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Daily Newsletter, Saturday, 09/13/2008

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Table of Contents

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

Market Wrap

Breakfast At Paulsons

Market Wrap

After another week of declining fortunes and rising revelations in the financial sector it appears we are setting up for another Sunday morning breakfast meeting with Hank Paulson on TV spelling out the terms of another bank takeover. Rumors were flying on Friday of a sale of Lehman to be completed by Sunday. Another rumor had Washington Mutual also being taken over by JP Morgan this weekend. AIG lost another 32% and is rumored to be in trouble as well with a major announcement only days away. Even GE was not immune to speculation over financial weakness from consumer credit transactions and its inability to sell the credit card business. All in all the markets took the news rather well with the Dow the only casualty with a $6 drop in AIG knocking nearly 50 points of the Dow and GE accounting for another -12 points.

NYSE Composite Chart - Weekly

On the economic front the Producer Price Index headline number fell -0.9% and nearly erasing the +1.2% rise in July. The sharp drop was almost entirely due to the fall in the price of oil and gas prices. Prices for finished energy goods fell -4.6% for the month. Core finished goods rose only +0.2% and right inline with the prior trend. If energy prices remain weak we could see a sharp drop in inflation pressures and that would be very Fed positive.

The University of Michigan Consumer Sentiment initial release for September soared to 73.1 and a +10 point gain over the August reading. This is the highest level since January. It was also the biggest monthly increase since Jan-2004. The spike was led by a +13 point surge in the expectations component. It was the biggest increase in that component since 1991 as that recession ended. Inflation expectations also fell sharply due to declining oil prices. The current condition component also rose sharply with a +5.5 point gain. The Michigan Sentiment survey emphasizes consumer finances and therefore the sharp drop in gasoline prices was quickly reflected. However, even at the present headline number of 73.1 it is still below any level seen between 1992 and early 2008. The spike also suggests consumers are expecting the election process to produce change regardless of who is elected and recent events in the news gave them hope on home prices and mortgage rates.

Consumer Sentiment Chart

Retail sales for August did not reflect that rise in consumer sentiment. Sales fell -0.3% and the July number was revised down to -0.5%. Auto sales actually provided a boost in August or the headline number would have been down -0.7%. Other decliners included electronics -1.3%, building material dealers -2.2%, clothing -0.3%, service stations -2.5% and nonstore retailers -2.3%. The drop in sales at service stations was expected given the drop in gasoline prices. Motor vehicles and parts dealers saw a +1.9% gain. The drop in overall sales came from the expiring tax rebates. The money has been mailed and spent leaving consumers with little excess cash for shopping.

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The economic calendar for next week is headlined by the Consumer Price Index or CPI on Tuesday along with the Fed meeting on interest rates. The CPI will tell us how much inflation is filtering down to the consumer level and tell the Fed how concerned they should be about raising rates. There is actually some talk about a potential rate cut in the future given the continued weakness in the banking and housing sectors. Nobody expects that at this meeting but it will be interesting to see what the Fed says in their statement. The Fed Funds Futures are showing a 40% chance of a 25-point cut by December. The next meeting is Oct-28th.

Economic Calendar

The big news for Friday and for next week will continue to be the big names in the financial sector and impending takeovers. Lehman announced on Friday it had put itself up for sale and a deal could be concluded by Sunday afternoon. The two main suitors appear to be Bank of America and Barclay's. According to analysts BAC would be a perfect fit. BAC is seen as a commercial bank but has a huge retail base. Gaining access to the top-notch bond trading division and the Neuberger Berman asset management division would be a perfect fit. BAC would also provide a migration path for employees in Lehman to spread their wings inside the banking giant. A Barclay's deal would be more subdued and is seen as less likely. HSBC was also mentioned but sources feel BAC has the lead.

The problem with a Lehman takeover is the potential portfolio risk. Nobody wants to take on tens of billions in high-risk exposure to the real estate and mortgage sector and then be forced to take billions in write-downs every quarter as the problems surface. Nobody, including Lehman, knows exactly what the current portfolio is worth. This suggests any buyer is going to be paying pennies on the dollar in hopes the good loans eventually overcome the losses from problem loans. On Friday the Fed and Treasury said they were aware of the negotiations but there would be no government money or guarantees involved. Saturday morning the WSJ reported that the Fed held an emergency meeting late Friday night on the Lehman problem. In attendance were Paulson, NY Fed President Timothy Geithner, SEC Chairman Christopher Cox, Morgan Stanley CEO John Mack and Merrill CEO John Thain. Identities of everyone else were not disclosed other than "senior representatives of major institutions."

Saturday Update: Late Saturday the NYT reported that the heads of the other major banks in the meeting were warned if they did not work together to resolve this crisis with Lehman their banks could be the next victims of the credit crunch. In the Long-Term Capital crisis major banks each contributed to a $3.65 billion bailout of the hedge fund, allowing it to be unwound in an orderly way. The current banking crisis is far worse than the LTCM meltdown. The meeting of all the major bank heads reconvened on Saturday at the offices of the New York Fed. The CEOs from Citigroup, Goldman Sachs, Morgan Stanley, Merrill and JP Morgan were in attendance along with the heads of the SEC, FED, FRB-NY and Treasury but there were no representatives from Lehman.

