Option Investor
Newsletter

Daily Newsletter, Saturday, 8/6/2011

Table of Contents

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

Market Wrap

U.S. Loses AAA Rating

by Jim Brown

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The final curtain in the debt debacle debate slammed down on the U.S. late Friday when S&P cut the U.S. rating for the first time in history from AAA to AA+.

Market Statistics

All day Friday there was a threat of a downgrade of U.S. debt by S&P hanging over the market. News that big is very hard to keep secret and that was responsible for the early morning swoon. Late Friday evening news broke that S&P had backed away from a downgrade of the debt after the White House challenged them on the basis for their move. When S&P is going to downgrade somebody they normally supply that entity with their analysis and reasons for the downgrade so the entity can verify all the assumptions are reasonable. Reportedly the White House responded with hostility claiming the agency was "trillions of dollars" off in its analysis, in part because of the complicated "baselines" that are used to compare long-term government spending and revenue projections. The Treasury Dept showed S&P where they miscalculated deficit projections by more than $2 trillion. S&P later admitted the error but said it did not make any difference in their final decision.

The rumored downgrade was blamed for the -416 point Dow decline mid-morning when the Dow declined from a +172 point gain at the open to -245 point decline just before noon. S&P had said he U.S. needed to announce spending cuts of $4 trillion in the debt limit compromise in order to avoid a downgrade. They backed off that position somewhat as the talks continued over the last couple weeks but it was always the elephant in the room. Fitch and Moody's have already affirmed the U.S. AAA rating but they are keeping the U.S. on credit watch negative until they see how the congressional committee works out with the secondary spending cuts.

Later Friday around 9:PM S&P followed through on the downgrade threat and cut the U.S. from AAA to AA+ with a negative outlook. The negative outlook suggests a further downgrade is possible within 12-18 months. This is the first time in history that the U.S. has not had an AAA rating from S&P. The agency said the U.S. did not go far enough to stabilize the country's debt situation. They also cited "political confusion" as part of the reason and they question the ability of the special congressional committee to make any material changes. U.S. bonds are now rated lower than France, Canada, Germany, Netherlands, Australia, Hong Kong, the Isle of Mann and Britain.

Link To S&P Downgrade

Analysts are mixed on what impact this will have on the markets next week. Several analysts said the market decline last week was in expectation of this downgrade. Apparently the rumor had been circulating in the hedge fund community since Tuesday. Analysts are split on what will happen to U.S. bonds because there are few alternatives to the U.S. treasury market in both depth and liquidity. There are $9.3 trillion in U.S. bonds outstanding. More than $580 billion trade every day and far more than the British Gilts at $34 billion or German bunds at $28 billion. Obviously rates on U.S. bonds will change on Monday. SIFMA, a U.S. securities industry trade group, said the down will likely add +0.7% to the rates and cost the U.S. $100 billion a year in additional interest. China holds $1.16 trillion and Japan $912 billion. They will not be selling because they can't without driving the market down and causing themselves a significant loss.

This will ratchet up the ideological issues over spending cuts and tax reform between now and the 2012 elections and you can bet this downgrade will be a hot topic in the election speeches.

The last downgrade threat came while Bill Clinton was president and a similar default scenario loomed. The U.S. debt at the time was $4.9 trillion. Once the limit was raised the rating agencies canceled their warnings.

The downgrade came despite a remarkable Nonfarm Payroll report for July that actually came in well above expectations. The BLS reported a gain of +117,000 jobs in July compared to consensus estimates for a gain of +85,000 and many whisper numbers at zero. Even better the 18,000 jobs created in June were revised higher to 46,000 and the 25,000 new jobs in May were revised higher to 53,000. That was a total gain of 173,000 jobs when most analysts were expecting something closer to zero.

Private sector jobs increased by +154,000 but that was offset by a decline of 37,000 government jobs. Much of that decline came from Minnesota and their government shutdown. More than 30,000 of those jobs losses came from there and they are temporary. They will reappear as job gains in August.

The companion Household Survey, which captures more of the small business trends showed a loss of -38,000 jobs BUT that was significantly better than the -445,000 drop in June and represents a significant reversal.

The jobs numbers suggest the second dip scenario that was so prevalent over the last two weeks may not be as certain as some thought. Yes, there was a new soft patch but maybe the July jobs gain is our evidence it was just a bump in the road and not a detour. If it were not for the S&P rumor early Friday morning the market outcome could have been a lot different.

Nonfarm Payroll Chart

The economic calendar for next week is pretty skinny with only a couple of reports worthy of highlighting. The biggest is the Fed meeting on Tuesday. I can't even imagine what the Fed is thinking this weekend. The market had its worst week in over two years on fears of a double dip recession. S&P downgrades the U.S. credit rating and Europe is on the verge of a meltdown if something is not done this weekend. It would seem like a perfect opportunity to announce some sort of stimulus except the economy added +173,000 jobs in July. The inflation hawks will be holding the line and Bernanke will have to find some way to stimulate without pushing them into a revolt.

There are things the Fed can do without announcing a QE3 program. I expect them to take some action even if it is only a token move because the wealth effect they worked so hard to create since last August has evaporated. If they can't find some way to shock the market back into rally mode we are likely to see a sharp decline in consumer spending for the rest of the year. The market has a direct impact on consumer sentiment and I suspect that sentiment took a very big hit last week.

This makes Tuesday the pivotal day this week. Monday could be crazy for reasons I will describe later so Tuesday is the Fed's chance to pull us back from the brink.

Friday has the Consumer Sentiment report for August and this month started off really bad. Sentiment declined -8 points to 63.7 in the final reading for July and I would be shocked if we didn't see another large drop. This makes Friday's report critical.

