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Daily Newsletter, Saturday, 08/30/2008

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Table of Contents

  1. Market Wrap
  2. Index Trader
  3. Trader's Corner
  4. The Contrarian
  5. New Option Plays
  6. In Play Updates and Reviews

Market Wrap

GDP Gives, Dell Takes Away

Market Wrap

Easy come, easy go. The GDP short squeeze on Thursday was erased by the Dell drop on Friday. Traders had been selling commodities and buying tech for the last few weeks and that trend may have ended on Friday. However, in a low volume market moves of this kind should be ignored. Last week was month end ahead of the historically bearish month of September. Traders are dazed and confused and hoping a real trend appears soon.

NYSE Composite Index Chart - Daily

Wilshire-5000 Total Market Index Chart - Weekly

Friday's economics were mixed but several key points emerged. The Personal Income and Spending for July showed personal income dropped a whopping -0.7%. Real spending fell 0.4%. The income number made waves in the market but it was really reported incorrectly. The impact of the tax rebates pushed June higher and distributions fell by 50% in July. This skewed the numbers and anyone bothering to look would have seen real income up, ex rebates, +0.5% for the month and the strongest level so far this year. The decline in spending was mostly a result of falling auto sales and consumers hurt by $4 gasoline. The core PCE deflator rose +0.3% and the fastest monthly rate since September. This pushed the core inflation rate to 2.4% over the last 12 months. The top-line PCE rate rose by +0.6% in July pushing the overall inflation rate to +4.5% over the last 12 months. That is a 17-year high. Not since 1991 has inflation been this high. This was actually a positive report on the income side but the market took it badly because of the inaccurate headline number. The sharp spike in the inflation rate also knocked the market down a few notches in expectation of future Fed rate hikes.

The final update on Consumer Sentiment for August came in at 63.0 compared to the first reading of 61.7 and the July level at 61.2. Consumer sentiment is really rebounding and that is a strong positive for the economy and the markets. The biggest gain came from the expectations component at 57.9, up from 53.5. That is nearly +9 points from their June low. However, the present conditions component continued to drop to 71.0 from July's 73.1. This suggests the end of the back to school shopping season is not going to be robust.

Consumer Sentiment Chart

The Chicago PMI exploded higher by 7 points to 57.9 from 50.8 in July. This was well above expectations for a minor +1 point gain. This is the highest level since June of 2007. The prices paid component fell sharply from 90.7 to 80.6 and that should be good news for the Fed. The production component gained a whopping +14 points from negative territory at 49.2 to a very positive 63.4. Order backlogs also exploded to 63.0 from 45.7. This current spike in the components cannot continue but it was an amazing jump in economic activity. A strong demand for exports has been instrumental in the improving economic conditions. If the ISM next week shows gains even close to the PMI it would be very market positive.

Chicago PMI Chart

In stark contrast to the Chicago PMI the New York NAPM showed exactly the opposite in conditions. The NAPM fell to 409.5 and the lowest reading since July 2006. The six-month outlook rallied +20 points to 64.1, current conditions +7 points to 45.3 and purchase quantity +8 points to 46.3 but the overall index still declined. The decline is credited with the continuing credit crisis and the impact on the financial sector in New York. Companies are cutting back on expenses, cutting employees and slashing expectations for bonuses. New York is probably the most tied to the financial sector than any other city in the world. With the markets in bear territory and banks in trouble that pretty well spells trouble for the New York economy. Analysts expect a drop in employment of 60,000 financial jobs in the New York area over the next year. I was encouraged by the +20 point spike in expectations.

NAPM-NY Chart

Next week has a heavy schedule of economic reports with several of major interest. Heading the list on Tuesday is the ISM Index for August. This is similar to the Chicago PMI only on a national basis. The ISM has risen off its February lows in contraction territory of 48.3 but is struggling to move back into positive territory over 50. If the ISM follows the PMI report higher it would be a strong positive for the markets. Expectations are for a flat report with the potential for a minor decline.

On Wednesday the Factory Orders report is expected to show only a minor +0.1% gain for July. This is a lagging report and the market is probably not going to care what is says as long as there are no surprises. The Fed Beige Book is also due out on Wednesday and all eyes will be focused on it. The Beige Book spells out economic conditions in the various Fed regions and is of much more interest to Fed watchers. On Thursday the ISM Services report is also expected to be flat and remain in negative territory. I believe we have the potential for a positive surprise in both ISMs.

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The Non-Farm payroll report on Friday is the biggest report for the week. The economy is expected to have lost -75,000 jobs compared to the -51,000 reported last month. This would be the eighth month of consecutive job losses with the last three months averaging -50,000 each. You may recall the unemployment rate spiked to 5.7% in July after hitting a cycle low of 4.4% in late 2006 and early 2007. Analysts are expecting this rate to climb over 6% as the financial crisis continues. I would like to stress again that during a normal recession monthly job losses are normally in the 250,000-350,000 range. We are a long way from that level and it appears we are going to dodge the recession bullet.

We are closing in on the OPEC meeting date and the FOMC meeting and that will start impacting equities as we get closer.

Economic Calendar

The inflation numbers shocked the market on Friday but the real downer was Dell. The computer company was widely expected to post better than expected results after Hewlett-Packard posted good results for the quarter. Dell disappointed analysts with its -17% drop in earnings and its falling gross margin. Michael Dell said the company might have been overzealous in cutting prices to compete with Hewlett Packard. He said the damage done to Dell earnings in Q2 was self-inflicted. Analysts pointed out that Dell sold more low-end computers rather than the high performance, high profit models. Where Hewlett Packard can make up for weak PC sales with hundreds of other products Dell is tied more to computer sales for the majority of its income. Dell has cut 8,500 workers since it began restructuring in 2007. Dell also said it could not give specific guidance for the current quarter but said it was seeing weaker technology spending spreading from the U.S. to Western Europe and Asia. Dell added they expect that weakening trend to continue. Dell's stock was hammered for nearly a 14% loss on Friday to $21.73. It was the biggest one-day loss for Dell in the last eight years.

Marvell (MRVL) was knocked for a loss after posting better than expected earnings. The problem came from their conservative guidance. Analysts felt the guidance was overly conservative and nearly everyone suggested buying the dip. The company said it was still uncertain about the impact of the weakening U.S. economy and predicted revenue growth below Wall Street expectations. The biggest problem for tech stocks came from the impact of that conservative guidance. Marvell chips are used in both the iPhone and the BlackBerry. If they are seeing weakness in those products then trouble is headed our way. As a result of the Marvell guidance Apple (AAPL) lost -$4.21 and Research in Motion (RIMM) lost -5.15.

The lowered guidance from both Dell and Marvell crushed nearly all the big techs and knocked the Nasdaq for a -44 point loss. Tech stocks have been the leaders of the recent rebound and these warnings along with others over the last couple weeks are making traders reconsider being long tech into the worst month of the year. Investors have to be worrying now that the slowdown in tech is telling us the global economic decline is increasing. Do the bulls continue to buy tech or do they pull in their horns and wait for September to pass?

