Option Investor
Newsletter

Daily Newsletter, Wednesday, 5/19/2010

Table of Contents

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

Market Wrap

That Wall of Worry is Just Too High

by John Gray

Click here to email John Gray
The "Flash Crash" (as it has become known) of May 6th is anything but a distant memory. It rattled traders, and it dealt a vicious blow to market sentiment. When you combine that with the seasonal factor (Sell in May, and go away) you have all the ingredients for a "sell first, and ask questions later" mentality. What seems to be a distant memory at this point is the huge 400+ DOW rally on Monday, May 10th prompted by the weekend announcement of an almost $1 trillion financial assistance package for debt-burdened European countries. The market seems determined to retrace all those gains.

While attention has been focused on Greece and the other debt-plagued southern European countries, the IMF has reminded us that the United States, Britain, and Japan are not far behind in terms of debt as a percentage of GDP. Daniel Arbess, of Perella Weinburg Partners summed it up best when he said, "The problem of the western world is we have too much debt. Rather than reducing our debt, we have been moving it from one balance sheet to another". He added, "All we are doing is shifting the chairs on the deck of the Titanic".

Debt to GDP ratios for all three (US, UK, and Japan) will go over 100% by the year 2014, according to the IMF. One economist said that by the year 2016 the United States will spend EVERY SINGLE PENNY of its TOTAL Tax Revenue just to pay the interest on the national debt. According to William Buiter, chief economist for Citigroup, "Public finances in the majority of advanced industrial countries are in a worse state today than at any time since the Industrial Revolution".

The official data doesn't tell the whole story either. Fannie Mae and Freddie Mac have been the responsibility of the U.S. government since they were placed in conservatorship in 2008. Fannie and Freddie's liabilities were $1.8 trillion at the end of last year. That represents 13% of GDP and is NOT included in the data.

If you want to get a glimpse of what the United States might be like, look at Japan. They have been in a recession since the 80's, principally because they took troubled (or failed) private assets and transferred them to the public balance sheet. Do you know anybody that has done that recently?

Warren Buffet weighed in on the currency debate over the weekend by saying that he was bearish on all currencies, for all of the aforementioned reasons. He pointed out that there are two ways that a country can solve its debt problems. The first (and most obvious) is to cut expenditures and raise taxes. The other is to print more money. Even a person that failed Economics 101 knows that the second "solution" is no solution at all because it effectively devalues the currency and causes inflation. However, Buffet points out that the United States is different than Greece (and the other European countries) in that we (the U.S.) control the printing presses and they do not (Greece, for example, can't print euro's).

And while we are on the subject of inflation, the Fed gives lip service about being dedicated to fighting inflation but privately they know that inflation is a good thing because it permits the government to repay its debt in cheaper dollars. What the Fed really fears is deflation and will take all steps necessary to combat it.

Gold has been in the news a lot lately after sprinting to a new high near 1250 about five days ago. Investors are flocking to the shiny metal as a perceived "safe haven". Traditionally, investors have thought of gold as a hedge against inflation. If government statistics are to be believed there is precious little of that (inflation) out there. In fact, the latest CPI data out of Spain suggests just the opposite (deflation). I believe the latest buying binge in gold is emotionally driven and is approaching bubble proportions. The latest COT (Commitment of Traders) report shows that retail speculators are over 96% long, whereas commercial traders (think smart money) are 60% short. I'll put my money on the big boys.


Gold Miners ETF

German Chancellor, Angela Merkel, lashed out at "speculators" and blamed these heinous miscreants for all of Europe's woes. She announced a ban on all "naked" short sales. The markets around the globe sent her a message, in no uncertain terms, about what they thought of it. What Ms. Merkel doesn't understand is that the "speculators" and short sellers are the least of her problems. The "Bond Vigilantes" are the ones she (and the rest of Europe) needs to worry about.

The term "Bond Vigilantes" was coined by Ed Yardeni (Yardeni Research) and he is referring to a handful of very large and powerful bond traders who can virtually dictate to countries what they can, and cannot do. Yardeni said, "If the fiscal and monetary authorities won't regulate the economy the bond investors will". They are the ones who decide how much a country's bonds are worth. Former Clinton advisor, James Carville, once quipped that he wanted to be reincarnated as the bond market because "they can intimidate anybody".

The oil spill saga in the Gulf continues. BP PLC said that it is recovering about 2000 barrels per day through a siphon pipe inserted into the main pipe that is leaking oil. The official estimate from BP is that 5000 barrels per day are leaking in the Gulf. However, two independent researchers (an oceanographer and a mechanical engineer) have concluded that the leak could be spilling between 25,000 BBL and 63,000 BBL per day. Tar balls, ranging in size from 3" and 8" have begun showing up in Key West. It has yet to be determined if these tar balls are from the site of the spill. If you are the government and you don't know what else to do about a problem you appoint a Commission to study the problem. That is what President Obama has done.