On Friday the Investor's Business Daily Optimism Index dropped -13.5% from July to August to the lowest point in its ten year history. The reading of 35.8 was down from 41.4 in July. It is roughly 20% below its 12-month average. All key components, the six-month outlook, confidence in federal policies and personal finances were also at historic lows. All 21 demographic groups polled showed an increasing level of pessimism over U.S. economics.

Economic Calendar

The earnings cycle is about over but there are a few big companies left to report. Cisco is probably the most important for the week after Juniper and other networkers disappointed with earnings. Cisco has been in a downhill slide since April of 2010 and every earnings report has caused massive drops in the stock.

Cisco Chart

MGM reports on Monday but they will probably be overshadowed by the external events in Washington and Europe. Kohl's and JC Penny's report late in the week and will give us another health check on the bargain conscious consumer.

Earnings Calendar

Last but not least we have Europe continuing its meltdown. Italy and Spain both saw their bond yields move over 6% and EU finance ministers and country leaders were holding emergency meetings and conference calls on Friday hoping to find a way out of the quicksand of financial stress. Italy took center stage with 120% debt to GDP and the most urgent of funding problems.

The ECB said earlier in the week it would buy bonds from troubled countries, the European version of QE2, but did not say it would buy bonds from Italy or Spain. This caused the markets to turn on those countries and the ECB was forced to announce on Friday they might buy their bonds but said they would only do it if the countries implemented some tough austerity measures.

Italy's premier, Silvio Berlusconi, told a hastily arranged news conference the government will speed up measures in its budget law approved last month by Parliament with the possibility of reaching a balanced budget by 2013 instead of 2014 as initially planned. He said he met by phone with world leaders and the G7 finance ministers would meet "within days" about the exploding financial crisis. Although that was an exaggeration his spokesman said a meeting was discussed. Italian politicians, normally on vacation in August pledged to keep working in order to respond to the rapidly worsening economic crisis.

It was enough to rescue the U.S. markets from a -245 point decline and produce a +400 point rally in just one hour. The ECB agreeing to buy Spanish and Italian bonds would be a key step in putting an end to the crisis. Buying bonds provides support and keeps rates low. The Federal Reserve had been buying Treasuries in QE2 in the same type of strategy.

The market rallied on the news and all eyes are going to be on Italy and the ECB on Monday. In the U.S. CNBC is going to have special coverage Sunday night on the European crisis when Europe opens the week for business.

If you thought the market was volatile last week just wait until next week. Last week Morgan Stanley released the results of a study on hedge fund leverage. They said funds had been aggressively going to cash over the last several weeks and where the average fund had been leveraged 1.5 or even as much as 2.0 times their capital the average today was only .45%. That means only 45% of their cash is invested. Hedge funds have been struggling to turn a profit in 2011 and the last couple months have been deadly. One noted analyst commented on Friday that the volatility last week could have been related to some hedge funds imploding. Funds behind the curve may have been over leveraged to try and catch up and instead got caught by the market reversal. Volatility is wonderful if you are on the right side of the market.

The volume in the market suggests there is something going on behind the scenes that we are not aware of yet. I am sure everyone remembers big market events with corresponding volume spikes. We have had dozens over the last decade including the Great Recession, bankruptcy of Lehman, the flash crash, etc. However, I don't remember volume suddenly spiking to the extreme we saw last week. Note how the volume spiked on Thursday with the -513 point loss to 13.8 billion shares with up volume almost microscopic. That is what a normal capitulation day looks like.

However, on Thursday night I wrote that I did not think Thursday was a normal capitulation day and I expected it to be Friday. The open on Friday with the big +171 point rally and then crash -416 points from the highs to a lower low was a capitulation event. The up volume in the afternoon was traders buying the dip on the news out of Europe. Friday's share volume was more than double the daily average. More than 36.1 million option contracts traded on Friday compared to a normal day at 4.5 million. That was a new record by nearly 20%. That is a lot of stop losses getting hit.

HOWEVER, I believe the massive amount of volume suggests there may have been something else going on behind the scenes. Hedge funds imploding? Maybe, but a hard leak of the impending S&P downgrade would make more sense. We know now that the story was given to the news networks earlier in the day but was embargoed until 8:30 Friday night. Bloomberg dispatched a news crew to meet with John Mauldin and Nouriel Roubini before it was public news.

Volume Table

The volatility hounds will be howling next week. With the S&P downgrade, an all night Europe watch Sunday night and FOMC on Tuesday the week could start out in dramatic fashion. It is hard to know for sure but the conventional wisdom would expect the U.S. market to plunge at the open on Monday thanks to the downgrade. However, since there were rumors the last several days we don't know if the downgrade is already priced in or not. I am betting NOT. This is a major event at least psychologically. Since Moody's and Fitch have already affirmed the AAA rating at least for August that may take some of the sting out of it. However, now that S&P has taken the plunge does that mean the other two will follow suit at the end of August? You know S&P is now going to be grabbing headlines every week now with downgrades of related agencies and corporations that depend on the government for their existence.

The wild card here is the Europe mess. If the ECB announces Sunday night they are going to backstop Italian bonds no matter what then the markets could rally on expectations for a final (really?) resolution to the European crisis.

Regardless of the reason for the crash last week there was some serious damage done to the technicals. This was the equivalent of a reboot of the markets. The Dow "only" lost -5% for the week but the Russell lost more than 10%. This was an instant correction.

