Option Investor

Daily Newsletter, Thursday, 05/22/2008

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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

Bifurcation: the Splitting of an Entity into Two Parts


It wasn't so many years ago that traders regularly heard the word "bifurcation." Tech-related and non-tech indices performed differently quite often at some market periods.

Bifurcation appears to be returning, with techs and the small-cap Russell 2000 having held up better this week than some other indices. Neither has yet broken out of the rising channels they began forming as they rose off March lows. Other indices have.

Bullish traders have taken comfort from that relatively stronger performance of the techs and the small-cap Russell 2000 during this week's downturn. However, all woke this morning to not-so-happy news. Some said that news crushed hope for anything more than a steadying today. In truth, technical considerations on the charts suggested that today was likely to be a consolidation-type day all along. Logic would suggest that, too, after this week's market behavior.

Overnight, crude had risen to yet another new high in electronic trading, this one above $135 a barrel. That occurred as traders braced for the National Hurricane Center's forecast for the about-to-be-upon us hurricane center. When that report arrived this afternoon, the prediction by the National Oceanic and Atmospheric Administration (NOAA) was that "projected climate conditions point to near normal or above normal hurricane season in the Atlantic Basin this year."

That includes a 60-70 percent chance that 12 to 16 storms will be named, with about 6-9 of them being hurricanes and 2-5 of those being major hurricanes. The average season has 11 named storms, NOAA said. If this were a company giving guidance, we'd say it was raising guidance, wouldn't we, as 12-16 named storms would be above the 11 average. I'm sure Jim Brown will be covering this in more depth in his reports.

In addition, a WALL STREET JOURNAL article this morning speculated that the IEA's ongoing study of the world's top 400 oil fields might result in a steep downward revision of forecasted supplies. That report is due out in November.

That speculation will not be new to our readers who have benefited from Jim Brown's in-depth study of energy matters over the last few years. It appears that in the past the IEA has stuck to assessing demand and suddenly decided it was time to look more closely at supply, but we've known about the supply problems through Jim's dedicated and in-depth research.

Other news involved a financial that had in the past cratered our markets. UBS announced a fire sale on its shares in an effort to raise $15.5 billion. Those new shares would be offered at a discount more than 30 percent below the current price, with the existing shareholders the ones offered the rights to this discounted stock. The rights will be tradable from May 27 through June 9. Just yesterday, UBS had engaged in another fire sale, selling subprime and Alt-A mortgage assets with a nominal value of $22 billion to BlackRock, Inc. (BLK) for $15 billion.

The bad news wasn't finished. David Bove of Ladenburg Thalmann downgraded Goldman Sachs (GS), Lehman Brothers (LEH) and Merrill Lynch & Co. (MER) to sell ratings and cut estimates for their 2008 earnings. Brokers would continue to feel the effects of a chaotic operating environment through the second quarter, he said. He kept Morgan Stanley's neutral rating.

With all that bad news to digest, the markets performed relatively well, even the indices such as the SPX. By the end of the regular trading session on the NYMEX, crude had dropped $2.43 to close at $130.74 a barrel. While that was considered good news for equities, it brought energy-related SPX composite stocks such as XOM lower, and many such stocks comprise the SPX.

What does that steadying today mean? Let's take a look at the charts.


Annotated Daily Chart of the SPX:

If the SPX bounces, the intraday charts at the end of this article list some levels to watch for stalling or rollover potential. However, the converging 10-sma and 200-ema provides an obvious spot on the daily to watch for that potential.

The chartist studying this daily chart is faced with a couple of quandaries that I'll lay out for you. A rising wedge as seen here is typically a bearish formation and fits with the whole idea of this being a bear market rally. Since it's my own belief--or possibly, just my fear--that the markets still need a retest of the year's low, if not more, then that wedge fits. Now the SPX has broken through that wedge's support.

ThThat's one argument. Here's another. It's possible that the SPX is doing nothing more than widening that wedge into a regular old rising channel with a lower boundary parallel to the top one. One bit of evidence for this is that the mid-April test of the bottom trendline coincided with a 30-sma test. If that channel's lower trendline were redrawn, the lower trendline test would again coincide with a 30-sma test, or perhaps just be a little off. So, we can't let our biases lead us into only one interpretation. In my own trading, I prepare for a sharp downside as best I can, but I don't preclude all bullish trades, either, as some of my credit spreads are bull put credit spreads. I just know where those stops are going to be and engage in fewer of those trades than in the bear call spreads.


