Option Investor
Newsletter

Daily Newsletter, Wednesday, 10/12/2011

Table of Contents

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

Market Wrap

Hope for Europe Inspires Further Rally

by Keene Little

Click here to email Keene Little
Market Stats

Fears of European debt contagion, followed by assurances that the problems will be fixed, followed by renewed fears, followed by more assurances, followed by...

The emotional yo-yo between fear and relief have been showing up in the market since July and the weekly gains and losses have been nothing short of phenomenal. After multiple 800-point swings in the DOW it is where it was on August 4, 16, Aug 29-September 1, 16-20 and now today (near 11500). Between those dates we saw the DOW tag 10600 three times and of course hit a low near 10400 on October 4th, followed by nearly a 1200-point rally in 6 trading days. A little manic-depressive perhaps?

The latest rally is based on hopes (and that's all it is so far) that Europe really will this time, they promise, fix their debt issues so that the banksters don't lose money. The DOW rallied more than 1200 points in 6 trading days following last week's low, without much of a breather along the way. It's another hard-charging algo-driven move (algo traders are essentially momentum traders) and the risk is that a reversal could see a correction back down that drives just as hard to the downside.

The HFT (high frequency trading) traders with their algorithms are doing the majority of the trades these days (in excess of 70%) and you and I are just along for the ride, literally. Catch that ride correctly and there's money to be made. Get on the wrong side of that trade and it's painful. Ask the bears who are still holding short from last week's low. And before that you could hear the bulls who bought near 11500 the last time it was there (September 20) squealing like stuck pigs when it was trading down to 10400.

The one dangerous thing I see in this market right now is that traders not using stops are being rewarded for bad behavior. No stop? What me worry? Nah, the market will come back. That has worked for both sides since August. One of these days one side is going to be left behind wondering why the market left them in the dust. Do not get complacent about this market!

There were no economic reports of note today except for the FOMC minutes released at 2:00 PM. The notes reflected the Fed's worry about even their expectations for a gradual improvement in the economy. The Fed members see "significant downside risk" to their growth expectations. Those risks include debt deleveraging, fiscal tightening and problems in Europe spilling over into the U.S. The stock market reacted with a little rally that lasted about 30 minutes, getting the S&P up to resistance at 1220, and then rolled over into the close, giving up about half of the day's gains.

The big news this week that propelled the market higher came from Europe and their plans to bail out every country that's in trouble. They have a plan and this time they promise it's a good one. They're not quite sure of the details yet but they plan on getting those details worked out so that their plan will work. And the market rallied on this news! It's just another plan with nothing backing it up!

At the moment Merkel and Sarkozy do not actually have a plan. But they plan on creating a plan and will let us know in November what their plan is. This of course assumes too that all of the individual governments will pass the "plan". Take Slovakia and multiply it by how many countries? Those receiving the money will of course be very willing to approve the plan, as long as they don't plan on cutting more out of their budgets. This whole thing would be laughable if it weren't so serious. I guess we'll just have to wait for a few more weeks to see what the plan will be and then whether or not the various governments will approve it. In the meantime the bears decided they just better run for cover -- buy first, ask questions later.

I came across an interesting statistic about Monday's rally, which had started with the big gap up following the Merkel-Sarkozy "plan to create a plan". The day experienced a very strong advance-decline ratio of 11:1 in the NYSE. There have been only two previous occasions in the last 27 years where we've seen that level of strength -- both within a bear market. October 13, 2008 and May 10, 2010 (following the flash crash) were the two previous occasions and interestingly both marked near-term highs for the market (the next day in October 2008 and 2 days later in May 2010), which were then followed by new market lows before a more lasting low was put in.

Will history repeat? Bulls, don't get complacent here just because we've had a big rally that's breaking through resistance.

Last week I showed a comparison between the 1st leg down from the October 2007 top and the leg down from the 2011 top, suggesting the October 4th low may have been the low for the year. The strong rally in the past week certainly helps support that view. But we now have a divergence from that analog pattern and it has me wondering if the October 4th low is going to hold this year or not.