Lehman Chart - Monthly

The problem with Lehman is not with liquidity. Reportedly they have plenty of liquidity and access to the Fed discount window. The Fed reported they have not accessed the Primary Dealer Funds Facility in 11 weeks. If they needed cash that would be the first place to turn. The problem is the declining balance sheet and capital requirements. As Lehman takes more write-downs it is forced by accounting rules to raise more capital. Lehman does not need the capital to operate, just to remain in compliance with the rules and maintain its credit rating. When it can't raise capital, as is the situation now, the rating agencies cut their rating and their cost of money and insurance goes up. Other firms are reportedly still doing deals with Lehman but analysts wonder at what level. The term used all day Friday was dead man walking. If the markets open for business on Monday without a Lehman takeover they may still be ok financially but without any business or a share price. If they can't get a deal done by Monday the rating agencies have already said they will downgrade them again. Every hour that passes makes it less likely they will pull out of it on their own and nobody wants to do billion or even million dollar deals with a company that may not be around next week. The Bear Stearns debacle is very fresh in the minds of investors and trading partners. Lehman continued to decline losing another 12.5% on Friday to $3.17 at the low for the day. That is down from $66 as recently as February.

Lehman's CEO Dick Fuld has taken home $466 million in compensation since he took office. If the company is sold he will get another $50 million or so as an exit package. Meanwhile employees who own stock have lost over $10 billion in the last year. If I were Mr. Fuld I would be wearing a bulletproof vest to work and be surrounded by armed guards. Fuld is famous for his April 2008 speech where he said the credit crisis was over.

Lehman was started in 1850 and was instrumental in establishing the futures markets in cotton, financed the major railroad expansions across the U.S., took Sears public and had its corporate offices wiped out in the 9/11 attacks. One analyst said on Friday, "The damage is done, the house of Lehman has been burned to the ground and suitors are just picking through the ashes for remains." There is significant doubt that a Lehman deal can get done this weekend without a Fed backstop. Lehman has a $600 billion balance sheet with untold complexity. CEO Fuld just started shopping the firm as a sale on Thursday. How can you perform due diligence on a $600 billion balance sheet over three days and have confidence you were not buying a toxic waste dump that will come back to haunt you? JPM bought BSC over the weekend because the Fed guaranteed $30 billion in debt. There is no Fed guarantee on Lehman. Bids are due for Lehman at 5:PM on Saturday. BAC and Barclays are the lead bidders with JC Flowers fronting for China Investment Company as a remote third bidder. Reportedly BAC and Barclays have both gone to the Fed for help and been turned down.

The second topic of the day was Washington Mutual (WM) and their prospects. WaMu has been under pressure since taking a $5.9 billion loss reserve and $2.7 billion bad loan write off in Q2. WaMu said on Thursday it was setting aside another $4.5 billion for credit losses in Q3. They made the disclosure six-weeks early in an effort to calm investors and depositors. WaMu said loan losses through 2011 could reach $19 billion. All of these losses may force WaMu to raise additional capital or sell itself as Lehman is trying to do. WaMu has already been forced to raise $7 billion in capital in 2008. Late Friday the American Banker trade paper said WaMu was in advanced talks to be acquired by JP Morgan. WaMu is the nations largest savings and loan and JPM is the third largest bank. Before the day was over there were several denials of any "current" talks but traders were placing side bets there was something past or present in the works.

Washington Mutual Chart - Monthly

WaMu is a monster thrift with $60 billion in home equity loans, $50 billion in option ARMs and $16 billion in subprime mortgages in addition to untold billions in higher quality loans. With WaMu stock at $2.75 the market cap of WaMu is only $4.6 billion. Compare that to their $143.6 billion in deposits and claimed $50 billion in available liquidity from "reliable funding sources." You may remember that Countrywide claimed $46.2 billion in available financing from "highly reliable" funding sources only two weeks before it was forced to draw down an $11 billion bank line when those sources dried up. Bear Stearns claimed they had $20 billion in liquidity only a week before they went under. It is not hard to understand that traders and counterparty firms are a little leery when they hear the same comments coming from WaMu. The more you have to reassure the markets that things are fine the more likely they are not fine.

Lastly AIG caused a major hole in the market with a -31% drop. After the close the drop continued with another -2.7% drop to $11.81. As a Dow component this was a major hit to the Dow and kept the Dow in negative territory at the close. S&P put AIG on CreditWatch negative saying it may lower it's rating by as much as three notches because of worries over liquidity and capital. The worry over AIG is concern that its financial position is deteriorating rapidly because of the gridlock in the credit markets and rising mortgage defaults. Analysts also worry about guarantees by AIG on billions in structured investment vehicles or SIVs. As more home mortgages default the risk of defaults on SIVs grows. Every time they are downgraded they have to immediately put up billions more in capital to cover their credit default swaps. Over the past three quarters AIG has lost about $25 billion in the value of their credit default swaps and lost about $15 billion on other investments. AIG stock has already lost 80% of its value since January and AIG is having the same liquidity/capital problems as Lehman and WaMu. AIG is the largest insurance company in the world and is planning on updating investors on Sept-25th on its financial condition. Hopefully they will still be around on that date. AIG has lost nearly $200 billion in market cap since last October. AIG has $40 billion in debt coming up for renewal over the coming months and analysts estimate they need to raise $15 billion in capital to meet obligations. It was announced well after the close that AIG had hired JP Morgan to advise them on how to raise new capital in the current market. AIG is now expected to announce its plan to raise capital by Sunday evening and the option being tossed around is an investment by Blackstone and/or Blackrock.

Chart of AIG - Monthly

Merrill Lynch (MER) was also under pressure with another -12% drop on fears that bad news from Lehman, WaMu and AIG are just flu symptoms that have yet to come to the surface on Merrill. Increasing fears over problems at Merrill also include counterparty risk to Lehman and AIG. If Merrill has deals with those companies then a failure there could explode back at Merrill. What started out as a problem in the subprime mortgage market has now translated to a crisis of confidence in the credit markets. That is now moving into a crisis of confidence in the equity markets for the investment banks. However, large retail banks like Wells Fargo (WFC) and US Bank (USB) are doing fine with WFC hitting a new high on Friday.

