Option Investor

Daily Newsletter, Saturday, 09/27/2008

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Table of Contents

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

Market Wrap

"The First Time since the Great Depression"

Market Wrap


The comparison to the Great Depression quoted in the title was excerpted from a MarketWatch article that appeared this week. That article detailed the record amounts of borrowing from the Fed's primary dealer credit facility. For the first time since the Great Depression, the article reminded us, non-bank primary dealers have been allowed to borrow from the Fed's discount window.

Other comparisons to the Great Depression have increasingly surfaced. Another MarketWatch article, also published on Thursday, referenced "Great Depression 2," when discussing how Federal Reserve Chairman Ben Bernanke responded to questions from lawmakers.

One reason for the references to the Great Depression can be found in the TED spread. The TED spread measures default risk. The TED spread's value has soared to levels exceeding those seen during the 1987 debacle. My Trader's Corner article last weekend covered the TED spread, updating an article originally published last May. I suggest you go back and read last weekend's version if you haven't acquainted yourself with the TED spread.

When I conducted the original research for that May article and then began updating subscribers to the Market Monitor daily, I had difficulty finding resource material. Financial presses have in the intervening months exploded with information about the TED spread. Everyone seems to be watching the TED spread because it's been telling us that, despite the government's plan to solve our dilemma and unfreeze the credit markets, little progress has been made.

One Financial Times article, while not specifically discussing the TED spread, nevertheless provided a chart that explains with a quick visual reference what's spreading in the TED spread.

Seizing of the Credit Markets
Source: Financial Times article published 9/24 and updated 9/25

This chart visualizes a flight to the safety of U.S. treasuries, their yields driven down, and a concurrent rise in LIBOR, the rate at which banks lend to each other. LIBOR has been rising. Why does this matter to us? Several reasons. This is the rate that banks loan to each other, but companies pay a certain number of points over LIBOR. With LIBOR rising, even those companies that can secure credit are doing so at higher and higher rates.

Companies may need to borrow from banks. Once again this week, the Federal Reserve's reports on outstanding corporate paper showed a severe drop, of $61.00 billion this week. The financials saw a $50 billion drop in outstanding paper. Corporate paper is the paper that corporations put out in order to finance their short-term needs. If outstanding corporate paper is dropping, either companies suddenly have no short-term needs they need to finance, an unlikely event, or else they're having trouble placing that paper. No one wants to buy it. That forces companies to go to banks for more expensive loans. These days, those bank loans are getting more and more expensive.

Not only that, but also the increasing TED spread points to another difficulty, one that threatens to freeze up the financial system. Several months ago, information was surfacing that banks wouldn't even loan to each other, but were hoarding cash. A rising LIBOR rate shows an increasing unwillingness of banks to provide those loans to each other. The FT article from which the chart was drawn noted another spread that was widening, saying that "the two-year swap spread reached 1.66 percentage points above the two-year Treasury yield--its highest in history."


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By Friday's close, the TED spread had narrowed to 2.92 from its high this week above 3.00. Friday's intraday high had been 3.11 and Thursday's, a whopping 3.37. All these values, even the 2.92 at the close today, remain well above the levels seen in the 1987 debacle..

A CNBC commentator Thursday evening summarized the concern expressed when the TED spread refuses to narrow: either there's uncertainty that the government's plan can be enacted or concern that it won't be effective if it is, or else there's some other big financial institution already in deep trouble and we just don't know about it yet. By Thursday evening, we had some idea that the last supposition at last was right: news surfaced about Washington Mutual being taken over by regulators.

Comparisons to our own Great Depression aren't the only ones being drawn. A spate of articles has compared our current situation to that of Japan, wondering if our government's currently anticipated actions mean we're doomed to follow Japan into a decade of stagnation. Some market pundits say it can't happen here, pointing out differences they consider obvious: claiming that Japan's housing bubble was bigger than the U.S.'s and that the U.S.'s FOMC had responded quicker than Japan's policy makers. An August 21 article found on Economist.com refuted some of those claims, with a chart included in that article concluding that in fact, the U.S.'s housing prices inflated more than Japan's bubble and that Japan acted quicker than our FOMC in the early stages to lower rates.

"A Tale of Two Bubbles" from Economist.com, August 21

Those were the comparisons being drawn this week, the worries exposed as Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and SEC Chairman Christopher Cox first crafted a plan and then spent days trying to convince lawmakers to pass it. By Thursday morning, lawmakers reportedly had cobbled together a version of a fundamental bipartisan plan that would be presented in a meeting with President Bush that afternoon. That plan would not hand over the full $700 billion the government estimates as the ultimate cost all at once, but would provide $250 billion at once, with the rest available later, if needed. Both presidential candidates were invited to the meeting, under the premise that one of the two would be dealing with the economy within a few months. Lawmakers spoke of finishing their work by Friday or Saturday, before recessing.

That Thursday afternoon meeting proved contentious, however, although it doesn't serve the purposes of this article to repeat salvos that each party lobbed at the other. I want to cover this as basically as possible without injecting any wording that would convey an opinion one way or another. Opinions among the public and presumably among our readership, too, have already polarized and I don't want to add to that polarization. The basics: a group of House Republicans presented an alternative plan.

The new plan proposed by House Republicans would insure all mortgage-backed securities, expanding the coverage from the half of such securities now covered, with the Treasury collecting premiums from the holders of those assets. According to press coverage, the House Republicans who presented the bill feel that it transfers the burden from the taxpayers to private capital.