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Summer is beginning and I think it's possible that we could have one of those dreaded awful summers when markets just chop around in seemingly random ways all summer. My best guess would be that the SPX could chop around between about 1360 and 1440 if such a pattern is set up. If there's a sharper downturn or a sharper upturn that's sustained, I'll have to throw that theory out the window, but it's one that I'm keeping on the radar screen for now.br>
That means, of course, that I wouldn't be surprised to see the SPX give way and drop toward 1382 or even 1360. Neither would I be surprised to see it climb toward the 200-sma again, and therein lies the quandary for us chartists.

I think it's moment-by-moment and day-by-day right now, a time to employ every carefully honed trading skill, including the skillful use of stops.

AAnnotated Daily Chart of the Dow:

Similarly to a possibility seen on the SPX's chart, this chart presents the possibility that the Dow could spend some time chopping around from about 12340 to 13170. Sustained daily closes below the descending green trendline would cause me to throw out that scenario.

Annotated Daily Chart of the Nasdaq:

A Keltner chart suggests that if values below 2440 are sustained the Nasdaq could drop toward 2360, so I would factor that possibility into my trading plans, but that same chart also presents a possibly higher probability that the Nasdaq will climb toward the top of the channel instead. Me? I'd be leery of stalling or rollover potential near the converging 10 and 200-sma's if the Nasdaq should climb that high.

Annotated Daily Chart of the SOX:

Lots of Keltner-style resistance gathers from 427-435.50 on the SOX's chart. Support looks relatively firm from 363-397 on that chart, too. Combining that information with what I've seen on other charts, chopping around between the 30-ema and about 436 might be possible for the SOX. A sustained break of the 30-sma might mean a quick trip down to 383 or perhaps even 375.

Annotated Daily Chart of the RUT:

A Keltner chart suggests that if the RUT sustains values beneath those rounding-up 30-sma and 72-ema's, it may be vulnerable to about 696-698, which would suggest a retest of that descending red trendline. For now, though, the RUT could just as easily press up toward 747-751, but I would be careful of stalling or rollover potential any time now. I wouldn't be surprised to see the RUT ping-pong back and forth between about 717 and 750 for a time now, but sustained levels below or above those would force me to throw out that scenario.

Annotated Daily Chart of the USDJPY:

Today's Developments

Today's developments included the usual roster of Thursday releases, including initial and continuing jobless claims at 8:30 am ET. Initial claims dropped 9,000 to 365,000, staying above the benchmark 350,000. The four-week moving average also dropped. At 372,250, however, the average is also above that 350,000 benchmark, signaling that employment is weak. For comparison, initial claims were just 311,000 a year ago. br>
Continuing claims also dropped, but their four-week average still climbed. The uninsured unemployment rate stayed at 2.3 percent. A year ago, it was alternating between 1.9 and 2.0 percent each week.

The Bureau of Labor Statistics announced April's Mass Layoffs at 10:00 am ET. Those numbered 1,308, down 263 from the prior number. The total mass layoff initial claimants totaled 133,914, down 23,242 from the prior number.

OOther releases included the first quarter Office of Federal Housing Enterprise Oversight (OFHEO) Housing Price Index at 10:00. Prices fell 1.7 percent when that quarter was compared to the prior one and 3.1 percent when compared to the year-earlier period. OFHEO said the declines were the steepest in their 17-year history of keeping records.

Weekly natural gas inventories came last. Natural gas inventories rose 85 billion cubic feet. A commentator on CBNC worried aloud that the build won't be enough to match the levels needed before the heating season begins next winter. He indicated that 3.5 trillion cubic feet were in storage before last winter's heating season began, but only 1.6 trillion cubic feet are in storage now.

Federal Governor Randall Groszner, a voting member of the FOMC, spoke on "Prospects for Recovery and Repair of Mortgage Markets" at 9:00 am ET. His talk followed Fed Governor Kevin Warsh's somewhat sobering speech yesterday. Warsh had emphasized the Fed's willingness to help provide liquidity and loosen tight credit markets but had asserted that the Fed couldn't do it alone. Private financial companies had to step in, too, to resolve the difficulties that resulted in what he said "may be the most pronounced time of testing for central banks in a generation."