I've updated the comparison chart from last week to show the updated price action on the bottom chart, which shows the rally off the low has spiked up to test the previous high (September 20) before dropping into the October 4th low. This rally is only 6 trading days, less than half the time it took for the equivalent move off the March 17, 2008 low (noted as "We are already here" on the top chart).

SPX daily chart, 2007 top vs. 2011 top

Why is this potentially important? It's because of the very sharp nature of the rally off the October 4th low. Ironically that could be very bearish since it may be the completion of an a-b-c bounce pattern off the August 9th low. This bearish interpretation of the pattern calls for another leg down into the end of the year instead of a rally.

In either case -- bullish or bearish into December -- we're going to get a pullback and the only question is how large the pullback will be. And the answer to that question won't come until we see what the pattern looks like in the decline (corrective vs. impulsive). The question for anyone holding long positions is whether or not you want to risk holding through a pullback correction that could become something much worse.

But the more immediate question is how high the current rally will go before turning back down. At this point, the higher it goes the higher the probability that it will lead to a strong selloff into the end of the year. So the bulls actually need to start rooting for a pullback sooner rather than later. I'll get into the reason for that in just a bit after looking at the SPX charts.

The weekly chart of SPX shows the strong 2-week rally has price back up to the previous highs since August and nearing, once again, the 62% retracement of the 2007-2009 decline, at 1227.28. Coming down to meet that level is the 20-week MA, currently near 1230. For users of Bollinger Bands, this MA is of course the mid line of the BB channel and often resistance on the first test.

S&P 500, SPX, Weekly chart

If we had a 5-wave move down from May into the October low then a 3-wave bounce (or something more complex) to correct that 5-wave move down is to be expected. I'm showing an a-b-c bounce into December, perhaps up to the 1260 area, maybe up to the broken H&S neckline (the smaller H&S topping pattern for this year) near 1280, before heading much lower next year. That projection calls for a pullback into November before we get the next leg up. The more immediately bearish possibility is shown with the light dashed red line and I'll cover that more on the DWC chart below.

Just below 1227, the 62% retracement level on the weekly chart, there is the 50% retracement of the May-October decline near 1222. That's close Fib correlation that should offer tough resistance if tested (close enough today?), especially on the first test of it in an overbought market. It's only speculation at this point but I'm showing a pullback that could be relatively deep, such as down to 1125, before heading higher again into December. The risk for anyone wanting to hold onto long positions and ride out the pullback is that the pullback could develop into a decline to new lows for the year. A sharp decline back down would begin to improve the odds for the more bearish scenario (light red dashed line).

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1225
- bearish below 1160

Today is October 12th, a turn date as measured by the moon phase and the Bradley Turn model. Many still scoff at the idea that you can trade the market based on moon phases but considering the market runs off emotions and we know the full moon does funny things to people, it's not hard to see why the two should correlate. The updated MPTS chart shows today's full moon and there is a good possibility we'll see a reversal after the strong rally.

S&P 500, SPX MPTS daily chart

On the daily chart I show the downtrend line from the August 31st high (showing declining highs in the consolidation pattern following the August low). Today's rally had SPX poking above that downtrend line but then closing at the line, making it look like resistance held after testing the September 20th high at 1220.39 (missed it by 14 cents). But the intraday chart shows price coming back down to that trend line and holding as support. This was a picture-perfect setup to keep both sides guessing into tomorrow. I never cease to be amazed at how well they can do this. I'm guessing we've seen the high and that support level will break and all those who may have bought the pullback to support will be scrambling tomorrow to cover. That prediction and $2.50 will buy you a latte at Starbucks.

S&P 500, SPX, 120-min chart

The DOW came within 15 points of tagging the 50% retracement of its May-October decline. Not shown on the daily chart but a 127% extension of the previous move (the September 27 - October 4 decline) is at 11621 and this extension is a common reversal level. The combination of Fibs and the DOW's high at 11625, along with today being a potential turn date, fits well for a high for the current rally leg. Look for at least a pullback, possibly something more bearish.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 11,640
- bearish below 11,000