Meetings took place. Press conferences were held. Assurances were made that a resolution would be found. The latest headlines late Friday afternoon have President Bush assuring the public that a deal will be reached by Monday.

Our country isn't the only one dealing with these issues. The U.K.'s Prime Minister Gordon Brown addressed the U.N. General Assembly saying that the crisis requires an international solution. Markets should first be stabilized and then the globe's international institutions should work toward transparency, regulation and responsibility, including "global oversight of international capital flows," according to an AP article by Michael Astor. While some might wince at the thought of an "international solution," the point of this comment is to note that the whole disconnect theory of last year has been proven wrong. We're all in this together.

All week, however, that TED spread was showing increasing danger that credit markets would freeze altogether. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson kept reminding lawmakers of the urgency of a quick decision, and SEC Chairman Cox and his employees kept adding names to the list of no-shorts companies, ranging far from the trouble financials originally covered. By Thursday, companies such as Zale Corporation and Autonation were on the list.

As if to emphasize the need for a quick decision, Federal regulators seized Washington Mutual late Thursday in the largest ever failure of a U.S. bank. The takeover of WaMu, with its $310 billion in assets, dwarfed the failures of Continental Illinois National Bank in 1984 and IndyMac this year, with their assets at $40 and $32 billion, respectively. Late Friday, another impending failure, covered in the last section of the Wrap, was to be characterized as a merger, and it was to be bigger than Washington Mutual.

Suddenly, the worries batted about last week about the FDIC running out of money assumed greater importance, but the FDIC announced that the WaMu seizure would not require the FDIC to dip into its insurance fund. As it had with Bear Stearns, JPMorgan Chase (JPM) took over WaMu, and all depositors and customers were assured of a seamless transition. JPM agreed to purchase certain of WaMu's assets, deposits and liabilities for a cost of $1.9 billion.

Last weekend, when I also substituted for Jim, I worried about submitting the article Friday evening, afraid that a resolution would be reached Saturday morning and the information I presented in the Wrap would be incomplete when it appeared in mailboxes Saturday evening. Here we are again at the same place, but this time, I have less worry that I'll turn in an article and that all parties will come to agreement minutes after I submit it. I've heard estimates that an agreement will be reached by the end of the weekend and avowals that it will take a week or two. You'd still be waiting for last weekend's Wrap if I'd tried to hold up its submission until an agreement was reached. This will be submitted Friday evening, so I urge subscribers to watch news reports Sunday evening for further developments.

The earlier optimism that markets will rebound immediately when an agreement is reached, having put in "the" bottom week before last, has waned, too. It wasn't an optimism that I personally shared, based on the monthly charts I included in last weekend's Wrap and will update in this one.

Ultimately, we could debate for hours the merits of what government agencies have done and will do in attempts to resolve this crisis. Politicians have been debating the merits, economists are, and Mom and Pop on Main Street are doing it, too. People whose only use of the word "swap" had previously been linked to the word "meet" are now debating why AIG used a faulty insurance-based assumption that because one institution failed did not mean that others would and why AIG failed to understand that each subsequent failure made those swaps in which they were counterparties more dangerous. In fact, who except a few Harvard attorneys and Wharton Business School graduates even discussed counterparties? We may discuss these terms and study them, trying to learn as much as we can as quickly as we can, but most of us can still empathize with policy makers and especially with lawmakers not well versed in the financial realm suddenly trying to understand the impact of the decisions that they'll make.

Friday morning, I read two articles, both by learned men. One applauded the firm stance the government had taken in the Freddie/Fannie solution and in letting Lehman sink. The other, Michael Kao, CEO and portfolio manager of Akanthos Capital Management, decried those same actions. Kao, writing as a RealMoney guest commentator, claimed the Fannie/Freddie action "eviscerated the preferred markets." Since I have little experience in the preferred markets, I'll let his words speak. Formerly AA-rated securities dropped to "mere cents on the dollar overnight," he said, adding that, "this market was one of the only capital markets that remained open to financial institutions in the last eight to nine months, and it raised $80 billion during this period from straight and convertible preferred issuance." He warned that allowing Lehman to fail "severely eroded confidence between counterparties."

Kao blamed these actions and others, such as the no-shorts rules, for the "harrowing near-deaths" of Goldman Sachs and Morgan Stanley. We options traders have worried about what that no-shorts rules mean to our options trades, and Kao warns that the convertible bond/preferred market is being adversely impacted "because its main participants are arbitrageurs who require the ability to short out their equity exposures for bona fide hedging purposes."

He echoed a warning that others have increasingly mentioned, that we look to Pakistan's example if we want to see what banning short-selling can do. After Pakistan banned short selling, equity markets experienced a massive short-covering rally, but when that was finished, equity markets quickly dropped 26 percent in the following weeks and month, he says.

So, while we all want a quick solution and I personally worry about the consequences of no quick solution, we also all must worry about the effects--especially the unintended ones--of the actions taken. Few of us can understand all the implications of the actions, and we should perhaps exercise some understanding toward those who are working so hard to do so. While I expressed worries last week about the unintended consequences to options market makers and traders, some of which are being realized in wider spreads in some options series, I never thought about that convertible bond/preferred market because it's not a market in which I'm active.

So, we must voice our concerns but also exercise patience for those whose opinions or experiences differ from ours. As options traders, I suggest we exercise something else: caution. We don't know how our trades will ultimately be impacted. This is not the time to plunge into new trades or employ unfamiliar strategies.

