Option Investor
Newsletter

Daily Newsletter, Tuesday, 11/9/2010

Table of Contents

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

Market Wrap

Pause To Reload

by Jim Brown

Click here to email Jim Brown
Two days of declines is not the end of the world. This was the first time on over a month that the S&P has ended with back-to-back losses.

Market Statistics

Despite two days of declines the Dow is still +248 points over last Wednesday's low at 11,097. That should put today's minor 60-point decline in context. After a seemingly unstoppable rally over the last couple months a couple days of profit taking have energized the bears but have barely fazed the bulls. I am glad to see some selling because it provides a buying opportunity for the next move higher.

Today was a slow news day for economics with no important releases. The Job Openings and Labor Turnover Survey (JOLTS) showed that job openings declined to 2,929,000 in September from 3,092,000 in August. This is a lagging report since we are already midway through November. The pace of job creation rose only +11.6% in September and separations barely offset hires. We already know September was not a good month for jobs with the Non-Farm Payroll report showing we lost -41,000 jobs. I do expect this report to improve in October and move up sharply in November.

The Wholesale Trade report for September showed a +1.5% surge and more than twice what analysts expected. The August numbers were revised up to +1.2% from +0.8%. Nondurable goods orders spiked a very strong +2.8%. The rapid increase in goods inventories is expected to push the Q3 GDP slightly higher in the next revision. That assumes other factors don't produce additional drag. That could be a bad assumption.

Weekly Chain Store Sales rose +1.3% as retailers began their pre Black Friday marketing programs. The firm BDO did a survey of retailers and consumers and projected 2010 holiday sales could climb by +3.5%. Apparently there is a lot of pent up buying that will be released this holiday season.

Wednesday also lacks any critical economic reports but we do have Cisco earnings after the close. This could be the next market-moving event. If John Chambers says business is improving briskly then the market could find some traction. Conversely if he warns that conditions are not yet indicating a recovery then the profit taking could continue.

Economic Calendar

Tivo fell 15% when the U.S. Court of Appeals posed some negative questions to the firm in its fight with Echostar and Dish over the DVR patents. Tivo has repeatedly won judgments that bar Dish and Echostar from using the patents and won multi million dollar judgments but the companies continue to appeal. The Federal Circuit court ruled that the companies were still infringing but the decision was set aside so that a full panel of judges could rehear the case.

Ask.com ran out of answers, at least answers on searches. Ask.com is dropping the search engine portion of its business due to lack of interest by the browsing public. Ask will cut 130 engineering jobs and outsource its searches. Ask realized it could not keep up with Bing, Google and Yahoo and threw in the towel. Ask had only 3.7% of the search market in September while Google had 65%. Ask will keep and expand its question driven answer service.

Goldman Sachs disclosed it lost money trading on only two days in Q3. It made between $75M and $100M on 24 days and mode over $100 million on seven days. Bank America disclosed it made a profit every day. On 25 of those days they made between $25M and $50M and more than $100M on five days. JPM reported they had no losing days and made more than $200 million on 12 days. You wonder how the new financial reform laws are going to impact this kind of trading profits. Goldman has already started closing its proprietary trading business.

Yahoo rallied +3% on news that KKR added their name to a list of firms that want to take the company private. Yahoo has lost more than half its value since Microsoft withdrew its $44.6 billion bid in 2008. Goldman Sachs is working with Yahoo to find an acquirer and/or arrange financing to take them private. Reportedly the private equity group approached AliBaba Group, which is 40% owned by Yahoo, about taking Yahoo private. Yahoo shares traded under $13 as recently as August.

Boeing took another hit today after a 787 Dreamliner was forced to declare an emergency and land in Laredo Texas. Smoke filled the rear cabin and the source was not immediately known. The plane made an emergency landing at the closest field and the crew evacuated.

Chevron announced it was buying Atlas Energy (ATLS) for $3.2 billion to gain a position in the Marcellus Shale gas field. Other majors buying into the Marcellus this year include XOM, RDS, TOT, BP and STO. The deal valued the Marcellus acreage at $9,000 per acre. That is down from $14,000 earlier this year so maybe there is something to be said for waiting for a pullback. Chevron will gain access to as much as 9 TCF of gas. Atlas has 850 BCF of proved reserves but much more than that in suspected reserves. Until they drill additional wells they can't call it proved. The Chevron offer was $43.34 for each share of Atlas. That was a 37% premium.

