Daily chart

I thought Monday's rally was going to do it--the sharp rally broke above the previous high on February 27th and it looked like the bulls were going to show us something. By the end of the day the candle was a shooting star (tall shadow above the small body made by the open and close near the lows of the day). That reversal candlestick was completed with Tuesday's and today's red candles so now it looks like the banks are headed lower again.

As is true for just about every index and sector I follow, the price pattern is choppy with lots of 3-wave moves. This leaves no sense of direction to the market which is why I like to stick with trend lines and channels. After the 1-day breakout the banks are back inside the down-channel from last year's high. I suspect we'll see the banks chop their way lower now but a rally back above 274 would be bullish.

3.2 U.S. Home Construction Index (DJUSHB), Daily chart

Like the banks, the quick stab above the February 27th high was followed by a steep pullback so far. The 200-dma is the line of resistance for the bulls to overcome. It could be just a pullback that will lead to another rally in which case watch for the possibility for a rally up to the top of the up-channel drawn on the chart. I show a Fib projection near 448 as a potential target. A drop below 350 would be a warning to bulls and back below 300 would put the bears back in the driver's seat.

3.3 Transportation Index (TRAN), Daily chart

The good news for the Transports is that they've broken above the top of the down-channel from last year's high. Today's pullback found support at its recovered 200-dma. Obviously the bulls don't want to give that up now. If they can manage to push this back up keep an eye on the 5145 Fib target. A drop below 4388 would be an indication there are new lows on the way.


4.0 Currencies

4.1 U.S. Dollar (DXY), Daily chart

Earlier this month the US dollar broke below the bottom of its longer-term down-channel from 2005 and then found support at the bottom of its shorter-term down channel from January 2007. The bounce then took it up just above the bottom of the longer term channel but found it to be resistance (very common). If it consolidates sideways for a few weeks (depicted in dark red) then I expect to see another leg down into May/June. This may coincide with the same kind of sideways consolidation I'm showing on the DOW and SPX daily charts. If dollar bulls can push it back above Monday's high then we should see it head up to at least its 50-dma or 100-dma near 75.


5.0 Commodities

5.1 Oil Fund and Index (USO and OIX)

Oil Fund (USO), Daily chart

The question in my mind for oil is whether or not we're going to get another new high out of the current bounce. If we do I suspect it will be accompanied by a big bearish divergence against the oscillators and would fit as the completion of its longer term rally. A push back up to retest its broken uptrend line from early February (red trend line) where it crosses the top of its up-channel (about 91) in early April would be an ideal short play setup.

Oil Index (OIX), Daily chart

The pullback from February 27th looks very corrective and suggests another push higher is coming for the oil stocks. I would think the broader market will have to participate to make that happen. It takes a rally above 865 to point to at least a retest of the early January high and a break below 760 to suggest we'll see new lows.

5.2 Gold Fund (GLD), Daily chart

The apex of the consolidation pattern in January/February is a common support level (resistance level for a bounce in a downtrend) and that's right where GLD bounced. I'm showing an idea for a retest of the broken uptrend line from December (dark red price path), near 97, to set up a short play in gold. But like oil, we could see a final high made in April in which case we should see GLD hitting about 102 (gold around $1050). I believe the new high would make for a very good short play setup. If GLD breaks below 88.63, the mid-February low, we will probably see a larger decline down towards the next support zone around 80.


6.0 Bonds

10-year Yield (TNX), Daily chart

The 10-year yield appears to have made a successful test of the January low (resistance for bond prices) with bullish divergence. I expect to see a higher bounce for TNX now, at least back up to the February high and likely higher. Have you locked in your refinancing?

7.0 Summary

My frustration with this market is something that I know many of you share. The number of emails I receive voicing it tells me we are not alone. The market continues to act very jittery. The bears have very little conviction to hold short for fear of another surprise from the Fed, Treasury, or another rating upgrade on a bank. Shorts buy first and ask questions later. Just the opposite is happening with the bulls--they are so spooked now by what we're all hearing about what's happening to the financial sector and they're holding the exit door open as they keep their eyes on the stock market while listening for news of another bank implosion.

Speaking of implosions, there are several rumors about some big hedge funds that are in real trouble. Margin calls may force more than a few to liquidate holdings by the end of the month in order to meet the calls from the banks. Banks are not in the mood to lend money to risky ventures and they sure don't want to see any more of their existing loans to hedge funds go up in smoke. They've got enough to write off as it is.