Despite the broken technicals the S&P performed exactly as it should have with the dip to 1175. Two weeks ago that was a level we would have never believed we would see again in 2011 with the S&P trading over 1350 as recently as early July. The panic dip Friday morning traded down to 1168 purely on momentum as millions of stop losses were hit. Within minutes the dip was bought and the rebound began. This preserved 1175 as short-term support. I could easily see this level tested again at the open on Monday. I would be a buyer if that level is tested again. If this level eventually breaks the next support is 1050.

S&P Chart - Daily

The Dow fell -1,612 points from the high on July 21st to the low on Friday. That has to rank right up there with one of the fastest declines in recent history. The Dow failed to drop to 11,000, which would be the equivalent level to S&P 1175. That does not mean it won't go there but the big cap blue chips are seen as safe deposit boxes in times of market stress so fund managers were more concerned about bailing from the small and mid caps than the Dow's blue chips.

I would be a buyer to any dip to 11,000 but that is 444 points away. (Oh, I forgot, we already had 400-point moves three times in the last three days.) If we are lucky enough to test 11,000 I would be a buyer of the DIA or SPY at that level.

Dow Chart

Nasdaq, different index, same story. Support at 2500 was tested with a dip all the way to 2465 thanks to the high velocity plunge after the open. Buying was pretty strong at that level and that would suggest there is a point where traders are willing to take a risk. Apple traded as low as $362 with support at $360. If you want a position in Apple or Amazon but always thought they were too high dollar then this may be your chance.

I like tech stocks but I would key any purchases on Monday based on the support levels for the S&P and Dow. The Nasdaq ended the day negative with the Dow up +60 so key on the stronger index.

Nasdaq Chart - Daily

The Russell has declined -18.6% from the 860 high on July 7th to Friday's 700 low. The Russell has long passed correction territory at -10% and is rapidly approaching bear market territory at -20%. Fortunately traders defended strong support at 700 and only allowed a 1.1 point incursion below that level. They clearly had their buy orders ready. If that level is tested again I would be a buyer of IWM calls for a trade.

Russell 2000 Chart

Last weekend we were watching the 200-day average on the S&P at 1284 as critical support. This weekend we are watching 1175. What a difference a week makes!

I have read dozens of articles on what to expect when the market opens on Monday. While nearly everyone expects a drop at the open, most believe the dip will be bought. Of course we will not know until 10:AM who was right. The Europe watch on Sunday night will complicate the issue. I am sure the newspaper headlines around the world telling of our rating downgrade could cause some knee jerk selling. However, I would expect that to be in treasuries not equities. Secondarily, strong selling in equities could actually promote strong buying in treasuries as a flight to quality. Yes, an AA+ rating is still quality.

I would use any weakness on Monday morning as a buying opportunity for a trade. We don't know how the long-term scenario is going to play out so I would want to grab a few points and then move to the sidelines later in the week if the market begins to weaken again. We are extremely oversold and it is only a matter of time until we get a real short squeeze.

You have to ask yourself if the economy and financial system is worse today than in 2008 or is it significantly better? Despite the weak reports over the last month we don't have any major U.S. banks failing, the TARP loans have been paid, 73% of S&P companies beat earnings, jobs were better than expected, the debt debacle is behind us and gasoline prices are falling. That would seem to indicate there is no real macro reason for the markets to be crashing. This is a political event roiling the markets. I think a lot of others will see it that way as well but since we have never had a ratings downgrade before there is no precedent in the USA. Other countries have been downgraded and nobody noticed. Of course the hype in the weekend news is going to create some selling from the nervous Nellie's and we just have to let it play out and then pick a spot to jump in.

Jim Brown

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"Knowledge speaks, but wisdom listens."
Jimi Hendrix


Index Wrap

MONSTER BREAK

by Leigh Stevens

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THE BOTTOM LINE:

What I thought was a 'trading range' market wasn't, as the indices dropped like a stone as the S&P and Dow pierced their long-term up trendlines. The bearish technical pattern that suggested a sizable sell off was seen on weekly charts as the S&P 500 (SPX) and 100 (OEX) in particular. I can't say that I saw this bearish pattern and was ready for it as I was looking to buy SPX at its support up trendline, intersecting at 1270. WRONG!

I've been through 3 major and rapid declines going back to 1987, including parts of the late-2000 and all 2008 bear markets. I've only occasionally been able to make major profits from these big breakdowns. The tip off for them were mostly major trendline breaks. Trendline penetrations by themselves don't always lead to 'waterfall' declines like this past week.

In our most recent big sell off, there were Head & Shoulder Top patterns that were traced out on the weekly charts, particularly the S&P indexes. I'll be reminded forever to put out a sell 'signal' after the formation of the Right Shoulder or 3rd. top in the H&S pattern when seen on weekly charts, implying a MAJOR top. The H&S top pattern is reliable enough usually to start buying index puts without waiting for a confirming 'neckline' break.

For more on the Head & Shoulder's pattern, you can go to my previous Trader's Corner article on this subject.

By the way, 'minimum' downside objectives implied by the SPX Head & Shoulder's Top pattern has already been met by the decline to SPX 1180 (weekly low was 1168 in the S&P 500). There are some other technical chart aspects that may suggest still lower downside objectives ahead.

Our most recent sell off is similar to last year with the decline in SPX from late-April to early-July; from (intraday) peak at 1220 to trough at 1010, this break ran 210 points. Our SPX correction to date is 202 points. This most recent decline covered the same ground FASTER of course. This looks like a function of the excessive bullish sentiment that's been a feature since August of last year, which also went in hand in hand with extreme skittishness about the sustainability of the economic recovery, both here and in the Eurozone.

