Option Investor

Daily Newsletter, Thursday, 12/11/2008

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews

Market Wrap

Follow the Money

Market Stats
[Image 1]

On Tuesday I had pointed out the chart of the banks (BIX) because of the setup that I saw that calls for a new annual low this month. The BIX gave up almost 10% today and broke its uptrend line from the November 21st low, after leaving yet another 3-wave bounce (correction). So far the pattern for the banks says we should follow the money and get bearish from here. At the very least we should be very cautious about the upside. But the broader market indices held support today and hint of a rally leg for Friday and into Monday. Whether the rally leg will hold, especially if the banks don't participate, is the bigger question.

I had discussed the credit spread problem that's still present in the market and that it's a reflection of continued fear in the financial markets. I showed the chart of credit spreads widening while the stock market has been rallying and that the rally was therefore suspect--built on more hope that things will get better. Therefore today's hard decline in the banks is a warning shot across the bow that the bounce off the November 21st low may in fact be just another bear market rally (+20-25%) before heading lower again. That's the risk but doesn't necessarily mean we're going to head back down now.

I also see the potential for the market to be entering a larger consolidation pattern that will basically have us marking time while the market figures out what's next. In the meantime I thought I'd cover a little more material about this credit market and why it's a doozy to deal with now. I showed a chart on Tuesday of the widening corporate credit spreads (inversely charted so it was dropping lower) laid over the top of the S&P decline over the past year. The following chart is next to impossible to read because I had to squish it so much to fit but I'll explain what it's showing:

S&P 500, Volatility and Credit Spread (1929-2008), courtesy Ned Davis Research
[Image 2]

The top chart is the S&P 500, the middle chart is the 100-day moving average of the absolute change in volatility and the bottom chart is the credit spread (between Moody's Baa bond yields and 30-year Treasury yields). The spike in the credit spread and volatility in 1929 and the early 1930s, corresponding with the steep decline in stock prices, is a warning that we may see something similar again. The volatility index (100-dma) has spiked up near the previous spikes in 1987 and 2003 but nowhere near the spikes in 1929, 1933 and 1938. The decline in the stock market is also not nearly as dramatic (in percentage terms) as what happened in the 1930s.

So the logical question out of all this is whether or not we'll have a repeat performance to what happened in the 1930s. So we'll compare the credit creation between then and now:

Total Credit Market Debt as Percent of GDP, 1929-2007, courtesy Elliott Wave International
[Image 3]

Again, this chart shows credit as a percent of U.S. GDP since the 1920s to today. Leading into the 1929 stock market crash there was a big buildup in credit but what's interesting is the huge (some would say ginormous) credit boom following the stock market crash. Then the credit collapse from about 1933 to the bottom in 1951. You can see we completely dwarfed the prior period as credit expanded during the last bull market (it's what made it the strongest bull market in history), providing more money than people knew what to do with it and consequently bid up every asset known to man, and created countless bubbles that have been popping for several years.

As the Fed tries to re-inflate the economy they're attempting to create more credit to counteract the credit collapse that has already started. There's no way to know what kind of correction we'll have from the huge run up in credit into the peak in 2007. I think we can safely assume it will come down as hard on the back side as it went up on the front side. To think that the stock market will simply shake this off and get back to "normal" business of leveraged buyouts and another alphabet soup of new derivative tools is simply na´ve. This market has some serious correcting to do over time.

But the key is "over time". Nothing moves in a straight line and while it will take a while to work out the excesses we will see plenty of trading opportunities in both directions, even some bullish ones that last months, if not a year, before heading lower again. The more the government fights the correction the longer it will last. Just ask Japan how well government interference has worked for them. It worked so well (not!) that we're now trying to same things, except more aggressively. The law of unintended consequences from the government's actions is what worries me most.

But we're here to trade. Long term buy and hold is dead, long live the trader. It's what our newsletters have always been about and now we'll do our best to help steer you through the treacherous shoals as the tide recedes further.

