Option Investor

Daily Newsletter, Monday, 09/29/2008

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Table of Contents

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

Market Wrap

Have We Bottomed\?

Market Wrap

As I watched todays trading action I tried to make sense of the volatility and get a handle on the answer to the most asked question of me Have We Bottomed? The best way to answer that question is to pose one to you, the reader and option trader. Did the market capitulate today? Has Main Street thrown in the towel and cashed out of the market? Have you taken your money out of the banks? Normally, I would point to the CBOE Volatility Index ($VIX) and point to the $VIX hitting 48.40, a level not seen since 2001. But with the up tick rule still out of the picture, the market can decline further and with more conviction than in the past. I realize that the financials are off limit, but do you really think that the Smart Money has been waiting for October 2nd to get short the financials? They are selling anything with a pulse in order to push the markets to the brink. By selling short oil and the energy complex, for example, the markets have been in a freefall and have pulled the Financial Sector along for the ride. By carefully selecting the proper sectors that have the most influence on the general markets (sector weightings), large institutions can affectively push the markets around and trigger other institutions to initiate sell programs. Is this market manipulation? Not in my book. If I had billions to trade, I would do the same exact thing. The Cascade trade is an effective tool for institutional investors. In normal markets where large investment banks have investment capital for proposition trades, a company like Morgan Stanley could downgrade a company like Apple Inc., as they did today, to possibly buy or cover a short a highly correlated competitor at a much lower price or force the NDX below a short strike price in order to save a large short NDX Call prop trade. I realize it all sounds like conspiracy theory but there are legal methods to move the markets. In todays market place, I wouldnt be surprised if a large Prime Brokerage client of Morgan Stanley requested the timing of the AAPL downgrade to coincide with the cross currents of the Bail Out package.
Todays internals may have pointed to signs of capitulation. On the NYSE, there were only 53 advancing issues and 2842 declining issues. That means that only 2% of NYSE stocks advanced today. There were only 17 New 52-Week Highs versus 1,055 New 52-Week lows on 2.6 Billion shares traded. However, the ARMs Index or TRIN was only 0.52 which suggests more selling. Usually, we look for the TRIN to spike above 2.0 to initiate an overnight long signal.

Today on the NASDAQ, there were 424 advancing issues versus 2,563 declining issues. There were 22 New 52 Week highs versus 685 New 52 Week lows. The NASDAQ had about 2.8 Billion shares traded today. Money came into the treasury market as the return of ones money became more important than the return on ones money. The TNX (10-Year Treasury Yield Index) dropped 1.95 to 3.62%. As the chart below shows, the TNX posted yields as low as 3.25% two weeks ago and has since run up as the bailout plan was unveiled. The TNX may fill in the gap over the next few days as foreign money looking for a safer haven is converted into dollars. Buying treasuries pushes the yields down. Foreign money can be tracked by seeing the relation between various currency pairs.

I am sure everyone is getting blasted with emails from friends on either side of the political spectrum about who is at fault for the problem and who is at fault for not solving it before it ever became an issue. It will be difficult, but I will try to recap todays events without indicating my political bias. In addition, I want to cover the story from a different angle than what you have already seen on TV or read. If you were paying attention on Sunday, the news sources announced that the Emergency Economic Stabilization Act was drafted and most likely to be voted on Monday. While the market got what it had anticipated the initial reaction this morning was to sell off today. One of my friends was dumbfounded because the market was down and the expectation was for it to bounce on the news. I clarified that the market moved in anticipation of the plan and the smart money decided to sell into the false strength and wait for the Act to actually pass the vote. Since the Act didnt pass (228 nay to 205 yes) for whatever reason and whoevers fault, the S&P 500 went from being down about 45 points at 1:30 PM EST to down 90 points by 1:46 PM. The SPX tried to run back to only down 60 or so but could hold onto any strength. Throughout the day the Dow Jones Industrials found more relative strength than the SPX because it wasnt so affected by the NASDAQs weakness. The Dow Jones Industrials ($DJI) only has two technology companies; Intel (INTC) and Microsoft (MSFT). As the Internals above show, the SPX closed down 106.85 at todays low of 1106.42. The Dow Jones fell 777.68 to 10365.45, also the $DJIs low. Since the NASDAQ 100 (NDX) and Russell 2000 (RUT) also closed at their daily lows, it appears that the selling climaxed at the close and drew the indices to close at their lows of the day. After the vote, the Republican Minority was the first to point out the faults of the Majority and not the faults of the plan itself. Since I live on Main Street and interpret Smart Money tendencies, I along with most of you reading this, have a bias for this plan to go through. After the Republicans were finished House Majority Leader Pelosi spoke about bi-partisan ship and not giving up on providing a solution. The back and forth action of blaming continued as Senator Osama rallied his audience against the Republican Administration and House. He commented on how the current administration provided an environment for Wall Street and Banks to take advantage of the American people and put the country at risk. Senator McCain spoke about how now is not a time to point out fault; it is a time to create a solution. A week ago, Warren Buffett was interviewed on CNBCs Morning Call. He basically stated that the general plan was a good plan and that he wished he had $700 billion to finance the plan. He also indicated that something needed to happen fast. So far, the clogging of credit pales in comparison to the House and Senates reaction to the problem. They spent valuable time trying to determine who and the why rather than relying the opinions of professional money managers like Paulson, Bernanke, and Pimcos Bill Gross. As indicated by the October Fed Funds Futures (currently at 98.38), my guess is that Bernanke will be forced to lower the Fed Funds and Discount Rates a minimum of 0.25% rather soon (100 98.38 = 1.62%). There is an assumed 100% chance of a 25bp and about a 50% chance of a 50bp rate reduction by October expiration (30 days from now). Finally, I kept waiting for gold to rally more than it did. The futures contract closed 14.9 higher at 909.30 after hitting a high of 920.10. Usually gold is the place where safe money goes when the end of days is upon us. I keep hearing people talk about how the US is going to go into a depression. Main Street is worried about the economy and their money but is apparently telling their representatives to vote against the Act because they dont want to bail out the fat cats on Wall Street. At this rate of consolidation there wont be a Wall Street as it is today. There will be a few big banks that control the world: JP Morgan, Citigroup, and Bank of America.