This afternoon we saw a quick buy-program spike that was just as quickly sold into. It appeared as though someone tried to goose the market to create some buying pressure (short covering or wannabe bulls) so that they could sell into it (the buying creates liquidity for them to sell into so that they don't pull the market down with their selling). The problem was there was no follow through buying and when they (whoever "they" is) sold into it there was nothing to hold the market up. This is a telltale sign of distribution (liquidation) and there may be a lot more of that coming our way if some of the rumors are true.

Countering the liquidation worries we of course have potential window dressing into end of quarter/month. Fund managers will clearly want to have as good a showing as they can for the end of the month. Of course if consumers are as depressed as the numbers indicate, they probably won't even open up their statements next month. It amazes me when I hear how many people simply stick their heads in the sand and hope the problem will go away before they notice. Everyone on TV says this is a great time to buy (wrong!) and yet I think most people are seriously wondering if that's true. But most will do nothing to protect themselves and they keep telling themselves the stock market is the best place to be long term.

SPX is below where it was in April 1999. In that 9-year period, according to Morningstar Inc., your index fund has lost 0.37% per year (and down -1.4% per year over the past eight years). Treasuries are up +4.7% per year over the same 9-year period and +5.8% per year since March 2000. And yet people still think most of their IRA belongs in a stock fund. I strongly suspect most will dearly wished they had reversed their allocation between stocks and bonds by this time in another nine years.

Commodities are clearly where we wanted to be invested since 2000. But investors in commodities should be watching closely to take profits. I've heard more ballyhooing from commodities newsletters, especially the grains, oil and gold, than I can ever remember. It tells me we're peaking. I shared with you a couple of weeks ago the strong bullish sentiment in commodities. Talk about a boat ready to tip over! Gold bulls at 97% is not what bulls want to see. The more I hear it's different this time the more I want to scream GET OUT NOW!! Just keep those stops up close now. Let the market take you out by having your stop just below this week's lows.

As for what we can expect in the stock market in the coming week, I hate to say it but I think more of the same. While the market has rallied the past week, the market internals are not supporting the price rise. New 52-week lows have outpaced new highs, even on big up days. Volume during the rallies has been somewhat anemic. Continue to trade very carefully and don't trust moves in either direction until this log jam is broken. Good luck and I'll be back next Wednesday.

Key Levels for SPX:
- cautiously bullish above 1396
- bearish below 1257

Key Levels for DOW:
- cautiously bullish above 12768
- bearish below 11630

Key Levels for NDX:
- bullish above 1865 (target 1945 by mid April)
- bearish below 1668 (target 1580 by mid April)

Key Levels for RUT:
- bullish above 737
- bearish below 643

New Plays

New Option Plays

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

New Calls

None today.

New Puts

None today.

New Strangles

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Apple Inc. - AAPL - close: 145.06 chg: +4.08 stop: 124.85

Shares of AAPL continued to surge on Wednesday. The company seemed to be getting more positive press about its iPhone business. The stock rallied 2.89% and broke out past resistance near $140. The intraday high was $145.74. Our target is the $148.00-150.00 zone. More conservative traders could start taking profits now! More aggressive traders could aim higher, maybe $160ish. The Point & Figure chart is bullish with a $166 target.

Picked on March 23 at $133.27
Change since picked: +11.79
Earnings Date 04/23/08 (unconfirmed)
Average Daily Volume = 48.5 million


DIAMONDS - DIA - close: 123.92 change: -1.21 stop: 120.75

Financials are big part of the market and the group got hammered today. This weighed on the DJIA and the DIA lost 0.9%. Overall we remain short-term bullish and would use this dip or a dip near $123.50 as a new entry point for bullish positions. We remain skeptical of whether or not the market can continue to rally past the end of the quarter. Our target is the $128.00-130.00 zone.

Picked on March 23 at $123.11
Change since picked: + 0.81
Earnings Date 00/00/00
Average Daily Volume = 19.1 million


Essex Prop. Trust - ESS - cls: 112.07 chg: -4.32 stop: 109.90

The REIT stocks were probably unfairly sold today as investors reacted to the new home sales data. Most of the homebuilders witnessed a lot of profit taking but ESS is a completely different business model. The REITs, which had been looking relatively strong, definitely suffered profit taking today. ESS should have support near its 10-dma near $112 and stronger support near $110 and its 200-dma. Wait for a bounce before considering new bullish positions. Our target is the $124.50-125.00 range. Traders should expect some resistance near $120 but it will probably be temporary. The Point & Figure chart is bullish with a triple-top breakout buy signal and a $132 target. FYI: Aggressive traders could also try buying calls on another dip near $111-110.