U.S. Dollar Index Chart - 15 min

The U.S. dollar was positively crushed on Friday with a -1.47% drop in the dollar index. Thursday saw a new 52-week high at 80.37 but Friday saw a -1.19 drop. In currency terms this is a monumental move. The problem is our weakening financial markets and fears that the government will be forced to bail an increasing number of companies. The automakers were pleading their case on Friday for a $50 billion bailout. There is an increasing feeling overseas that the U.S. will also have to bailout individual homeowners and the numbers begin heading off the scale when economists start trying to tally the potential liability. They could be completely wrong in their assumptions but the impact on the dollar was huge.

Crude Oil Chart - Daily

Normally when the dollar tanked the price of oil exploded. Normally when a hurricane blows through the oil patch and shuts down 20% of the nations refining capacity for a week oil prices explode. Normally no longer works. Texas Governor Rick Perry was on CNBC doing his imitation of Ray Nagin's "storm of the century" warning on Gustav. Perry was warning Ike could cause $100 billion in damage and be the most expensive natural disaster ever seen in the states. There was no bounce in oil and it fell to trade under $100 for the first time since April. Early Saturday morning officials said damage was much lighter than feared with mostly downed trees and broken windows although low lying areas were flooded. Valero said they were inspecting their refineries and were restarting one and waiting for power to be restored on another. Shell, the largest gulf oil producer, said they were already doing over flights to check for damage and starting to put crews back on the platforms.

With all the negative points this weekend if Ike did NOT cause significant damage to the oil infrastructure we could easily see oil trade down to the mid $90s next week. I have never seen oil trade lower as a major hurricane arrived. 20% of the U.S. refiners or 4 mbpd were shut down ahead of the storm. 96% of gulf production is offline and has been most of the week. Gasoline supplies were already depleted at eight-year lows and last week's shutdown from Gustav and this weekend's shutdown for Ike is only going to make it worse. Based on this week's price action on crude I could see gasoline rising and crude falling next week if there is only manageable damage. I am not even sure oil will go up if there is damage. Russian long-range Backfire bombers landing in Venezuela and Hugo Chavez threatening again to cut off oil shipments to the U.S. had zero impact. Funds are still liquidating oil positions and until that ends normal conditions do not apply.

Ike Making Landfall In Houston Friday Night

Chart of Gulf Production Shut In for Hurricanes Gustav & Ike

There was some positive news on Friday. Karl Case co-inventor of the Case-Shiller Home Price Index released every month believes it is time to be optimistic. In a paper presented at the Brookings Institute he laid out his "case." He feels there are plenty of reasons why we are nowhere near the end including high inventory levels of unsold homes and home still underwater with high mortgage balances. He also believes there could be legal delays in unraveling the credit derivatives associated with the initial sale of the mortgages to investors. He also warned that tighter credit could make it tougher to buy homes. However, he noted that in almost all areas foreclosures have dropped and the Case-Shiller index for those regions has moved higher. He also believes as California goes so goes the rest of the nation and California sales are rebounding. Prices are falling at a much slower rate and foreclosures have fallen to less than a third of total sales. He said the real gross residential investment hit 3.5% of GDP at the bottom of previous cycles. It is currently 3.1 and suggests California is at a bottom. Also, historically when housing starts fell under 1 million the cycle has rebounded quickly. As of July 2008 starts dipped to 965,000. In the Case-Shiller report 9 of the 20 regions reported are already rebounding. Mortgage rates fell under 6% last week and that is also historically stimulative to buyers. Based on his decades of analyzing the housing market he believes these are clear signs of a rebound.

Next week could be crazy. We have the LEH, WM, AIG, MER saga and there are some worries about Citigroup and Goldman Sachs. Citi has seen huge put buying over the last week on fears there is something they are not telling us. Goldman Sachs was crushed by almost daily downgrades on earnings estimates started by Meredith Whitney on Monday. GS traded in a $22 range with every bounce drawing another downgrade. They report earnings on Tuesday and they can either emerge as a zero or hero depending on what they report. Other reporters on Tuesday include AIR, ADBE, BBY and DRI.

We are also heading into the earnings warning cycle. It seems like we just finished Q2 earnings but we are only a week away from the Q3 warning cycle heating up. I would bet that the ratio of negative warnings moves substantially higher for Q3 and that could impact the markets. This is also a quadruple witching week with everything expiring by Friday. I watched the interaction between volume, volatility and the markets last week and even though there was high volume there was very little indication that we were seeing expiration moves. I believe the deck is stacked so heavily that funds are waiting until next week to roll out of their positions. Most of the high volume has been in those key news event stocks. On Friday there were nearly 1.2 billion shares traded in just five stocks, LEH, AIG, MER, WM and Citi.

Despite all the volatility in the indexes the volatility index (VIX) was rather tame. It has been hovering in the 24-26 range all week. That is far from a level over 30 that would indicate a bottoming process. The last three days the internals have been evenly split with upside volume slightly over downside. The market appears scared. Several sectors are rising but the overall market is struggling. With the major indexes finishing close to neutral on Friday I was shocked to see the NYSE Composite up strongly at +80 points. I could not find a specific reason other than a strong showing by energy stocks. That is even more confusing with oil prices declining.