And then I suggest that we allow ourselves to hope. We've been in tough places before, and we're a resourceful people. The fact that we are so passionate about our views and so willing to voice them perhaps increases the possibility that a resolution will be cobbled together, that some voice somewhere will propose a workable solution that others will embrace.

Let's look at charts. As was true last weekend, I want to look at monthly charts so we get a better perspective on what's going on. Then we'll look at intraday charts in the last section, to give us a close-up view.


Annotated Monthly Chart of the SPX:

Vulnerability to the bottom of the channel must be factored into trading plans, providing the background against which shorter-term action takes place. There's no guarantee that the SPX will slide lower, but the possibility certainly exists.

The weekly chart's (not shown) candle showed the lowest weekly close since October, 2005. That's obviously bearish. Couple that news, however, with the realization that weekly candles have been springing up from support, leaving lower shadows behind. If in bearish positions, I usually start getting nervous when I see a number of candles in a row with long lower shadows, as someone is doing some buying as prices probe those lower values, sending prices back up again. If only candle bodies are considered, then the SPX this week broke below the support that it had been forming with all weekly closes above 1239.49 in the last few months. If one looks at those lower shadows, though, bears would be advised to keep updating their just-in-case profit-protecting plans. That leaves chartists with some difficulty interpreting the charts, but that's not unexpected. We're in a situation in which big money doesn't know what's going to happen next, and trying to read the tracks they've left behind provides little help since they, too, seem to be running in circles.

The daily chart unfortunately provides little clarity. That chart suggests that a climb toward 1249 appears about as likely as a drop toward 1175, and vice versa. Think in terms of vulnerabilities to certain levels, consider lowering the risk you're willing to take in trades and well as, in some cases, the time frame you'll stay in a trade.

I'll say this: nothing on those charts can yet prove to me that we can't have another sharp downturn in a typical September/October pattern or at least to test the previous low.

Annotated Monthly Chart of the Dow:

The Dow did not close the week below the weekly low reached on the week of July 7, but it wasn't far off it, either. The narrower Dow is easier to prop up or even send higher than a broader-based index such as the SPX or especially the NYSE, so its out-performance on the daily chart (not shown) should be taken with a grain of salt. That chart gave a slightly higher chance of the Dow reaching toward 11,330 than of dropping toward 10,590, but only a slightly higher and not quite trustworthy greater chance. RSI on the daily chart has been squiggling along either side of the neutral 50 most of the week, and the chart pattern defies definition. Is the Dow chopping out the parameters of a big triangle at the bottom of its decline? Is it instead forming up a wide channel of higher highs and higher lows, a possible bear flag but a wide one in which it might retrace a significant portion of the decline from last year's high before dropping lower again? Pick your bias, but be aware that nothing seen on that monthly chart yet negates the idea that Dow could slide back down to retest that big channel's support.

Annotated Monthly Chart of the Nasdaq:

The Nasdaq closed its week at its lowest weekly close since 2006 (weekly chart not shown). Weekly candles are sliding lower along the midline of its descending price channel. It's been piercing that midline, however, with the candle bodies closing at or above it and with long lower shadows left below, so bounce potential must be considered here, too. Vulnerability to the lower support of the channel must be factored into trading plans, but bears should also be factoring in the possibility that the Nasdaq will either slide lower along the midline rather than drop all the way to the lower red trendline or bounce. If the Nasdaq scrambles above about 2185 early Monday morning and maintains a daily close above that, then its daily chart (not shown) presents the possibility that the Nasdaq could climb toward 2281. Remember the possibility that an early morning climb could be quickly reversed back below about 2185, too, however.

Annotated Monthly Chart of the SOX:

The SOX's weekly chart (not shown) illustrates that since breaking below the 335-ish support on weekly closes about a month ago, the SOX has been churning just below that. It hasn't fallen away steeply but neither has it scrambled back above that former support. That chart shows that it's as likely to find resistance on weekly closes at about 341.50 as it is to find support on weekly closes at above 311 or perhaps 297. The daily chart (not shown) sets up a similar tale, although it would lower the likely resistance level on daily closes to about 338-339.

Annotated Monthly Chart of the RUT:

The RUT's weekly candle (not shown) was an ugly one, a bearish engulfing candle that threatens to send the RUT lower, but there's a caveat. It occurred in the middle of a months-long choppy consolidation zone and it stopped right at the weekly 72-ema. Although there was a spring off that weekly candle, too, as well as the daily one, the daily candle formed beneath likely strong resistance. The daily Keltner chart suggests that unless the RUT can produce daily closes above 710.50 and perhaps not even unless it can produce daily closes above about 720, it's vulnerable to another drop, perhaps toward 671.

Annotated Monthly Chart of the TRAN:

The TRAN is obviously in a chop zone. It's holding up near its high, at least when viewed on a monthly or weekly (not shown) chart. The possibility of a double-top formation exists, but it requires a drop below 4032.88 before it's confirmed. The possibility of an upside break also exists, but I would suggest you require at least a weekly close above previous highs before you believe too strongly in any upside breakout. The weekly and daily charts present the possibility that the TRAN could be trending down toward 4546 or perhaps even its weekly 200-sma, now at 4476, but perhaps not until another pop up toward 4843.

Why is the TRAN important? In past times, the TRAN has been important because it's sensitive to both crude prices and economic outlook. It tends to lead the SPX, OEX and Dow, and it's obviously not leading to the downside.