Groszner believes that "any assessment at this stage about the recovery and repair of the mortgage markets is preliminary." As all FOMC members have done over the last year, he outlined the steps that the FOMC had taken to ameliorate credit and liquidity problems. He noted that many types of investors had sought out CDOs because they were tagged as investment-grade vehicles but yielded more than other investment-grade vehicles. He talked about the differences in the current, more complex "two-layer securitizations" and previous iterations of these securities.

We've heard all that, so there was nothing new in those statements. He listed a number of needed changes, current initiatives by the Federal Reserve, the Basel Committee on Banking Supervision, the Conference of State Bank Supervisors (CSBS), the American Association of Residential Mortgage Realtors and others to resolve the problems. He believes that the financial system will eventually become more resilient but that the efforts will take time. All in all, the talk seemed a bit more soothing than yesterday's by Warsh.

When the Federal Reserve released its weekly figures on outstanding commercial paper, the figures showed the first gain in outstanding paper in at least six weeks and perhaps longer. For the last two to three months, despite assertions about the easing of the credit crunch, most weeks have created declines in outstanding commercial paper. br>
This week's result is good news for those watching for an improvement in companies' abilities to place corporate paper for short-term needs without going to banks for more expensive loans. However, the gain was oddly enough mostly in financials, with non-financials still showing some negative numbers.

In company-related news, Ford Motor (F) announced that it will cut production this year in response to the weakening U.S. market. That weakening economy, coupled with higher commodity prices, means that the company no longer expects to be profitable in 2009.

AApple (AAPL) received happier news. Oppenheimer upgraded the stock to an outperform rating. With techs outperforming recently, a Briefing.com article noted that large-cap techs now had the largest sector in the SPX, surpassing financials, a claim I haven't checked out.

Another writer claimed yesterday that energy-related securities had bypassed financials to obtain the largest weighting. One energy-related stock that was in the news today was NRG Energy, offering to acquire Calpine (CPN) in an all-stock offer.

After hours, GAP (GPS) reiterated its profit forecast for 2008 and reported first quarter profit that rose 40 percent but climbed due to inventory control measures. Sales actually dropped. Barnes & Noble (BKS) cut its forecast for full-year sales and said it was exploring whether a transaction with Borders Group (BGP) was feasible. Ann Taylor (ANN), Computer Sciences (CSC), Gamestop (GME) and Hormel (HRL) all reported today, too, with those considered having beat expectations.

Tomorrow's Economic and Earnings Releases

Tomorrow's schedule will be particularly light with only the 10:00 am ET release of April's Existing Home Sales having the capacity to move the markets. Those sales are expected to be an annualized 4.86 million, down from the previous 4.93 million. The weekly ECRI leading index will follow at 10:30, but that doesn't tend to be a market mover.

What about Tomorrow?

Annotated 30-Minute Chart of the SPX:

Annotated 30-Minute Chart of the Dow:

Annotated 30-Minute Chart of the Nasdaq:

The other intraday charts were 30-minute ones, but I've switched to a 15-minute one for the RUT, because this index did not even approach its potential downside target on the 30-minute chart.br>
AAnnotated 15-Minute Chart of the Russell 2000:

Tomorrow is the last day before the long weekend, and many traders will be leaving early, so volume may well be light, making trading patterns unpredictable. Trade only if you have a stellar setup and evaluate long and hard whether you want to carry those options positions over a long weekend. In fact, unless there's a sharp downturn tomorrow that plumps up volatility levels, you may notice that your options' extrinsic value (what's sometimes called the "time value") decreasing beginning about noon tomorrow, so plan ahead.br>
I wanted to note that this is my last regular Thursday Wrap. As much as I love charts and discussing the markets, a family member's health situation has made it necessary for me to cut back on obligations. I will be substituting for Jim next Tuesday and then will be substituting occasionally for other writers when needed. You can still find me in the live portion of the site and in the weekend's Trader's Corner articles.

Have a happy long weekend, everyone! Our gratitude goes out to those who gave their lives in support of our country this Memorial Day Weekend, and our sympathy goes out to their families.