Volatility Index Chart - Daily

I had a reader whose opinion I respect email me on Friday saying hedge funds had been heavily into a pairs trade of long financials and short energy for the last two months. With financials up +47% from the July lows and energy stocks down over 30% in some cases it is time to unwind those trades. With oil at support and the financial sector showing cracks again they may want to unwind it quickly. He also pointed out that Sept-30th is the last day this year that most hedge fund investors can withdraw funds. He was suggesting the need for month end cash could accelerate the unwinding of the pairs trade. Obviously that is just speculation on our part but a possible explanation why energy stocks had been up for the last 2-3 days with oil trading under $100.

Twice this week the Dow tested support at 11000 and both times it was quickly bought. Unfortunately the rebounds ran out of steam below 11500. The Dow is going to remain hostage to the financial mess with Monday having the potential for another gap open. The only question is up or down. If Lehman and AIG report deals by Sunday night we could move higher even if it is only temporary. The financial sector has been moving from event to event at a leisurely pace since the Bear Stearns, Countrywide takeovers. Conditions have now deteriorated to where we now have a hand full of major companies in crisis all at the same time and we may be nearing a point where investors don't want to be in any major investment institution for fear of another LEH/AIG/WM problem. On the bright side the FDIC did not announce any bank closures this Friday. Bottom-line the Dow and S&P are going to remain hostage to the financial news.

Dow Chart - Daily

Nasdaq Chart - Daily

The Nasdaq tested 2200 on Thursday and managed a +70 point rebound but like the Dow ran out of steam at initial resistance and faded into the close. With AAPL down -3.71 and RIMM off -3.53 it was amazing the damage was not worse. Were it not for the solar stocks it would have been very different. Most of the Nasdaq point gainers for Friday were names most people probably would not recognize. That would be a positive for next week if I really thought the rebound was broadening but I suspect it was just a statistical anomaly. Resistance is 2270 and support 2200. That support at 2200 should be relatively strong but this is a pivotal week.

The Russell touched support at 700 on Thursday but the rebound failed at 720. The Russell has given up its role as sentiment leader and I fear that 700 level could be broken.

Russell-2000 Chart - Daily

S&P-500 Chart - Monthly

The NYSE Composite tested support at 7875 four times over the last week and gapped down to 7800 on Thursday only to instantly rebound sharply. I hesitate to say the NYA has a bullish chart but it appears it is trying to put in a bottom. Unfortunately we need a lot more confirmation before calling anything a bottom ahead of next week.

The coming week is quadruple witching. That normally produces huge volume and huge volatility. Add in the FOMC meeting on Tuesday and the financial news events scheduled for Monday and toss in a couple earnings warnings and we could be in trouble. It is impossible for anybody to accurately pick a direction in this market for more than 30 minutes. There are too many cross currents and lots of white water between here and next Friday. This is historically the worst week in September and the worst month of the year for the markets. Let's hope whatever happens next week marks a turning point towards an end of year rally. That may be too much to wish for but it is a good start.

Jim Brown

Index Wrap

LIMITED UPSIDE, LIMITED DOWNSIDE\?

THE BOTTOM LINE:
The Nasdaq Composite (COMP) could have bottomed this past week. By this past Tuesday, the 3 key indicators that I rely on to be in synch got down to the extremes associated historically with high-potential bottoms. These 3 indicators, that of the 10-day Nasdaq Up volume average, the 13-day RSI and my 'sentiment' indicator, are seen on my first chart. What is lacking is the same type 'line up' on the S&P side, but more on that later.

In the ABOVE daily COMP chart, the RSI indicator didn't get quite to (or under) its typical 'oversold' 30 reading but it fell quite close to that level. In terms of price action, which is also a major determinant of whether there's a trend reversal that's developed (or developing), recent lows haven't quite retested the prior COMP double bottom low at 2170, but that's not an expected thing necessarily. In fact, triple bottoms are not all that common. My other thought is that given the extreme stresses in the economy, a bottom may not form quickly this time. A period of sideways 'basing' action could still lie ahead. On balance, there are more signs of a short to intermediate-term bottom at this juncture than not.

In the S&P, the key indicator that didn't get to an extreme and then turn up was the RSI, as seen on the chart BELOW of the S&P 500 (SPX). The NYSE daily up volume total for the New York Stock Exchange, on a 10-day moving average basis, turned bullish with the turn up in the average seen below. My sentiment indicator is the same one used for both SPX and COMP. The RSI didn't get to the 'usual' extreme associated with high-potential bottoms. The S&P therefore presents a somewhat more mixed picture based on the indicator patterns I normally see at significant lows. However, in chart terms there is an approximate double bottom in place.

Bottom line: time to at least cover puts in the S&P and NDX, especially on dips; NDX calls look attractive also on dips, especially to 1700 and under (e.g., to the 1680 area), with exiting stops at 1650.

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.

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 where e-mails were not getting to me from OI Daily Subscribers.

** MAJOR STOCK INDEX TECHNICAL COMMENTARIES **

S&P 500 (SPX); DAILY CHART:

The S&P 500 (SPX) chart is bearish in its pattern in terms of it building a top in August after a limited rally, followed by further sharp declines. There is the possibility that a double bottom low has or is forming in the area of the July bottom. The index could get more oversold before it's in a position to mount a sustained rebound with enough upside potential to make calls attractive.

Support was seen this past week in the 1220 area and a bit under; major support begins at 1200. First anticipated technical resistance is the 21-day average, which was 1268 as of Friday. 1280 is a next resistance, with 1300 the beginnings of major resistance.