While I would never utter those dreadful words "it's different this time," some special considerations should be noted here. In this case, I'm not so sure of the importance of the TRAN's leading or not leading. Although some economic releases are disappointing and showing the possibility of increasing weakness, both here and abroad, others are not so conclusive and the TRAN may be reacting accordingly. However, our greatest immediate danger currently is a crisis in credit, not recessionary fears. When those fears fully assert themselves, we may find the TRAN tumbling down, or, if the credit crisis is resolved, we may find it breaking higher after a period of stabilization. For now, it's diverging and that should be watched. It's not giving us a lot of information now, but it may provide more when it finally breaks one direction or another.

Annotated Monthly Chart of the NYSE:

The NYSE is the broadest of our indices and it's taken over a leading role from the TRAN. It's been leading down. The weekly chart (not shown) shows that its weekly close was the lowest since late '05, but it, like some of the other indices, has been producing weekly candles with lower shadows. While a slide lower along that lower red trendline not only is possible but may in fact be likely, bears should be aware of the possibility of a break up toward the weekly 9-ema, now at 8221.60. The NYSE has not produced a weekly close above that 9-ema since the week of May 28, 2008, so a weekly close above it would be a short-term change in tenor. Until that happens, watch for likely resistance on a weekly close at that level. The daily chart gives about equal likelihood that the NYSE will climb to test 8160 as that it will drop toward 7684.

Length requirements don't allow a presentation of all charts that might be important and my personal area of expertise might vary from that of other commentators. However, it's important to note that worries about the bailout that have spread across the globe have sent some investors rushing into the perceived safe haven of gold while some other commodities sink amid worries about demand.

This Week's Developments

For the second week in a row, so many events have occurred so quickly that developments that would have been considered extraordinary and worthy of whole articles in themselves must be brushed aside. That includes some of this week's economic releases. The Richmond Manufacturing Index, House Price Index (HPI), Existing Home and New Home Sales, Durable Goods Orders, and the Final GDP all disappointed.

Friday's revision lower of the GDP resulted at least in part from a lower personal consumption reading. The Price Index component eased to 1.1 percent from the prior 1.2 percent.

Friday's revised University of Michigan Consumer Confidence came in on or near target, but below the prior 73.1. The expectations component rose to 4.3 percent.

Research in Motion (RIMM) also reported this week, with the company's outlook and results disappointing, despite revenue and net income growth that was solid.

Other developments on Friday included a speech by President Bush, a brief talk in which he assured the public that the country would find some consensus on the method by which financial companies would be funded. Other press conferences occurred with other speakers assuring the public that an agreement could be reached while warning of significant consequences if one was not. Democrats and Republicans agreed to postpone their recess and returned to negotiations to complete a plan.

Next Week's Economic and Earnings Releases

What about Next Week?

As I warned last weekend, developments this weekend will likely trump anything shown on these short-term charts or any scheduled events listed on that calendar. In addition, market participants appeared to fear some settlement of the crisis and bailed from bearish positions into the close, with the last-minute positioning somewhat untrustworthy and distorting the chart action. Still, let's see what we can see.

Annotated 30-Minute Chart of the SPX:

Choppy price action is apparent with most of the week spent chopping between a 38.2 percent and 61.8 percent retracement of the rally from the 9/18 low into the 9/19 high. Friday's action in particular took the choppy back-and-forth action of a bear flag climbing off support, with the SPX then stopping short of besting Thursday's high.

For the sake of the clarity of this short-term chart, I have not drawn the flag, but the SPX needs to sustain values above Friday's high to avoid the possibility of falling back toward the flag's support. If the OEX does sustain those higher values, first resistance on 30-minute closes is now near 1225, but would be shoved higher by any strong rise early in the day. Therefore, I would be careful of any early punch higher to the 23.6 percent Fib level that then falls back beneath about 1225 and maybe even 1230 by the end of the first 30-minute period.

If the SPX drops immediately Monday morning, as is at least possible, watch for potentially strong support on 30-minute closes near 1203-1205.80. If that support doesn't hold, and particularly if 30-minute closes are beneath 1199, then vulnerability to 1187 and perhaps 1175.63 must be considered. As long as the SPX chops between about 1175 and 1225, it's in a chop zone, and technical indicators may be less and less predictive of what happens next. Breakouts above or below those levels, sustained on 30-minute closes, could result in strong moves either up to the 9/19 high and beyond or down to the 9/18 low and beyond.

Annotated 30-Minute Chart of the Dow:

Similar setup. As long as the Dow maintains 30-minute closes above about 11,085, it maintains a possible upside target of 11,202, but that will get shoved higher by any early climb. Watch for potential resistance on 30-minute closes beginning about 11,200 and extending up to about 11,240. Be wary of an early breakout toward 11,270 that is quickly reversed back below 11,200 and particularly below the rising red 9-ema. If an early breakout were maintained, however, a retest of the 9/19 high might be possible, although I would watch for potentially strong resistance there.

If the Dow descends immediately Monday morning, as could happen, watch for potentially strong support on 30-minute closes first near 11,080-11,090 and then near 10,980-11,020. A failure to maintain 30-minute closes above that zone could set the potential for a drop toward 10,900 or even 10,700. A breakdown there, confirmed by a 30-minute closes beneath that support, suggests a potential drop toward the 9/18 low.

Annotated 30-Minute Chart of the Nasdaq:

The Nasdaq climbed in a formation that looks like a bear flag and stopped cold at the 120-ema as well as gap resistance. A breakout above that resistance, confirmed by 30-minute closes above it, targets black-channel resistance, which is likely to be shoved toward the 38.2 percent Fib level shown above. Watch for likely strong resistance there. A breakout there suggests a move toward 2260 and perhaps even the 9/19 high.