Picked on March 24 at $115.50 *triggered
Change since picked: - 3.43
Earnings Date 05/05/08 (unconfirmed)
Average Daily Volume = 408 thousand


FPL Group - FPL - close: 62.69 chg: +0.09 stop: 59.49

Believe it or not we are still sitting on the sidelines in FPL. The stock did spike higher and it did breakout over its 50-dma and 200-dma on an intraday basis. Yet the intraday high was only $63.54. Our suggested trigger to buy calls was at $63.55. It doesn't get any closer. FPL did have some news today. They announced plans to build a solar energy plant in California, which should be able to generate enough energy for 175,000 homes. We are maintaining a trigger to buy calls at $63.55. We're setting our first target in the $67.00-67.50 zone. This is not the most attractive risk/reward set up with a wide stop loss under Friday's low but if FPL can close above its 50-dma we'll tighten the stop. FYI: An alternative entry point would be another dip or bounce near $60.00.

Picked on March xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/30/08 (unconfirmed)
Average Daily Volume = 2.6 million


Fluor - FLR - close: 142.32 chg: +0.55 stop: 134.45

FLR continues to inch higher and is flirting with a breakout over its trendline of resistance. We are sticking to our plan. The P&F chart is already bullish with a $184 target. We need to see FLR breakout so we're suggesting a trigger to buy calls at $146.50. The biggest challenge is controlling our risk. The stock can see huge intraday swings, which makes this a more aggressive trade. We're going to try and play it with a stop at $134.45. That might be too tight. We're setting two targets. Our first target is the $159.00-160.00 zone. Our second target is the $168.00-170.00 zone. We do not want to hold over earnings in early May.

Picked on March xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 05/07/08 (unconfirmed)
Average Daily Volume = 2.3 million


Reynolds American - RAI - close: 60.85 chg: -0.47 stop: 59.65

RAI tested short-term resistance at its descending 10-dma. Traders continue to buy the dip and did so at $60.54. We remain bullish with RAI above $60.00. We're suggesting a stop loss under the recent low. There is a lot of congestion in the $64 region but our target is the $65.50-66.00 zone. We do not want to hold over the late April earnings. FYI: The P&F chart is bearish and points lower.

Picked on March 25 at $ 61.32
Change since picked: - 0.47
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 1.6 million


Intuitive Surgical - ISRG - cls: 323.97 chg: - 1.96 stop: 278.00

ISRG is holding up pretty well. Today's $2 dip suggest there appears to be an absence of sellers. We remain bullish here but we're not suggesting new positions. You might want to consider taking some profits off the table now. We are not suggesting new positions at this time. Our target is the $339.00-340.00 zone. More aggressive traders may want to aim higher. The bullish target on the P&F chart just jumped from $360 to $456 on Monday.

Picked on March 23 at $300.69
Change since picked: +23.28
Earnings Date 04/17/08 (confirmed)
Average Daily Volume = 1.1 million

Put Updates

Ambac Fincl. - ABK - cls: 6.38 change: -0.32 stop: n/a

ABK is just bouncing sideways, up 4% one day and down 4% the next. The company's chairman and CEO was supposed to present at the Bank of America 2008 Smid Cap Conference on March 26th but we didn't hear any specific news come out of the conference. We are not suggesting new bearish positions in ABK. 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).

The bounce from $5.00 is struggling.
Picked on January 27 at $ 11.54
Change since picked: - 5.16
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 10.9 million


Cytec Ind. - CYT - close: 54.02 chg: -0.17 stop: 56.15

The general trend in CYT is still down but short-term the stock looks like it wants to bounce higher. More conservative traders may want to tighten their stops. We are not suggesting new bearish positions at this time. The $50.00 level looks like nearest support so we are targeting a drop into the $50.25-50.00 zone. More aggressive traders might want to consider aiming lower.

Picked on March 09 at $ 54.72
Change since picked: - 0.70
Earnings Date 04/17/08 (unconfirmed)
Average Daily Volume = 601 million


MBIA Inc. - MBI - close: 13.24 change: -0.89 stop: n/a

Weakness in financials pulled MBI to a 6% loss. 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). We will definitely hold over the April earnings if we get the chance.

Picked on January 27 at $ 14.20
Change since picked: - 0.96
Earnings Date 04/24/08 (unconfirmed)
Average Daily Volume = 15.2 million

Strangle Updates


Dropped Calls


Dropped Puts


Dropped Strangles


Trader's Corner

Volatile, Non-Trending Periods: Trade More or Not at All

I went to the mail bag this week to make sure I stuck to a subject on the minds of our subscribers in this wild and crazy period.

"...any suggestions for trading in periods like this extreme volatility and seesaw action?"