This was the week that wasn't. Volume the last two days barely broke five billion shares. There was no trend and volatility was huge. It was exactly what I warned about last week. Nothing worked in terms of trading. Not even oil worked ahead of two different hurricane threats and a warning from Russia. Crude traded in an $8 range and ended the week only a buck higher than where it started. With the NOAA painting a bulls-eye on the oil patch you would think oil prices would be soaring but every bounce was sold. The problem it seems is coming from "private" weather forecasters. The rumor on Friday had Gustav coming ashore in Texas instead of Louisiana and at a Cat-1 intensity instead of the Cat-3 the NOAA is predicting. I would bet a few of these private forecasters are going to be out of a job if they miss this very public call. Also hurting the price of oil was a statement from the government that they would release oil immediately from the strategic petroleum reserve and continue to release it until any shortfall from damage was recovered. In reality that is a longer process to get the oil released but it sounded good as a sound bite and had the desired reaction of keeping prices in check.

October Crude Oil Chart - Daily

Gustav was upgraded to a category four hurricane Saturday afternoon as it moved away from land and intensified over water. It will cross Cuba by Sunday morning and be over the water in the gulf and gaining intensity again. NOAA was projecting it to be a category three when it hits the oil patch but after the sudden strengthening on Saturday they are now projecting it to be a category 5. A category three may not sound as devastating as a category five but it is still capable of inflicting damage. Katrina was "only" a cat-3 when she hit Louisiana. This is also exactly the same week that Katrina hit in 2005. Rita hit two weeks later in the same area. These two storms are going to put a major crimp in oil deliveries by tanker over the next 10 days.

The description of the categories of hurricanes include:

Category 1: Winds 74-95 mph, storm surge 4-5 ft.
Category 2: Winds 96-110 mph, storm surge 6-8 ft.
Category 3: Winds 111-130 mph, storm surge 9-12 ft.
Category 4: Winds 131-155 mph, storm surge 13-18 ft.
Category 5: Winds greater than 155 mph, surge over 18 ft.

It is even more surprising that oil prices are not rising because tropical storm Hanna is strengthening and is now moving towards the gulf instead of northward as previously predicted. Hanna is now on roughly the same track as Katrina in 2005. That track is headed for the gap between Florida and Cuba with the potential for a right turn into the oil patch only a couple days after Gustav. The potential for damaging winds and waves is intensified from back to back storms. I am going to show a lot of charts today because I want you to see the potential for a rocky week. The last chart is a map of the major oil installations in the gulf and the tracks for hurricanes Katrina and Rita. There are over 4,000 installations in the gulf but these are the major platforms. Gustav is headed right between those two tracks.

NOAA Gustav Storm Track as of Saturday evening

NOAA Hanna Storm Track as of Saturday evening

Combined Wind Warning Tracks

Gulf Oil Installations (left track RITA, right track Katrina)

On the positive side a study of the markets after 15 major storms made landfall showed a bullish market. The rebuilding efforts after a major storm reportedly produced an average of a 5% gain in the S&P within six months. While I could understand that logic I disagree with the conclusions. Since major storms occur in August and September, the two worst months of the year for the markets, I don't believe the gain in the S&P is related to the storms. It is a timing issue. The fourth quarter is normally the most bullish quarter of the year. My birthday is in early September. As a statistician I could probably come up with a statistic that said the markets responded with a 5% gain over the next six months whenever I had an even number birthday or an odd number birthday, take your pick. My wife says all my birthdays are odd but I don't think she means in the years. The point I am making is that hurricanes do promote building cycles but I doubt they are responsible for routine market rallies of 5%. Some statistician simply had too much time on his hands and failed to take the calendar into his analysis.

While generally on the subject of oil I need to mention Russia. Russia has gone from ignoring threats of sanctions from NATO and the West to outright threats of violence. The world is moving ever closer to a real confrontation with Russia and most people don't even know it. The West along with many NATO countries have been very vocal about punishing Russia for its foray into Georgia and up until now Russia has been fairly quiet. Several events on Thursday suggest those taunting Russia and talking about sanctions may be walking on thin ice.

The NATO countries, spurred forward by the West and the European Union have threatened sanctions against Russia if they don't return the two breakaway countries to the state they were before the conflict began. That may be even more difficult after South Ossetia announced on Saturday it would join the "one united Russian state" and they would sign an agreement on Tuesday to allow Russia to build military bases there. Georgia announced on Friday they were severing ties with Russia and calling diplomats home. In response Russia may be preparing to cut off oil supplies to Germany and Poland as early as this weekend in retaliation according to an article in Britain's Daily Telegraph. On Friday Russia denied they would cut supplies to any country. "We are a responsible energy provider." I guess that is a new position because they have not been afraid to cut supplies in the past when things did not go their way.

Stratfor reported Russian President Dmitri Medvedev flew to Tajikistan on Wednesday for a summit with China and four central Asian countries who were previously members of the former Soviet Union. The meeting had been scheduled for some time but it took on more significance given the talk about sanctions by the EU. News out on Friday said the four nations in the Singapore Council slammed him for his war in Georgia. It is unclear to what length Russia will go to rebuild the former Soviet Union and bring all the breakaway states back into the fold but Russia does appear headed in that direction and they are not bashful about using their wealth of oil and gas supplies to do it. Satellite photos out Friday showed ethnic neighborhoods were torched and refugees making their way to shelters told of ethnic cleansing murders by Russian soldiers.

Russia also warned NATO about a possible confrontation between Russia, NATO and the West in the Black Sea. Vladimir Putin called it a potential flash point for conflict with the NATO and warned about any further warships entering the Black Sea. He warned there could be direct confrontations should NATO or its member nations increase their presence in the area.
http://www.timesonline.co.uk/tol/news/world/europe/article4622422.ece

There are currently four NATO ships in the Black Sea on a previously scheduled exercise called Active Endeavor. Putin also explicitly warned that there could be consequences if additional vessels belonging to NATO countries but not under NATO command were to attempt entry. For instance a British or American warship not under NATO command. Putin basically posted a "Keep Out" sign on the Black Sea and that may not go over well with the West or those NATO countries. Nobody likes to be told you can't go anywhere and in the case if the U.S. they tend to test those restrictions very quickly just to prove their dominance of the seas. They do it against China all the time. We found out on Friday that the U.S. sent several warships in this week to "deliver aid to Georgia." Russia stepped up the rhetoric on Friday saying the U.S. was responsible for the 5-day war. VP Dick Cheney will be in Georgia on Tuesday as a show of support for the country. NATO is moving to strengthen its forces close to the Russian borders in expectations of more attempted land grabs. Britain called off September's scheduled military exercises in Georgia when Moscow warned it would be seen as a declaration of war.