But the Nasdaq looks weaker than some other indices, with those others looking neutral while the Nasdaq remained in the lower half of the Keltner channels shown here. Sustained 30-minute closes beneath the 9-ema and particularly below about 2164, it sets a potential downside target near 2135.65 and perhaps down to 2128 by the time it's tested.

Annotated 30-Minute Chart of the Russell 2000:

The RUT, like the Nasdaq, spent the end of the week in the lower or bearish half of these Keltner channels and, also like the Nasdaq, stopped at the top of its gap from Friday. The possibility of another pullback exists, perhaps not until a bump up to test 708-710. If the RUT does pull back, watch for potentially strong support on 30-minute closes at its 30-minute 9-ema, now near 701, as this average sometimes has special relevance for the RUT. Sustained 30-minute closes beneath it, however, would suggest a drop down to 693-694. A breakout above 708 on 30-minute closes, suggests a test of 715-717, where next resistance might be strong.

In other words, the RUT may be setting up a pattern similar to the SPX's, in which it chops between two Fib levels before deciding next direction. Breakouts above or below black-channel resistance or support, confirmed by 30-minute closes, suggest moves up to or down to the next Fib levels, where chop might resume.

Taken all together, we must cast anything seen on short-term charts in the light of monthly ones that show all these indices firmly ensconced in descending price channels or patterns. That hasn't changed from last week. Until they break to the upside out of those channels or price patterns, nothing has changed, as simplistic as that sounds, and resistance at the top of those channels must be presumed to remain resistance. Further downside potential and perhaps sharp downside potential remains and must be factored into trading plans without counting on it happening. I hope it doesn't happen.

Cast against that, we have short-term action that shows that mostly spent the week chopping between certain Fib levels. The longer they chop there, the more indicators and moving averages and Keltner channels will flatten. Bollinger bands will narrow. Little guidance will be offered. Charts are in waiting patterns. We're in waiting patterns. The financial sector is, big money is, and the whole world is.

Of course, big events--resolution of the crisis, failures of other banks, news of big investments by other tycoons and any number of as yet-unforeseeable events--could break the indices out of those chop zones. Don't assume that you know the direction they'll break, however, piling on more risk than is optimal for you, your personality and your trading account. Big negative news could send markets reeling only to have that trigger buying the bottoms of those channels are hit again. News of the resolution could result in a bounce that's promptly sold into in a buy-the-rumor, sell-the-fact reaction.

In the old world paradigm, before sending my articles off for publication, I used to check afternoon news sources to make sure some company had not warned or else announced upbeat news that would change the landscape the next days. It's a sign of our new financial world that Friday evening, before submitting this article, I checked financial print and television sources to make sure that no bank failure had been announced.

What did I find? Wachovia (WB) was in talks with Citigroup (C), and perhaps also Santander and Wells Fargo, with those early stage discussions centering on a merger, but being called another bank failure (of WB) by some sources. Wachovia is bigger than Washington Mutual, and the FDIC wants a deal like Washington Mutual's to be put into effect, so that it doesn't have to pay claims from its funds.

As I have urged so many times lately, spend time with those people and activities that renew you. Relish your part in making history, as difficult as that can be, as we're all taking part. Educate yourselves about the candidates and exercise your vote to change what you want changed. Have hope, but don't hope yourself into more risk than is optimal for you. Standing to the side and watching can be a wise action these days.

Trader's Corner

Not Just a Coincidence

When I was writing fiction, I avoided coincidences. Readers don't believe in coincidences, I was taught and went on to teach others. It's the sign of a lazy writer.

Coincidences happen more in real life than they do in fiction, however, and one happened recently. Just after sending in a recent Trader's Corner article on the Granville's OBV or on-balance-volume indicator, I picked up an old STOCKS & COMMODITIES magazine. An article referenced OBV when introducing another indicator that links price and volume. Granville's OBV was created to "uncover hidden coils in an otherwise noneventful, nontrending market," Buff Pelz Dormeier wrote in "Between Price and Volume" (25: 7, 21-28).

Dormeier wasn't writing about OBV, however. Dormeier was introducing another indicator that links price and volume: the VPCI or volume price confirmation indicator. If you didn't read the prior article on OBV, you might be wondering, what's the big deal about indicators that link price and volume? The big deal is actually two big deals. The first is that volume tends to lead price.

The second is that price and volume are independent measurements. Many indicators rely on inputs related only to price. However, that means that the indicator itself correlates rather well to the price action. While such indicators can offer hints about the strength of the price action, they can't be considered independent of that price action.

Volume is different. As mentioned in the Trader's Corner article several weeks ago discussing OBV, volume and price are non-correlative. Prices can move up while volume moves down. Price can decline while volume rises. Volume can be huge and prices can stay where they are or can move in a matching huge range. As Dormeier states, volume measures "participation, enthusiasm and interest" (21). The two are independent of each other.

What's the problem with correlative indicators? In an article on neural networks, Connie Brown employed an example that pinpoints the problem. "As an example," Brown writes in "Neural Networks with Learning Disabilities" (STOCKS & COMMODITIES, V. 11:5, 207-214), "it is generally accepted . . . that Eurorates and the price of gold are significant factors to forecasting the US dollar against the major currencies." Trying to use such highly correlated inputs to forecast movements of the US dollar against the major currencies is an example of one "major trap of financial forecasting." While highly correlated inputs might confirm price movement, they may not be as helpful in forecasting it.