I noted last week that I thought SPX downside might be limited, no re-test of 1200 and more chopping around. "The chart most suggests a trading range market still, only now between the low-1200 area and 1300 on the upside." This is still my view.

SPX's ability to climb and stay above about its 21-day average should signal an ability for some further upside progress. I don't see big downside potential left in puts. Maybe buying calls was worthwhile on dips to/under 1220 but I'm leary of being caught in a lengthily sideways move.

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

The S&P 100 (OEX) continues to hold above the lowest intraday lows of the July bottom and the chart is neutral in the sense of the index being currently locked in a trading range between 550-560 on the downside to 600-608 on the upside. If trading for 30 points price swings is attractive, there have been some opportunities, given good execution.

Near resistance is 585-590, with pivotal resistance in the 600 area. Near support is in the low-560 area, with pivotal support at 550.

I thought last week that OEX would get down toward 560 again and rallies stopped right at the 21-day moving average which also wasn't surprising in a yo-yo market like this. A daily and especially weekly close below 567 creates a still weaker looking chart.

I also wrote last time that a close above 580 would be a cause to exit puts but there was no upside follow-through that followed. A close or better two such closes, above the 21-day average is a better sign of a possible reversal move. I've been on the trading sidelines in this choppy period.

MARKET 'SENTIMENT'
As I noted in my initial 'bottom line' commentary, this past week (Tuesday) finally brought enough of a surge in equities put volume to create an oversold extreme in terms of a bearish extreme in trader sentiment. This may be an indication that the market is at or near at least a short-term bottom. Given enough uncertainty on the outlook for the market and for earnings, such sentiment extremes can come again or a few times, before the market sets up for a substantial rebound.

DOW 30 (INDU) AVERAGE; DAILY CHART

The Dow 30 (INDU) is neutral to bearish in its chart pattern. Neutral in that its going sideways and still bearish in the absence of an upside breakout move.

Resistance/selling interest is coming in on moves up to the 21-day average, typical of a trading range affair with a bearish bias. Next resistance above the average is on rallies toward 11800. Support has been found on dips to the low 11100 area. Major support begins at 10800.

With this sideways type move, there's little percentage in buying Dow Index puts or calls, only in strategies involving the capture and erosion of time premiums.

Many of the 30 Dow stocks are quite oversold on a long-term basis and while a re-test of 10800 could happen, I don't see much lower downside risk currently. A close above 11800, not reversed the next day (back to the downside), is needed to suggest a possible upside breakout.

NASDAQ COMPOSITE (COMP) INDEX, DAILY CHART:

In a switch, the Nasdaq Composite (COMP) has had a bearish chart pattern, as it's been in steep slide with anemic rallies, while the S&P and Dow are holding up relatively well. 2200 is again proving to be an area of support; next lower support and buying interest since March has come in on (short-lived) dips to the 2170 to 2160 zone.

Maybe there's limited downside from here, but upside potential may be limited also at least for awhile. I've noted resistance at 2300, with next resistance at 2350. The chart pattern suggests a sideways to lower, backing and filling period ahead, perhaps for another week or two. Resistance at 2300-2320 may cap any rally attempts in the coming week.

NASDAQ 100 (NDX) DAILY CHART:

The Nasdaq 100 Index (NDX) looks like it's a bit in no man's land as the index took out its July lows but hasn't re-tested its March bottom. A rebound to above 1800 that isn't a short-lived day only affair is needed to suggest that the index may have seen its low for the recent downswing.

Near support is in the low-1700 area. A further sell off back to 1670-1680 where there was prior good buying support back in March would suggest a possible major double bottom and present a good buying opportunity in calls. Too obvious to come true? Maybe, but every so often it's just like that.

If you have puts and have been riding this decline, the oversold condition recently suggested by the RSI reading below 30, was a signal to take the money and run. It's a bearish trend but a flattening out sideways move will spell the end to further profit potential.

NASDAQ 100 TRACKING STOCK (QQQQ); DAILY CHART:

I've noted support in the 42 area in the Nasdaq 100 tracking stock (QQQQ) with next support around 41. Near resistance is at 44, then up in the 45.75 area.

My own trading recap: I covered stock I was short on the first decline to the 44 area, which looks to have been too soon of course in retrospect, but that was my objective and I was happy with the gains I had.

Turning around and getting long half of what I covered wasn't my best trading decision ever. Stock I bought on the first decline to the 44 area, got kicked out on a 42.5 sell stop. I guessed that support would again be found in the 44 area like occurred in July but selling kicked up instead and kicked me OUT. Better to have risked 75 points only as once QQQQ fell under the line of support seen in July, it was look out below.

There should be a substantial buying opportunity on a successful retest of lows in the 41 area. Will there be enough sellers in an oversold market to push the Q's this low again? I won't hold my breath waiting for that but 41 would be a measured move objective where the two down legs would equal out.

RUSSELL 2000 (RUT) DAILY CHART:

The Russell 2000 (RUT) Index continues to hold up well and support has been coming in between the area of its 55-day moving average and 700, which I thought might be the case. Still, I'm impressed with the relative strength being seen in small to mid-cap stocks. But stock money has to go somewhere and this sector has been a perennial favorite with many individual investors.

RUT has now retraced a little less than half of its last advance and that's a good performance in this market. 700 remains a key or pivotal support, especially on a closing basis. Next lower support is in the 680 area.

740 is near resistance, then 750-755 and of course the prior high around 763.

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

Up for a Challenge?

If I told you about a technical analysis tool that might take up to a year to fine tune, could be rife with built-in errors and would eventually become obsolete, would you be interested in using it? Me, neither. Lots of people are, however, including corporations.