S&P 500, SPX, Daily chart
[Image 4]

SPX closed on the trend line across the highs of November 14th and 28th (the neckline of the potential inverse H&S pattern that many are watching) so that's still potentially bullish. The uptrend line from November 21st is slightly lower at 863 so watch for a possible tag of that line first thing in the morning followed by a renewed rally. If SPX drops below that uptrend line it could be a quick trip back down to the 818 low on December 5th. If that breaks then the downside targets are 800, 768 and then possibly as low as 661 if things really turn nasty this month.

Right now I'm leaning towards the short-term bullish depiction (dark red) that calls for a leg up to the 940-950 area early next week (although the after-hours futures have me wondering about that). SPX 943 is an important Gann level and it coincides nicely with the downtrend line from October 14th (possible top of the large sideways triangle pattern for price to consolidate into February) and the top of a possible rising wedge pattern for price action from the November 21st low. Higher than 950 would have the next upside targets of 973, 1005 and 1050 in play. Otherwise a quick rally higher into early next week should be followed by another trip back down inside a large sideways triangle pattern.

Key Levels for SPX:
- cautiously bullish now above 8600
- cautiously bearish below 850
(either side is only for a quick trade)

S&P 500, SPX, 120-min chart
[Image 5]

I'm showing a potential rising wedge pattern which has slight bearish divergence on the oscillators thus supporting the bearish interpretation of price action here. As labeled in pink it's possible we've already completed an A-B-C bounce off the November 21st low. So far the pullback from Monday's high looks corrective and has formed a bull flag. I would normally expect a bullish resolution out of the flag pattern but recognize that the market tends to move quickly when a well recognized pattern fails. A drop out the bottom of the flag would clearly be bearish. Then the last line of defense for bulls is the uptrend line from November 21st, currently near 863. That's why a break below 860 would be bearish, especially if it then holds below the uptrend line on any retest. But assuming for now the bulls will get back in the game here, we should see another leg up to the 943 area before turning back down again.

Dow Industrials, INDU, Daily chart
[Image 6]

I'm showing the same rising wedge pattern for the DOW and the upside target for the DOW is the 9400-9500 area. Any higher than that and it will run into resistance at the 9700 level and then clearer sailing up to the 10300 area. Its uptrend line from November 21st sits near 8500 so watch for either a break or hold there. So far the 50-dma has acted as strong resistance, including today again. If the DOW breaks below its last low of 8118 I think we'll see new annual lows this month (dashed line).

Key Levels for DOW:
- cautiously bullish now above 8500
- cautiously bearish below 8100

Nasdaq-100, NDX, Daily chart
[Image 7]

As I've pointed out before, the blue chips give me the impression, if key levels can be held from here, that we've seen the lows for the year and we'll consolidate for a couple of months before heading lower again. But the techs have been weaker and continue to give me the impression that we're going to get another new low this month (a few other sectors give me the same impression, some of which I'll review below). I show, in dark red, the same sideways consolidation pattern as the blue chips but much tighter in the price range and potentially ending about a month sooner.

NDX found support at gap closure from Monday's gap up. A gap down tomorrow would clearly break that support level and could bring the previous low at 1096 into the bears' sights. If we do have a new low coming I think the 940 level makes for a good target/support level.

Key Levels for NDX:
- cautiously bullish above 1270
- cautiously bearish below 1096

Russell-2000, RUT, 120-min chart
[Image 8]

Rather than show the daily chart for the RUT, which is not much different than the others, I wanted to show the rising wedge pattern for price action since the November 21st low. Without looking at the after-hours futures I would look at this chart and be bullish for another 3-wave move up as depicted, with an upside target near 520 by early to mid week next week. The 120-min candle is a bullish hammer at support. It was a good setup to get long into the close. Now we'll have to see how the market opens in the morning to tell us whether we'll instead get a flurry of sell orders.

