Option Investor
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Daily Newsletter, Tuesday, 11/20/2012

Table of Contents

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

Market Wrap

Market Consolidates 2-Day Gains

by Keene Little

Click here to email Keene Little
The big rally off Friday's low used up a lot of buying power (short covering) and the market is now consolidating in front of the holiday. It's probably going to be a slow week from here.

Market Stats

Jim and I have swapped days this week; he'll be with you tomorrow.

It was a quiet day in what should be a quiet week. All of the week's action likely happened on Monday and you can see in the numbers above that the indexes closed about as flat as we can get. Taking the rest of the week off is probably a pretty good recommendation since it will help you keep from hurting yourself by trying to trade something that's not tradable. Trading a slow choppy market, like today, is usually a recipe for feeding your broker, enabling him to send his kids to a nicer school. Once we had the big day on Monday it was a good indication that the rest of the week is likely to be dull. In a bit I'll show you the pattern and why this is so.

Oh mon Dieu! Moody's Investors Service downgraded France's government bond rating from Aaa to Aa1 and maintained a negative outlook. Wow, sure didn't see that one coming (wink). My only question is "what took you so long to recognize this?" As a comparison, the U.S. currently has a rating of Aaa but Moody's has threatened to lower it again if we reach the fiscal cliff without an agreement on taxes and spending.

Moody's downgrade for France follows the one from Standard & Poor's in January, from AAA to AA+, and these downgrades will pressure President Hollande to find ways to improve their growth prospects. This is very difficult to accomplish in the face of austerity, which is of course also needed in order to rein in spending. Most of the developed countries face exactly the same fiscal cliff, but with different timelines to reach the cliff.

Moody's reiterated its negative outlooks on all the European countries that are facing the burden of bailing out the other countries in need of debt relief. This would likely affect the ratings for Germany, the Netherlands and Austria. If Mario Draghi had his way we would do away with ratings agencies and learn to assess creditworthiness by other methods. No doubt the central bank heads would love to rate everyone AAA and tell all investors "not to worry, we have everything under control." Where's Al Haig when we need him most?

Monday's rally was strong and in many respects had the same signature we've seen at previous important lows -- we had a 90%+ up day, which means more than 90% of the volume was in stocks making new highs vs. new lows, and the advance-decline hit highs that we've seen at the start of previous rallies. In other words, market breadth was strong. But it's not clear sailing for the bulls from here and in fact it could be nothing more than a volatile pattern we're likely to see in the market. Keep in mind that some of the strongest rallies occur in a bear market decline and the rallies fizzle quickly.

To show visually what I mean about the volatility, the chart below shows SPX with the up vs. down volume above the SPX chart and the down vs. up volume under the SPX chart. The advance-decline is at the bottom of the chart. At the top, when the NYSE up volume vs. down volume gets above 10 it means the up volume is more than 10 times the down volume. I've lined up the peaks since September that are above 10 with the rallies that occurred on those days, including Monday's. You can see in previous cases that a strong rally has typically led to additional highs for the market but often after first consolidating or pulling back.

At the bottom of the chart is the advance-decline line. The thing to note here is that when there's a peak in the a-d line on the same day as a 90% up day it's likely to set up at least a consolidation day (or more) if not a reversal. Monday's 90% up day was also accompanied by a strong peak in the a-d line. Today was a consolidation day (possibly a reversal back to the downside but it's too early to tell).

Below the SPX chart is the measure of down volume to up volume and again, anything above 10 shows a 90%+ day and the two most recent selling peaks were November 8th and 14.

SPX with 90% up and down volume

Sometimes you'll get a double signal that sets up a reversal, especially to the upside. Because volume tends to increase into a low (capitulation selling) it's common to see a peak in the down- vs. up-volume measurement as well as a negative spike in the a-d line at the completion of a decline (or only a day or two away). The most recent example is the selling spike on November 8th, followed by a stronger selling spike on November 14th and then a key reversal day on Friday, November 16th.

But when you get a buying spike it's not usually the completion of the move. It can easily be the kickoff to a stronger rally if it's coming off a low, which can be seen on multiple occasions on the chart above. It's also common to see these spikes off a low followed by a few days of consolidation, such as today and likely the remainder of the week.

At the top of a rally you'll typically see a little different behavior when the buying momentum is waning. Unlike a strong decline into a capitulation low you'll often see buyers simply fade away at tops. You need to watch for a possible reversal setting up when you get a 90% up day followed by another 90% up day that's weaker and shows a weaker a-d line. This happened at the September high where there was a buying spike on September 6th and then another one on September 13th but look at the lower high on the up-down volume and a slightly lower high on the a-d. It was another indication of waning momentum at the new price high on September 13th that did not have confirming market breadth. The market topped the next day on September 14th.