Dormeier cautions that OBV and VPCI are used differently. While OBV picks out "hidden coils" in disorganized markets, VCPI depicts the health of trends already underway. Dormeier believes that VCPI gives earlier signals and that backtesting show it would have provided superior gains on lower risk. (I offer caution about relying on backtesting results when making trading decisions. Test it for yourself in real-life trading.)

A portion of a TM weekly chart provided in the article shows how VPCI looks.

Annotated Weekly Chart of TM (Stocks & Commodities, V. 25:8, 26):

Someone must have agreed with Dormeier's conclusions about the usefulness of VPCI. Dormeier's work on the VPCI proved so masterful that he won the Market Technicians Association's 2007 Charles H. Dow Award for a work that either used established techniques in innovative ways or broke new territory. Consider this: in its press release noting the conferring of the award, the MTA said it grants the award only if it discovers a work that warrants it. It's not automatically given each year. At the time Dormeier received it, three years had passed since the MTA had last granted the award.

Unfortunately, a canvass of other technicians turned up information that VPCI didn't appear to be included as an available indicator on StockCharts, QuoteTracker or QCharts. Stocks & Commodities did provide formulas and programs for the VPCI for TradeStation, MetaStock and eSignal, as well as several other charting programs. Those subscribers who use those charting platforms could try the indicator.

Calculation of the VPCI requires several steps, with each step meant to determine whether VPCI is positive, confirming the trend, or negative, contradicting it, and to weight each confirmation or contradiction. After the VPCI is constructed, a smoothed VPCI can be added as was done on the chart shown above. Crossovers up through or down below the smoothed VPCI signal confirmation or contradiction of a trend.

Those of us using QCharts, Stockcharts or QuoteTracker do not yet have access to the VPCI, but Dormeier's work still confirms the importance of at least considering some non-correlative studies in our technical analysis. Until now, I typically have preferred my volume patterns rather pure, studying price spreads in conjunction with volume patterns, but then I don't tend to trade directionally. For those who do and can employ the coding provided by STOCKS & COMMODITIES, it might be worthwhile to check out Dormeier's VCPI as a method of confirming or contradicting trends. Those using QCharts, Stockcharts or QuoteTracker still have OBV and other studies combining price and volume studies, but Dormeier's work has still helped. It's pointed out the necessity of understanding just how a given indicator is best used.

Index Wrap


Will or won't Congress pass the proposed monster rescue package? The big question in the season for political football! I find it difficult to say based on a technical read as to where the major indexes are going next. They look like they are 'basing' more or less in the area of the July lows and that the major indexes might not piece their September lows, but the reality is also that the market has been in a downtrend since highs were made a year ago. The S&P 500 (SPX) has now fallen under its 2006 closing low at 1236; the S&P 100 (OEX) closed a scant 2 points under 567, its prior closing weekly double bottom low from 2006 and July '08. Still holding above their 2006 closing lows are the Dow 30 and the two Nasdaq indexes.

In terms of how oversold this market is, it's getting there on a long-term weekly chart basis but isn't quite at such extremes all around and especially is not when viewed on the daily charts. As far as the market timing indicators I rely on, trader sentiment got to a bullish 'overbought' extreme on the sharp run up into a week ago this past Friday. I warned last weekend that this looked bearish and I exited index calls bought on that strong Thursday-Friday rebound. I didn't start out to be such a short-term trader but the inflated expectations looked unrealistic and that the sharp bounce had much to do with short covering.

Assuming there is a Congressional agreement hammered out this weekend or fairly soon in the coming week, based on the charts, it looks basically sideways after that; maybe there's one more shot down to retest recent lows. In fact, without an agreement, there's probably just one more significant sell off ahead also. In that case, it's a tossup whether recent lows hold or not.

The bullish case given a settlement deal is I think at most for a rebound back to the 1300 area or to the 'line' of its August highs in SPX, but probably not to more than 2350-2370 in the Composite, which would be well under its August peak (at 2452).

Please e-mail me with any questions or comments at Click here to email Leigh Stevens support@optioninvestor.com and put "Leigh Stevens" in the subject line.

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.



The S&P 500 (SPX) index rebound from under 1150 to the 1265 area met resistance implied by the low end of the prior trading range. The rally looked unsustainable given the rapid rise and a short-term overbought extreme but especially by the major jump in bullishness I mention above (and you'll see vividly on my sentiment indicator displayed along with the S&P 100 chart coming up). Sure enough, it was downhill again on Monday.

Another decline to the 1150 area is my most bearish outlook currently. If SPX manages to show renewed upside momentum by closing above its 21-day moving average (currently at 1231.8) and then above 1265, a rally could extend to at or near 1300 again and is my most bullish expectation at present. I suspect SPX is going to be confined to a trading range in this uncertain period and don't see any sustained up leg setting up.

I've noted support at 1180, then in the 1150 area or a bit under; e.g., at the prior 1133 intraday low. Another shot down could pull the RSI to an oversold extreme again, which is more typical of intermediate-term bottoms.


The S&P 100 (OEX) chart remains within its bearish downtrend channel at about midrange between 525 and the low end of this channel and 610, at the upper trend channel line. Near resistance is at the 21-day average at 569 currently with next resistance at 583, 595, then at 600-604.

Near support is at 545, then at 530, extending to the prior intraday low at 523. Below support in the 520 area, major support comes in around 485. I anticipate a trading range affair ahead between perhaps 530 on the downside and upside resistance at 583, which extends to 590-595.

Bullish sentiment appears too high to suggest that OEX will mount any sustained advance. The index would need to close above 600 for more than a single day to suggest a bullish chart breakout above the price range I've projected.