Yesterday NDX stopped at resistance at its downtrend line from July and just above its 200-dma near 2291. This morning is gapped up over resistance and if the bulls can do a little more work we could see NDX push up to potential resistance at its broken uptrend line from March 2009 - July 2010, currently near 2345. It stopped about 6 points shy of its September 20 high and not shown on the daily chart is the 38% retracement of the 2000-2002 decline, which is at 2331, right where NDX stopped today. This is one reason why it pays to keep an eye on the longer-term charts even if you are a day trader. Today's candle looks like a shooting star. If tomorrow were to gap back down it would leave a very strong candlestick reversal pattern.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 2350
- bearish below 2195

For NDX I show a pullback, from here or a little higher, into November before heading back up again into December for what could be a retest of the July high at 2438. But interestingly, the strong rally off the October 4th low is potentially very bearish. In the bearish wave count it fits as the c-wave of a larger a-b-c bounce off the August low (c-waves tend to be very sharp moves and certainly the past week has been one). That suggests the next big move is going to be a very strong decline into the end of the year. Keep that in mind if you're thinking of holding long through a pullback correction since the pullback could end up being something much more.

The more bearish idea that we could get a strong selloff into the close would become more likely if we see a stronger rally first. That sounds a bit paradoxical but an even stronger leg up from last week's low would strongly suggest that it's a c-wave completing an a-b-c bounce off the August low. This is shown on the Total Market index (Wilshire 5000) chart below and I reference some Fibs on it to show the setup.

Total Market index, DWC, Daily chart

The October low nearly tagged the 127% extension of the previous move (August rally), which is common in what's called an expanded flat correction where the b-wave exceeds the start of the a-wave. The c-wave that follows often achieves a 162% projection of the a-wave, which is shown at 14437 (but it's not required to achieve that much). If that plays out this month you'll want to mortgage the house, sell all your belongings and load up on LEAP puts because it would point to a painful 2012. So bulls really don't want to see the rally continue from here.

It's the same picture for the RUT. Today's rally stopped at the 38% retracement of the May-October decline, at 703.65. If the market can press higher this week (or next after only a small pullback) we should see the RUT push up to the 50% retracement at 735, which would also be a test of its August 31st high at 737. But as part of a larger correction of this year's decline we could first see a big pullback into the end of the month and then press higher again next month.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 704
- bearish below 656

The VIX is at an interesting location within its consolidation pattern as well. It has pulled back to the bottom of a large bull flag pattern since its August high (matching with the stock market's low). If this bull flag pattern is correct then we should be looking for a resolution to the upside. Of course a rallying VIX would mean a declining stock market. Time will tell.

Volatility index, VIX, Daily chart

Bonds have been selling off while the risk-on trade takes front and center. With the relaxation of worries over Europe and bank failures we've seen money managers quickly moving back into the riskier assets hoping for some upside gains into the end of the year. They're chasing performance in an attempt to keep ahead of the market and their competition. If the stock market turns back down we could see fear reenter the market quickly as those gains evaporate. The allocation of bonds into stocks could reverse very quickly as the flight to safety sees money running back into Treasuries.

The 10-year yield has a 3-wave bounce off its September 23rd low and the 2nd leg of the bounce has nearly achieved 162% of the 1st leg, which is at 2.31% (high so far is 2.27%)

10-year Yield, TNX, Daily chart

The KBW bank index tried to push through its 38% retracement of the July-October decline but dropped back down to it, at 38.97, into the close. If the banks continue their rally, which would obviously be supportive for the broader market (follow the money), we could see BKX push up to the 50% retracement at 42.94 before pulling back/selling off. In the meantime watch for a pullback to support a pullback in the broader market. If we get one more pop higher tomorrow, two equal legs up for the bounce off last week's low is at 40.10, which may complete a correction, to be followed by another selloff, or it might be just the first leg up in a larger correction, which is shown in green.

KBW Bank index, BKX, Daily chart

Since the TRAN made a new high in July its decline into the August low is more like the conclusion to that leg down, making it appear that all the price action since August 23rd is part of a correction. Similar to the pattern that I described for DWC above, we could see the TRAN push higher to a Fib projection near 4879, maybe even up to its 200-dma near 5000 by next week (opex), to complete the c-wave of an a-b-c correction. That would then set up a strong decline into the end of the year. Otherwise a corrective pullback in the next couple of weeks would likely set up another rally leg to match the broader market (as part of a larger corrective pattern off the August low).