I explained all this because Russia is the second largest oil producer on the planet and in the top five gas producers. Most of Europe is hostage to the Russian supplies and Russia has doubled the prices over the last two years and turned off the supplies when the countries protested. Russia understands the power of oil and is not afraid to use it as a weapon. This Georgia skirmish is taking on all the appearances of the beginning of a bigger problem. What better time for Russia to make its moves than with America tied down in Iraq, Afghanistan and with a lame duck president and the final stages of a political campaign? You can bet this skirmish has been planned for sometime. Russia also announced it test fired a new "stealth nuclear missile" on Thursday. Was that just a coincidence?
http://www.thesun.co.uk/sol/homepage/news/article1621970.ece

The new U.S. president is going to have his hands full the moment he takes the oath of office. For us as traders next week will have an economic focus as we move into September. I believe the Dell drop was Dell specific and overdone but the warnings of slowing technology spending may linger. I have mentioned several times that September is historically the worst month of the year for the markets. That trend tends to reverse in election years but I have to think the market has got a lot more on its mind this year than the election. The biggest election gains tend to come after the election when one half of the worries are taken out of the market. Right now professional traders are hedging against both candidates and their anticipated moves once in office. That suggests this September may be choppy rather than directional. That is even more a possibility with the new tech worries and oil that won't move higher in the face of hurricanes and war. When the markets move against conventional wisdom we have to focus on the charts and pick our entries carefully.

The Dow rallied on the Thursday short squeeze to a dead stop at resistance at 11700. I struggled to find a convincing pattern in the Dow's movement and the only thing that stood out was the solid resistance at 11700 and a very minor pattern of higher lows into Tuesday. I would not want to bet the farm on the eventual outcome. The Dow and S&P are tied to the financials and the XLF has rallied for the last three days with a stop at initial resistance at 21.50 on Friday. Is the rally over or just getting started? We have the insurers; MBI and ABK up huge over the last two weeks, as conditions seem to be improving for them. MBI has gone ballistic with a breakout over $15. Fannie and Freddie were up all week with minor profit taking on Friday. Their financial health does not seem as dire as analysts were predicting a couple weeks ago. Lehman is reportedly ready to announce a restructuring of billions in problem loans and will move them off its balance sheet soon. Lehman also rallied for the last three days. Does this mean the financials are about to lead the faithful out of the Wall Street desert? Obviously nobody knows and that makes the Dow chart irrelevant for next week unless we suddenly get a breakout over 11700 or a breakdown under 11350. The key to the Dow will be the financials. The FDIC announced late Friday they closed the Integrity Bank of Alpharetta Georgia. This was the 10th bank to fail this year as banks fail at the fastest rate in 14 years. The bank had assets of $1.1 billion and operated five branches. The bank will be taken over by Regions Bank and will reopen on Tuesday.

Dow Chart - 120 Min

S&P-500 Chart - 120 Min

The S&P is following the Dow and remains stuck in its recent range of 1250-1300. A breakout over 1300 would be a buy signal given the strong resistance waiting there. Under 1250 would have me looking for a new low in October. If the hurricanes evaporate before hitting the oil patch I truly believe oil is going to test $100 ahead of the OPEC meeting. To not rally over $120 ahead of these storms is absolute proof the speculation in oil is dead. A declining oil sector will weaken the S&P making it even more critical to watch the financials.

The Nasdaq is ugly. Every short squeeze for the last three weeks has been sold hard. We had two major gap down opens just last week. Investors may have been buying techs in hopes of a Q4 rally but they are very skittish and lack conviction. Tech leaders Apple and RIMM both closed at new 3-week lows on Friday and appear to be in trouble. I am sure the phone faithful will find a dip to buy in both but it remains to be seen if it will stick. The Nasdaq has solid support at 2350 and falling resistance now at 2410. A break under 2350 is the kiss of death for me and I could see a retest of 2200. That may be too grim an outlook but after a couple of lower highs it looks like the momentum has disappeared.

Nasdaq Chart - Daily

Russell Chart - Daily

The Russell was the strongest index this week but I believe it was calendar related. The Russell tends to do well the last three days of the month and the first two days as retirement deposits are put to work. It also does well on a rising dollar and the dollar index came very close to a new 8-month high last week. I am not ready to jump on the Russell as a long candidate with strong resistance at 760. Critical support is still 720. I know I sound like a broken record but that is the facts and they have not changed.

Remember last week I said the low volume and high volatility would probably push the market around unreasonably. That is exactly what happened. I warned that any moves could be quickly erased once traders returned to work next week. That is why we can't apply too much importance to what happened on five billion share days leading up to a holiday weekend. Historically the day after Labor Day has opened higher 11 of the last 13 years. If that happens again it will be a real test for the bulls because the ISM will be released at 10:AM. If the markets open higher and the ISM surprises to the upside we could get another monster short squeeze. Conversely if the ISM surprises to the downside we could see any opening rally quickly fade. However, just like last week I would not apply too much importance to the day after a holiday. We want to see a trend develop not just a series of triple digit days with alternating directions. The markets will also be reacting to what happened in the oil patch since the current track suggests it will all be over by midnight Monday night. I would continue to maintain a cautious outlook and trade the moves but don't get married to them. Under Nasdaq 2350, Russell 720 I would become much more bearish.

If you have registered for the ASPO Peak Oil conference and have not received a personal email from me with conference notes please send me an email. There is still time to register and join the crowd. Go here to register: http://www.aspo-usa.org/aspousa4/

Jim Brown
 

Index Wrap

SLOWING MO

THE BOTTOM LINE:

Short to intermediate-term momentum has shifted from up to sideways in the Dow and the S&P indices and sideways to lower in the Nasdaq, which is especially apparent in the Nasdaq big-cap index, the Nas 100 (NDX). The fact that NDX is flagging here and the Nasdaq Composite has been holding up relatively well, suggests that they're buying the dogs and cats and not the elephants. Bullish is when NDX leads.

I view this slowing (upside) momentum has a prelude to another strong up leg down the road. It would be typical in fact to see a rally (July-August) followed by a pullback and then a second, perhaps stronger upswing later on, which is seasonally prevalent in the mid-Sept to October period.

I anticipate more of a sideways to lower trend ahead for the major indexes, followed by another strong advance; this more in 2-3 weeks or beyond rather than in a 2-3 day time frame. It's my time to exit outright plays dependent on a market advance at a rate that is faster than the erosion of time premiums.

One key indicator that I use to suggest major bottoms is a 10-day average of Advancing volume for both the Nasdaq and the NYSE. When this average contracts to certain key levels and then turns UP, accompanied by an 'oversold' RSI and at least 1 day of high bearish 'sentiment', this combination of indicators will suggest substantial rally potential ahead. My key volume indicator for Nasdaq is now, after many months, in a position to generate a bullish signal at some point ahead. I'll show these 3 key factors in my first chart.

A continued sideways to lower move creates the possibility that all three of my key indicators could get in synch and generate another buy 'signal' like seen in March. We're not there yet however, but for the first time since March, buying has slowed enough to suggest bullish forces contracting to a point that has in the past suggested another buying surge to follow. As the movement ahead may not be sharply lower, I'd rather wait to buy calls than be in puts now.