Not much change in the key support/resistance levels and the chart overview for the Dow 30 Average (INDU), except that we've now seen a low (at 10459) that touched the bottom end of a broad downtrend channel dating back many months. The rebound off that technical support didn't get up beyond the 21-day moving average except as a 1-day affair. I believe that the low end of the channel will continue to 'define' support, so we have an idea of the parameters of support. Near resistance continues to be seen in the area of the declining moving average.

I've noted support at 10800, then in the 10600 area. Resistance comes in around 11200, then up at 11500.

A tough period to trade DJX index options on an outright basis, given the sideways trading range pattern INDU has been in. There was an opportunity in puts with entry made after the repeated failure to break out above 11800 OR on the break below up trendline support in early-Sept, with exit on the sell off to the 10500 area at the lower channel line. For nimble traders, a call buying opportunity also came on the decline to and under 10500, especially sweet if a profit was grabbed on the rapid rebound to 11400.

The price swings have been fast and furious and quickness has been called for in the aforementioned trades. The safest course looks like staying out of buying calls or puts and to utilize strategies that take advantage of a range-bound trade. I calculate that the Dow is going to be locked in such a range for a while yet. A bailout may supply a short-term pop, but unknown is how far to a bottom in earnings needed to propel a sustained rally.


The Nasdaq Composite Index (COMP) remains bearish in its pattern. The latest decline has now equaled the extent of the decline seen in its prior downswing from May high to July low. Such a 'measured move' objective could mean that the recent intraday low at 2070 may be an interim, if not 'final', low for the current move.

Support has developed in the 2150 area, but rallies have been anemic so far. Lower support is at 2100, extending to the prior recent low at 2070. Near resistance is at 2200, with a next resistance implied by the declining 21-day average, currently at 2240. The prior rally high at 2318 has to be assumed to offer resistance again, with further resistance estimated for the 2350 area.

I have no solid conviction about what how the next significant COMP move will unfold. The chart and some indicators suggest potential for another rally. The last rebound showed the potential for an oversold rebound even though short-lived, after price action traced out a classic key upside reversal. While the trend remains down and prices may drift sideways to a bit lower, I don't look for a big further decline.


The most bullish thing that can be said about the Nasdaq 100 chart pattern is that the Index has gotten to the low end of its downtrend channel and may have limited downside risk from here. Perhaps a move to the 1600 area, but that's about the most bearish projection I have currently. 1650 looks like a very near support. I'm anticipating looking to buy NDX calls again if the index fell again to the low-1600 area, setting an exit point if the index fell to 1580 and with a minimum objective to 1750 once more.

I estimate very near resistance as being in the 1700 area, then as noted by the red down arrows, at 1750, then at 1775; a close above this prior swing high would be bullish on at least a short-term basis, suggesting further upside potential perhaps to as high as 1850. (If so, I'd be a buyer of the October 1850 puts.)

I don't have a similar projected target on the downside if NDX were to break below 1600. Major support implied by the 2006 lows lies in the 1450 area.


This dog won't hunt! The Nas 100 tracking stock (QQQQ) has had short-lived rallies with buying interest quickly fading and the bears back in control. Near support is at 40, with next lower support suggested by the low end of my highlighted downtrend channel at 39.25.

Near resistance is at what was prior support at 42, next resistance implied by the 21-day average at 42.9 and then at 43.8, at the prior recent intraday high.

If short, any advice from me to cover would be contrary to the trend. When I've thought that there is not much further downside potential, prices keep sliding lower. Ah, the beauty of being short stock versus long puts sometimes, as there's no erosion of premium! If I give up on picking a bottom, can a rally be far away!?

The spikes in daily trading volume in QQQQ have continued to come on the declines, suggesting continued liquidation and which keeps the volume pattern concurring with bearish price action. A sizable volume surge on a further big upside move would be encouraging for the bulls and suggest new buyers coming in, not just buying by those short the stock.


You know the old saying about 'location, location, location' in real estate. With the Russell 2000 (RUT), it's 'trading range, trading range, trading range'. RUT has slid to 675, not yet to the line of prior lows around 652-650, but another decline to this area remains a possibility.

Recent price action suggests again that RUT may stay confined to the 100+ point range of recent months. A close above 720 would suggest some upside momentum, but such a move might only lead to another rebound to the low-760 area followed by another period of price weakness. I've noted near support at Friday's low at 691, then at the recent 675 low.

If there were another decline to the 650 area, I'd be a buyer of calls, risking to 640 and with trading objective to 753.


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]
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.

New Plays

Most Recent Plays

Click here to email James
New Option Plays
Call Options Plays
Put Options Plays
Strangle Options Plays
SRCL None None

Play Editor's Note: We strongly debated not adding any new plays this weekend. A number of professional traders have gone to all cash or if they are trading they're trading very small positions. I continue to stress that the best trade here is probably no trade at all. Sitting out on the sidelines is perfectly fine. The prevailing wisdom is that congress will eventually come to some sort of agreement on the bailout plan before Monday morning. However, there is a large camp of investors and market pundits who are calling it a coin toss whether or not an agreement is reached. No agreement on Monday means more volatile and probably more losses by the end of the day.

Please note that if/when an agreement on the bailout plan is reached I do expect a bounce but I don't expect the bounce to last very long. The rescue effort doesn't change the underlying economic environment, which is slowing. I would be watching very closely to short the bounce as it begins to falter. We're still in a bear market. Furthermore the end of September could see a lot of selling from funds facing rising redemptions. They don't have to do all of their selling by September 30th. It could carry into the first few days of October.