New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays

New Calls

Priceline.com - PCLN - close: 130.39 chg: +1.68 stop: 126.99

Company Description:
Priceline.com Incorporated provides online travel services in 21 languages in over 60 countries in Europe, North America, Asia, the Middle East and Africa. (source: company press release or website)

Why We Like It:
PCLN exploded to new highs a couple of weeks ago on its earnings news. Now the stock has pulled back to fill the gap. Traders are buying PCLN near its trendline of higher lows (see chart). The stock can be very volatile so we consider this an aggressive, higher-risk play, but the bounce looks like a potential entry point. Just to be sure we want to see more follow through so we're suggesting a trigger to buy calls at $132.75. If triggered our target is the $139.50-140.00 zone. FYI: We do want to point out that the consolidation over the past two weeks has turned the P&F chart bearish.

Suggested Options:
Remember, this is an aggressive play. PCLN can be a volatile stock. Our suggested entry point to buy calls is at $132.75.

BUY CALL JUN 130 PUZ-FW open interest= 888 current ask $6.60
BUY CALL JUN 135 PNE-FG open interest= 944 current ask $4.30
BUY CALL JUN 140 PNE-FH open interest=1845 current ask $2.65

Picked on May xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 05/08/08 (confirmed)
Average Daily Volume = 1.5 million


Molson-Coors Brewing - TAP - cls: 58.05 chg: +1.55 stop: 55.49

Company Description:
Molson Coors Brewing Company is one of the world's largest brewers. It brews, markets and sells a portfolio of leading premium quality brands such as Coors Light, Molson Canadian, Molson Dry, Carling, Coors, and Keystone Light. It operates in Canada, through Molson Canada; in the US, through Coors Brewing Company; in the UK and Europe, through Coors Brewers Limited. (source: company press release or website)

Why We Like It:
Shares of TAP displayed relative strength today. The stock rallied to resistance near $58.00 again. Now after two weeks of trying to breakout we think TAP might be able to do it. A failure here would be a very wide and very bearish double-top pattern (see chart). A breakout should spark another wave of short covering. We're suggesting a trigger to buy calls at $58.51. If triggered our target is the $64.00-65.00 range. The P&F chart is bullish with a $69 target.

Suggested Options:
We are suggesting the June or July calls. It is up to the individual trader to decide which month and which strike price best suits your trading style and risk.

BUY CALL JUN 60.00 TAP-FL open interest=1526 current ask $0.75

BUY CALL JUL 60.00 TAP-GL open interest= 438 current ask $1.50
BUY CALL JUL 65.00 TAP-GM open interest= 325 current ask $0.30

Annotated Chart:

Picked on May xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 08/07/08 (unconfirmed)
Average Daily Volume = 1.1 million

New Puts

3M Co. - MMM - close: 76.64 chg: +0.52 stop: 77.01

Company Description:
A recognized leader in research and development, 3M produces thousands of innovative products for dozens of diverse markets. 3M's core strength is applying its more than 40 distinct technology platforms - often in combination - to a wide array of customer needs. With $24 billion in sales, 3M employs 75,000 people worldwide and has operations in more than 60 countries. (source: company press release or website)

Why We Like It:
MMM has been consolidating sideways for four months. The stock's bullish breakout from its bearish channel back in March never saw any follow through. Now shares of MMM are nearing support around $75.00. A breakdown can be used as a new entry point to buy puts. Our suggested trigger to buy puts is at $74.95. If triggered our first target is the $70.25-70.00 zone. Our secondary target is the $66.00-65.00 range. The P&F chart is bearish with a $69 target.

Suggested Options:
We are suggesting the June or July puts. Our suggested entry point to open positions is at $74.95.

BUY PUT JUN 75.00 MMM-RO open interest=4387 current ask $1.00
BUY PUT JUN 70.00 MMM-RN open interest=1148 current ask $0.25

BUY PUT JUL 75.00 MMM-SO open interest=5179 current ask $1.85
BUY PUT JUL 70.00 MMM-SN open interest=3914 current ask $0.65

Picked on May xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 07/24/08 (unconfirmed)
Average Daily Volume = 4.0 million

New Strangles

Amgen Inc. - AMGN - close: 42.77 chg: +0.67 stop: n/a

Company Description:
Amgen discovers, develops, manufactures and delivers innovative human therapeutics. A biotechnology pioneer since 1980, Amgen was one of the first companies to realize the new sciences promise by bringing safe and effective medicines from lab, to manufacturing plant, to patient. (source: company press release or website)

Why We Like It:
Biotech giant AMGN has seen its stock narrow into an increasingly smaller trading range. This can't happen forever so a breakout is imminent. We're suggesting a strangle to take advantage of any change in trend. Aggressive traders could try the June options. Everyone else can use the July options. We would open strangle positions in the $42.00-43.00 zone.