When ALL three of the above indicators (as highlighted back in March) reach lower extremes, that confluence of my 3 key technical indicators will suggest strong potential ahead for another sustained rally.

QUESTIONS/COMMENTS:
Please e-mail me with any comments or questions at Click here to email Leigh Stevens support@optioninvestor.com and put "Leigh Stevens" in the Subject line. We have straightened out past months' problems that occurred where e-mails were not getting to me from OI Daily Subscribers.

FUNDAMENTAL MARKET NEWS and INFLUENCES:
Other index and sector closes, recaps of market influences like earnings, company news, related market events, government reports and activities, etc. are found in the Option Investor 'Market Wrap' section.

** MAJOR STOCK INDEX TECHNICAL COMMENTARIES **

S&P 500 (SPX); DAILY CHART:

The S&P 500 (SPX) trend, after this past week's action, now can be seen to be in more of an obvious trading range or sideways trend, between 1300 on the upside and 1260 on the downside.

It's still the same outlook I spoke of last week: a close above 1300 for two or more days running is needed to suggest that SPX was headed still higher. Conversely, a close under 1260 for more than a day suggests that 1240 could get 'tested' as the low end of a broader trading range.

Resistance above the key 1300 level is anticipated at 1320, representing a 50 percent retracement of the May-July decline; more broadly, I would peg next resistance at 1320-1330.

S&P 100 (OEX) INDEX; DAILY CHART:

The S&P 100 (OEX) daily chart is of course mirroring its big brother/big sister S&P 500 (SPX) index in tracing out a trading range and showing faltering upside momentum. Momentum can be sideways and has this third possibility. The big question is how long this will go on? Sooner or later the odds favor a breakout above or below this congestion or this trading range market. The sideways trend may extend well into Sept.

Key near resistance is at 600, then in the 608-610 area. Above 610, next resistance should come in around 620. Major resistance begins at 640.

Key support is at 580, and then should be found around 570. I wrote last week that a rally that carried back to 600 (to 610) might struggle to achieve much headway after that. So far this prediction seems to be in tune with the unfolding trend. Stay tuned for how much 'struggle' for the bulls is ahead. Seems that support in the 580 area could be re-tested again.

MARKET 'SENTIMENT'
Bullish sentiment is holding up as seen above in the sideways movement of my "CPRATIO" line and this reflection of the outlook of traders may be part of the dynamic that is 'holding' the market back.

I don't think that a next rally will take off without a bit more fear of the downside risk in a slowing economy. In other words, I would anticipate a dip in my market sentiment indicator before this market is in a position to take off again.

DOW 30 (INDU) AVERAGE; DAILY CHART:

The Dow 30 (INDU) chart pattern has the most pronounced sideways pattern. INDU has been in basically in a 11730 to 11290 price range since mid-July.

I anticipated last week that INDU was headed to the 11700 area but also thought that the Average could make it through this key resistance. However, resistance/selling interest at 11700-11730, at a prior key 'breakdown' point, is proving to be trouble for the bulls. With this past week's action, there's more and continued evidence of a sideways trading range pattern.

Key resistance remains at 11730, extending up to 11800. Tough resistance then lies at 12000.

Near support is still the same at highlighted below, at 11290-11300. A close below 11290 not reversed back to the upside the next day would be bearish and suggest a downside break of the current trading range.

NASDAQ COMPOSITE (COMP) INDEX, DAILY CHART:

Key support in the Nasdaq Composite (COMP) is at 2350 and this area may continue to define the low end of a trading range, with 2470 being the top end. A close below 2350 that continued into subsequent days, would turn the trend from neutral to bearish on a near to intermediate-term basis. (I consider 'near-term' to be 2-3 days and 'intermediate-term' as 2-3 weeks or more.)

I was more bullish last week than I am after the struggle to move higher seen this past week. Resistance above 2450, extending to 2500 doesn't look to be tested for a while.

While the 2350 area looks like it should be decent chart support, there is then some distance to go to reach major support in the 2300 to 2250 area.

NASDAQ 100 (NDX) DAILY CHART:

The Nasdaq 100 Index (NDX) spent last week continuing to break down or reverse trend in terms of its chart. The rally failure in the 1970 area appears more clearly now to define at least a short-term top. This past week finally saw a key support reached, at the top end of the prior trading range in the 1865 area.

A line of prior tops, once decisively penetrated to the upside, is seen to be a key technical support on subsequent pullbacks. This because sellers who kept exiting in this area, reversed position and bought on the upside breakout or once the index cleared this multiweek resistance. Potential buyers will then tend to support the market at the prior 'breakout' point, figuring this will work again; i.e., be the new support.

I can repeat what I said last time in that Nasdaq 100 (NDX) chart remains bullish as long as the 'line' of prior highs in the 1865-1870 area is not pierced. Next support below 1865-1870 isn't apparent on the chart until 1800.

NASDAQ 100 TRACKING STOCK (QQQQ); DAILY CHART:

The Nasdaq 100 tracking stock (QQQQ) appears to be headed toward technical support in the 45.8 area. Assuming that this anticipated support is pierced, there is then a long fall to expected support in the 44.0 area.

Key near resistance is at 47.25, then at 48.3-48.35; with major resistance begins at 49.0. The sharp break below the 21-day average is bearish for the near-term and a decisive downside penetration of support in the 45.75-45.8 area would be bearish on a intermediate-term basis and suggest more weakness into September.

As long as the aforementioned key support holds up in QQQQ around 45.75 the chart is neutral in its pattern. Assuming that the Q's hold this technical support, the stock will have some buying appeal even if there's some more backing and filling. If selling tips the stock well lower again, I'd be a buyer in the 44 area.

RUSSELL 2000 (RUT) DAILY CHART:

The Russell 2000 (RUT) is holding near the top of its broad price range and this reflects stronger buying interest than in the straight Nasdaq indexes currently. There is however the fact that RUT has traced out a possible double top. The longer that the prior highs in the 763 area are not penetrated, the more significant is this potential top pattern. So, there's no question as to the KEY or pivotal resistance (at 763). Major resistance is then in the 800 area.

RUT has support in the 720 area and this was shown again this past week. Next support is at 700.

I'm not in this index myself, but puts are the tempting play if I was to trade RUT options, looking for a retest of the 700 area again at a minimum. At least the overhead risk point is well defined, since any breakout above the prior double high should be the exit point.

GOOD TRADING SUCCESS!

NOTES ON MY TRADING GUIDELINES AND SUGGESTIONS
CHART MARKINGS:
1. Technical support/areas of likely buying interest are highlighted with green up arrows.
2. Resistance/areas of likely selling interest: red down arrows.
[Gray up/down arrows: support/resistance levels that got pierced]
I WRITE ABOUT:
3. Index price areas where I have a bullish bias or interest in buying index calls (or selling puts or other bullish strategies).
4. Price levels where I suggest buying index puts (or, adopting other bearish option strategies).