Now we've had a 90% up day (Monday), with a high peak in the a-d line so a few days of consolidation could be followed by another leg up for the rally off last Friday's low. If we get another strong up day but with a lower up-down volume peak and a lower a-d line then we'll have a clue that we might get only an a-b-c bounce off Friday's low rather than something more bullish. I'll show this potential setup on the regular charts. Paradoxically, the bulls would be better off from here without a lot of buying exuberance since it has more staying power (look at the strong rally from January to March of this year and the ho-hum up-down volume). Too much buying too quickly is usually the mark of short covering, which gets little to no follow through. We don't know yet if Friday's and Monday's rally was mostly short covering in front of the holiday week.

The market sagged midday because Bernanke's speech to the Econ Club of New York did mention specifically what the Fed would do to help the market with further easing efforts. Bernanke has used past speeches such as today's to announce how the Fed would help the stock market, I mean economy, with their easing programs. No mention of it today spooked some investors. But the dip was quickly bought (we can't be embarrassing the boss) and SPX was kept above its 200-dma, which was recovered with Monday's rally. There will likely be an effort to hold SPX above its 200-dma, currently at 1382.70, for a weekly close.

In addition to the 200-dma the 50-week MA at 1368.18 has been recovered, which so far gives us a pattern like the June low. The bulls would certainly like to repeat the rally that followed the June low and that remains a possibility. I think the higher-odds scenario is for the market to make it a little higher (potentially after one more new low next week) into December before tipping back over for much lower lows. Looking at the weekly chart with the arithmetic price scale shows the uptrend line from 2009 is currently near 1400 so that's upside potential before running into potentially strong resistance.

S&P 500, SPX, Weekly chart

The rally off Friday's low has SPX testing the top of a parallel down-channel for its decline form October 18th. This down-channel was created with a trend line from the 1st to 3rd waves and attaching a parallel line to the 2nd wave. It's often a good way to tell where the 4th wave will stop, which is where it currently is. Today's candlestick is a dragonfly doji so a red candle on Wednesday would create a reversal signal, in which case I'll be looking for a minor new low next week to set up a larger bounce into December. But the hard part here is figuring out what kind of bounce pattern we could get if last Friday's low was the end of a 5-wave move down from October 18th, which would mean a higher bounce into the end of the month before heading lower again (it would mean no Santa Claus rally or one from a much lower low). There remains the bullish potential for a rally into the new year so I'll be watching for evidence of that as well. A rally above 1403 would get me thinking a little more bullishly.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1403
- bearish below 1362

The DOW has rallied back up to its broken uptrend line from 2009 (log scale) and its trend line along the lows from September 28th, and also formed a dragonfly doji for today's candlestick. A reversal from trendline resistance here would look like a back test followed by a kiss goodbye. As with SPX, we could get just a pullback and then a higher bounce into the end of the month, which would fit the pattern for a higher bounce expectation following Monday's 90% up day, as discussed with the 1st chart above.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 12,980
- bearish below 12,600

If the Nasdaq can rally a little higher it would run into its 20-dma and the top of its down-channel from September. The bearish wave count would look better with one more new low while the bulls would be looking much better if the index can break above its November 2nd high near 3034. If we get another leg lower it should find support at its uptrend line from 2009, near 2800 (arithmetic scale).

Nasdaq Composite, COMPQ, Daily chart

By climbing back above resistance near 790, as well as back inside its parallel down-channel, it's looking more bullish. A pullback to the bottom of the channel could launch another rally leg (for at least a larger a-b-c bounce off Friday's low or higher in a rally to new highs into the new year). But if it closes Monday's gap near 776 I would expect to see a new low, near 758, before setting up a larger bounce.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 790
- bearish below 776

The only two economic reports we got today were housing related. The Housing Starts was a good number, beating September's 872K (revised up from 863K) with 894K. This was also better than expectations. But Building Permits, at 866K, came in lower than expected and below September's 894K (revised up from 890K). As we approach the winter months it's not surprising to see a drop in permits but considering expectations were for an increase to 900K it was a little disappointing.

The Home Construction index (DJUSHB) had a nice bounce today, up +3.25%. Now the test is on since it has bounced back up to its broken 20- and 50-dma's, which are about to cross near 438 and today's high was 437. If the bounce off last Thursday's low is just a correction to the decline from November 2nd, which I believe it is, the back test of its dma's is a setup for the next leg down. But if it can get above 438 on a closing basis and stay above those dma's it will be a bullish signal.

DJ U.S. Home Construction index, DJUSHB, Daily chart

The next chart may be the most important in tonight's review. It shows a pattern for the bond market, which in turn could help determine what the stock market will do between now and the end of the year.