I'm talking about neural networks.

Why even consider setting up neural networks, Dima Vonko asks in "What Can Neural Networks Do for You?" (Stocks & Commodities, V. 24:12, 60-61). Vonko insists that neural networks give traders an edge over those who don't use them.

Neural networks might best be described as a form of artificial intelligence. The simplest explanation is that you show the neural network a set of inputs with a desired output then train it to sort through new sets of data and recognize patterns that might not otherwise be apparent.

Proponents of neural networks speak of the architecture of the network and the training algorithms employed to teach the neural network. Fortunately, you don't have to have a Masters in Software Engineering from Carnegie Mellon, as my son-in-law does, or understand each detail of the architecture or algorithms to set up neural networks. Software, either purchased or freeware, does that for you via a graphic-user-interface (GUI) program. Traders considering using neural networks do need to understand their basic uses, strengths and shortcomings.

What can the neural networks be trained to do? Although Justin Keupper ("Neural Trading: Biological Keys to Profit") says in an article found through Investopedia that neural networks can be trained to "predict future price movements," others argue against expecting neural networks to predict prices. Both Vonko and Connie Brown ("Neural Networks with Learning Disabilities," Stocks & Commodities, V. 11:5 (207-214)) warn that neural networks are better at picking out patterns or predicting whether a trend, once in place, will continue than at predicting prices. "It's not price forecasting," Vonko warns in the Stocks & Commodities article and in one for Investopedia.

What neural networks can do is to thoroughly analyze all sorts of complex inputs and anticipate the next direction, revealing opportunities or probabilities that might not have been apparent to the trader. Elements of "fundamental analysis, technical analysis, markets sentiment, economic factors, and even (arguably) randomness" can all be input and analyzed by neural networks, Keupper claims. Brown's article offered examples of neural networks being trained to analyze ADX, CCI and RSI figures together with volatility bands on underlyings such as cotton or the Deutschemark per U.S. dollar. Various offsets and other parameters were tested.

Pattern recognition can be a strength of neural networks. Yet Brown warns in her article of the ways that neural networks can go wrong. Like the unlucky first grader who supposedly learns to read but is in fact only memorizing sight words rather than understanding phonetics, neural networks can memorize data rather than learn from it. During the training phase, data from a trending market might need to input out of chronological order, Brown warns, to keep the network learning rather than memorizing. Vonko cautions that it might take up to a year to set up or train your neural networks. Keupper warns that they "are neither perfected nor proven."

Several writers advise against buying into all the claims of the commercially available services and applications. If an application works so well that profits are guaranteed, Keupper questions, why would a company sell it? Vonko worries that recent claims of faster training of the networks may compromise the quality of the results. Technical traders already understand that faster signals may not equate to more reliable ones, and Vonko's warning suggests that may be true of neural networks, too. Boris Schlossberg, Senior Currency Strategist, FXCM, offers another caution in an article linked to Investopedia. These networks eventually become obsolete, he warns, and must be discarded.

Yet Vonko wrote in both articles about that edge that traders gain from using neural networks. Keupper offered links to freeware such as Merchant of Venice and Joone that allow for different approaches to setting up neural networks.

I was surprised that only one of the writers spoke of the one trait that I had thought might be most advantageous about neural networks. In the efforts to mimic the human brain, no effort has been made to mimic our emotional response to trading decisions, of course. Market pundits speak quite often about the advantages of removing emotion from trading decisions. Not true, Schlossberg says when writing about the benefits of keeping a trading diary. "In fact," he writes, "I have witnessed the results of hundreds of systems trade in real time and not one of them was profitable in the long term. Trading requires all of our emotional and analytical capabilities in order to produce success."

During the course of researching this article, the knowledge that there is a freeware proves appealing. If I can find spare time from my writing duties, I might even investigate it. If those other writers are right, though, don't expect to hear back from me about my results for up to a year.
 

New Plays

Most Recent Plays

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New Option Plays
Call Options Plays
Put Options Plays
Strangle Options Plays
BDK HIG None
  RE  

Play Editor's Note: This is an extremely tough market to trade. As Jim said in the wrap this weekend there are a lot of cross currents pulling at the market. Seasonally this is the worst time of year for stocks and we're already in a bear market. The path of least resistance should be down. A lot of traders are keeping an eye on the VIX for a spike to the 30 region as a sign for a potential bottom. A perfectly good strategy this week would be to do nothing. I would be looking for any bounce in the major averages to fail.

FYI: I have a lot of stocks on my watch list for this week. I wanted to list a few here:

ESRX looks bullish. The stock is poised to breakout from its recent trading range. Technicals are turning positive again.

CALM tends to bounce near its 200-dma. I wouldn't chase Friday's move but a dip might be an entry point. Alternatively a move over possible resistance near $35.00 could be an entry point.

WFR: There is no arguing that the trend in WFR is down but shares are bouncing from its trendline of lower lows. Aggressive traders might want to speculate on a bounce.

BCR has a bullish pattern of higher lows. Shares could be setting up for a run at resistance near $100.

WYNN delivered an oversold bounce back toward resistance near $90.00. Watch for the bounce to roll over.

DVA has a bullish pattern of higher lows and shares look ready to breakout from their recent trading range. A move over resistance at $60.00 could be an entry point.

VNO: I'm surprised to see a real-estate related stock doing well. VNO has a bullish trend and could be near a breakout over $105.

KSS: I can really close to adding KSS as a short-term bullish play. The stock is bouncing from its trendline of higher lows. Readers could buy Friday's late afternoon bounce with a tight stop and target $55.00.