To better understand where the indexes are in relation to the bigger picture, I'll include weekly charts, instead of just the dailies, as part of my index commentaries.

MAJOR STOCK INDEX TECHNICAL COMMENTARIES

S&P 500 (SPX); WEEKLY AND DAILY CHARTS:

In the weekly S&P 500 (SPX) chart, there was a major penetration of SPX's weekly up trendline at 1270 and the chart has turned intermediate-term bearish. A long-term bear market would be 'signaled' on a weekly close below 1011.

I point out 4 technical aspects with the weekly index charts: 1), the lead in to this sell off was a Head & Shoulder's Top formation; 2)the retracement of the last big advance has now exceeded 50% and a 'normal' correction; 3) a further Fibonacci 61.8% (rounded to 62%) retracement, extending to a 2/3rd or 66% retracement, could take SPX to the 1128 to 1146 price zone; 4), in terms of the 8-week RSI, the index has just entered 'oversold' territory. Of course, an oversold condition can go on for some time.

If SPX gets to 1150, this may be an area to exit bearish positions. My daily SPX chart seen next will include the 62-66% retracement levels as potential further downside objectives.

If the weekly chart is bearish, then of course so is the daily chart here. I've kept my 4% trading envelopes or 'bands' as a reminder of how far SPX is below it's 'normal' trading range. It's rare for prices to be this far under the lower envelope line. Of course, the moving average and the simple moving average envelopes are falling and will 'catch up' with prices soon enough on even modest further weakness. I didn't note support at 1200 but on an hourly chart basis (not shown), you can see prices mostly stabilizing on its dip below 1200-1190.

I've noted pivotal resistance at 1260, extending to 1300 and the level of the current 21-day moving average.

I've noted potential support at the aforementioned retracement levels seen on the weekly chart above; i.e., in the 1145 to 1128 price zone. On a daily chart basis, SPX is quite 'oversold', although oversold readings can go on for a while after what's been going on. Then, there's the S&P debt rating reduction by the Standard & Poor's that the market hasn't reacted to yet.

We don't see the extremes in bearish sentiment (see above) that there could be given the steep decline, the speed of which works against an equally quick buildup in bearish strategies. Option traders haven't been spooked into puts in such large numbers. Of course, with such volatility as we've seen the premiums got very inflated, making outright purchases more daunting. VIX ended the week at 32, up from 23 at the start.

S&P 100 (OEX) INDEX; WEEKLY AND DAILY CHARTS

The S&P 100 (OEX) wasn't a buy in the 570-565 area as I thought it might be; my suggested stop point if anyone was brave enough to try to catch a falling knife was to exit on a close below 560. Anticipation of buy/sell points works well over time with index options, with occasional whack jobs along the way. The weekly chart 'breakdown' point was 575.

The weekly and daily charts are bearish on an intermediate-term basis but I would note that OEX has now retraced just over half of the last major advance. It's not uncommon for deeper retracements of 62 to 66%, which could end up with OEX trading down to the 510-517 area as highlighted on the weekly chart below.

The daily OEX chart, with its 4% moving average envelope lines (relative to the 21-day centered moving average) visually highlights how far below the lower band the OEX got this past week. There's a strong tendency for prices to get back closer to the broader bands, either by a rebound in the index or the falling average and its lower envelope to converge. Stayed tuned on what rebound potential exists in such a bearish environment!

Key resistance is noted at 568, extending to the 580 area. 'Support' and areas of potential buying interest is guesswork in this kind of panic environment. I'm using the big fibonacci retracement levels to suggest potential bottoming action in the 517 to 510 area. As with the S&P 500, OEX is now oversold on a daily and weekly chart basis; more so on the daily chart.

DOW 30 (INDU) AVERAGE; WEEKLY AND DAILY CHARTS:

I was last week of the mind to reverse from DJX puts into calls if the decline ended 11900 and what I saw as the low end of a broad trading range. However, major support was penetrated at 12917, basis the weekly chart up trendline and the sell off snowballed.

Only 6 Dow stocks are still trading above their 200-day moving averages: AXP, CVX, KFT, KO, KFT, MCD and IBM. No doubt now there will now be a long process of recovery just to get back to this key average; one that investors do look at more than most technical/chart factors.

The weekly chart highlights the 50% as well as the 62-66% retracements levels. Support in the 11257 area might again offer some support, but a move to or a bit under 11000 may be more likely to bring in buyers again. I've highlighted the 10716 to 10873 zone as a next target or objective. I can't call these levels 'support' in the sense of a prior bottom for example.

If there was an area I'd like to own the basket of 30 Dow stocks at this point, it would be on dips below 11000 of 200-300 points. On a risk to reward basis it looks reasonable right now as a call buy and more so as an area to exit puts. INDU is 'oversold' in terms of the past bull market; NOT so much, if looking at a new bear market. I don't believe in a second recession ahead but also have renewed caution on betting on a continued bull trend.

The daily INDU chart is now established as bearish given the sharp downside break below prior lows in the 12000-11860 area. This past week's sell off was well outside the expected envelope ranges that were 'working' so to speak in showing bullish/bearish extremes; that is BEFORE the market dove off a cliff.

I'm going with the idea that the 50% retracement level for the broad trend could be a continued support area and have noted 11287 as a potential first support. The 10873-10716 area, representing the 62-66% weekly chart retracement levels seen above, is of more interest as a potential support zone.

Resistance is at 12000, extending to 12200. This market is quite oversold now and suggests not chasing the indexes lower cause the world is going to fall apart. There's not much that is different this week in terms of already established bearish influences, versus speculation of all the troubles that could happen.