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Other Important Factors

As mentioned earlier, AAPL was downgraded to equal-weight from overweight by Morgan Stanley. Morgan Stanley said slowing demand and margin risk isn't priced in and PC unit growth is decelerating. The remaining source of growth is increasingly in the sub-$1,000 market where Apple does not play. Also, earnings per share growth will decelerate "meaningfully" from June quarterly levels due to tough comparisons and investments in iPhone growth.

Wachovia sold its banking operations at fire-sale prices to Citigoup (C) who confirms agreement-in-principle to acquire WB's banking operations in an FDIC-assisted transaction. C will be raising $10 billion and cutting its dividend to $0.16. C will pay Wachovia (still WB) $2.16 billon in stock and assume $53 billion in senior and subordinated debt. The transaction will result in C acquiring more the $700 billion of Wachovias banking subsidiaries assets and related liabilities. The FDIC has agreed to provide loss protection in connection with $312 billion of mortgage related and other assets while C is responsible for the first $30 billion. Citi is also responsible for the next $12 billion in losses up to a maximum of $4 billion per year for the next three years. Citi has also agreed to issue to the FDIC preferred stock and warrants with a combined value of ~$12 billion. The FDIC has agreed to be responsible for any further losses on this portfolio. There were reports that several European financial institutions had to be bailed out and concerns that the changes made to the financial relief plan over the weekend would limit financial firm participation.

Tomorrows Factors

The Chicago PMI will be released tomorrow morning. The market expects a decline in the Purchasing Managers index to 54 from 57.9. Consumer Confidence is also expected to decline to 55 from 56.9. The end of the week is loaded with employment data which could be the catalyst for the Fed to act more quickly. However, lower rates may not matter since banks arent lending to anyone, especially each other. The TED Spread, which is the difference between what banks charge each other for 3-month dollar loans (3-month Libor) and what the U.S. government pays (3-month T-bill) -- rose 63 basis points to 3.55%.

The EPS cycle is about to start in about 2 weeks. We will have many more companies to discuss then.

The Indices

As mentioned earlier, the various indices I follow all closed at their respective lows of the day. It would be of no surprise to me to see the markets gap higher and the fall lower intraday; mainly because there wont be a resolution to the Economic Stimulus Act until Thursday, at the earliest. Lets first discuss the S&P 500 (SPX) support and resistance. Last week I wrote that a trader should short rally attempts until it doesnt work anymore. Last Thursday and Fridays run up was inspiring of a bottoming process in that the market opened lower and closed higher. The usual action was to open higher and close lower or open lower and close even lower. None of that matters now. Todays failure to find any support and subsequently break through all previously established support has greatly altered the picture of the market.

The chart above shows that the RSI is in oversold territory again. But the Slow Stochastics has yet to follow through to indicate downside momentum. Fridays high did close above the 8 day exponential moving average (EMA) but it failed to break above the 21 day moving average. Todays close was lower that the lower Bollinger band (1132.39). My Bollinger bands may appear different than yours because I use the 21 day EMA as the base moving average. As with most canned Bollinger bands, the upper and lower bands are calculated according to 2 standard deviations of the center line.