Trading suggestions are based on Index levels, not a specific option (month and strike price) and entry price for that option. My outlook often focuses on the intermediate-term trend (next few weeks) rather than the next several days of the short-term trend.

Having at least 3-4 weeks to expiration tends to be my guideline for trade entry choice. I attempt to pick only what I consider to be 'high-potential' trades; e.g., a defined risk point would equal in points only 1/3 or less of the index price target.

I most often favor At (ATM), In (ITM) or only slightly Out of the Money (OTM) strike prices in order not to 'overtrade' my account. Exit or 'stop' points, as well as projected profitable index price targets, are based on my technical analysis of the indexes.


Trader's Corner

Free Falling

When will the bottom be in? John Hussman of Hussman Funds (www.hussmanfunds.com) offered a prediction. In an August 5, 2008 article, Hussman predicted that markets will near their bottoms only when we again start hearing the phrase "free fall" spoken with some regularity.

Others, including Art Cashin when appearing on CNBC, mention the need for capitulation. When one types in the word "capitulation" on the Investopedia.com site, other phrases such as "bloodletting," "panic selling," "falling knife," and "losing your shirt" come up, too. A definition becomes almost superfluous after such evocative synonyms.

"True capitulation," Investopedia says, "is accompanied by sharp declines, extremely high volume and panic selling." In "Panic Selling--Capitulation or Crash," Rick Wayman characterizes capitulation as a painful selling frenzy that is at least mercifully quick. During a capitulation, almost no one wants stock, he says.

An extreme example of capitulation occurred in October, 1987, of course, when the Dow lost 508.32 points or 22.6 percent in a single day. The selling frenzy was so intense that the NYSE's computer system was overwhelmed and people sold without knowing the prices at which they were selling. They just wanted out, at whatever price they could get out. Fear took over and investors reacted. While the percentage loss in a single day was unique, that "get me out at any cost" feeling wasn't. That's typical of capitulation.

Martin Pring, writing in TECHNICAL ANALYSIS EXPLAINED, likely would use the term "selling climax" to encompass both ideas: free fall and capitulation (p. 272). Prices fall at an accelerated rate, he says, bringing in the idea of a free fall, with the selling climax accomplished on big volume. In MASTER THE MARKETS, Tom William's explanation of a selling climax echoes Pring's, also encompassing the ideas of a period of free falling prices followed by capitulation. Selling will have occurred "day after day, week after week," he says (p.70). Finally, some level will be reached at which weak holders can no longer endure the losses, and that level, perhaps helped by a catalyst such as bad news, will trigger "the herd" to dump stocks at any price.

Not all bottoming processes require capitulation, and we can have sneaky bottoming process that result in bulls being the ones in the frenzy, this time to buy. However, when Art Cashin, John Hussman and people of their ilk worry, I worry along with them. As the historically worst period for equity markets approaches, I'm listening for that "free fall" phrase to be used more frequently before I believe too strongly that a bottom has been put in.
 


The Contrarian

The Contrarian Trade

As an additional service to the Market Wrap subscribers, the weekly contrarian commentary will be initiating a hypothetical trade to illustrate the current signals bias. Some of the content may be at a higher level so there will be some explanation of terms and concepts in each of the posts. As of last night the CBOE Equity Volume Put/Call ratio indicates a Neutral bias. Similarly, the Investors Intelligence poll indicates that the sentiment signal is Neutral. However, as the CBOE Volatility Index indicators 10 and 20 day moving average continue to decline the signal remains at a Positive bias. Therefore, as option traders we want to position our portfolios conservatively with a slight upside bias. Depending on your primary portfolio, you may choose to sell out of the money SPX or OEX calls against the portfolio as a way to hedge some downside risks while positioning for equal or greater upside potential (i.e. Sell the 1350 calls for $2.60 per contract). One could also establish a new covered call position on the S&P 500 Spiders (SPY) and sell slightly out of the money as a way to have a slightly delta positive position. Delta refers to the theoretical profit or loss on each point move in price in the underlying. For instance, a position with a Delta of 230 would increase in value (non-realized) approximately $230 for a one point increase in the underlying securitys price. The Delta of the overall position also changes as the price of the underlying security increases or decreases in price. A position with a positive Delta increases in value as the underlying security increases in price.

Since I write the option writer newsletter I am going to use short calls and puts within the hypothetical trade. Hopefully everyone can understand why I am selling out of the money calls and puts to create the trade. First of all, because the brokerage firm I use calculates margin on the overall position and credits the lesser margin requirement on straddles, strangles, double diagonals and iron condors, I can create a short option position with built in risk management that doesnt cost a lot of capital to establish. While I am not going to go into when to use Iron Condors instead of Double Diagonals in this article, I will begin by defining Iron Condors. Simply stated, an Iron Condor (IC) is a Call Spread and a Put Spread combined. ICs can be credit or debit and be bullish, neutral or bullish. Credit ICs have positive Theta or a time decay component to aid in profitability while Debit ICs primarily profit from Delta and Volatility. This will make more sense as we get into the position.



Since we are on a Neutral bias with a slightly bullish tint, we want to sell out of the money puts at near term support and out of the money calls at a step above the closest resistance. Referring to the chart above there is short term resistance at 1315 on the SPX and some additional resistance at 1335 and then 1350. The 1350 level is a resistance level from a gap down on June 18th. While we can be more aggressive in the future, we will sell the 1350 September Calls and buy the 1360 Calls to hedge and create a credit spread. Since we are slightly bullish we can sell the puts closer to the underlying securitys price. Basically we want to sell puts (bullish) closer to the money and sell calls (bearish) farther out of the money to create a positively biased position.



The picture above shows the Risk Profile of the Iron Condor. Instead of combining the four strike prices and obtaining a single net credit, I decided to break apart the position into two credit spreads. The Put credit spread provides a credit of $1.85 per contract. The spread is 10 points wide and requires $10 X 100 shares per contract of margin per contract. The Call credit spread only provides a credit of $1.05 per contract. As mentioned earlier, this brokerage only charges margin on one side of a market neutral trade. The reason is because they have determined that only one side of the trade can be at risk at expiration. Therefore, charge risk premium for only one side. The total credit equals $2.90 per contract. If you had $7,200 in your account, you could initiate this trade. The $10,000 margin requirement (10 contracts X requires $10 X 100 shares per contract) is reduced by the $2,900 credit to require $7,100 without commission. Notice on the above Risk Management chart that there is a lot more upside room than downside room for the position to move. There is about $50 points until the put position becomes at risk on expiration and $65 points until the call strike becomes at risk on expiration.