Atlas had previously sold 40% of its Marcellus acreage into a partnership with Reliance Industries of India. Chevron will take over the Atlas position. As part of that sale Reliance has to fund all the drilling costs so Chevron gets a free ride on that portion.

Register for my OilSlick.com newsletter and receive free daily updates and commentary on the energy sector. Register here

Crude oil hit a two-year high at $87.55 early this morning before the spike in the dollar knocked out support. Crude declined a buck on the dollar spike.

Oil Chart

A report out today from the Kaufman Foundation claims ETFs pose a systemic risk to the market and could cause disruptions larger than the flash crash. You may remember after the flash crash more than 70% of the trades that were busted were on ETFs. Mutual funds and hedge funds are now using ETFs as a proxy for stock investing. The ETFs have significantly higher volume than individual stocks and they are easier to short.

They are so easy to short that back in June there were six major ETFs that had a short interest of more than 100%. How is that possible you ask? It is the miracle of blind borrowing. If you have shares of the ETF in your account and you have not told your broker he can't lend them then the next time somebody shorts those shares it could be your shares he is borrowing. If the person buying the shorted shares holds them in a margin account then the broker can lone them out for someone else to short.

ETFs With High Short Interest - June

My question is simply, what happens if suddenly everyone wants to cover and there are no shares available to be purchased? That seems like a reasonable question. In the chart above the S&P Retail ETF had 16.9 million shares outstanding and 94.9 million shares short. That sounds like a recipe for a serious short squeeze. That was a question posed in the ETF systemic risk report.

Another problem they highlighted was the lack of a requirement for ETF managers to actually own the shares they are indexing. If you look closely at the prospectus of some ETFs they specifically allow the manager to retain a portion of the money invested and use that money for anything they want and for buying and selling securities not indexed by the fund. Hypothetically you could be invested in an energy ETF that has a portion of its funds invested in Apple or gold, tulips or pork bellies.

So what happens if the fund sees a significant short squeeze and the manager is holding cash or other securities that is not participating in the squeeze? For instance, if you held an energy fund and Iran dropped its first nuke on Saudi Arabia you would hope your ETF manager was 100% invested in oil stocks and not some pet side project where he was trying to scalp a couple dollars off an airline stock.

If an ETF has 100% of its shares shorted it would imply a negative leverage of about 50:1. Rules state that there must be 102% collateral against all short sales of any stock. That collateral is covered by your margin account when you sell short.

Without going into great detail about this report I think you can see why they feel the market risk is growing. That risk is not just to the downside but there is also risk to the upside. If something happened to start a serious generic short squeeze in the market it could become positively explosive as those ETFs with monster short interest all tried to cover at once. An ETF manager has to cover redemptions with the actual shares of the stocks in the index not with something he may be holding that is not relative to the ETF.

In 1995 there were FOUR ETFs with $2.3 billion in assets.
In 2000 there were 106 ETF/ETP with $74.3 billion in assets.
In 2005 there were 525 ETF/ETP with $412 billion in assets.
In 2010 there are 3257 ETF/ETP with $1.2 trillion in assets.
There are currently 972 ETF and 878 ETP in the pipeline to market.

An Exchange Traded Product (ETP) can be in the form of an exchange traded note or exchange traded commodity. These are backed by the sponsor, like Barclays, which promises to guarantee the value of the ETP. In a major market meltdown the impact of an imploding ETP could be more than the guarantor could cover.

Lastly, with the thousands of products there are hundreds of cross collateralizations. That means a company with 25 million shares outstanding could be represented in the index list for a couple hundred ETFs representing more than a billion shares.

It smells a lot like a CDO or Mortgage Backed Security. Each ETF represent slices of tens to hundreds of individual stocks. In theory there is no way for a default but we saw how that theory broke down in real life in 2008. The homes still exist and many of the owners are the same but the CDOs and MBS products all caused significant losses for the purchasers. In a major market event will the ETFs implode from the leverage and take everyone's retirement down the tubes with them?

Here is the link to the report: ETF Systemic Risk

Debt concerns in Europe created another day of currency problems for the market. Worries that Ireland and Portugal may need a bailout or they will default on debt sent the Euro plunging more than 1% and the dollar up more than 1%.

Gold prices rallied to a new high at $1,424 before rolling over on the afternoon rebound in the dollar. Gold was also supported by the World Bank president suggesting that leading economies should consider readopting a modified gold standard.