Transportation Index, TRAN, Daily chart

The dollar's decline since its high on October 4th has been supportive of the stock market's rally, including today's. The dollar dropped through support at its 38% retracement of the leg up from late August and the top of a parallel up-channel for its price pattern since May. It's possible we'll see a much deeper retracement, but I would expect the dollar to find strong support if it drops down to its 50 and 200-dma's and 62% retracement, all near 76. But the dollar is short-term oversold with some bullish divergences showing up at today's low, which could be setting up at least a bounce before turning back down again. Another leg up, to at least retest last week's high, is also a possibility from here. Any rally in the dollar would likely have the stock market under pressure again so keep the dollar on your radar.

U.S. Dollar contract, DX, Daily chart

Gold continues to chop its way higher from its September low but hasn't benefitted as much from the sinking dollar as I would have thought it would. At the moment it's struggling with the downtrend line from September but if it can press a little higher, a common retracement level is the projection for two equal legs down for the decline from the August high, which is at 1711 (and that projection is shown with the light red dashed line). I continue to expect a deeper retracement of gold's rally and a break below the uptrend line from September 26th, currently near 1648 would be the first signal that the next leg down has begun, especially if the dollar is pushing back above 77.50. Watch for MACD to roll over (or not) at the zero line, which would give us a sell signal.

Gold continuous contract, GC, Daily chart

Silver has the same bounce pattern so the two should trade in synch.

Oil continues to trade more in synch with the stock market than not so its next direction will be dependent on what the stock market does. It could be completing an a-b-c correction off its September 26th low, which projects to 87.34 for the c-wave of that bounce, which would be followed by renewed selling below 75. Or if it pushes a little higher it could test the top of its down-channel from May, currently near 88.70. A rally above 89 would be a bullish move. But back below 81 would be a signal that the bears may be back in control.

Oil continuous contract, CL, Daily chart

Tomorrow's economic reports should not move the market. There are the normal unemployment numbers but not much else to worry about. Friday's retail sales and Michigan Consumer Sentiment could move the market if there are any surprises. Earnings are the focus these days but as always, good or bad news about earnings doesn't necessarily tell us how the market will react. Stick with the charts and see how they're setting up. GOOG's earnings tomorrow night could set the tone for Friday morning.

Economic reports, summary and Key Trading Levels

Once again we've had a rally that's gone too far too fast, which is the hallmark of a bear market rally. It seems strange to think that a slower rally is actually a healthier one. Otherwise the rally looks and smells too much like short covering. The volume has been dropping off as the rally has progressed since last week's low (the low was on high volume), with only Friday's volume heavier and that was a down day. Today's volume finally exceeded the previous two days but most of that came in the final 30 minutes, which was selling instead of buying. So the pattern of weak volume on rallies and stronger volume on selling continues to hold and that's bearish.

The price pattern can be interpreted a couple of ways and while there is the potential for the market to push higher over the next week I think the probabilities point to a pullback at a minimum. The pullback has the potential to continue down to lower lows and possibly Much lower. I would not want to hold long stock hoping for just a pullback before pressing higher again. Downside risk remains, especially since this hopium-filled balloon is just a pin prick away from deflating. One piece of bad news about the European bailout plan not moving forward and it'll all come crashing down again, led by the banks.

If last week's low was the completion of the leg down from May then we're due a larger bounce correction before heading lower again. That calls for a pullback before heading higher again, giving the market some time to get the weekly charts into overbought again. It could be a volatile and choppy ride higher over the next several weeks so neither side can get complacent -- cut your losses quickly and take profits early. Rinse and repeat and your account will do just fine.

Good luck and I'll be back with you next Wednesday.

Key Levels for SPX:
- bullish above 1225
- bearish below 1160

Key Levels for DOW:
- bullish above 11,640
- bearish below 11,000

Key Levels for NDX:
- bullish above 2350
- bearish below 2195

Key Levels for RUT:
- bullish above 704
- bearish below 656

Keene H. Little, CMT


New Option Plays

Home Furnishings & Medical Devices

by James Brown

Click here to email James Brown

Editor's Note:

After a huge bounce the market looks tired but so far the short-term trend is still up. We're at a pivotal spot for the market. I'm expecting a pull back but there is always a chance the rally defies the odds and keeps going. Tonight we're listing both a call play and a put play.