Suggested Options:
A strangle involves buying both an out of the money call and an out of the money put. This is a neutral strategy. We don't care what direction the stock goes as long as it moves enough to push one side of the trade into a profitable position. Traders will want to try and balance the amount of their investment on both side of the trade to keep it neutral.

June strangle: Our estimated cost is $0.56. We want to sell if either option hits $1.10 or more. June options expire in four weeks.

BUY CALL JUN 45.00 AMQ-FI open interest=6370 current ask $0.29
BUY PUT JUN 40.00 AMQ-RH open interest=6192 current ask $0.27

July strangle: Our estimated cost is $1.65. We want to sell if either option hits $3.50.

BUY CALL JUL 45.00 AMQ-GI open interest=13430 current ask $0.92
BUY PUT JUL 40.00 AMQ-SH open interest=12507 current ask $0.73

Picked on May 22 at $ 42.77
Change since picked: + 0.00
Earnings Date 07/24/08 (unconfirmed)
Average Daily Volume = 6.7 million

Play Updates

In Play Updates and Reviews

Call Updates

Carbo Ceramics - CRR - close: 48.52 change: -1.00 stop: 46.45

CRR spent the session in a relatively tight range. Overall the very short-term trend is still down following Wednesday's failed rally above $50.00 and CRR is still facing a potential double top pattern, which would be bearish. We are not suggesting new bullish positions at this time. If CRR closes under its 10-dma around $48.50 we might exit early. We're aiming for the $52.00-52.50 zone.

Picked on May 11 at $ 47.45
Change since picked: + 2.07
Earnings Date 04/24/08 (confirmed)
Average Daily Volume = 303 thousand


Fortune Brands - FO - close: 70.35 change: +0.17 stop: 69.45

FO spent the day in a tight 83-cent trading range. Overall we don't see any changes from our previous comments. A rebound from the $70.00 level, like today, can be used as a new bullish entry point but readers may want to stay defensive given the market's volatility this week. Conservative traders might want to tighten their stops further. Our target is the $74.00-75.00 range. The 200-dma is technical resistance near $74.50. The P&F chart is bullish with a $95 target.

Picked on May 07 at $ 70.05 *triggered
Change since picked: + 0.13
Earnings Date 04/24/08 (confirmed)
Average Daily Volume = 971 thousand


Harsco - HSC - close: 62.27 change: +0.41 stop: 59.85

If you're the optimistic type then today's session was positive for HSC. There was no follow through on yesterday's weakness. However, we would still expect a dip toward the $61.00 level and probably the $60 region but a bounce from either level could be used as a new entry point. Our target is the $64.50-65.00 range but more aggressive traders may want to aim higher.

Picked on May 01 at $ 60.38
Change since picked: + 1.48
Earnings Date 04/22/08 (confirmed)
Average Daily Volume = 613 thousand


IHOP Corp. - IHP - close: 47.15 change: -1.08 stop: 49.49

IHP continues to under perform. We didn't see anything specific in the news to account for this relative weakness. If we don't see a bounce tomorrow from the 100-dma we'll drop IHP as a potential bullish play. Right now we're waiting for a breakout over resistance. Our plan is to buy calls if IHP trades at $53.75. Traders might want to switch directions and buy puts if IHP breaks under the $45.00 level. If triggered at 53.75 our target is the $59.50-60.00 zone. The P&F chart is bullish with a $68 target. FYI: The most recent data listed short interest at more than 26% of the very small 14.8 million-share float. That's about two weeks worth of short interest so if IHP breaks out it could see a huge squeeze. Note: we have to label this a more aggressive play because the option spreads are so wide.

Picked on May xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/27/08 (unconfirmed)
Average Daily Volume = 326 thousand


iShares Russ.2000 - IWM - cls: 73.15 chg: +0.50 stop: 71.45

The small caps out performed the S&P 500 today. This equates to a 0.6% gain for the IWM. The trend is still bullish but we're not suggesting new positions at this time. Our multi-week target is the $77.50-80.00 zone. The P&F chart is bullish with an $87 target.