FYI: CEPH broke out from its multi-week trading range. The MACD turned bullish. Friday's move or a dip back toward $78.00 looks like an entry point on CEPH. Meanwhile Friday's bounce in FLIR also looks like a potential entry point for calls. Unfortunately, my big-picture market outlook is just too bearish. Readers will want to keep an eye on airline stocks. The U.S. dollar is likely to roll over, which will push oil higher and thus airlines lower.

New Calls

Stericycle - SRCL - close: 63.24 change: +0.90 stop: 60.99

Company Description:
We are a business services and consulting company that specializes in protecting people and reducing risk. Our services include medical waste disposal and sharps disposal management, product recalls and retrievals, OSHA compliance training, pharmaceutical recalls and medical device returns, healthcare on-site waste stream management, pharmaceutical waste disposal, medical safety product sales, and high volume notification services. (source: company press release or website)

Why We Like It:
SRCL looks like a tempting bullish candidate. The stock broke out to new highs in mid September. Recent market weakness has pulled shares back toward previous resistance, which is now new support. Friday's bounce from this region of support looks like a new entry point to buy calls. The Point & Figure chart is bullish with an $84 target. While the technicals are positive for SRCL this doesn't mean shares won't decline if the broader market crashes next week. If an agreement on the government's bailout package for the financial sector isn't reached by Monday morning I would strongly hesitate to open new bullish positions in SRCL or anything else for that matter. We're going to try and play with a tight stop loss to minimize our risk. We have two targets. Our first target is $66.00. Our second target is $69.00.

Suggested Options:
We are suggesting the November calls.

BUY CALL NOV 60.00 URL-KL open interest= 308 current ask $5.90
BUY CALL NOV 65.00 URL-KM open interest= 416 current ask $3.10
BUY CALL NOV 70.00 URL-KN open interest= 405 current ask $1.35

Picked on September 28 at $ 63.24
Change since picked: + 0.00
Earnings Date 10/23/08 (unconfirmed)
Average Daily Volume = 624 thousand

New Puts

None today.

New Strangles

None today.

Play Updates

Updates On Latest Picks

Click here to email James

Call Updates


Put Updates

Volatility Index - VIX - cls: 34.74 chg: +1.92 stop: n/a

The failure of congressional leaders to come together on a bailout plan raised investor concerns on Friday. The VIX gapped higher Friday morning and looks like it could be setting up for another spike toward 40.00 again. Another failed rally-type of pattern around 40.00 would be a new entry point to buy puts on the VIX. We are eliminating our second target at 21. While we are keeping the target at 25.50, if you're opening new put positions in the 36-40 zone you may want to set an early target at 30.50 to take some money off the table. I would expect the VIX to move sharply on Monday as the market reacts to any developments or lack thereof on the bailout plan. If you're opening new plays, use the November strikes.

Suggested Options:
Aggressive traders could still use October puts. We're suggesting November puts if the VIX offers another entry point.

Picked on September 16 at = 30.30
Change since picked: + 4.44
Earnings Date 00/00/00
Average Daily Volume = --- million

Strangle Updates


Dropped Calls

Allergan - AGN - close: 55.29 change: -2.09 stop: 55.29 *new*

On Thursday we were concerned that AGN's bounce might roll over under its 200-dma and we suggested readers considered an exit or raise your stop loss. We raised the stop to $55.29 and AGN quickly hit our stop on Friday morning. The action over the last few days has grown more and more bearish and if AGN trades under the early September lows it could portend a drop back to the $50.00 level.

Picked on September 21 at $ 58.68 /stopped out 55.29
Change since picked: - 3.39
Earnings Date 11/06/08 (unconfirmed)
Average Daily Volume = 2.4 million


Washington Mutual - WM - close: 0.16 change: -1.53 stop: n/a

WM has become the latest and one of the biggest casualties of the financial crisis on Wall Street. The company was the largest thrift in the nation and the Office of Thrift Supervision decided on Thursday night that WM's liquidity had become insufficient to meet its obligations. The government seized the company and its assets, handed it over to the FDIC who orchestrated an auction. The winner bidder was J.P. Morgan Chase who paid $1.9 billion for all of WM's deposits, assets, some liabilities, while also gaining its thousands of branches and employees. We warned readers that this was a speculative bet and our risk was the government stepping in. What surprised us was the speed at which WM suddenly took a turn for the worse. The company didn't even make it to bank-failure Friday when the government normally announces the failed banks it's taking over. It was only a few days ago that six different banks from around the world were looking at WM as a takeover candidate. We thought at least one of them would have been a bidder for the company.

Picked on September 21 at $ 4.25 /bankruptcy
Change since picked: - 4.09
Earnings Date 10/22/08 (unconfirmed)
Average Daily Volume = 113 million


SPDR S&P Oil - XOP - cls: 48.58 chg: -2.07 stop: 48.45

Both crude oil and the dollar spent most of Friday's session churning sideways. Yet the oil and oil service stocks hit some profit taking on Friday morning. The XOP dipped to $47.08 by lunchtime before paring its losses. On Thursday we had raised our stop loss to $48.45 so the play was closed early on. This ETF had hit our first target on September 19th.

Picked on September 16 at $ 46.70 /1st target hit 9/19/08
Change since picked: + 1.88
Earnings Date 00/00/00
Average Daily Volume = 2.0 million

Dropped Puts


Dropped Strangles


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


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