NASDAQ COMPOSITE (COMP) INDEX; WEEKLY AND DAILY CHARTS:

The Nasdaq Composite (COMP) weekly chart shows a break of the major up trendline this past week at 2640, now a potential future resistance.

The big first retracement of the July 2010 to July 2011 advance was the give back of half of those gains; i.e., at 2472. This level may offer at least initial support in the coming week. Or, of course, it may be a knife through butter on the way to the deeper retracements seen on the weekly chart. I favor covering tech shorts on dips below 2400.

The daily chart of the Nasdaq Composite (COMP) looks like a minor disaster as the dip was well under its prior range in terms of the moving average envelopes. However, 2470 may hold on further declines, as tech should be the first to recover. If 2500-2470 is penetrated, I've highlighted the 2374 to 2334 levels as possible objectives. Again, I don't like to imply that these levels are 'support' in the way that a prior low might be. Think of this zone as a target area.

I've noted resistance at 2650, extending to 2700. 2765, at the current 21-day moving average, is another resistance; it had been 'acting as' support but is assumed to now be a key rally stopper.

COMP is at an oversold extreme and my sentiment readings are mildly bullish. Price action MUST confirm any recovery expectations based on 'oversold' indicators alone. Markets get overbought and oversold and can stay that way for periods of time as investor and trader psychology/sentiment doesn't usually turn on a dime.

NASDAQ 100 (NDX); WEEKLY AND DAILY CHARTS:

The Nasdaq 100 (NDX) index weekly chart broke key trendline support at 2210 and could be headed lower. However, this trendline break is very slight and could reverse by the end of the coming week. Stay tuned on that! The key thing is that NDX is mostly just back at the low end of its prior broad trading range.

If NDX sinks to 2068 area, it will retrace half of its last big advance and I've noted this level as potential support. In terms of deeper retracements, the 1945-1980 price zone is next up as a potential price target.

I doubt that NDX is going to sink a much lower than to a 50% retracement. A give back of half of a prior big move is quite substantial for a stock group that's previously been as strong as this one.

I wrote last week about the 2250 area as an area to exit NDX puts and buy calls. Such a trade to establish call positions isn't a disaster, but stay tuned as to whether 2180-2200 continues to attract buying interest. This recent sell off seems overdone but the market will seek its equilibrium and I don't argue with it.

Resistance is at 2284, then in the 2317 area, extending to 2353 and the current 21-day moving average.

I've noted NDX support at 2170 based on buying that was showing up last this week as seen on an hourly chart basis (not shown). The 50% retracement level seen on the weekly chart above is 2068 and my next highlighted 'support'. A final target or potential support is highlighted at 1980 or just below the 2000 level which should be a major psychological support.

NASDAQ 100 TRACKING STOCK (QQQ); WEEKLY AND DAILY CHARTS:

The Nasdaq 100 tracking stock broke under its weekly up trendline when it dipped below 53.5, but on a weekly Closing basis the Q's hung in at this support. QQQ didn't extend its losses to what would be a 50% retracement of its last major upswing, which I've noted as a next potential support at 50.7. The deeper weekly chart retracements (of 62 to 66%) are at 47.7 to 48.6.

The Nas 100 QQQ tracking stock is back at the low end of ITS broad trading range but the Friday and weekly close (at 53.8) has held the low end of its broad trading range. Is this enough to buy the stock? I'm leery of making such a prediction in advance of the coming week's trade, but buying a further dip may be attractive. More price action is needed.

If you were to cover any shorts and get lightly long, this index is probably the one to look at on deleveraged basis especially; buying the stock not the options. Volume on Friday was huge and I don't hear of many new buyers coming in. A volume climax? Could be.

Look for support at 52.5, then at 50.7, with major support beginning around 48.6.

RUSSELL 2000 (RUT); WEEKLY AND DAILY CHARTS:

The Russell 2000 (RUT) chart pierced its weekly support trendline at 753 and then went on to slice through the 50% retracement level and nearly touched the next lower 62% retracement. The support zone possibly represented by the 62 to 66% retracements is at 681-695.

RUT is oversold now on a weekly chart basis, something not seen since the early-2009 bottom.

The daily chart is bearish, mirroring the weekly chart. However on a daily chart basis, RUT is quite oversold and I don't know that there's any further big down leg ahead.

RUT support is at 700-695, then at 680 based on the retracement zone mentioned above regarding the weekly chart.

Resistance is at 775, then at 800. A close over 800 in the Russell is needed to turn the chart picture to a more bullish hue. A close above the RUT 21-day moving average, currently at 809, is another milestone. As always, a single day's Close above prior or expected resistance is best 'confirmed' by a subsequent day's Close at or above the same level.



GOOD TRADING SUCCESS!


New Option Plays

How Low Will It Go?

by James Brown

Click here to email James Brown

Editor's Note:

If you have not yet read tonight's market wrap, please do. If last week wasn't bad enough for the stock market we are now facing a very uncertain Monday. After the closing bell on Friday the credit rating agency Standard & Poor's announced they were downgrading the U.S. credit rating to AA+ from AAA. While this event has been considered a possibility for months no one was expecting it so soon after the debt ceiling extension was passed.

There is no way to gauge just how violently the stock market might react to this news. We are expecting the U.S. market to gap down lower at the open on Monday but how far the selling pressure takes the market down is anyone's guess. The S&P 500 is already down -10.7% in just the last two weeks. At the low on Friday the index was down -13.1% in two weeks. It is too late to buy puts on the market. The market is already oversold and stocks will gap open lower on Monday.