The SPX hasnt been at these levels since 2004. As the chart above shows, the 100% retracement from the 2004 breakout low is at 1060.71. We could see a move down to those levels as the market figures out how to price in the governments lack of action. Historically, when Money Flow is at these levels (21.877) on the weekly chart, the market is near a low. Long term moving averages are so far out of play that they dont even deserve mention. These are circumstances when old fashioned support and resistance and pivot points are useful.

As mentioned last week, the 50 day moving average provided the SPX with substantial resistance. The mention of the plan wasnt enough to move the market that much. A plan is an idea and not the action or result. Even though the plan will be adopted as an Act latter this week, the entire results of the plan of action wont be revealed for years. Right now there isnt support until 1060 and the next resistance level is last weeks low at 1133. The trend is still down. That means the best trade is to short at tests of resistance and cover at extreme lows or signs of capitulation.

Speaking of capitulation, looking at the VIX chart over the last ten years I have noticed that each time the VIX spiked to about 48 50 the market established a bottom soon after. Sentiment is dim and portfolio managers are willing to pay anything for protection right now. We never want to be asked why we didnt have some sort of hedge or a way to participate on the downside of the market so some traders actually buy puts at the low. Today the VIX peaked at 48.40 which lines up to past highs not seen since 2001. I drew a yellow line to depict the high level and another to depict the low that the VIX ran up from. The difference or amplitude of the VIX is fairly consistent in each market top scenario as indicated by the low VIX. The lower yellow line is marked at around 17.50 from April 2001. The VIX ran to a high of 48.46 in July 2001. While we dont know if todays high is the high the low is 15.82 from around May 1st.


I could get lazy and mention that the NDX chart appears very similar in shape as the SPX chart but that wouldnt be very nice. The NDX had been in a relative range throughout the year until September 1st when a few of the NASDAQ components reported weakened outlooks. Once the 1750 support level was broken the NDX has been in virtual freefall. The daily chart has the Slow Stochastics ticking down today while the Stochastics moving average (blue line) is also curling over. This provides potential downward momentum and room for the NDX to drop further until the Stochastics reaches oversold territory. However, the RSI is already oversold. Normally, we look for the RSI to close above 30 to trade the long side of an oversold bounce. Otherwise we would be trying to catch a falling knife.

Since there isnt much support in the near term I had to draw a weekly chart to see where the NDX had previously found price support. The NDX hasnt been this low since 2005 when it almost came down to its 200 day moving average. This time is different since there isnt a moving average that poses any significance within sight. At some point institutions and mutual funds will have to abandon their rules to trade only above the 200 day moving average pr some other lethargic indicator. Our next support level is 50 points lower at 1446. The weekly Money Flow Index is curling upward which may indicate that a bottom may be developing. A bottom doesnt mean that the trend is changing; it just means that there is a decent probability counter trend trading opportunity that is developing. Trade the bounce and cover and reverse at resistance. Trading can be very simple if you make it so. Trade patient!

Trader's Corner

More on "Capitulation, Panics and Turnarounds"

I was not able to write this column in my 'usual' Thursday time slot last week and given all that's happened in recent days and especially today, I thought to add some analysis and charts relating to the subject of whether today's sell off might be a low for a while if not a 'final' low. When I last wrote on the subject of 'capitulation' bottoms back earlier this month (9/18), I thought that perhaps we were seeing this type bottom when the Dow closed the day at 10459 and here we are today at 10365.

The dictionary definition of "capitulation" relates to the act of surrendering or giving up. Charles Dow said eons ago that the market in his long experience NEVER made a major bottom without this quality of 'giving up' on stocks among the majority of investors. A major question is how you measure 'capitulation' and there are no perfect tools to do this. The one that has come closest for me over the years is really a measure of (option) trader sentiment or how much volume is seen in equities calls versus puts.

Ahead of intermediate to major bottoms, we see at least 1-day if not a few where daily put volume is greater than that of equities call volume, so the ratio of calls to puts is less than 1 when dividing total call volume by put volume. I do it this way so that it's like other 'overbought/oversold' indicators where the lower the number, the higher is the degree of bearishness. The higher the number, the greater is the degree of bullishness (e.g., a reading of 2 or above where call volume runs double that of put volume).

We have an historical pattern relating to my call/put indicator in a big 'capitulation' bottom in 2002, at the end of the bear market following the dot-com bust, where traders and investors gave up on stocks and assumed that the decline was going to never end so to speak. The bulls surrender!