A new term has crept into our lexicon and that is "Strategic Default". These are individuals (or families) who intentionally default on their home mortgages and continue to meet other "meaningful" financial obligations. It has been estimated that 34% of all mortgage default are of the "strategic" variety. Many of these occur in places like California and Florida where real estate prices have dropped the most, and properties are "underwater" by as much as 25%. These homeowners know that it will take the bank one to two years to kick them out of their homes.

The Euro is trading at a four-year low to the dollar. The price this morning was just over 1.22.

Let's move on to the charts and survey some of this scorched earth and see if we can make any sense of it. SPX has suffered some serious technical damage since the "Flash Crash" on May 6th. Various levels of support (1200 and 1180) were decisively broken and will now act as resistance in future rallies. As I show on the chart below, the 20 DMA has move through and dropped below the 50 DMA (Daily). This is known as the "Death Cross" and is used by many fund managers and technicians as a sell signal. This cross occurred at the 1175 level which should offer significant resistance going forward.


Death Cross

Now that we have identified where rallies might stop, let's see where SPX might see some areas of support. The first logical support area would be at 1100. This is where the 200 DMA is located. This index has not traded below its 200 DMA since July, 2009. A drop below would be another "sell" signal to many fund managers that watch this closely. Coincidentally, this represents a 10% decline from the April high. Below that is the "gap fill" area at 1080 from February 15th. Of course, the February low of 1044 might offer some support if we get that low. And finally, we have a 50% retracement of the entire 14-month rally from March, 2009, which is at 942. I think it is safe to assume that if we get below that number SPX might head straight for the March (2009) low of 660.


Support Levels

The small caps (RUT) and the techs (NDX) have led the rally from March, 2009. If we have, indeed, had a trend change I would expect these two to lead us going down. First, let's have a look at RUT. I would anticipate that the downtrend line on the chart below at 710 would pose some serious resistance in a rally. I would also expect the swing low of 650 to offer some support as well.


RUT

The high-beta tech stocks were the favorites of the momentum investor during the big bull run, but they are getting kicked under the bus (along with everything else). NDX started 2010 at 1860 and after reaching a high of 2060 scarcely three weeks ago it is almost back where it started. I would anticipate that the swing low at 1835 would offer some support and the downtrend line at 1942 would pose substantial resistance.


NDX

While I am encouraged by economic reports that point to an improving economy, and corporate earnings that are better than anticipated, I am dreadfully afraid that the fiscal and monetary policies being pursued by the United States (and most of the rest of the western world) is going to lead to chaos and financial ruin. Societal acrimony has already begun to rear its ugly head, and I predict that it is going to get much worse before it gets better. It is already manifesting itself at the ballot box as angry voters toss out incumbents on their ear. It would be unwise, in my opinion, to flippantly dismiss the "Tea Party" people as simply some crazy right-wing zealots. I get the sense that there is a growing unrest, if not unmitigated rage, among many "mainstream" Americans. President Obama can poke fun of Arizonians about their Immigration Law if he want to, but he does so at his peril because several polls show that over 70% of Americans applaud Arizona for doing what the U.S. government is either unwilling or unable to do with a federal law that has been on the books for years.

What does this have to do with the stock market? It has everything to do with the stock market. Markets don't just respond to fundamentals (earnings, economic reports, etc.); they reflect people's moods as well. If people feel good - they buy. If people feel bad and/or angry - they sell. While I shall stop short of predicting the beginning of a Kondratieff Winter, I don't mind confessing that my mood is rather gloomy and filled with trepidation.


New Option Plays

Long Candidate

by Scott Hawes

Click here to email Scott Hawes

EMC Corp. - EMC - close 18.20 change -0.18 stop 17.65

Company Description:
EMC Corporation (EMC) develops, delivers and supports the information technology (IT) industry’s range of information infrastructure and virtual infrastructure technologies and solutions. The Company operates in two business segments: EMC's Information Infrastructure business and the EMC's VMware Virtual Infrastructure business. EMC's Information Infrastructure business provides a foundation for customers to manage and secure their quantities of information, automate their data center operations, reduce power and cooling costs, and information for business agility and advantage. EMC's VMware Virtual Infrastructure business is the provider of virtual infrastructure software solutions from the desktop to the data center and to the cloud. As of July 22, 2009, EMC had acquired approximately 94.2% interest in Data Domain, Inc. (Data Domain). In August 2009, EMC acquired FastScale Technology, Inc., a provider of software platforms and solutions for enterprise IT. (source: company press release or website)

Target(s): 19.00, 19.50
Key Support Areas: 18.00, 17.80, 17.65
Key Resistance Areas: 18.50, 18.85
Time Frame: 1 to 2 weeks

Why We Like It:
EMC is just above a long term pivot level dating back to June of 2007 at $18.00, which is also near its 20-week SMA. On a weekly chart the stock is converging with the pivot level and an upward trend line that began in May 2009. I like the specific technology sector of EMC's business and I believe the stock is poised to bounce here with the overall market. The stock also bounced nicely off of its 20-week SMA and trend line today. I suggest readers initiate long positions at current levels or on a pullback near $18.00. The stock has good support at $18.00, $17.80 (March 30 low - see dashed line on weekly chart), and again at $17.66 (May 7 low). This gives us a good reference point to place a stop just below these levels at $17.58. Our target is $19.00 and our time frame is a couple of weeks.