The max return of the trade is calculated by taking the max premium of $2,900 and dividing that by the initial cash requirement of $7,100 ($10,000 - $2,900). The return is about 40.85% without trade costs. The probability of expiring within 1232.4 and 1352.16, the breakeven points is 64.74%. The probability of expiring within the strike prices is 62.42% (not shown above). To get an idea of whether or not the trade is good or not subtract 1 by the max return and compare with the probability of closing within the prices. If the number is less than the probability then the trade is good. In this case, 1 0.4085 = 0.5915 is less than 0.6242 and is therefore a good trade setup. Basically, over the long term, many trades will lose money but if your return is greater than your probability then your chances of making money increase. For instance, if you make 10 trades with 90% probability with an average of 9% return you would lose money. The reason is that on 9 trades you make 89% on your capital but lose your max loss on one trade. Conversely, assuming you make 12% on 9 trades and lose your max loss or margin requirement on 1 trade. You are up about 18%. Probabilities of returns are more important than returns on capital. If the contrarian bias shifts, then so will this trade. It may lose money on adjustments in order to profit more on Deltas and Thetas. I hope this was helpful.
 


New Option Plays

Most Recent Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
None APD None
  LLL  
  LNN  
  MON  

Editor's note: I want to comment on a few stocks I'm watching. PCP broke out higher on Thursday last week. A dip back toward the $100 level might be a new bullish entry point. NOC is another defense stock that looks like it's poised to mover lower. YHOO has pulled back toward its pre-MSFT merger bid prices. This might be a good time to speculate on another big move in YHOO. I was considering a strangle with October options using the $21 call and the $17.50 put.


New Calls

None today.
 

New Puts

Air Products - APD - cls: 91.85 change: -1.81 stop: 94.15

Company Description:
Air Products serves customers in industrial, energy, technology and healthcare markets worldwide with a unique portfolio of atmospheric gases, process and specialty gases, performance materials, and equipment and services. (source: company press release or website)

Why We Like It:
It looks like the August bounce in APD is running out of gas. Shares failed to rally past the $94.00 level last week, which coincided with the top of its bearish channel. Short-term technicals are turning bearish and this looks like a good spot to buy puts. More conservative traders might want to wait for a breakdown under $90.00 before initiating positions. We are listing two targets. Our first target is $87.00. Our second target is $84.00. The Point & Figure chart is bearish with a $73 target. We do not see any significant amounts of short interest on the stock. If we do not see APD follow through on Friday's reversal we'll try to be quick to close it early. Let's give it two or three days and re-evaluate. Right now a lot of traders expect a market bounce on Monday.

Suggested Options:
September options have a lot more open interest but they expire in three weeks. We're suggesting the October puts. It is up to the individual trader to decide which month and which strike price best suits your trading style and risk.

BUY PUT OCT 90.00 APD-VR open interest= 7 current ask $3.00
BUY PUT OCT 85.00 APD-VQ open interest=24 current ask $1.40

Picked on August 31 at $ 91.85
Change since picked: + 0.00
Earnings Date 10/22/08 (unconfirmed)
Average Daily Volume = 1.8 million

---

L-3 Comm. - LLL - close: 103.94 chg: -1.65 stop: 106.65

Company Description:
Headquartered in New York City, L-3 Communications employs over 64,000 people worldwide and is a prime contractor in aircraft modernization and maintenance, C3ISR (Command, Control, Communications, Intelligence, Surveillance and Reconnaissance) systems and government services. L-3 is also a leading provider of high technology products, subsystems and systems. The company reported 2007 sales of $14 billion. (source: company press release or website)

Why We Like It:
The earnings news in July was bullish for LLL. The company beat estimates and guided higher for 2008. This produced a bullish double-bottom pattern and launched the stock into a rally that appears to have topped out on August 18th. The defense sector looks like it is producing a bearish double-top pattern with last week's failed rally. LLL is seeing a similar performance and last week actually set a new lower high as part of its own double-top pattern. We are suggesting aggressive put positions now with a stop loss at $106.65, which is just above the August highs. More conservative traders may want to wait for a drop under $102.00 before considering new positions. Our target is the $97.50 mark, just above the 50% retracement of its July-August rally and currently above its 50-dma. I want to repeat that this is an aggressive play. We're betting on a correction in what has been a strong stock the past several weeks.

Suggested Options:
We are suggesting the October puts.

BUY PUT OCT 105.00 LLL-VA open interest= 429 current ask $3.90
BUY PUT OCT 100.00 LLL-VT open interest= 363 current ask $1.95
BUY PUT OCT 95.00 LLL-VS open interest= 544 current ask $0.95

Picked on August 31 at $103.94
Change since picked: + 0.00
Earnings Date 10/23/08 (unconfirmed)
Average Daily Volume = 1.0 million

---

Lindsay Corp. - LNN - cls: 81.91 chg: -2.60 stop: 83.35

Company Description:
Lindsay manufactures and markets irrigation equipment primarily used in agricultural markets which increase or stabilize crop production while conserving water, energy and labor. (source: company press release or website)

Why We Like It:
The trend in LNN is definitely bearish. The stock produced a very clear and very volatile bearish double-top pattern with the April and June peaks. The July oversold bounce stalled out at its 50-dma and shares have been failing under the 50-dma ever since. Now LNN is struggling to hold support near $80.00. Aggressive traders may want to jump in now. We are going to wait for a breakdown under $80.00. Our suggested trigger to buy puts is $79.85. If triggered we have two targets. Our first target is $75.25. Our second target is $71.00. This can be a volatile stock so we're starting the play with a relatively wide (aggressive) stop loss at $83.35.

Suggested Options:
We are suggesting the October puts.

BUY PUT OCT 80.00 LNN-VP open interest=23 current ask $6.70
BUY PUT OCT 75.00 LNN-VO open interest= 3 current ask $4.60

Picked on August xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/08/08 (unconfirmed)
Average Daily Volume = 480 thousand

---

Monsanto - MON - close: 114.25 chg: -2.59 stop: 118.55

Company Description:
Monsanto Company is a leading global provider of technology-based solutions and agricultural products that improve farm productivity and food quality. (source: company press release or website)

Why We Like It:
The oversold bounce in MON has been struggling with resistance at its simple 50-dma for several days now. Technical indicators are rolling over and shares look vulnerable to another leg lower. The stock can be very volatile, which always makes playing MON a higher-risk play. We're suggesting put positions now with Friday's close under its 200-dma and the breakdown under $115. We're use a stop loss at $118.55, which is actually a tight stop for MON. Our target is the $101.00. The $100.00 level should be round-number support.

Suggested Options:
We are suggesting the September puts since this should be a very quick play. Keep in mind that September options expire in three weeks.

BUY PUT SEP 115.00 MFP-UC open interest=1563 current ask $4.60
BUY PUT SEP 110.00 MON-UB open interest=1888 current ask $2.45
BUY PUT SEP 105.00 MON-UA open interest=5056 current ask $1.20

Picked on August 31 at $114.25
Change since picked: + 0.00
Earnings Date 10/08/08 (unconfirmed)
Average Daily Volume = 6.7 million
 

New Strangles

None today.
 