In addition to tonight's candidates, consider these symbols as well.

CGX - We were about to add CGX as a bullish trade tonight but the option spreads are too wide. If you trade stocks, check it out. $38.00 is short-term support.

COG - This oil stock is underperforming its peers and the market. COG is a volatile stock so keep positions small. You could target a drop to $60.00 or a drop toward the 200-dma.

- James


NEW DIRECTIONAL CALL PLAYS

Bed Bath & Beyond Inc. - BBBY - close: 59.68 change: +0.22

Stop Loss: 58.90
Target(s): 64.75
Current Option Gain/Loss: Unopened
Time Frame: 2 to 4 weeks
New Positions: Yes, see below

Company Description

Why We Like It:
Shares of this home furnishings retailer have rallied from technical support at its rising 200-dma to resistance near $60.00. After the big bounce there are probably a lot of traders expecting BBBY to roll over. Shares could see some short covering if it unexpectedly broke out above resistance.

I am suggesting we launch small bullish positions if BBBY can trade at $61.00. We'll exit at $64.75.

Trigger @ 61.00 *Small Positions*

- Suggested Positions -

buy the NOV $62.50 call (BBBY1119K62.5) current ask $1.22

Annotated Chart:

Entry on October xx at $ xx.xx
Earnings Date 12/21/11 (unconfirmed)
Average Daily Volume = 3.4 million
Listed on October 12, 2011


NEW DIRECTIONAL PUT PLAYS

Edwards Lifesciences - EW - close: 70.89 change: -0.79

Stop Loss: 73.55
Target(s): 66.00
Current Option Gain/Loss: + 0.0%
Time Frame: exit prior to earnings on Oct. 19th
New Positions: Yes, see below

Company Description

Why We Like It:
Shares of EW have stopped participating in the market's rally. It looks like EW has already begun correcting lower. This looks like a good spot to open bearish positions with a stop loss above the recent high.

I am suggesting we buy puts now. We will aim for $66.00.

NOTE: We do not want to hold over the October 19th earnings report.

- Suggested Positions -

buy the NOV $65 PUT (EW1119W65) current ask $2.05

Annotated Chart:

Entry on October 13 at $ xx.xx
Earnings Date 10/19/11 (confirmed)
Average Daily Volume = 1.3 million
Listed on October 12, 2011



In Play Updates and Reviews

SHLD & UTX Hit Targets

by James Brown

Click here to email James Brown

Editor's Note:

Stocks extended their gains but the major indices tagged resistance and retreated. Traders should be cautious here.

We saw SHLD and UTX hit our exit targets. GMCR underperformed and hit our stop loss. The SINA trade has not been opened yet.

-James

Current Portfolio:


CALL Play Updates

Hewlett Packard - HPQ - close: 25.87 change: -0.05

Stop Loss: 22.90
Target(s): 29.50
Current Option Gain/Loss: +70.5%
Time Frame: 8 to 12 weeks
New Positions: see below

Comments:
10/12 update: HPQ rallied to a new six-week high this morning at $26.29 but shares eventually faded. There was news that HPQ actually gained market share in the PC market even after the company announced it might spin off its PC business.

Short-term I am still concerned that HPQ is a bit overbought and due for a dip. No new positions at this time.

Earlier Comments:
I am not suggesting new positions at this time. The next level of resistance for HPQ is the $26.25-26.50 zone.