Key Levels for RUT:
- cautiously bullish above 520
- cautiously bearish below 423

I mentioned the techs look more bearish than the blue chips and I like to look at the semiconductors as somewhat of a tie breaker. A review of the weekly chart of the SOX is not encouraging for the bulls:

Semiconductor sector, SOX, Weekly chart
[Image 9]

I'm showing two parallel down-channels to point out what is happening with the first down-channel. The SOX broke below the bottom of the first channel in October and then more firmly in November. Oftentimes you'll see price bounce back up to the bottom of a parallel down-channel and give it a kiss goodbye. That may be what it's currently doing. The wave count for the move down also suggests it's got another leg down before a larger bounce into next year. I show the bottom of the slightly steeper down-channel near 120 in January. That would be another 40% decline for the semis and I would bet my bottom dollar that NDX would be following it and therefore the blue chips. I'll be watching this sector closely over the next week or so.

Banking index, BIX, Daily chart
[Image 10]

I showed the BIX chart on Tuesday because I felt it was at an important level where it could reverse back down and head for a new low this month. Today's decline (nearly -10%) led the market lower this afternoon and I don't see much bullish on this chart yet. It broke its uptrend line from November 21st and may be showing the way for the rest of the market. Between the techs and banks I have to say I'm feeling a little uneasy about my expectation for another leg up for the blue chips before rolling back over.

Back to another weekly chart to show the home builders and a pattern that also has me thinking a new low sooner rather than later (although it could bounce slightly higher over the next few days before starting lower again).

U.S. Home Construction Index, DJUSHB, Daily chart
[Image 11]

The final leg down from the March 2008 high looks to be putting in a descending wedge--a very typical pattern for the final move. The bullish divergences on the chart support the bullish interpretation of the pattern, but not yet. The bottom line is that the pattern still looks more bearish than bullish at the moment. As noted on the chart, the remarkable thing about the downside projection to about 60 would mean a 95% loss for this index from its 2005 high. A stunning loss.

Transportation Index, TRAN, Daily chart
[Image 12]

The transports could give us a heads up if they drop below the 3179 level on December 5th. Unless it's going to stay inside a tighter sideways consolidation before heading lower again, we could see this index head for a new annual low this month. Once again, if it does then I suspect we'll see the broader market follow.

On Tuesday I showed the oil chart and why I thought it was at or close to support. The $41 level is support and if that breaks then it should head for $34. Gold's weekly chart has me thinking more bearishly for the next couple of months and that could mean oil will also turn back down (it got a nice bounce today but failed to get above the bottom of its broken parallel down-channel).

Gold Fund, GLD, Weekly chart
[Image 13]

Gold could bounce a little higher to hit the top of its parallel down-channel for this year's decline, currently near $85. But notice that it continues to struggle with its broken uptrend line from July 2005. Gold made a new high for the month today but it was not confirmed by silver so it's suspect for now. Assuming we'll get another leg down, which I believe will happen, the downside target is near $63 where I'd be interested in buying gold.

Economic reports, summary and Key Trading Levels
[Image 14]

Today's initial claims data continues to show this recession is clearly worse than the previous one in 2001. The 4-week average has already spiked higher than what we saw at the end of 2001 and also now higher than we saw in 1991. The initial claims number of 573K is the highest in the past 26 years (1982). Most analysts now believe we're headed for the worst job market since the 1970s recession. And many are forecasting the worst market since the Great Depression. Going back to those credit charts I showed at the beginning of this report I'd say you can count on this recession being the worst since the Great Depression.

If we're heading into a deflationary environment, which we already are when you consider the deflation of all asset prices (and export and import prices dropped by a record amount in November, even excluding oil prices), then the situation will become more dire than anything we've experienced since the 1930s.

The good news, for our longer-term financial health (and a sign of true fear), is that Americans paid down their debt in the 3rd quarter for the first time since 1952. But there's a good news/bad news component to this report. The reason debt has been paid down is primarily due to people taking on less mortgage debt. The home equity ATM has been empty for a while and we all know how the housing market has dried up with fewer mortgages being written. The worse news is that people continue to pile up debt in credit cards and auto loans (even though auto sales are down more than 30% so it's more credit card debt than anything else). The big Kahuna when it comes to figuring out how to get deeper into debt? No surprise, it's our favorite uncle, the US government, which boosted its debt by a post-war record of +39.2%. My poor kids, and their kids.