The G20 meeting that starts on Thursday has also increased hostility and volatility over currencies. The extreme volatility in currencies is causing havoc in commodities and metals. Today that volatility crossed over into equities as well.

Dollar Index Chart

Euro Chart

Gold Chart

Twice now the S&P has reached 1227 and stalled. This is not a problem, yet. The S&P rallied nearly 50 points from last week's lows and a -10 point decline is just a blip. It will be a bigger problem if we start stringing several days of declines together. This was the first time the S&P has had back-to-back losses in 24 trading days. It is due for a rest.

I mentioned last week that I wish we could get a decent decline so those still on the sidelines would feel comfortable joining the crowd at the table. I could easily see a decline to 1200 or even 1190 to erase last Thursday's big spike. I do not see any potential drop below 1190. Remember, we have the Fed put to protect the market. The S&P stalled exactly where it should have stalled at just under 1228.

This profit taking is simply that, profit taking from the pre FOMC rally. The indexes were up 14% to 18% over the prior two months. Once the pressure eases we should continue moving higher.

S&P-500 Chart

The Dow has the same challenge as the S&P. The big gain from last week was unsupported and needed to back fill before moving higher. There is significant support at 11100 and we could easily test that level if the G20 currency battle heats up. That will give traders the excuse they need to take profits.

Dow Chart

The Nasdaq came very close to testing uptrend support at 2550 late this afternoon. The dip to 2552 was instantly bought and on heavy volume. I believe this support should hold and provide a launching point for the next bounce. The Cisco earnings on Wednesday evening will be the major test. That needs to be a good news only report because the bad news bulls are taking the week off.

Nasdaq Chart

In summary the markets are taking a rest. Traders needed to take profits from the two-month rally now that all the announcements and monthly economics are behind us. They needed a reason to justify taking profits and the debt/currency issues were blamed.

This is the week before option expiration and this is when the expiration volatility normally occurs. Don't get shaken up by the declines unless support at S&P 1190 and Dow 11100 are broken. It is a buying opportunity not the start of a new bear market.

Jim Brown


New Option Plays

Failing at Resistance

by James Brown

Click here to email James Brown

Shares of this specialty chemical company have seen their oversold bounce fail.


NEW DIRECTIONAL PUT PLAYS

Lubrizol Corp. - LZ - close: 107.68 change: -1.20

Stop Loss: 110.25
Target(s): 100.50
Current Option Gain/Loss: +0.00%
Time Frame: 3 to 4 weeks
New Positions: Yes

Company Description:
The Lubrizol Corporation (NYSE:LZ - News) is an innovative specialty chemical company that produces and supplies technologies to customers in the global transportation, industrial and consumer markets. These technologies include lubricant additives for engine oils, other transportation-related fluids and industrial lubricants, as well as fuel additives for gasoline and diesel fuel. In addition, Lubrizol makes ingredients and additives for personal care products and pharmaceuticals; specialty materials, including plastics technology and performance coatings in the form of specialty resins and additives. Lubrizol's industry-leading technologies in additives, ingredients and compounds enhance the quality, performance and value of customers' products, while reducing their environmental impact. With headquarters in Wickliffe, Ohio, The Lubrizol Corporation owns and operates manufacturing facilities in 17 countries, as well as sales and technical offices around the world. Founded in 1928, Lubrizol has approximately 6,800 employees worldwide. Revenues for 2009 were $4.6 billion. (source: company press release or website)

Why We Like It:
Shares of this specialty chemical company soared to new all-time highs back in October. When the company reported earnings they smashed the earnings estimate and management guided higher. Yet revenues were a miss. The stock was hammered on then news. Now LZ has fought its way back toward the $110 level, which seems to be new resistance. I'm not convinced the correction is over and it looks like LZ could retest support near $100 again.

I am suggesting bearish positions now. We'll use a stop loss just above resistance. Our target is $100.50. More aggressive traders could aim for $97 or even the 200-dma.

Suggested Position: Buy the December $105 puts (symbol:LZ1018X105) current ask $3.10

Annotated Chart:

Entry on November xxth at $ xx.xx
Earnings Date 02/03/11 (unconfirmed)
Average Daily Volume = 525 thousand
Listed on November 9th, 2010


In Play Updates and Reviews

Market-wide Decline Hits Triggers

by James Brown

Click here to email James Brown

Editor's Note:

We have been waiting for a pull back and today's decline hit a couple of triggers. CAT and IYF, both call plays, have been opened. I have adjusted the triggers on CLF and NKE. Shares of ESS plunged hitting both our trigger and stop loss in the same move.