In Play Updates and Reviews

Updates On Latest Picks

Call Updates

Arch Coal - ACI - close: 54.24 chg: -1.16 stop: 52.37

Strength in the U.S. dollar weighed on commodity stocks. The coal sector inched lower. Shares of ACI gave up 2%. Short-term technicals indictors for ACI are suggesting a deeper pull back. We are not suggesting new bullish positions at this time. Last week's low bounced from the exponential 200-dma near $52.81. If you wanted to tighten your stop that's where I would put it (52.80ish). Our target is the $58.00-60.00 zone but readers may want to exit at the 50-dma if it falls under $58.00. The P&F chart is bullish with a $68 target.

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

Picked on August 20 at $ 52.37
Change since picked: + 1.87
Earnings Date 10/20/08 (unconfirmed)
Average Daily Volume = 6.4 million

---

Chesapeake Energy - CHK - cls: 48.40 chg: -0.84 stop: 46.90

Natural gas stocks continued to retreat following Thursday's reversal. Shares of CHK have pulled back to short-term support near $48 and its 10-dma and 200-dma. We have been suggesting that more conservative traders might want to raise their stops toward the $48.00 level. Overall the rally in CHK may be in trouble. Its upward movement stopped dead at the 40-dma and its 38.2% Fib retracement of its mid-July to August sell-off. A bounce from here might be a new bullish entry point but we're not very enthusiastic about putting new capital at work here. We have two targets. Our first target is $52.00. Our second target is $54.85.

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

Picked on August 20 at $ 48.05 *triggered
Change since picked: + 0.35
Earnings Date 11/06/08 (unconfirmed)
Average Daily Volume = 20.2 million

---

Itron Inc. - ITRI - close: 103.58 change: -1.95 stop: 101.25*new*

Last week delivered a decent gain for ITRI. The stock hit our first target at $105.75. Unfortunately, Friday's widespread market sell-off took a chunk out of ITRI's gains. The MACD on the daily chart looks vulnerable and is nearing a new sell signal. Additional short-term technicals also look worrisome. More conservative traders will want to strongly consider an early exit right here if you have not already done so. We are upping our stop loss to $101.25. We're not suggesting new positions. ITRI may struggle to get past resistance near $106. Our second target is $109.90. FYI: The Point & Figure chart is bullish with a $122 target.

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

Picked on August 14 at $ 101.50 /1st target hit 105.75 (08/28)
Change since picked: + 2.08
Earnings Date 10/30/08 (unconfirmed)
Average Daily Volume = 616 thousand

---

United States Oil - USO - cls: 92.87 chg: -0.52 stop: 89.79

The last four days in a row has seen oil (or at least the USO) gap higher at the open and then trade lower. This is not a bullish development. If oil cannot rally with hurricanes barreling toward the Gulf of Mexico then odds of a bounce are pretty low. At this time I would suggest more conservative traders exit early or raise their stop loss toward the $92.00 region. Of course by Tuesday's open it could be a different story since hurricane Gustav is supposed to hit our shores by Monday. The impact or the miss by Gustav could send oil sharply higher or lower. Another factor to watch is the escalating conflict with Russia. If something happens over the three-day weekend it could also send oil higher. The USO has support at $90.00 so we're going to keep our stop loss at $89.79 for now. Aggressive traders still looking for a bullish entry point could buy a bounce from $92.00 or a bounce (or dip) near $90.00. If you missed it our entry point for this play was one hour after the August 27th oil inventory report was announced. Our target is $99.50.

Suggested Options:
We are not suggesting new positions at this time. Should the USO provide another entry point we'd use the September calls since this should be a short-term play. September options expire in three weeks.

Picked on August 27 at $ 95.12 *triggered 1 hour after report
Change since picked: - 2.25
Earnings Date 00/00/00
Average Daily Volume = 13.9 million

---

CBOE Volatility Index - VIX - close: 20.65 chg: +1.22 stop: n/a

Hmm... the situation may be changing for the VIX. This was the first week in a while that the VIX did not see a new relative low. The market's weakness on Friday fueled a 6% gain in the VIX. Right now the volatility index still has a bearish pattern of lower highs but it wouldn't take much to break it. We've been suggesting that readers buy calls on a new move over 22.50. More aggressive traders might want to consider jumping in early over 21.50 instead. Don't forget that this is a very speculative play (as in no stop loss) as we bet on a strong enough market sell-off to send the VIX toward 30.00. In our favor is the time of year with September and the first several days of October historically the worst time of year for stocks. Plus, we have the ongoing credit crisis, financial sector woes, and escalating tensions with Russia (not to mention Iran), oh and let's throw in a couple of hurricanes. Our target is 29.75 but readers might want to consider scaling out of positions in the 28-29 region.

Suggested Options:
If the VIX provides a new entry point we have been suggesting the October calls.

Picked on August 03 at $ 22.57
Change since picked: - 1.92
Earnings Date 00/00/00
Average Daily Volume = x million

---

Whiting Petrol. - WLL - cls: 96.24 chg: +1.67 stop: 91.95 *new*

A lot of the oil stocks have begun to roll over in the last couple of trading days. Not so for WLL. Thursday was rough but traders bought the dip on Friday near its 10-dma and 50-dma. This move actually looks like a new bullish entry point. However, considering the recent weakness in the oil sector, buying calls now makes this an aggressive play. We're going to try and reduce our risk with a stop loss at $91.95. More conservative traders could put their stop under Thursday's low of $92.70. We have two targets. Our first target is $103.50. Our second target is $107.00. The P&F chart is bullish with a $132 target. FYI: WLL is due to present at an investor/analyst conference on September 2nd.

Suggested Options:
We would suggest the September or October calls. Keep in mind that September options expire in three weeks.

Picked on August 26 at $ 95.80
Change since picked: + 0.44
Earnings Date 10/30/08 (unconfirmed)
Average Daily Volume = 1.1 million
 

Put Updates

Chipotle Mex.Grill - CMG - cls: 69.32 chg: -0.92 stop: 73.65

Investors have soured on CMG. The stock remains in a long-term bearish trend. This last week undermined investor confidence again when fellow food stock Darden Restaurants (DRI) issued an earnings warning. Traders are worried that CMG is facing a slowing consumer and rising ingredient costs. The short-term trend is also negative and CMG is poised to mover lower. The stock can be volatile so we're keeping a slightly wider stop loss but more conservative traders could probably get away with a top near $72.00 or 71.50. We are suggesting new put positions here. We have two targets. Our first target is $65.50. Our second target is $61.00.

Suggested Options:
We would use the September or October puts. Keep in mind that September options expire in three weeks.