Instead of trying to play the downside we would rather focus on trying to play the oversold bounce that should appear pretty soon. It could be intraday on Monday or the oversold bounce could be on Tuesday after the FOMC meeting. Trying to predict the future is a tough gig. Part of the challenge is your stop loss placement. If you open bullish positions at the open on Monday morning (assuming a gap down) then where do you put your stop loss? You don't know if the market will see a -2%, -5%, or -10% move on Monday. We do want to keep in mind that a number of analysts and market pundits believe that a U.S. credit downgrade has already been anticipated by Wall Street. Thus while the market should see a flush lower on Monday morning it may not be as bad as if this had occurred several days ago.

The smartest trade on Monday is probably no trade at all. Art Cashin had a great quote on Friday. "Sometimes it's the second mouse who gets the cheese!" The best play may be to let someone else step in front of this train and we can pick an entry point once the dust has started to settle. Trying to catch a falling knife is dangerous. Trying to catch it with options can be deadly.

We are going to go ahead and list some bullish trading ideas but consider these lottery ticket style trades. If we win, we should win big. If we lose, we could lose it all. Keep your position size very small.

FYI: In addition to tonight's new candidates here's a list of stocks that should offer some opportunity for a bullish bounce and I would be tempted to buy calls on another dip: HFC, PM, IBM, SM, ANF. I also like AAPL and AMZN but their options are pricey.

- James


NEW DIRECTIONAL CALL PLAYS

Cabot Oil & Gas - COG - close: 66.87 change: -0.64

Stop Loss: To be determined
Target(s): 69.75, 72.00
Current Option Gain/Loss: Unopened
Time Frame: 2 to 3 weeks
New Positions: Yes, see below

Company Description

Why We Like It:
COG still has a long-term bullish up trend in spite of the market's massive sell-off in the last two weeks. Back in May and June of this year investors were buying the dip near COG's rising 50-dma. They bought the dip again at the 50-dma on Friday. I will point out that on the weekly chart the last two weeks look like a potential top. This past week painted a big bearish engulfing candlestick pattern but that doesn't mean COG can't see a strong bounce.

The low on Friday was $64.58. I am suggesting we buy calls on Monday if COG dips to $64.75. Please note that this is an aggressive, higher-risk trade. We are not using a stop loss on Monday. The Aug. $70 call will be less than $2.00 at our trigger and the Sept. $70 call could be under $3.00. I am suggesting we keep our position size small to limit our risk. After we see where COG closes on Monday, then we'll consider where to place a stop loss.

FYI: August options expire in two weeks. We're expecting the bounce to be fast and sharp but you may want to trade September calls for the extra time.

Buy-the-Dip Trigger @ $64.75

- Suggested Positions -

buy the AUG $70 call (COG1120H70)

- or -

buy the SEP $70 call (COG1117I70)

Annotated Chart:

Entry on August x at $ xx.xx
Earnings Date 10/25/11 (unconfirmed)
Average Daily Volume = 1.9 million
Listed on August 6, 2011


Green Mountain Coffee Roasters - GMCR - close: 95.99 change: -6.76

Stop Loss: To Be Determined
Target(s): 99.50, 104.00
Current Option Gain/Loss: Unopened
Time Frame: 2 to 3 weeks
New Positions: Yes, see below

Company Description

Why We Like It:
GMCR has delivered significant gains this year thanks in part to lots of short covering. Technically traders have been buying dips near the rising 40-dma. Look at the daily chart. The S&P 500 has been falling for two weeks straight. GMCR has only been correcting for two days. Friday's drop did not even hit the 40-dma. Instead the stock managed an intraday bounce after it came close to filling the gap from late July.

The low on Friday was $92.13. I am suggesting we use a buy-the-dip trigger to buy calls at $92.25. More conservative traders may want to hold out for a dip to $90.50 or the 50-dma near $88.50 instead as your entry point.

This is a higher-risk, speculative trade. We're not using a stop loss on Monday. We'll wait to see where GMCR closes on Monday night and then consider a stop. Use small positions to help limit risk.

FYI: August options expire in two weeks. We're expecting the bounce to be fast and sharp but you may want to trade September calls for the extra time.

Buy-the-Dip Trigger @ 92.25

- Suggested Positions -

buy the AUG $95 call (GMCR1120H95)

- or -

buy the SEP $100 call (GMCR1117I100)

Annotated Chart:

Entry on August x at $ xx.xx
Earnings Date 12/08/11 (unconfirmed)
Average Daily Volume = 2.9 million
Listed on August 6, 2011


O'Reilly Automotive - ORLY - close: 58.35 change: +1.44

Stop Loss: To Be Determined
Target(s): 61.75,
Current Option Gain/Loss: Unopened
Time Frame: 2 to 3 weeks
New Positions: Yes, see below

Company Description

Why We Like It:
The sell-off in ORLY actually started to pause about three days ago. The big whoosh lower in the market on Thursday barely managed to push ORLY to a new relative low. Shares were showing relative strength on Friday afternoon. I would be tempted to buy ORLY now. However, we're expecting a gap down at the open on Monday. We'll try a buy-the-dip entry point instead.

The low on Friday was $56.25. I am suggesting a buy-the-dip entry at $56.50. If triggered we will not use a stop loss on Monday. The options are going to be cheap. Use a small position size to limit your risk.

FYI: A slow down in the economy, an uncertain labor market, nervous consumer sentiment should all contribute to consumers keeping their cars longer instead of buying new cars. This should keep business strong for the auto parts and service companies like ORLY.

FYI: August options expire in two weeks. We're expecting the bounce to be fast and sharp but you may want to trade September calls for the extra time.