- Suggested Positions -

Long 2012 Jan. $24 call (HPQ1221A24) Entry $2.14

10/11 new stop loss @ 22.90
10/11 planned to sell half at the open
bid 2012 Jan. $24 call @ $3.60 (+68.2%)
10/10 Take some $$ off the table. Sell 1/2 at the open tomorrow
09/27 new stop loss @ 21.45

Entry on September 23 at $22.52
Earnings Date 11/21/11 (unconfirmed)
Average Daily Volume = 26.6 million
Listed on September 22, 2011


Sina Corp. - SINA - close: 78.48 change: -3.30

Stop Loss: 70.85
Target(s): 94.50
Current Option Gain/Loss: Unopened
Time Frame: 3 to 4 weeks
New Positions: see below

Comments:
10/12 update: Ouch! What happened to SINA today? The stock really underperformed with a -4.0% loss. Thankfully, SINA gapped open lower at $81.26 so our call trade was not opened. There was an intraday rally to SINA's 10-dma and then the stock fell off a cliff this afternoon. It looks like the reason for this bearishness was a Citigroup analyst had downgraded their price target on SINA from $165 to $93 in a note out today.

I am removing our entry point on SINA. We will keep the stock on the newsletter for one more day to see if there is any follow through on today's bearish reversal. No new positions in SINA at this time. Aggressive traders could turn bearish and buy puts instead.

No new positions at this time.

10/12 We are postponing bullish positions. Re-evaluate tomorrow.
10/12 Trade not opened. SINA opened lower.

Entry on October xx at $ xx.xx
Earnings Date 11/15/11 (unconfirmed)
Average Daily Volume = 8.0 million
Listed on October 11, 2011


PUT Play Updates

None. Currently there are no active put plays.


CLOSED BULLISH PLAYS

Green Mountain Coffee Roasters - GMCR - cls: 89.90 chg: -3.72

Stop Loss: 89.90
Target(s): 99.75
Current Option Gain/Loss: -57.8%
Time Frame: less than 2 weeks
New Positions: see below

Comments:
10/12 update: GMCR was a big underperformer in the NASDAQ. News that the company made a deal with Jarden to distribute more GMCR products with their Mr. Coffee line did not have a positive affect on the stock. Shares were selling off the first half of the day and hit our stop loss at $89.90.

The plan was to keep our position size small because GMCR is a volatile stock.

(Small positions) - Suggested Positions -

OCT $95 call (GMCR1122J95) Entry $4.65, Exit $1.96 (-57.8%)

10/12 stopped out at $89.90
10/10 trade opened. GMCR gapped higher at $93.71.

chart:

Entry on October 10 at $93.71
Earnings Date 12/07/11 (unconfirmed)
Average Daily Volume = 3.4 million
Listed on October 08, 2011


Sears Holding - SHLD - close: 70.11 change: +3.15

Stop Loss: 59.45
Target(s): 69.75
Current Option Gain/Loss: Oct$65 +124.0% & Nov $67.50: +70.1%
Time Frame: 2 to 4 weeks
New Positions: see below

Comments:
10/12 update: Target achieved. SHLD had a big day. The stock rallied to an intraday high of $74.30, above its 200-dma, before paring its gains. The stock was up almost +11% just today before the afternoon pull back. Our target to exit was hit at $69.75.

Earlier Comments:
It's worth noting that the Point & Figure chart on SHLD has reversed higher and is now pointing to an $83 target. FYI: The most recent data listed short interest at 47% of the float.

- Suggested Positions -

OCT $65 call (SHLD1122J65) Entry $2.41, exit $5.40 (+124.0%)

- or -

NOV $67.50 call (SHLD1119K67.5) Entry $3.35, exit $5.70 (+70.1%)

10/12 target hit at $69.75
10/08 new stop loss @ 59.45, new target 69.75

chart:

Entry on October 7 at $64.13
Earnings Date 11/17/11 (unconfirmed)
Average Daily Volume = 644 thousand
Listed on October 06, 2011


United Technologies - UTX - close: 74.24 change: +0.50

Stop Loss: 69.75
Target(s): 74.50
Current Option Gain/Loss: + 109%
Time Frame: 3 to 4 weeks
New Positions: see below

Comments:
10/12 update: Target achieved. UTX gapped open higher at $74.29 and rallied to $75.00 before paring its gains. Our exit target was hit at $74.50.

- Suggested Positions -

OCT $70 call (UTX1122J70) Entry $2.24, exit $4.70 (+109%)

10/12 target hit at $74.50
10/10 new stop loss at $69.75

chart:

Entry on October 05 at $69.61
Earnings Date 10/19/11 (confirmed)
Average Daily Volume = 6.3 million
Listed on October 04, 2011