Picked on August 20 at $ 69.90 *triggered
Change since picked: - 0.58
Earnings Date 10/30/08 (unconfirmed)
Average Daily Volume = 888 thousand

---

Millicom Intl. - MICC - cls: 79.37 chg: -1.29 stop: 81.55*new*

We have been patiently waiting for MICC to breakdown and hit our entry point at $78.49. On Friday the stock spiked lower to $78.36 before bouncing back. The play is now open. It still looks like the path of least resistance is lower but Friday's afternoon bounce may not be over yet. We would watch for a failed rally under $81.00 or a new relative low (78.35) before initiating new positions. We're also adjusting our stop loss to $81.55 based on the bounce. We have two targets. Our first target is $75.05. Our second target is $72.50. FYI: A move under $78.00 will produce a brand new Point & Figure chart sell signal.

Suggested Options:
We are suggesting the October puts but September options would probably work, just remember that Septembers expire in three weeks.


Picked on August 28 at $ 78.49 *triggered
Change since picked: + 0.88
Earnings Date 10/23/08 (unconfirmed)
Average Daily Volume = 1.0 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.)

---

Lehman Brothers - LEH - close: 16.09 chg: +0.22 stop: n/a

Shares of LEH have rallied four days in a row as hope grows the company may find a solution or that someone might make a bid for them. It's worth noting that the overall trend is still very bearish and the rebound has failed to break resistance. Nor has there been any volume on the bounce. We're not suggesting new strangle positions in LEH at this time. We only have three weeks left and LEH still has to make some big moves. If you wanted to exit now you might be able to recover about 40-45 cents of our initial investment. Anything can happen in the next three weeks and odds that LEH just bounces around the $13-20 zone is growing, which would end with a complete loss for us. We need to see LEH significantly above $24.00 or under $10.00. The options we suggested were the September $24.00 calls (LYH-IR) and the September $10.00 puts (LYH-UB). Our estimated cost is $2.15. We want to sell if either option hits $3.50 or higher.

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

Picked on July 27 at $ 17.05
Change since picked: - 0.96
Earnings Date 09/18/08 (unconfirmed)
Average Daily Volume = 63 million
 

Dropped Calls

None
 

Dropped Puts

None
 

Dropped Strangles

None
 

Today's Newsletter Notes: Market Wrap by Jim Brown, Index Trader by Leigh Stevens, Trader's Corner by Linda Piazza, The Contrarian by Robert Ogilvie, and all other plays and content by the Option Investor staff.


The Contrarian

The Contrarian Trade

As an additional service to the Market Wrap subscribers, the weekly contrarian commentary will be initiating a hypothetical trade to illustrate the current signals bias. Some of the content may be at a higher level so there will be some explanation of terms and concepts in each of the posts. As of last night the CBOE Equity Volume Put/Call ratio indicates a Neutral bias. Similarly, the Investors Intelligence poll indicates that the sentiment signal is Neutral. However, as the CBOE Volatility Index indicators 10 and 20 day moving average continue to decline the signal remains at a Positive bias. Therefore, as option traders we want to position our portfolios conservatively with a slight upside bias. Depending on your primary portfolio, you may choose to sell out of the money SPX or OEX calls against the portfolio as a way to hedge some downside risks while positioning for equal or greater upside potential (i.e. Sell the 1350 calls for $2.60 per contract). One could also establish a new covered call position on the S&P 500 Spiders (SPY) and sell slightly out of the money as a way to have a slightly delta positive position. Delta refers to the theoretical profit or loss on each point move in price in the underlying. For instance, a position with a Delta of 230 would increase in value (non-realized) approximately $230 for a one point increase in the underlying securitys price. The Delta of the overall position also changes as the price of the underlying security increases or decreases in price. A position with a positive Delta increases in value as the underlying security increases in price.

Since I write the option writer newsletter I am going to use short calls and puts within the hypothetical trade. Hopefully everyone can understand why I am selling out of the money calls and puts to create the trade. First of all, because the brokerage firm I use calculates margin on the overall position and credits the lesser margin requirement on straddles, strangles, double diagonals and iron condors, I can create a short option position with built in risk management that doesnt cost a lot of capital to establish. While I am not going to go into when to use Iron Condors instead of Double Diagonals in this article, I will begin by defining Iron Condors. Simply stated, an Iron Condor (IC) is a Call Spread and a Put Spread combined. ICs can be credit or debit and be bullish, neutral or bullish. Credit ICs have positive Theta or a time decay component to aid in profitability while Debit ICs primarily profit from Delta and Volatility. This will make more sense as we get into the position.



Since we are on a Neutral bias with a slightly bullish tint, we want to sell out of the money puts at near term support and out of the money calls at a step above the closest resistance. Referring to the chart above there is short term resistance at 1315 on the SPX and some additional resistance at 1335 and then 1350. The 1350 level is a resistance level from a gap down on June 18th. While we can be more aggressive in the future, we will sell the 1350 September Calls and buy the 1360 Calls to hedge and create a credit spread. Since we are slightly bullish we can sell the puts closer to the underlying securitys price. Basically we want to sell puts (bullish) closer to the money and sell calls (bearish) farther out of the money to create a positively biased position.



The picture above shows the Risk Profile of the Iron Condor. Instead of combining the four strike prices and obtaining a single net credit, I decided to break apart the position into two credit spreads. The Put credit spread provides a credit of $1.85 per contract. The spread is 10 points wide and requires $10 X 100 shares per contract of margin per contract. The Call credit spread only provides a credit of $1.05 per contract. As mentioned earlier, this brokerage only charges margin on one side of a market neutral trade. The reason is because they have determined that only one side of the trade can be at risk at expiration. Therefore, charge risk premium for only one side. The total credit equals $2.90 per contract. If you had $7,200 in your account, you could initiate this trade. The $10,000 margin requirement (10 contracts X requires $10 X 100 shares per contract) is reduced by the $2,900 credit to require $7,100 without commission. Notice on the above Risk Management chart that there is a lot more upside room than downside room for the position to move. There is about $50 points until the put position becomes at risk on expiration and $65 points until the call strike becomes at risk on expiration.



The max return of the trade is calculated by taking the max premium of $2,900 and dividing that by the initial cash requirement of $7,100 ($10,000 - $2,900). The return is about 40.85% without trade costs. The probability of expiring within 1232.4 and 1352.16, the breakeven points is 64.74%. The probability of expiring within the strike prices is 62.42% (not shown above). To get an idea of whether or not the trade is good or not subtract 1 by the max return and compare with the probability of closing within the prices. If the number is less than the probability then the trade is good. In this case, 1 0.4085 = 0.5915 is less than 0.6242 and is therefore a good trade setup. Basically, over the long term, many trades will lose money but if your return is greater than your probability then your chances of making money increase. For instance, if you make 10 trades with 90% probability with an average of 9% return you would lose money. The reason is that on 9 trades you make 89% on your capital but lose your max loss on one trade. Conversely, assuming you make 12% on 9 trades and lose your max loss or margin requirement on 1 trade. You are up about 18%. Probabilities of returns are more important than returns on capital. If the contrarian bias shifts, then so will this trade. It may lose money on adjustments in order to profit more on Deltas and Thetas. I hope this was helpful.
 

DISCLAIMER

Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.

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