After the market closed news came out about the possibility there may not be enough votes in the Senate to pass the bailout bill for the Big 3 auto companies. Futures are down hard as I finish this up (S&P futures are down -24 points). Whether the drop will hold into tomorrow's open is anyone's guess, especially if some good news leaks out in the morning. I think we all have to assume some kind of bailout plan will eventually be passed. Even if it's to escort them into bankruptcy and hold their hand through the process to make sure they stay a viable manufacturing company (if not a watered down version).

If the market drops much further Friday morning it will obviously look bearish. It could be a quick spike down followed by a fast reversal and rally into Monday. That's just a guess but let's just say nothing would surprise me in this market. As I had shown for the blue chips, the pattern would look best with another push back up to complete the bounce pattern from November 21st. SPX 943 is a good upside target if the bulls can take the reins on Friday and lead the cavalry to the rescue. Remember, we're heading into opex week and many times we've seen a quick spike down on Thursday or Friday prior to opex get reversed with a v-bottom recovery. Opex shenanigans by the biggest players.

Several other sectors, including the techs, give me the impression that it may be wishful thinking to expect any more rally this month and in fact point to new annual lows by Christmas rather than a Santa Claus rally. We'll have our own rerun of the Grinch Who Stole the Rally. In fact, even if we get a rally leg into early next week I don't think it will lead to a Santa Claus rally (unless it's from a lower level). I think we're due for a whippy couple of months and therefore look at each strong move as an opportunity to fade it. That's easier said than done since it's very difficult to identify the turning points. But that's what we'll continue to attempt to do and see if we all can't become better traders in one of the more difficult markets you'll ever trade.

Good luck tomorrow and next week. Just keep in mind that opex does funny things to this market. I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish now above 8600
- cautiously bearish below 850
(either side is only for a quick trade)

Key Levels for DOW:
- cautiously bullish now above 8500
- cautiously bearish below 8100

Key Levels for NDX:
- cautiously bullish above 1270
- cautiously bearish below 1096

Key Levels for RUT:
- cautiously bullish above 520
- cautiously bearish below 423

Keene H. Little, CMT
Chartered Market Technician

New Option Plays

Play Editor's Note

Play Editor's Note: I don't recall if we have ever gone three days without listing new play candidates. Unfortunately, the market isn't doing much. Yes, the major indices have been slipping, which is exactly what I expected. Yet the pull back has not been deep enough to hit most of the triggers for our bullish candidates. I think that might change tomorrow. Stocks closed near their lows on Thursday and another drown draft on Friday morning could finally hit some of our suggested entry points.

However, there is no guarantee that stocks will see a bounce. We remain in a bear market and this remains a very tough market to trade. I continue to hear how many hedge funds and professional traders have closed up shop for the year and stopped trading. A few bearish short funds have stopped taking money because they don't see any opportunities for new short positions.

I think there is opportunity in the market but we have to remain quick and nimble. We also have to be patient and wait for our entry point. The newsletter will be adding new candidates this weekend.

In Play Updates and Reviews

One Play Triggered, Two New Stop Adjustments

CALL Play Updates

Apple Inc - AAPL - close: 95.00 change: -3.21 stop: 88.99

Shares of AAPL plunged lower in the last two hours of trading and settled right at the $95.00 mark, which was expected to be short-term support. I think the dip continues and the stock trades a couple of points lower. More conservative traders will want to just step back and wait to see where it bounces. It's very possible that AAPL drops closer to $90 before bouncing, which would be a much better entry point. Currently we're suggesting readers buy calls on a dip into the $94.00-92.00 zone.

If triggered at $94.00 we have two targets. Our first target is $99.85. Our second target is $107.50.