The answer I myself first took to heart on this subject is what the chief technical analyst (Bob Farrell) at Merrill Lynch (at the time I was there) used to say about periods like this. It was to the effect of 'trade more or not at all'. When there is heavy volatility and whipsaw action, you either are forced to do short-term trading or stay out and wait for a more definite trend to develop again. After all, the markets only trends in one direction or the other for part of the time, followed by non-trending periods, sometimes long ones.

It seems like an oxymoron to say to option traders that's there a need to do 'shorter-term' trading. But there are degrees of being quicker to get into and out of the market. When trends shorten up, we're looking at the trend that typically unfolds over 2-3 days to 2-3 weeks. In periods like the current situation of extreme volatility, I focus the MOST on the HOURLY oscillators or price momentum indicators that measure the most extreme short-term 'overbought' or 'oversold' situations.

If I don't want to attempt trading the short-term extremes that develop in the major stock indexes or bellwether stocks of great liquidity, I need to determine as best I can the intermediate-term direction, LACK of direction (i.e., sideways) and if there is a sideways trend, is it a trading range that is wide enough and well-defined enough to enable me to buy at the low end and sell at the high end of that price range.

The long-term, month-to-month trend is going to be of lesser concern to options traders EXCEPT as it might impact the intermediate (2-3 week or longer) trend. For example, if the major indexes appear to be bottoming, as may be the case currently, look also at the long-term weekly charts to see if there's something on those charts that help us see if the market is ALSO in an area of potential long-term technical support. Most important is when prices hold at, near or above a prior major low. Second in importance as a forecasting tool for the trend is whether prices hold at, near or above a trendline.

Just as fundamental analysis (e.g., earnings prospects, impact of Fed policy, etc.) of the current market is quite MIXED, so (of course) is the current technical picture.

The intermediate-term trend MAY be turning up, but further price action is needed. In any trend, short (e.g., 2-3 days), intermediate (e.g., 2-3 weeks) or long-term (2-3 months) the trend is DOWN as long as each new low is BELOW the previous downswing low and each rebound following each low, stops BELOW the prior upswing high.
This is the only way to determine the trend direction on a technical basis, but a secondary way to ascertain potential trend changes is by use of trendlines; a decline stops at, near or above an UP trendline, which is followed by a turn up in prices.

Along with trendline analysis, or secondary methods of determining possible trend changes or reversals, is to look at so-called 'overbought' or 'oversold' extremes and to look at bullish or bearish 'sentiment' extremes.


The RSI is a ratio line that measures the 'relative strength' of X number of higher closes VERSUS X number of lower closes. Up or down closes can be calculated on an intraday, daily, weekly or monthly basis. The number of periods is the 'length' setting. If set to 14 the RSI measures 14 closing periods on whatever chart you select; e.g., hourly, daily, etc.

The RSI also attempts to define an 'overbought' extreme as when the RSI registers at or above 65, typically 70, or when the underlying instrument is 'oversold' by registering at or below 35, typically, 30 or under.

The length setting is a key one. For the hourly RSI, I use '21', a fibonacci number and one that I have found best defines extremes that develop after strongly trending periods of a few days. In 3 trading days, there are close to 21 hourly closes.

Sometimes, a bullish or bearish 'divergence' develops where price and RSI trendlines slope in opposite directions. A bullish divergence has prices trending lower as RSI starts trending up; i.e., higher 'relative strength'. A bearish divergence is where prices are trending higher but the RSI is declining on balance.

The overbought extremes on a 21-hour basis tend to occur with readings at or above 60 in the major market indexes, such as is seen with the S&P 100 (OEX) chart below; buying index puts only when those extremes were seen and not otherwise, has been quite profitable in recent weeks.

There were more 'overbought' extremes than oversold ones in the period seen below in the hourly chart, which is ideal in a bearish period as more signals occurred on the right side of the dominant trend. The 21-hour RSI 'touched' an overbought reading a week ago, on Wed., the 19th, but it wasn't quite conclusive as I like to see it well into this zone IF I'm going to base a trading decision on this indicator more than on more this PLUS more conclusive price considerations; e.g., a possible double top or that the index has reached the high end of its likely trading range. This more conclusive OVERSOLD reading was reached at the beginning of this week per the last down red arrow on the OEX hourly chart below:

There was ONE oversold extreme seen in the OEX chart above that was a good call entry signal given the oversold extreme below 30. A quick profit could have been realized as the Relative Strength Index approached its common oversold level the first time and a further call entry made when there was a lower low made later on, on HIGHER relative strength, per the diverging trendlines seen above. I don't minimize that fact that is can be quite hard to take that kind of 'signal' in the heat of that highly emotional and volatile week!