The bond pattern has been very choppy for several months and I keep waiting for clarity to help figure out its next big move. Some clues may come from TLT, the 20+ Year Treasury ETF. As shown on its chart below, there was a 3-wave pullback from its high in July into the September low. This has been followed by a 3-wave bounce into last Friday's high and that high tagged the projection at 127.05 for two equal legs up from September (Friday's high was 127.19). The a-b-c bounce fits as a larger degree b-wave in a large a-b-c pullback from July. Two equal legs down from July would target 113, which crosses the bottom of a parallel down-channel in the first week of January. If this plays out as depicted it's going to be bullish for stocks through the end of the year, potentially leading to a new high for stocks.

20+ Year Treasury ETF, TLT, Daily chart

The banking index, BKX, has made it up to its 20-dma and only slightly higher, near 49 is the bottom of its previous consolidation pattern from which it broke down. It would be typical to see this support turn into resistance so that's the first level the bulls need to get through.

KBW Bank index, BKX, Daily chart

The dollar remains bullish as long as it holds above 80.80 since a break below that level would have it breaking down from its up-channel from mid-October as well as the top of its previous up-channel from September. I see the potential for one more new high before pulling back. How deep the pullback will be depends on what kind of pattern is playing out to the upside, something that can't be known yet. A dollar pullback in December would be another thing supporting the stock market.

U.S. Dollar contract, DX, Daily chart

Gold's short-term pattern supports the idea we'll get a higher bounce before it tips back over. The risk is that gold could drop from here and therefore I would not want to chase gold higher right here.

Gold continuous contract, GC, Daily chart

Oil had a negative day today, reversing Monday's entire rally. It dropped back down to its broken downtrend line from September and bounced off it (with only a minor break) so that's bullish so far. A rally above Monday's high at 89.80 is needed by the bulls, in which case I would then look for a move up to resistance at 91-92. It doesn't turn bullish until it can rally above 93.70.

Oil continuous contract, CL, Daily chart

Because of the holiday-shortened week the rest of the economic reports will be out tomorrow, including the usual Thursday unemployment number. We'll get the Michigan Sentiment, which is not expected to change much, and the Leading Indicators, which is expected to show some deterioration.

Economic reports and Summary

We've probably seen most of this week's price action. The very first chart I showed tonight shows the probability for a few days of consolidation/pullback following Monday's strong rally. Most traders will be leaving Wednesday and many will not be back until next week. There's going to be very little interest in the market unless something wild happens geopolitically. I don't think there's much more the central banks can say that they haven't already said.

I'm seeing enough mixed signals right now that's keeping me cautious and mostly sidelined. The pattern for the stock market supports the idea for at least one more new low before setting up a larger bounce into December and then down hard into the new year. But the bond market's pattern has me thinking we could see a steeper decline in bond prices (rally in yields) and that supports a stronger rally in the stock market into the new year. Stocks tell me to look at bounces to short while bonds tell me to look to buy the dips in the stock market. As long as I see mixed signals between these two I will remain cautious. I don't expect it to clear up this week so we'll have to see how they look next week.

Trade carefully, or better yet, not at all, this week and I hope everyone has a very nice holiday with family and friends. I'll be back with you next Wednesday.

Keene H. Little, CMT

In the end everything works out and if it doesn't work out, it is not the end. Old Indian Saying


New Option Plays

Industrial Goods & Energy

by James Brown

Click here to email James Brown


NEW DIRECTIONAL CALL PLAYS

Armstrong World Industries - AWI - close: 49.35 change: +0.71

Stop Loss: 49.25
Target(s): 54.50
Current Option Gain/Loss: Unopened
Time Frame: 3 to 6 weeks
New Positions: Yes, see below

Company Description

Why We Like It:
AWI is in the industrial good sector. The stock is bouncing after a painful November correction lower. Now shares are poised to breakout past $50.00 again. Shares could see another short squeeze. The most recent data listed short interest at 20% of the small 26.4 million share float.

I am suggesting a trigger to buy calls at $50.25. If triggered our target is $54.50.

Trigger @ 50.25

- Suggested Positions -

buy the DEC $50 call (AWI1222L50) current ask $1.35

Annotated Chart:

Entry on November xx at $ xx.xx
Average Daily Volume = 685 thousand
Listed on November 20, 2012


NEW DIRECTIONAL PUT PLAYS

InterOil Corp. - IOC - close: 59.99 change: -1.49

Stop Loss: 61.05
Target(s): 50.50
Current Option Gain/Loss: Unopened
Time Frame: 3 to 5 weeks
New Positions: Yes, see below

Company Description

Why We Like It:
I am honestly surprised that shares of IOC did not see a bigger bounce on Friday last week or yesterday. There appears to be significant short interest in the stock. The most recent data listed short interest at almost 22% of the small 41.4 million share float. Yet the bounce has failed at resistance near $65.00 and its 20-dma. Now IOC looks poised to continues its bearish trend and breakdown to new lows.