Suggested Position: June $18.00 CALL at current levels or on a pullback near $18.00, current ask $0.83.

Annotated Weekly Chart:

Entry on May xx
Earnings Date: More than 2 months (unconfirmed)
Average Daily Volume: 25 million
Listed on 5/19/10


In Play Updates and Reviews

Stopped on STLD

by Scott Hawes

Click here to email Scott Hawes

Editor's Note:

Good evening. Our long positions struggled today but our key support levels have held, for now. Last night I suggested readers consider closing short positions on weakness today. If you did you should have booked very nice gains. I am still urging readers to be careful with short positions down at these market levels as I believe we have seen the bottom in the market for at least a few days, if not weeks. I suppose there could be a push down to the 1,085 to 1,090 area in the S&P 500 but I'm not counting on it. This is just my opinion so take it for what its worth.

We have kept a good balance in the portfolio due to the recent volatility and we have booked nice gains on our short positions, sometimes at the expense of our long positions. But this is what hedging is all about which makes it paramount to take profits when the opportunity presents itself. We are now more biased to the long side and positioned for a relief rally. There will be a time in the near future when we need to get more biased on the short side but I think that could be a couple of weeks away. The S&P 500 range I am focused on now is 1,100 to the 1,155 area. However, I maintain my believe there is much more downside risk than upside opportunity so staying nimble is a must. Please feel free to email me with any questions.

Current Portfolio:


CALL Play Updates

Becton Dickinson & Co. - BDX - close 73.73 change -0.57 stop 72.20

Target(s): 77.50
Key Support Areas: 74.00, 72.50
Key Resistance Areas: 75.65, 76.70
Current Gain/Loss: -13%
Time Frame: Several weeks
New Positions: Yes

Comments:
BDX sold off right into its trend line from 5/5/09 and bounced. The overall market was weak which weighed on the stock but I expecting follow through to the upside from here. I'll leave my technical comments from the play release as they have not changed. We are looking for a move up to the $77.50 area which is our target and near the 50-day SMA. The stock remains near a key pivot level at $74.00 dating back to early 2008 which should act as support if BDX can follow through higher. Our stop is $72.20 and our time frame is several weeks.

Current Position: JUNE $75.00 CALL, entry at $1.55.

Entry on May 18, 2010
Earnings Date More than 2 months (unconfirmed)
Average Daily Volume: 1.6 million
Listed on May 17, 2010


Celgene Corp. - CELG - close 58.29 change +0.29 stop 56.90

Target(s): 60.90, 62.95
Key Support Areas: 58.00, 57.00
Key Resistance Areas: 58.60, 60.00, 61.25
Current Gain/Loss: -17%
Time Frame: Several weeks
New Positions: Yes

Comments:
CELG has been oscillating between $58 and $60 since last Monday and it looked like it might shoot right back up to $60 in early trading today. But sellers stepped in erasing the early gains, however, CELG managed to post a +0.50% gain at the end of the day. CELG remains above a key support area at $58.00 and I'm looking for more follow through to the upside in this stock and the overall market in general. The support looks solid at this level but it needs to bounce from here and get back above its 20-day SMA or our position could be in jeopardy. I want to lower our target just a bit to $60.90 which is just below the 50-day SMA. If the support breaks and things fall apart our stop is in place, which is $56.90 and below the April 22 low.

Current Position: JUNE $60.00 CALL, entry at $2.58.

Entry on May 17, 2010
Earnings Date: More than 2 months (unconfirmed)
Average Daily Volume: 4.3 million
Listed on May 15, 2010


Hewlett Packard Co - HPQ - close 47.00 change +0.21 stop 44.90

Target(s): 49.70
Key Support Areas: 46.50, 45.50
Key Resistance Areas: 48.25, 50.00
Current Gain/Loss: +0.00
Time Frame: Several weeks
New Positions: Yes

Comments:
HPQ traded down to $47 which is where we suggested to initiate CALL positions. We are now long June $47.00 CALLS at $1.47 which is about the price that they closed the day. I'll leave my comments from the play release as they have not changed. HPQ reported earnings after the bell on Tuesday that beat estimates and the company raised its guidance for the remainder of the year to $4.45 to $4.50 per share. This means that HPQ is now trading at less than 11 times forward earnings. The stock also has support at $46.50 and $45.50 which gives us a good reference to place a stop and to limit risk. There is no doubt HPQ's chart looks terrible but most stock charts do, and I'm viewing the pullback as opportunity to enter a quality name that may catch a bid as investors flee from more speculative names. I'm eyeing two areas as a potential entry: $47.10 or $46.10 depending price action on Wednesday. Our time frame is a couple of weeks and our stop $44.90 which is below the low on October 2, 2009.