The hourly chart of the Dow 30 (INDU) below showed mostly the same overbought extremes, with the exception of one more reading in the 'overbought' zone with INDU, with one other difference: there was a higher relative high made after the first OEX bottom and 21-period RSI didn't diverge from what was occurring with price action; i.e., the trendlines below both slope in the SAME upward direction. The second, higher, DOW bottom might have helped keep you long OEX calls (or to buy them) when OEX fell briefly under its prior low; INDU which often develops the most consistent technical patterns.

As to whether I now want to be in Dow Index puts based on the extreme RSI seen above (when INDU got up to its recent high above 12400), I'm not sure I want to be in Dow index puts, as there are some other considerations I have relating to the INTERMEDIATE to LONG-TERM TRENDS, as well as the extremes in bearish sentiment seen recently which is a next topic. Yes to being in puts based on the record for the period seen above when there were the same RSI hourly upside extremes, but patterns relating to overbought/oversold won't always stay as consistent as that seen on the INDU hourly chart above.


To date, there has not been a single rally that has carried above a prior rally high, which would have to come in order to be most conclusive that the intermediate trend had turned; see the S&P 100 (OEX) chart below.

I don't want to go into the theory of why high bearish sentiment often is an indication that the market may be making an intermediate to long-term bottom, even if only an interim bottom that will be 're-tested' later (as in the end of the bear market in 2002-2003). I would just note that the recent very LOW bullish sentiment (high bearishness) seen above, may set the stage for a rally that will carry further than traders expect currently; in all the major stock indexes, not just the OEX, which happens to be the chart I display this indicator on.

Another analysis I have made about whether the intermediate, multiweek, trend could be shifting here from down to up is that the S&P has managed to pierce its down trendline (to the upside). The decline today, took SPX back to possible support implied by the previously broken down trendline, so the next couple of days should tell the story on whether a further advance will develop. Where SPX could manage to get above its prior highs at 1388 to 1395, which would be MORE conclusive of a change to a more 2-3 week bullish outlook.

Pattern recognition, given sufficient experience at it, will often tell you by looking at a chart whether a trend is strongly up, strongly down or just whipping back and forth and maybe setting up a trading range. A TECHNICAL indicator that can help you determine whether an index or stock is 'trending' or not is the Average Directional Index or ADX.
Welles Wilder, who also developed the Stochastics indicator, came up with the Average Directional Index (ADX) to evaluate the strength of a current trend, be it up or down. He came up with the ADX when trading the commodities markets and the stock market isn't as volatile generally so the scale is less extreme.
The ADX is an 'oscillator' in that it fluctuates between 0 and 100. Even though the scale is from 0 to 100, readings above 50-60 are relatively rare even in the more volatile commodities markets, but in stocks and stock indexes, readings above 35 are unusual. Low readings, below 20 down to 15 indicate a weak trend; readings above 30 in the major stock market indexes indicate a strong trend.
The ADX indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend; i.e., readings above 30 can indicate a strong downtrend as well as a strong uptrend.
ADX can also be used to identify potential changes in a market from trending to a weak trend or non-trending. When ADX begins to strengthen from the 15-18 area and moves above 20, it is a sign of a developing trend. When ADX begins to weaken from above the 33-35 area and then moves below 28-30, it is a sign that the current trend is losing strength.

The current assessment of Average Directional Index (ADX) as seen above, is that of a weak or we could say a still intermediate-term 'non-trending' S&P 500 index. This of course isn't any mystery to anyone closely following recent price action that is so volatile. However, if you have doubt about this or want to 'measure' the intermediate trend direction with an objective type statistical model, you can use the ADX indicator. The 14 'length' setting is the typical default setting for this indicator that you'll see and I don't change from it when I use this indicator and this 'length' setting is close enough to my preferred '13' setting, a fibonacci number.

If we look at the long-term, multiyear, up trendline for SPX, it has held that line based on my current assessment of where that trendline should intersect. More importantly even, recent lows have to date held ABOVE its (2006) prior low. This suggests to me that the LONG-TERM uptrend could still be intact and this has some influence on my thinking on the current prospects for the market to work higher. A similar chart picture on the Nasdaq 100 (NDX) chart is seen, but not shown here.

Moreover, a long-term oversold assessment based on the 13-week Relative Strength Index (RSI) seen above is another aspect to the current technical picture. This market may not have to go up much, but it may also be resistant to declining much further in the next few weeks. Stay tuned on that!

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


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


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