Market pundits were in an uproar this afternoon about the widespread decline today where stocks, bonds, and metal (gold, silver) all surged lower in the last couple of hours of trading. Everyone was talking about buying puts to protect their stock positions. This is clearly a bearish reversal for many securities. The question is, "Will there be any follow through?" Is this just a temporary dip like the ones we've seen over the past twelve weeks? Or is this the start of something more?

If this is another temporary dip then we want to look for entry points as stocks and the market nears clear support levels. If this is a real correction then the market could see a -5% decline (or more) and we'll see most of our bullish candidates get stopped out. Readers will want to keep positions small for the time being.

-James

Current Portfolio:


CALL Play Updates

Caterpillar - CAT - close: 81.91 change: -1.21

Stop Loss: 79.40
Target(s): 84.85, 89.50
Current Option Gain/Loss: + 6.0%
Time Frame: 3 to 4 weeks
New Positions: Yes

Comments:
11/9: We've been hoping for a pull back and the market finally provided one today. CAT dipped to $81.41 intraday. Our trigger to buy calls was hit at $81.75. If you missed the entry point you could buy calls now or wait for a pull back closer to the $80.00 level.

Earlier Comments
Our first target is $84.85. We want to exit the majority of our position here. We'll set a secondary target at $89.50 but again I warn you the $85 level should be tough resistance. FYI: The P&F chart is bullish with a $118 target.

Current Position: Long the December $85 calls (symbol: CAT1018L85)
Entry @ $1.40

Annotated Chart:

Entry on November 9th at $ 81.75
Earnings Date 01/27/11
Average Daily Volume = 7.7 million
Listed on November 6th, 2010


Cliffs Natural Resources - CLF - close: 68.83 change: -2.06

Stop Loss: 64.75
Target(s): 71.50, 74.75
Current Option Gain/Loss: Unopened
Time Frame: 4 to 6 weeks
New Positions: Yes, see trigger

Comments:
11/9: Commodity-related stocks were not immune to the sell-off. Actually strength in the U.S. dollar may have accelerated the pull back in CLF, which lost -2.9% on Tuesday. The low today was $68.11 - not enough to hit our trigger. Today's session certainly looks like a short-term bearish reversal so I am moving our trigger from $68.00 to $67.00 and we'll put the stop loss at $64.75.

Earlier Comments
We'll use a stop loss at $64.75. Our upside targets are $72.00 and $74.75.

Trigger to buy calls @ $67.00 <-- new trigger

Suggested Position: Buy the 2010 December $70.00 CALL

Entry on November XX
Earnings Date 02/17/11
Average Daily Volume = 4.3 million
Listed on November 1, 2010


Costco Wholesale - COST - close: 64.22 change: -0.59

Stop Loss: 62.90
Target(s): 69.00
Current Option Gain/Loss: -14.6%
Time Frame: 3 to 4 weeks
New Positions: Yes, see trigger

Comments:
11/9: The correction continues following Friday's failed rally at $66. Shares of COST dipped toward short-term support near $64.00 and its 30-dma this afternoon. If the market continues to sell-off sharply then we'll probably get stopped out soon but if traders buy the dip then today's move in COST looks like another bullish entry point. Remember, we want to keep our position size small to limit our risk.

Current Position: December $65.00 calls (symbol: COST1018L65)
Option Entry @ $1.50

Entry on November 8th at $64.50
Earnings Date 12/09/10
Average Daily Volume = 3.4 million
Listed on November 6th, 2010


Humana Inc. - HUM - close: 59.12 change: -0.50

Stop Loss: 51.75
Target(s): 59.75
Current Option Gain/Loss: Unopened
Time Frame: 4 to 6 weeks
New Positions: Yes

Comments:
11/9: HUM held up relatively well only slipping -0.8%. Shares still look poised to correct lower. There is no change from my previous comments.

Earlier Comments
We want to wait for a dip and use a trigger at $55.25 to buy calls. Aggressive traders may want to consider puts while we wait since we're expecting such a big correction. If HUM hits our bullish trigger at $55.25 we'll use a stop loss at $51.75.

Suggested Position:

Trigger to buy calls at $55.25

BUY the 2011 January $55 calls.