Picked on April 28 at $ 72.55 *triggered
Change since picked: + 0.60
Earnings Date 00/00/00
Average Daily Volume = 84.6 million


Lufkin Industries - LUFK - cls: 80.87 chg: +0.91 stop: 77.85

LUFK is still trying to rally. The stock added more than 1% today, which was enough to land it back above the $80.00 level. It might be a stretch of the imagination but LUFK might be forming a bull flag pattern. We would still look for entry points in the $80-78 zone. The short-term target is $84.75-85.00. The P&F chart is bullish with an $87 target.

Picked on May 18 at $ 80.59
Change since picked: - 0.63
Earnings Date 07/17/08 (unconfirmed)
Average Daily Volume = 209 thousand


Reliance Steel - RS - close: 66.97 chg: +0.69 stop: 59.99

RS is still consolidating sideways. We may have to change our entry strategy on this stock. For now we're still waiting for a dip. Our suggested entry point is a pull back into the $64.75-64.00 zone. If triggered we're setting two targets. Our first target is the $69.50-70.00 range. Our secondary, more aggressive target is the $73.00-75.00 range. The P&F chart is bullish with a $73 target.

Picked on May xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/17/08 (confirmed)
Average Daily Volume = 851 thousand

Put Updates

Apollo Group - APOL - close: 43.99 chg: +0.11 stop: 49.01

There is nothing new to report on here. APOL is still drifting lower. Today's bounce was nominal. More conservative traders may want to tighten their stops. Our target is the $40.50-40.00 zone.

Picked on May 18 at $ 46.71
Change since picked: - 2.83
Earnings Date 06/26/08 (unconfirmed)
Average Daily Volume = 5.4 million

Strangle Updates

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


McDonald's - MCD - close: 58.53 chg: -0.25 stop: n/a

MCD continues to sink. We are not suggesting new strangle plays at this time. The options we suggested were the June $62.50 calls (MCD-FZ) and the June $57.50 puts (MCD-RY). Our estimated cost was $1.10. We want to sell if either option hits $1.65 or higher.

Picked on May 18 at $ 60.53
Change since picked: - 2.00
Earnings Date 07/24/08 (unconfirmed)
Average Daily Volume = 7.5 million

Dropped Calls


Dropped Puts


Dropped Strangles


Trader's Corner

Key 'Technical' Aspects to the Recent Reversal

I wrote this column last Thursday about a couple of principles that fall mostly under what is considered to be technical analysis, that of chart 'gaps' and 'bellwether' stocks, indexes and sector indexes.

I say 'mostly' that fall into what is technical analysis, as the concept of 'bellwethers' is not exclusively the purview of technical analysis. However, saying that hitting a significant technical resistance followed by an apparent trend reversal in the bellwether New York Stock Exchange Composite Index (NYA), also suggests a top in the other indices, is more of a 'technical' analysis. Technical analysis only makes predictions based on PRICE and volume inputs and not on such factors as earnings, interest rate and consumer spending trends. I leave the aforementioned 'fundamental' analysis to our excellent Market Wrap analysts.

It happened that the recently red-hot Nasdaq 100 (NDX) Index reversed sharply the other day its prior downside price 'gap', which is an area where overnight events caused there to be NO trading between the one day's Low and the next day's High. Overhead (downside) gaps, when approached later on, often turn our to be an area of renewed selling/resistance and that's what happened recently as highlighted in my first chart below, which simply reflects updated prices to a chart I used last week in the 5/15 OI daily newsletter.

There is more to say on my first chart, reflecting another important technical chart principle, which is that the 'fibonacci' retracements of 38, 50 and 62% of prior declines tend to act as resistance areas. If a retracement of a prior move in an index or stock exceeds 38%, prices often continue up toward 50%; if a retracement exceeds one-half of the prior decline, the move often will reach a fibonacci 62% or a little bit more.

The 'little bit' more is important and reflects a retracement idea from legendary 20th century stock trader WD Gann, who thought that the 1/3rd and 2/3rd retracements were also important future resistance or support. I often find that strong retracements of around 62 percent will hit 66%, a 2/3rds retracement, before reversing, assuming there is going to be a downside reversal.

NOTE: MY CHARTS REFLECT CLOSING LEVELS AS OF YESTERDAY, WED 5/21. It's my last Trader's Corner article from a time zone (London) that is way ahead of the New York close!