Current Position: JUNE $47.50 CALL, entry was at $1.47

Entry on May 19, 2010
Earnings Date More than 2 months (unconfirmed)
Average Daily Volume: 16 million
Listed on May 18, 2010


PUT Play Updates

Baidu, Inc. ADR - BIDU - close 70.13 change -1.44 stop 72.75 *NEW*

Target(s): 71.50 (hit), 69.10, 65.10
Key Support Areas: 68.50, 65.00
Key Resistance Areas: 75.64, 78.50, 82.25
Current Gain/Loss: +32%
Time Frame: Several Weeks
New Positions: No

Comments:
BIDU hit our first target of $71.50 yesterday and today the stock traded down to a few cents below our key support area of $68.50 listed above before immediately reversing. BIDU still closed -2% on the day. I mentioned yesterday that traders may want to exit positions at current levels or on any further weakness to protect profits. If you took that suggestion and exited the position before noon today you have a very nice gain. At current levels we still have a nice +32% gain in the position and I urge readers to be careful of a reversal here and to protect profits. I'm listing a new target of $69.10 that I think is a great place to exit positions. BIDU looks vulnerable from here but if there is a bounce in the overall market we may endure a little pain before it heads back down. Ultimately I think BIDU easily trades to $65.10 but that may not happen within days or even weeks and we do not want to sit through a bounce. We need to take profits when the ducks are quacking and the stock is weak, and not wait through a hard reversal. If the market is moving higher tomorrow morning and showing relative strength compared to the last few days I would suggest exiting this position and booking a nice gain. I'm placing a tight stop at $72.75 to protect profits here. This stock can be volatile and is prone to gaps so please be smart when considering position size.

Current Position: JUNE $73.00 PUT, entry at $4.65

Entry on May 14, 2010
Earnings July 15, 2010 (unconfirmed)
Average Daily Volume: 68 million
Listed on May 13, 2010


Leggett & Platt, Inc. - LEG - close 23.60 change -0.23 stop 24.25 *NEW*

Target(s): 23.35, 23.00, 22.25
Key Support Areas: 23.75, 23.42, 23.00
Key Resistance Areas: 24.75, 25.15
Current Gain/Loss: +25%
Time Frame: Several Weeks
New Positions: No

Comments:
LEG closed below its 20-day SMA for the 2nd consecutive day, which is the first time since January. The stock traded down to within 15 cents of our $23 target before reversing and closing at $23.60. I am concerned of a reversal here in LEG and the overall market in general so I urge readers to protect their profits and consider exiting LEG tomorrow. I am going to tighten our stop to $24.25 and move our target up to $23.35. If the market rebounds tomorrow LEG could get some bids. Our position is up +25% right now but to reach lower targets we are probably going to have to live through a bounce which I suggest avoiding. LEG is still below its downward trend line which started on April 30. If the overall market remains weak LEG will probably trade down to its 50-day SMA at $22.66 but I anticipate a bounce which is why I want to book profits. I suggest taking profits here and not holding through any bounce.

Current Position: June $25.00 PUT, entry at $1.60

Entry on May 17, 2010
Earnings More than 2 months (unconfirmed)
Average Daily Volume: 2 million
Listed on May 15, 2010


CLOSED BULLISH PLAYS

Steel Dynamics - STLD - close 14.50 change -0.36 stop 14.15

Target(s): 16.25, 16.80
Key Support Areas: 14.50, 14.25
Key Resistance Areas: 15.00, 15.50, 15.85
Current Gain/Loss: -35% Time Frame: About 2 weeks
New Positions: Stopped

Comments:
STLD found our stop this afternoon so we are flat on the position for a relatively small loss of 30 cents. Although I never like a loss it simply can't be avoided. When I reviewed the thesis on this long trade I don't know that I would have done much different. Maybe a loser stop to keep us in the trade longer but hindsight is 20/20. I think the market bounces here and I think STLD will perform. Readers who still have positions could place a new stop at $13.95, which is below today's low. I would use the resistance areas and targets listed above as guide to exit positions.

Closed Position: JUNE $15.00 CALL @ $0.55, entry was at $0.85.

Annotated Chart:

Entry on May 17, 2010
Earnings Date More than 2 months (unconfirmed)
Average Daily Volume: 6.7 million
Listed on May 17, 2010