Picked on December xx at $ xx.xx <-- see TRIGGER
Change since picked:      + 0.00
Earnings Date           01/22/09 (unconfirmed)
Average Daily Volume =      52.8 million  

Amazon.com - AMZN - close: 48.25 change: -1.45 stop: 43.25

AMZN lost 2.8% and looks ready to drop toward $45.00. I'm going to modify our entry range from $46.00-45.00 to $46.00-44.00. More conservative traders will want to wait and see if AMZN nears $44.00 (or wait for the bounce) before initiating positions. Officially the newsletter will open the play at $46.00. We have two targets. Our first (short-term) target is $49.95. Our secondary target is the $54.00 mark. The P&F chart is bullish with a $74 target.

Picked on December xx at $ xx.xx <-- see TRIGGER
Change since picked:      + 0.00
Earnings Date           01/28/09 (unconfirmed)
Average Daily Volume =      12.9 million  

China Mobile Ltd. - CHL - close: 51.83 change: -0.09 stop: 47.75

The CHL didn't move much and spent the majority of the session in a narrow 65-cent range. The stock eventually pulled back late in the day. We continue to suggest that readers take profits here. We're not suggesting new bullish positions. CHL hit our first target at $51.75 two days ago. We still have a secondary, more-aggressive target at $57.00.

Note: I was unable to find an earnings date for CHL, which does raise our risk since we prefer to avoid holding over an earnings report.

Picked on December 03 at $ 47.11 /gap down entry
Change since picked:      + 4.72 /originally listed at $47.85
Earnings Date           00/00/08 (unconfirmed)
Average Daily Volume =       3.9 million  

Chipotle Mexican Grill - CMG - close: 55.05 chg: -3.86 stop: 48.45

CMG encountered some profit taking today. The stock lost 6.5% but has not yet broken its short-term trend of higher lows. We are sticking to our plan. Our suggested entry point is to buy calls on a pull back into the $51.00-49.00 zone. Our stop loss is at $48.45. If triggered at $51.00 we have two targets. Our first target is $54.85. Our secondary target is $59.00.

Picked on December xx at $ xx.xx <-- see TRIGGER
Change since picked:      + 0.00
Earnings Date           02/12/09 (unconfirmed)
Average Daily Volume =       475 thousand 

Express Scripts - ESRX - close: 57.72 change: -1.36 stop: 55.95

Traders need to remain cautious here. ESRX just produced its third failed rally attempt at the $60.00 level in the last three days. This is bearish. I would seriously consider exiting early right here! We are not suggesting new bullish positions at this time. Our target is $64.00.

Picked on December 06 at $ 59.36 /gap higher entry 
Change since picked:      - 1.64 /originally listed at $58.58
Earnings Date           02/19/09 (unconfirmed)
Average Daily Volume =       3.1 million  

FTSE/Xinhau China Index - FXI - close: 30.12 chg: -1.12 stop: 28.45*new*

The FXI lost 3.5% as the late-day sell-off in stocks pulled the ETF toward the $30.00 level. We are not suggesting new bullish positions at this time. If you have not taken any profits yet I would do so now. Four days ago we started telling readers to exit at $30.00 and above. Our secondary target is $34.00. Please note our new stop loss at $28.45.

Picked on December 03 at $ 26.27 /gap down entry point
Change since picked:      + 3.85 /originally listed at $27.25
Earnings Date           00/00/00
Average Daily Volume =      51.2 million  

Goldman Sachs - GS - close: 69.71 change: -1.82 stop: 67.49

It was a volatile day for GS. Shares plunged toward $69 early on only to bounce just as quickly and rally to $74.00. The rally faded and GS drifted back toward $69 before the day was out. The weakness today and the short-term trend of lower highs is bearish. Readers may want to seriously consider raising their stop loss toward the $69.00 level. We're not suggesting new positions at this time.

We have two targets. Our first target is $79.85. Our second target is $89.00 or the 50-dma, whichever one GS hits first. We do not want to hold over the December earnings report. Thus we only have a few trading days to enter and exit this play.