Another technical principle that can be quite significant in forecasting a possible trend reversal is the concept of overbought and oversold and I find the 13-day Relative Strength Index (RSI) is the best measure of when a stock or an index gets to an 'overbought' extreme as seen above with NDX. The combination of the three technical factors related to the prior chart gap, retracement amount and RSI extreme occurred in tandem and strongly suggested at the VERY LEAST that it was time to take profits on index calls.

By the way, if retracements EXCEED 66%, a next move often equals a 100% retracement or a 'round-trip' back to the prior top or bottom. The 2/3rds retracement level at 2050 in NDX can be seen as a test of whether the rally from the mid-March low is a COUNTER-trend move only OR a RESUMPTION of the prior major (up) trend.

The bellwether NYSE Composite Index (NYA) showed the same reversal pattern at the 66 percent retracement level (of the October to mid-March decline) and an overbought RSI, as was seen in the Nasdaq 100 (NDX) index.

I also wrote last week that "The 13-day RSI has not following prices to a new closing high, giving a small divergent note to today's renewed rally. It may be NYA gets to near 9700 and a significant top made there." This statement was not genius analysis, just 'technical' analysis. That's why I use and write about it.

Another bellwether stock index that is often a better than average predictor for the overall market and one of the two Dow averages that are part of 'Dow theory' analysis, is the Dow Transportation Average (TRAN). Amazingly enough, given the sharp climb in fuel costs, TRAN recently hit a weekly closing high that was equal to the prior ALL-TIME high and setting up a possible (likely?) DOUBLE TOP.

Stay tuned on whether we have a major top in place, but I thought that it defied reason to think that TRAN was going to keep climbing. TRAN's double top also suggested to me that the overall market had formed another significant price peak. A good bellwether is useful for what it shows about the broad market.

The STARTING point in beginning a retracement measurement or which prior high or low to use, is a consideration in using a retracement-charting tool. I used as my starting point the October top in the NDX and NYA daily charts above, which was of course the absolute top. The recent highs in NDX and NYA retraced 66 percent of the entire October to mid-March decline.

Experience also suggested looking at the retracement levels of the major stock indexes for the big downswing measured from the December high. The big part of the decline was the December to mid-March downswing and IF the recovery move went beyond 62-66% of THAT move, it was a good bet that the recovery rally at least could make it back to the December high.

When the retracements were measured using the December-March declines, there were consistent patterns: the big downside reversals in the S&P 500 (SPX), the Dow 30 (INDU) occurred after the indexes recovered a key 2/3rds or 66% of the major down leg from the December highs to mid-March lows.

In SPX, the rally peak in early-May reversed at the 62% fibonacci retracement level. The second and most recent high spiked up to the 66% retracement level around 1435, before the index experienced a downside reversal.

An interesting and telling added take on the recent reversal was that the move to a new relative high in SPX occurred on declining 'relative strength', which is visually highlighted by the up sloping trendline on the price portion of the chart above and by the sideways to down sloping trendline drawn on the Relative Strength Index graph below SPX's daily price history. This pattern is a bearish price/RSI divergence and provided another clue as to a possible trend reversal situation that was developing.

The Dow 30 (INDU) chart shown next has the same reversal pattern as SPX occurring in the area of the 62-66% retracement area. In terms of ITS price pattern it however also has a double top formation. Technical patterns and indicators make a stronger prediction when there are multiple technical aspects pointing toward the same resistance or support and possible trend reversals.

While the INDU Relative Strength Index did not also reach what I consider to be 'overbought', which starts typically at a reading around 70, the last run up in INDU was accompanied by a significantly lower RSI to what came before, which also qualifies as a divergent 'sell signal'.

My last chart is that of the Nasdaq Composite (COMP), which at the risk of being redundant and boring you all, shows the same reversal as SPX and INDU after a 66% retracement, showing the consistent outcome of these similar patterns in these indexes.

The difference between the Nasdaq Composite and the Nas 100, is that COMP didn't get as high as resistance implied by the downside gap highlighted on the COMP chart below; at the yellow circle. Relative to which aspect, chart gap or retracement level, is the more 'significant', it's the later.

You can e-mail me at Click here to email Leigh Stevens support@optioninvestor.com with any questions or comments. Just put 'Leigh Stevens' in the Subject line so it gets forwarded to me.

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


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