Buy-the-Dip Trigger @ 56.50

- Suggested Positions -

buy the AUG $60 call (ORLY1120H60)

- or -

buy the SEP $60 call (ORLY1117I60)

Annotated Chart:

Entry on August xx at $ xx.xx
Earnings Date 10/26/11 (unconfirmed)
Average Daily Volume = 1.7 million
Listed on August 6, 2011


SPDR S&P500 ETF - SPY - close: 120.08 change: -0.18

Stop Loss: To Be Determined
Target(s): 119.75, 122.50
Current Option Gain/Loss: Unopened
Time Frame: 2 to 4 weeks
New Positions: Yes, see below

Company Description

Why We Like It:
If at first you don't succeed, try, try, again.

The S&P 500 and the SPY have been way more volatile than expected. Stocks are very short-term oversold but the market can always get more oversold. There is no way to know how low the SPY might fall on Monday as investors react to the U.S. credit downgrade news. Has it been priced in or not? I would not be surprised to see the SPY retest its Friday lows near $117 but we do not want to buy it there.

The 1,150 level on the S&P 500 index (i.e. the $115 mark for the SPY) should be support. I am suggesting we use a buy-the-dip trigger to buy calls on the SPY just in case this ETF happens to fall that low. This is a purely speculative trade and we're essentially trying to catch the falling knife here. I'm suggesting the August $118 call or the September $120 call and I estimate they will be trading around $2.25 if we're triggered at $115. We will not use a stop loss on Monday.

FYI: August options expire in two weeks. We're expecting the bounce to be fast and sharp but you may want to trade September calls for the extra time.

Buy the Dip trigger @ $115.00

- Suggested Positions -

Buy the AUG $118 call (SPY1120H118)

- or -

Buy the SEP $120 call (SPY1117I120)

Annotated Chart:

Entry on August xx at $ xx.xx
Earnings Date --/--/--
Average Daily Volume = 235 million
Listed on August 6, 2011



In Play Updates and Reviews

Another Intraday Plunge

by James Brown

Click here to email James Brown

Editor's Note:

The U.S. stock market witnessed another intraday plunge on Friday in spite of the better than expected July jobs number.

The S&P 500 saw a -2.6% drop from its opening print near 1200 down to a new relative low at 1168. The index managed an intraday rebound but failed to close above the 1200 level.

It was not a great day for our new trades since the higher open triggered some trades and the big intraday plunge stopped us out.

-James

Current Portfolio:


CALL Play Updates

Core Labs - CLB - close: 103.25 change: +3.70

Stop Loss: 95.45
Target(s): 104.90, 109.75
Current Option Gain/Loss: +60.0% & +70.0%
Time Frame: 3 to 4 weeks
New Positions: see below

Comments:
08/06 update: Friday proved to be another very volatile day for the stock market. CLB was no exception. Shares opened at $100.23 only to plunged to $96.78 that morning. When stocks did reverse higher CLB outperformed and rallied to a +3.7% gain with a close back above its 100-dma. Volume was very strong on the session. The rebound near its 200-dma is also a bounce near its long-term weekly trendline (see chart below).

The $105.00 level could be short-term resistance, which is why our first target is $104.90. I am not suggesting new bullish positions at this time.

Stop Loss Placement: Readers need to decide what you're going to do about a stop loss on CLB. We are expecting the market to gap open lower on Monday due to the S&P downgrade of U.S. debt. There is no way to know how big this knee-jerk reaction could be but we're expecting traders to buy the sell-off after the initial move lower. That could be near the S&P 500 index at 1150 or at 1100. We just don't know.

Do you raise your stop loss on CLB an effort to reduce risk since you can always jump back later? Or do you remove your stop loss and just give CLB room to maneuver on what will likely be a crazy, crazy Monday and the re-set your stop loss on Monday night? We are moving our stop loss down to $95.45, which keeps it under the simple 200-dma and gives CLB a little room to move. You have to decide what works best for you.

FYI: August options expire in about two weeks.

- Suggested (SMALL) Positions -

Long AUG $105 call (CLB1120H105) Entry $1.25*

- or -

Long SEP $105 call (CLB1117I105) Entry $2.00
08/05 stop loss @ 95.45, under the 200-dma
08/05 play opened.
08/05 *entry price is an estimate. option did not trade today
08/04 Adjusted our strategy for the decline. New stop loss @ 95.80. New targets are $104.90 and $109.75. Buy calls if both CLB and S&P 500 are positive at the open tomorrow.

Annotated Chart:

Weekly Chart:

Entry on August 5 at $100.23
Earnings Date 10/20/11 (unconfirmed)
Average Daily Volume = 526 thousand
Listed on August 2, 2011


PUT Play Updates

CBOE Volatility Index - VIX - close: 32.00 change: +0.34

Stop Loss: n/a
Target(s): 26.00, 22.50
Current Option Gain/Loss: -56.0% & -27.5%
Time Frame: 2 to 3 weeks
New Positions: see below

Comments:
08/06 update: Friday's session turned out seriously different than expected. Did we get an unexpected jobs number? Yes. Did the VIX open lower because stocks were bouncing at the open? Yes. Unfortunately after that reality quickly veered from expectations. Stocks accelerated lower again and this time the VIX shot higher and traded above 39.00. Then the ECB news that they might buy Italian and Spanish bonds helped turn the market around. The VIX fell back toward Thursday's close.

New Positions?
Now that S&P has downgraded the U.S. credit rating the market could see a very sharp, knee-jerk reaction lower on Monday. Stocks will most likely gap open lower and the VIX will most likely gap open higher, potentially a lot higher.