I'm not saying that this current economic and market situation is going to be the SAME as the 2002 bottom, as the very shaky economic conditions this time may well be worse than 2002. Because of this widely perceived perception I would anticipate that my 'sentiment' indicator would measure significantly higher levels of bearishness if today's low was at least a tradable bottom; e.g., time to cover puts and buy some calls. Not so, as you'll see.

First, a look at the 2002 bottom in terms of the CBOE equities call to put volume ratio or what I call my sentiment 'indicator'. I display this indicator with the S&P 100 (OEX) chart, but this indicator 'stands in' very well for the OVERALL market sentiment; i.e., the collective expectation as to further declines or the reverse.


A few things I've learned about this type sentiment indicator:
-Daily sentiment extremes tend to come BEFORE an actual bottom
-At a MAJOR bottom there tends to be a cluster of such extreme readings
-It's not crucial to use a moving average to smooth the extremes but a 5-day average can be illuminative

Call/Put readings of 1.1 and below (below the green line above) suggest an 'oversold' market in the sense that the bearish outlook has gotten so extreme that the market gets into a position of being able to recover once the selling has dried up from the large number of investors panicked into dumping stock. This is also reflected in the preponderance of put volume relative to calls. Selling puts reflects a bullish or an outlook for a sideways trend of course, but experience suggests that a lot of the activity at bottoms in puts are hedges for individual stock holdings or speculative buys in the expectation of another downswing.

Note in the above chart that in 2002 the final bottom, besides being a double bottom low which is a powerful bullish pattern, but a cluster of 'bullish' call/put readings came (with one exception) before the 2002 bottom. Moreover the 5-day average got 'fully' oversold ahead of the final bottom, which is an uncommon occurrence. I take approaches to a prior major low as potentially bullish given the prospect for a double bottom, but when the market outlook is so heavily bearish, investors tend to anticipate a breakdown to a substantially lower low.


When we look at the recent pattern for my trader sentiment indicator seen above, it's notable for:

1.) How the 5-day CPRATIO average dipped to an 'oversold' extreme a few days back, suggesting today's lows in the major indexes might be it for a while. Today's decline looks extreme enough. What's lacking is the typical cluster of individual daily readings at and below 1.1 to suggest any kind of 'final' bottom. There were two tradable bottoms reflected by the same type 5-day CPRATIO extreme back in late-January and mid-March that correlated pretty closely to short to intermediate-term lows, especially around the March extreme.

2.) How FAST sentiment got to a bullish ('overbought') extreme on the recent rebound in OEX to 583 and how the CPRATIO didn't fall to the kind of extreme TODAY that would be suggested by the magnitude of today's decline. Too many traders anticipating a bottom? Probably. I'm not sure if we've at or near at least a temporary or interim bottom, but do know that MAJOR bottoms tend to occur only after there are a few (2-3 or more) bearish extremes in my indicator caused by a certain high level of high daily put volume relative to calls.

Another technical characteristic of major bottoms tends to be if and when prices reach major prior lows and/or register an oversold extreme in terms of the Relative Strength Index (RSI) indicator applied to daily and weekly charts. Due to the nature of the unfolding of this particular decline, the daily RSI readings haven't yet reached extremes, especially in the S&P and Dow. However, the weekly RSI levels are getting to very oversold levels. I will close with the Nasdaq (Composite) and S&P 500 weekly charts. However, not all prior lows that might suggest technical support/buying interest have also been reached, such as 10,000 on the Dow as highlighted on the INDU weekly chart below.

You'll note with the Dow 8-week RSI seen above that this widely followed index is now as oversold as it was back at the 2005 bottom, but we haven't seen 10000 retested again which has got to be a major psychological support.

In the case of the Nasdaq Composite (COMP), this index is more oversold than the Dow Jones Average as the RSI seen below is measured on a longer-term 13-week basis and suggests that COMP is already more oversold than it was at the 2005 and 2006 lows. Can we make major trading decisions based on such indicators? I would say no as to hitting any particular oversold extremes, as any overbought or oversold market can just get more extreme. But, when such extremes occur along with successful retests of prior major lows, such as COMP 1900 and Dow 10000, yes.


Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

New Plays

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New Option Plays
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AAPL None None

Play Editor's Note: I was expecting the market to eventually trade lower but we wanted to short the post-bailout-vote bounce first! Over the weekend the prevailing logic was that a deal would get done. I was looking for a bounce, which we could then use as an entry point for bearish plays. Obviously that didn't happen. Investor pessimism and fear is skyrocketing but stocks rarely fall in a straight line for very long. If you want to buy a bounce, I'm not suggesting you try, but if you are looking for one anyway, I would watch for the NASDAQ composite to find support in the 1925-1900 zone. I would watch the S&P 500 to find support in the 1090-1075 zone. One way to play the NASDAQ is the QQQQ or the QLD, which is the double-long ETF. If you want to buy options on the S&P 500 try the SPY or the SSO, which is the double-long ETF. If you are interested in double-shorts you'll want the SDS for the S&P 500 and the PSQ for the NASDAQ.