New Calls

Black & Decker - BDK - close: 67.65 chg: +0.90 stop: 63.75

Company Description:
Black & Decker is a global manufacturer and marketer of quality power tools and accessories, hardware and home improvement products, and technology based fastening systems. Our products and services are marketed in more than 100 countries, and we have manufacturing operations in eleven countries. (source: company press release or website)

Why We Like It:
Shares of BDK have developed a bullish trend since their July lows and last week the stock broke out past resistance near $67.50 and its simple and exponential 200-dma. Adding to BDK's relative strength could be the hurricanes. Hurricane Ike was huge and the damage is being estimated in the billions. BDK could see a surge of demand for its tools as the rebuilding begins. We see Friday's breakout as a new entry point to buy calls. Our target is the $74.00 mark. The Point & Figure chart for BDK is bullish with a $78 target.

FYI: Traders may want to check out Home Depot (HD) and Lowes (LOW) who have also seen a rally ahead of the hurricanes.

Suggested Options:
We are suggesting the October calls.

BUY CALL OCT 65.00 BDK-KM open interest= 463 current ask $6.40
BUY CALL OCT 70.00 BDK-KN open interest=1411 current ask $3.70
BUY CALL OCT 75.00 BDK-KO open interest=1096 current ask $2.00

Picked on September 14 at $ 67.65
Change since picked: + 0.00
Earnings Date 10/23/08 (unconfirmed)
Average Daily Volume = 1.0 million
 

New Puts

Hartford Fincl. - HIG - cls: 60.38 chg: -1.68 stop: 62.25

Company Description:
The Hartford, a Fortune 100 company, is one of the largest diversified financial services companies in the United States, with 2007 revenues of $25.9 billion. The Hartford is a leading provider of investment products, life insurance and group benefits; automobile and homeowners products; and business property and casualty insurance. (source: company press release or website)

Why We Like It:
The IUX insurance index looks poised to breakdown and make a run at new lows. Weighing on the sector are headlines from AIG and concerns about the company's future. Investors worry that rivals to AIG might be in similar peril. HIG already has a long-term bearish trend of failed rallies and lower highs. The latest failed rally occurred on September 9th near its 100-dma. Now the technical indicators are rolling over again. More aggressive traders could open positions now. We are suggesting a trigger to buy puts at $58.70. If triggered our target is $54.00. The July low was $53.20, which happens to be near the late 2004 lows. The P&F chart is bearish with a $53 target.

Suggested Options:
We are suggesting the October puts.

BUY PUT OCT 60.00 HIG-VL open interest=1230 current ask $3.80
BUY PUT OCT 55.00 HIG-VK open interest=1992 current ask $2.10

Picked on September xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/29/08 (unconfirmed)
Average Daily Volume = 3.5 million

---

Everest RE Group - RE - close: 78.49 chg: +0.54 stop: 80.75

Company Description:
Everest Re Group, Ltd. is a Bermuda holding company that operates through the following subsidiaries: Everest Reinsurance Company provides reinsurance to property and casualty insurers in both the U.S. and international markets. (source: company press release or website)

Why We Like It:
RE is another struggling insurance stock. The bounce from its July lows stalled around resistance in the 83.50-84.00 zone. Now shares are breaking down into what appears to be the next leg lower. We are suggesting readers buy puts now after Friday's performance. At this point our biggest risk is probably some amazing rescue for insurance giant AIG. As of Friday AIG was desperately trying to raise capital. If Monday morning rolls around and AIG has been successful enough to alleviate investors fears then it's conceivable that RE could bounce. Look for a failed rally near $80.00 or its 50-dma as another entry point to buy puts. We are listing two targets. Our first target is $75.05. Our second, more aggressive target is $71.00. If you're following the trendline of lower lows then you could aim much lower.

Suggested Options:
We are suggesting the October puts.

BUY PUT OCT 80.00 RE-VP open interest=1168 current ask $3.80
BUY PUT OCT 75.00 RE-VO open interest= 763 current ask $1.85

Picked on September 14 at $ 78.49
Change since picked: + 0.00
Earnings Date 10/20/08 (unconfirmed)
Average Daily Volume = 522 thousand
 

New Strangles

None today.
 

Play Updates

Updates On Latest Picks

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Call Updates

UltraShort Russell2000 - TWM - cls: 68.37 chg: -0.92 stop: 64.75

The small cap Russell 2000 is trying to bounce and continues to look poised for a rebound but it's struggling. This is putting pressure on the TWM, which moves twice the inverse of the RUT. Technically the TWM looks short-term bearish with two failed rallies near its exponential 200-dma in the last several days. I would look for a dip and a bounce in the $66.00 area before considering new bullish positions in the TWM. Of course things could change on Monday morning if the market's plunge on negative news. More conservative traders could always exit early now and jump back in when we see another entry point. We have two targets. Our first target is $77.50. Our second target is $82.50.

Suggested Options:
If the TWM provides a new entry point we would use the October calls.

Picked on September 09 at $ 71.37
Change since picked: - 3.00
Earnings Date 00/00/00
Average Daily Volume = 7.4 million

---

CBOE Volatility Index - VIX - close: 25.66 chg: +1.27 stop: n/a

The VIX is still inching higher. A number of traders are waiting for the VIX to spike towards 30% volatility before considering bullish positions. A few pundits expect that could occur soon. This week has enough drama in it that it could happen before September option expiration. We're not suggesting new positions at this time. Our target is the $29.75 mark. Readers might want to consider scaling out of positions in the 28-29 region.

FYI: More conservative traders might want to stick a stop loss under 22.00.