Entry on November xxth at $ xx.xx
Earnings Date 11/01/10 (confirmed)
Average Daily Volume = 2.1 million
Listed on October 16th, 2010


iShares DJ Financial ETF - IYF - close 54.89 change -1.08

Stop Loss: 53.40
Target(s): 57.50, 59.75
Current Option Gain/Loss: -5%
Time Frame: 6 to 8 weeks
New Positions: Yes

Comments:
11/9: Financials were some of the worst performers today with heavyweights like BAC down -2.6% and WFC down -3.1%. The IYF slipped -1.9% and hit $54.63 intraday. Our trigger to buy calls was hit at $55.00. If you're still looking for an entry point readers may want to wait for a dip closer to $54.00.

Earlier Comments
Our first target is $57.50. Our second, longer-term target is $59.75.

Current Position: Long the December $55.00 CALLS, entry @ $2.00

Annotated Chart:

Entry on November 9th @ 55.00
Earnings Date N/A (unconfirmed)
Average Daily Volume: 1.0 million
Listed on November 4, 2010


Nike Inc. - NKE - close: 83.20 change: -0.41

Stop Loss: 79.90
Target(s): 87.25
Current Option Gain/Loss: Unopened
Time Frame: 4 to 6 weeks
New Positions: Yes, see trigger

Comments:
11/9: Shares of NKE held up very well during today's market-wide decline. I still think shares will dip toward $82.00 and I'm moving our trigger to buy calls from $82.50 to $82.00.

Earlier Comments
Stop loss at $79.90. Our first target is $87.25. FYI: The Point & Figure chart is very bullish with a long-term target of $115.

Trigger to buy calls @ 82.00 <-- New Trigger

Suggested Position: Buy the December $85.00 CALLS (symbol:NKE1018L85)

Entry on November xxth at $ xx.xx
Earnings Date 12/21/10
Average Daily Volume = 2.3 million
Listed on November 6th, 2010


VimpelCom Ltd - VIP - close 15.89 change +0.17

Stop Loss: 14.80
Target(s): 16.75, 17.75
Current Option Gain/Loss: - 4.7%
Time Frame: 6 to 8 weeks
New Positions: Yes

Comments:
11/9: It was another rocky session for VIP. Shares rallied toward Friday's highs but didn't quite make it. The stock then rolled over with the rest of the market. Wait for a dip into the $15.50-15.25 zone before considering new bullish positions. FYI: VIP is due to report earnings around Nov. 24th.

Current Position: December $15.00 CALLS, Entry @ $1.05

Entry on November 8, 2010 @ 15.60
Earnings Date 11/24/2010 (unconfirmed)
Average Daily Volume: 3.5 million
Listed on November 3, 2010


PUT Play Updates

Millicom Intl. - MICC - close: 93.16 change: +0.10

Stop Loss: 98.25
Target(s): 92.50, 90.25
Current Option Gain/Loss: + 6.1%
Time Frame: 3 to 4 weeks
New Positions: No

Comments:
11/9: MICC is still hugging technical support at its rising 100-dma. There is no change from yesterday's comments. I am not suggesting new positions at this time. We still have our final target at $90.25.

Current Position: Long December 2010 $90 puts (MICC1018X90)
Entry @ $2.45

11/08 Target hit @ 92.50, option @ 2.85 (+16.3%)

Entry on November 1, 2010
Earnings Date 02/01/11
Average Daily Volume = 490 thousand
Listed on October 30th, 2010


CLOSED BULLISH PLAYS

Essex Property Trust - ESS - close: 110.03 change: -5.21

Stop Loss: 111.80
Target(s): 119.50, 124.50
Current Option Gain/Loss: -22.2%
Time Frame: 4 to 6 weeks
New Positions: Yes

Comments:
11/9: Our new candidate in ESS didn't last long. We were expecting a dip back toward $114.00, maybe $112.00. Instead shares plummeted lower through out the session for a -4.5% decline. There was no let up in the selling and I couldn't find any specific catalyst behind the market's widespread pull back. Shares of ESS hit our trigger at $114.00 and quickly hit our stop loss at $111.80 closing the play. The stock has now broken its trendline of higher lows and broken below its 50-dma. We wanted to keep our position size small to limit risk.

Opened & Closed Position:
Triggered @ $114.00 - Closed at $111.80

2011 January $120 calls (symbol: ESS1122A120):
Estimated entry @ $2.25, Estimated exit @ 1.75 (-22.2%)

Annotated Chart:

Entry on November 9th at $114.00
Earnings Date 02/02/11
Average Daily Volume = 209 thousand
Listed on November 8th, 2010