Picked on December 10 at $ 71.00 *triggered
Change since picked:      - 1.29
Earnings Date           12/16/08 (confirmed)
Average Daily Volume =        29 million  

Jacobs Engineering - JEC - close: 47.72 change: -5.46 stop: 42.45

JEC, after two days of struggling to breakout over its simple 100-dma, finally hit some profit taking. The stock gave up more than 10% and closed near its lows for the day. The intraday low was $46.59. Our suggested entry point to buy calls is a dip into the $46.00-45.00 zone. If triggered we have two targets. Our first target will be $51.00. Our second target will be $54.90.

Picked on December xx at $ xx.xx <-- see TRIGGER
Change since picked:      + 0.00
Earnings Date           01/21/09 (unconfirmed)
Average Daily Volume =       3.0 million  

Priceline.com - PCLN - close: 60.96 change: -1.12 stop: 59.75*new*

Something happened this morning but I can't find the news to account for the gap higher and sudden spike in PCLN to $67.70 a share. The rally quickly faded and PCLN eventually closed down 1.8%. This failed rally is bearish. We are raising our stop loss to $59.75 and any follow through lower tomorrow will stop us out.

We're not suggesting new bullish positions at this time. PCLN has already hit our first target near $65.00. We currently have a secondary, more aggressive target at $69.90. FYI: The Point & Figure chart is bullish with a $102 target.

Picked on December 06 at $ 61.60 /gap open higher
Change since picked:      - 0.64 /originally listed at $60.46
Earnings Date           02/12/09 (unconfirmed)
Average Daily Volume =       1.8 million  

Wynn Resorts - WYNN - close: 40.70 change: -3.60 stop: 38.45

WYNN was a big under performer today. The stock produced a failed rally under $45.00 and then lost 8%. The decline was strong enough to push WYNN to our suggested entry point at $40.75. Now that the play is open our stop loss is at $38.45. More conservative traders may want to use a stop loss closer to $40.00 instead. We have two targets. Our first target is $44.75. Our second target is $49.00. I would expect some resistance at the 50-dma but the P&F chart has turned bullish with a $62 target.


Picked on December 11 at $ 40.75
Change since picked:      - 0.05
Earnings Date           02/12/09 (unconfirmed)
Average Daily Volume =       3.2 million  

PUT Play Updates

*Currently we do not have any put play updates*

Strangle & Spread Play Updates

SPDR GOLD Trust - GLD - close: 80.65 change: +0.90 stop: n/a

A sharp drop in the U.S. dollar helped the GLD rally past $80 and technical resistance at its 100-dma. Yet the GLD has not yet broken out past its late November highs.

We're quickly running out of time as December options expire in six trading days. I am reiterating previous suggestions that more conservative traders cut their losses and exit early. FYI: The December $75 call hit $7.10 intraday.

We are not suggesting new strangle positions in the GLD.

What is a strangle?
A strangle involves buying both an out-of-the-money call and an out-of-the-money put. We don't care what direction the stock goes as long as it moves one direction. If the stock moves far enough one side of our trade will rise in value and pay for the entire trade and make a profit.

-December Strangle-

We suggested readers buy the December $75 call (GVD-LW) and the December $70 puts (GVD-XR). Our estimated cost was $6.30. We want to sell if either option hits $12.00.

Picked on November 09 at $ 72.50
Change since picked:      + 8.15
Earnings Date           00/00/00
Average Daily Volume =      19.3 million  

Ultra S&P500 ProShares - SSO - close: 25.00 change: -1.36 stop: n/a

The S&P 500 index lost 2.8% and is developing a very short-term trend of lower highs. It's possible we are seeing a bull flag develop. Unfortunately, we're running out of time. The SSO lost 5.1% on the session. We only have six trading days left before December options expire.

We're not suggesting new strangles at this time.

Note: The SSO is an ultra-long ETF that typically moves twice the daily performance of the S&P 500 index.

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

-December Strangle Details-
We suggested readers buy the December $30.00 call (SOJ-LD) and the December $20.00 put (SOJ-XT). Our estimated cost is $3.75. We want to sell if either option hits $6.00.

Picked on November 12 at $ 24.84
Change since picked:      + 0.16
Earnings Date           00/00/00
Average Daily Volume =       126 million  


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