Suggested Options:
We're not suggesting new positions. We were using the October calls.

Picked on August 03 at $ 22.57
Change since picked: + 3.09
Earnings Date 00/00/00
Average Daily Volume = x million
 

Put Updates

Intuitive Surgical - ISRG - cls: 278.19 chg: +0.52 stop: 280.55

I am a little surprised that ISRG did not hit our stop loss on Friday but the market was not acting very bullish. Thus far resistance at the $280.00 level is holding. Of course Murphy's law will probably influence the situation and ISRG could spike above $280 on Monday, hit our stop, and then collapse! That's the way it goes. You have to play with stop losses. As long as the $280 level, bolstered by the exponential 200-dma and now the 10-dma, holds up as resistance we're going to let resistance do its job. I'd probably wait for a new decline under $270.00 before initiating new bearish positions. Right now we're only listing one target at $251.00. More aggressive traders might want to consider aiming for the January 2008 lows near $225 but keep in mind the $250 level could be strong support. This should be considered a higher-risk play because the stock price can be so volatile and the options can have wide spreads.

Suggested Options:
If ISRG provides a new entry point we'd use the October puts.

Picked on September 09 at $268.11
Change since picked: +10.08
Earnings Date 10/16/08 (unconfirmed)
Average Daily Volume = 655 thousand

---

Lamar Advertising - LAMR - cls: 37.16 chg: -0.14 stop: 38.01

The long-term trend for LAMR is lower. The bounce from its summer lows has failed at its descending 200-dma twice in the last few weeks. Early last week was the latest bearish reversal. More aggressive traders may want to buy puts now. We want to see LAMR break support near $36.00 first. We're suggesting a trigger to buy puts at $35.90. If triggered our target is 31.50 mark. More aggressive traders could aim for a new relative low.

Suggested Options:

Picked on September xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 11/06/08 (unconfirmed)
Average Daily Volume = 1.4 million

---

Roper Industries - ROP - cls: 58.13 chg: +0.09 stop: 60.55*new*

After looking more closely at ROP I'm starting to wonder if our stop loss is a little too tight. Look at the chart below and you can see the larger trendline of lower highs. More aggressive traders might want to adjust their stop to just over the $61.00 level. We're going to move our stop to $60.55, which is above technical resistance at the 50-dma and above the 200-dma. Wait and watch for another failed rally in the $59.00-60.00 zone as an entry point to buy puts again. Our target is $54.25. FYI: The Point & Figure chart is bearish with a $45 target but the P&F chart also shows some support near $53.00.

Suggested Options:
If ROP provides a new entry point we would use the October puts.

Picked on September 03 at $ 58.19
Change since picked: - 0.06
Earnings Date 10/23/08 (unconfirmed)
Average Daily Volume = 664 thousand

---

Unibanco - UBB - close: 108.53 chg: +5.65 stop: 110.85

Wow! We thought UBB might bounce but not all in one day. On Thursday we warned readers that UBB could bounce back toward $110 and its 10-dma. That's exactly what happened on Friday. Shares rallied to $110.38 before paring its gains a bit. This actually looks like another entry point to buy puts again. The rebound back toward $110 is a 50% retracement of its two-week sell-off. UBB has already exceeded our first target at $100.50. Our second target is $92.50. The Point & Figure chart has produced a triple-bottom breakdown sell signal and the bearish target has dropped from $92 to $84. The stock can be volatile so readers should consider this a higher-risk play.

Suggested Options:
We are suggesting the October puts.

Picked on September 04 at $108.82 /1st target hit 9/10/08
Change since picked: - 0.29
Earnings Date 11/06/08 (unconfirmed)
Average Daily Volume = 1.5 million
 

Strangle Updates

None
 

Dropped Calls

United States Oil - USO - cls: 81.49 chg: -1.48 stop: 77.45

Did you read the weekend wrap yet? A massive hurricane is hitting the Gulf of Mexico. Most of our Gulf oil and gas production is shut down. Yet the price of oil barely budged. Even a big drop in the U.S. dollar wasn't enough to spark a rally in oil on Friday. We're dropping the USO as a bullish candidate. More nimble traders may want to keep trying. We were looking for a dip near $80.00 (maybe $79.00) as a potential entry point to buy calls. At this point it looks like oil will continue to slide. It will bounce eventually but that bounce may not last very long. Our official entry point to buy calls was $80.50, which has not been hit yet.

Picked on September xx at $ xx.xx <-- Never Opened
Change since picked: + 0.00
Earnings Date 00/00/00
Average Daily Volume = 13.8 million
 

Dropped Puts

Valero Energy - VLO - close: 35.87 chg: +2.84 stop: 32.01

VLO has bounced from one edge of its trading range to the other. Shares are challenging resistance near $36.00 and the bounce has been fueled by strong volume. It is the big volume that makes this move look so bullish. A sharp reduction in the amount of gasoline available and the refinery shutdowns along the coast due to hurricanes is contributing to the rebound in VLO and the rest of the refiners. Aggressive traders might want to consider bullish plays if VLO can clear $36.25 or $36.50. I don't trust the bounce just yet and if VLO does break out we'll probably get another chance to jump in on a pull back. If shares can breakout broken resistance near $36.00 should become new support. Watch the 100-dma near $40.00 to be overhead resistance. Our plan for this bearish play was to buy puts at $28.99, which the stock never hit.

Picked on September xx at $ xx.xx <-- Never Opened
Change since picked: + 0.00
Earnings Date 11/04/08 (unconfirmed)
Average Daily Volume = 11.7 million
 

Dropped Strangles

None
 

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

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