New Calls

Apple Inc. - AAPL - close: 105.26 chg: -22.98 stop: 97.45

Company Description:
Apple ignited the personal computer revolution in the 1970s with the Apple II and reinvented the personal computer in the 1980s with the Macintosh. Today, Apple continues to lead the industry in innovation with its award-winning computers, OS X operating system and iLife and professional applications. Apple is also spearheading the digital media revolution with its iPod portable music and video players and iTunes online store, and has entered the mobile phone market with its revolutionary iPhone. (source: company press release or website)

Why We Like It:
The sell-off in AAPL looks way overdone. Shares gapped down from $128 to open at $119 and then just plunged. Fueling the move was two different analyst downgrades. One analysts slapped a $115 price target and said AAPL would probably have to cut prices this holiday season to keep up sales, which would negatively impact earnings. The stock eventually found investors willing to buy the dip near psychological support near $100. The low was $100.59. More aggressive traders may want to buy calls on AAPL right here. I suspect AAPL will retest the $100 region tomorrow since the broader market is still sinking due to the bailout uncertainty. I am suggesting that traders consider buying a dip in AAPL in the $102.50-100.00 zone with a stop loss at $97.45. You may want to play with a stop loss closer to $100.00. This is a very aggressive play. We are technically trying to "catch the falling knife". If triggered at $102.50 we will have two targets. Our first target is $112.00. Our second target is $118.50.

Suggested Options:
We are suggesting the November calls.

***CAUTION*** The VIX has surged to multi-year highs and that pumps up the price of options. These options listed below are "expensive". AAPL could hit our targets and it's possible the options actually go down in value if the VIX deflates too quickly. Bear this in mind as you plan your trades.

BUY CALL NOV 100.00 QAA-KT open interest= 233 current ask $19.10
BUY CALL NOV 110.00 QAA-KB open interest= 235 current ask $14.25
BUY CALL NOV 115.00 QAA-KC open interest= 294 current ask $12.15

Picked on September xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/22/08 (unconfirmed)
Average Daily Volume = 28.5 million

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Put Updates

Volatility Index - VIX - cls: 46.72 chg: +11.98 stop: n/a

It's been said before but I'll say it again, these are historic times in the stock market. The DJIA just posted a 777-point loss. The S&P 500 index lost 8.8%. The NASDAQ Composite plunged more than 9%. All told the market lost more than 1.3 trillion dollars. Naturally this sort of panic sent the volatility index, aptly named the "fear gauge", to new multi-year highs. The VIX hasn't closed over the 46.00 level since October 2002. This is extremely rare for the VIX to be this high and it never lasts very long. There was one instance where the VIX was over 40 for three or four weeks but it always corrects.

I would use today's spike in the VIX as a new entry point for buying puts. If you like to play blackjack this is where you double down. I'm going to keep track of our VIX play as two different positions. The position we published on September 16th at 30.30 and today, September 29th at 46.72.

I would buy the November puts on the VIX. My first target is 36.00. My second target is 31.00. We're not listing a stop loss. The VIX could spike over 50 but it would only be a temporary spike. Speaking of spikes, if you have intraday access, you might want to wait and see if the VIX does spike near or over 50.00 and then open put option positions.

The first position, entry at 30.30, has a 25.50 target.

Suggested Options:
Buy the November puts.

BUY PUT NOV 35.00 VIX-WI open interest= 318 current ask $7.60
BUY PUT NOV 30.00 VIX-WF open interest=3710 current ask $4.10

Picked on September 16 at = 30.30 first position
Change since picked: +16.42
Picked again Sept. 29 at = 46.72 second position
Changed since picked: -0.00
Earnings Date 00/00/00
Average Daily Volume = --- million

Strangle Updates


Dropped Calls

Stericycle - SRCL - close: 59.61 change: -3.63 stop: 60.99

It should come as no surprise that SRCL was stopped out on market day like today. We were using a relatively tight stop loss to limit our risk. There were expectations for a bailout package over the weekend but they failed to come to fruition. SRCL hit our stop at $60.99 closing the play.

Picked on September 28 at $ 63.24 /stopped out 60.99
Change since picked: - 3.63
Earnings Date 10/23/08 (unconfirmed)
Average Daily Volume = 624 thousand

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


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