The spike higher in the VIX on Monday could be a great new entry point to buy puts. It's up to you if you buy the open or wait and watch to see where the VIX might falter but trying to pick a top intraday is pretty hard. Alternatively you could look for a spike into the 45-50 zone as an entry point to buy puts again.

The newsletter will open a second position at the open, but these should be very small, speculative trades.

Earlier Comments:
I am not listing a stop loss on this trade. We should consider this a higher-risk, speculative trade. I'm setting our targets at 26.00 and 22.50. NOTE: August VIX options expire after the 17th of the month. You may want to buy Septembers instead.

- Suggested Positions -

Long AUG $25.00 PUT (VIX1117T25) Entry $2.50

- or -

Long SEP $25.00 PUT (VIX1121U25) Entry $4.00

chart:

Entry on August 5 at $28.48
Earnings Date --/--/--
Average Daily Volume = xxx
Listed on August 4, 2011


CLOSED BULLISH PLAYS

Dow Jones Industrial Avg. (ETF) - DIA - close: 114.25 change: +0.54

Stop Loss: 112.40
Target(s): 117.75, 119.75
Current Option Gain/Loss: -44.2% & -30.5%
Time Frame: 1 to 2 weeks
New Positions: see below

Comments:
08/06 update: Wow! Friday was another volatile session. After Thursday's -5% plunge the DIA opened at $115.13 on Friday morning thanks to a better than expected jobs report. Then suddenly the market collapsed again and The DIA fell -3.3% from is opening print on Friday. The DIA hit new 8-month lows at $111.26 before bouncing back into positive territory. Volume on Friday was 30.5 million shares compared to the average of 8 million.

Our trade was opened on Friday morning but we were stopped out at $112.40.

- Suggested Positions -

AUG $115 call (DIA1120H115) Entry $2.60, exit $1.45 (-44.2%)

- or -

SEP $115 call (DIA1117I115) Entry $3.60 exit $2.50 (-30.5%)
08/05 opened at $115.12. stopped at $112.40.

Chart:

Entry on August 5 at $115.13
Earnings Date --/--/--
Average Daily Volume = 8.0 million
Listed on August 4, 2011


ProShares Ultra QQQ - QLD - close: 78.23 change: -1.07

Stop Loss: 77.75
Target(s): 84.75, 89.00
Current Option Gain/Loss: -49.6% & -20.8%
Time Frame: 1 to 2 weeks
New Positions: see below

Comments:
08/06 update: The story is virtually the same with the QLD. Stocks opened higher on the jobs report. The QLD opened at $81.06. Then the market reversed sharply lower on EU debt issues and economic concerns. We were stopped out at $77.75. The QLD hit $73.85 before bouncing back and actually trade above $80 again before settling in the red. Volume today was massive at 15.8 million shares versus the normal 4.0 million.

- Suggested Positions -

AUG $85 call (QLD1120H85) Entry $1.55, exit $0.78 (-49.6%)

- or -

SEP $85 call (QLD1117I85) Entry $3.60, exit $2.85 (-20.8%)

08/05 traded opened at $81.06, stopped at $77.75.

Chart:

Entry on August 5 at $81.06
Earnings Date --/--/--
Average Daily Volume = 4.0 million
Listed on August 4, 2011


Range Resources Corp. - RRC - close: 57.13 change: -2.35

Stop Loss: 56.40
Target(s): 68.00, 69.75
Current Option Gain/Loss: -63.4% & -61.5%
Time Frame: 3 to 4 weeks
New Positions: see below

Comments:
08/06 update: The market's open higher on Friday morning and RRC's gap open at $60.75 triggered our play. Unfortunately the gains immediately faded. RRC was an underperformer and hit our stop loss at $56.40 before noon on Friday. This was a breakdown below what should have been support near $58.00 and its 50-dma. RRC actually hit $54.84 at its worst levels.

- Suggested Positions -

AUG $60 call (RRC1120H60) entry $2.60, exit $0.95 (-63.4%)

- or -

SEP $62.50 call (RRC1117I62.5) entry $3.90*, 1.50 (-61.5%)
08/05 opened at $60.75, stopped at $56.40
08/05 *entry & exit price is an estimate. option did not trade today

chart:

Entry on August 5 at $60.75
Earnings Date 10/27/11 (unconfirmed)
Average Daily Volume = 3.1 million
Listed on August 3, 2011


SPDRs S&P 500 ETF - SPY - close: 120.08 change: -0.18

Stop Loss: 117.90
Target(s): 124.50, 126.25
Current Option Gain/Loss: -47.4% & -35.4%
Time Frame: 1 to 2 weeks
New Positions: Yes, see below

Comments:
08/06 update: Our bet on a bounce and the conditional entry point to only buy calls if the market opened higher did not work on Friday. The trade was opened because the July jobs report was better than expected and stocks opened higher. The SPY gapped open at $121.76. Unfortunately the market immediately sank and the selling was vicious once again. The drop from the open to our stop was -3.1%. The plunge from the open to the low of the day was -4.0%. Stocks managed to rebound intraday on news the EU might buy Italian and Spanish bonds. Even then the SPY still closed negative for the day.

- Suggested Positions -

AUG $122 call (SPY1120H122) Entry $2.72, exit $1.43 (-47.4%)

- or -

SEP $124 call (SPY1117I124) Entry $2.79, exit $1.80 (-35.4%)

08/05 opened at $121.76. stopped @ 117.90
490

chart:

Entry on August 5 at $121.76
Earnings Date --/--/--
Average Daily Volume = 218 million
Listed on August 4, 2011