The low on Nov. 19th was $58.74. I am suggesting a trigger to buy puts at $58.50. If triggered our target is $50.50. I would keep our position size small to limit risk. IOC can see some wide intraday swings.

Trigger @ 58.50 *Small positions*

- Suggested Positions -

buy the DEC $55 PUT (IOC1222x55) current ask $2.24

Annotated Chart:

Entry on November xx at $ xx.xx
Average Daily Volume = 790 thousand
Listed on November 20, 2012



In Play Updates and Reviews

The Rebound Slows

by James Brown

Click here to email James Brown

Editor's Note:

France lost its AAA rating from Moody's last night. S&P had already downgraded the country back in January. Meanwhile Fed Chairman Bernanke suggested there is little the Fed could do if congress doesn't solve the fiscal cliff issue but if they did then 2013 could be a strong year. Elsewhere Goldman Sachs warned the market could see another -8% plunge. Traders were nervous today and probably looking forward to the upcoming holiday.

DDS and ORLY were triggered.

Current Portfolio:


CALL Play Updates

Dillard's Inc. - DDS - close: 85.63 change: +0.73

Stop Loss: 82.75
Target(s): 89.75
Current Option Gain/Loss: + 4.7%
Time Frame: 3 to 4 weeks
New Positions: see below

Comments:
11/20/12: Our new play on DDS has been triggered. Shares added +0.8% and look poised to hit new multi-year highs. Our target is $89.75.

- Suggested Positions -

Long Dec $90 call (DDS1222L90) entry $1.05

Entry on November 20 at $85.05
Average Daily Volume = 489 thousand
Listed on November 19, 2012


Dover Corp - DOV - close: 63.12 change: +0.14

Stop Loss: 59.85
Target(s): 67.50
Current Option Gain/Loss: + 4.7%
Time Frame: 3 to 6 weeks
New Positions: see below

Comments:
11/20/12: The rally in DOV paused on Tuesday with shares chopping sideways. Readers may want to wait for a dip back toward $62.00 as a new entry point.

- Suggested Positions -

Long 2013 Mar $65 call (DOV1316c65) entry $2.10

11/19/12 triggered @ 62.30

Entry on November 19 at $62.30
Average Daily Volume = 1.7 million
Listed on November 17, 2012


Netflix, Inc. - NFLX - close: 82.40 change: +1.04

Stop Loss: 79.25
Target(s): 89.75
Current Option Gain/Loss: - 18.4%
Time Frame: 3 to 4 weeks
New Positions: see below

Comments:
11/20/12: NFLX is slowly working its way higher and tagged a new multi-week high intraday. I remain cautiously bullish here. We're still waiting for the temporary short squeeze to show up. Please note that I am raising the stop loss to $79.25.

Earlier Comments:
NFLX could see a short squeeze. The most recent data listed short interest at 31% of the 54.1 million share float. NFLX can be volatile so I am suggesting small positions to limit our risk.

- Suggested Positions -

Long DEC $85 call (NFLX1222L85) Entry $4.60

11/20/12 new stop loss @ 79.25
11/16/12 triggered @ 82.25

Entry on November 16 at $82.25
Average Daily Volume = 6.5 million
Listed on November 15, 2012


O'Reilly Automotive - ORLY - close: 91.37 change: -0.11

Stop Loss: 89.95
Target(s): 95.75
Current Option Gain/Loss: -18.4%
Time Frame: 3 to 4 weeks
New Positions: see below

Comments:
11/20/12: It was a cowardly session for ORLY bulls. The stock danced across resistance at $92.00 this morning only to see the stock retreat again. Our trade was opened at $92.05. I would wait for a new rally past $92.00 before considering new bullish positions. Our target is $95.75 but more aggressive traders may want to aim for the $99-100 zone instead.

- Suggested Positions -

Long DEC $95 call (ORLY1222L95) entry $1.90

Entry on November 20 at $92.05
Average Daily Volume = 1.8 million
Listed on November 19, 2012


Pharmacyclics Inc. - PCYC - close: 51.82 change: -0.87

Stop Loss: 49.65
Target(s): 56.50
Current Option Gain/Loss: - 45.8%
Time Frame: 3 to 4 weeks
New Positions: see below

Comments:
11/20/12: Hmm... the relative weakness in PCYC today could be a warning signal. Readers may want to scale back positions. I am raising our stop loss to $49.65.

Earlier Comments:
I do consider this a more aggressive, higher-risk trade. Anytime you trade a biotech stock it can be a high-risk trade since you never know when a negative headline could send the stock crashing. Our target is $56.50. More aggressive traders could aim for the $59-60 zone instead.

- Suggested *Small* Positions -

long Dec $55 call (PCYC1222L55) entry $3.60

11/20/12 new stop loss @ 49.65
11/19/12 trade opened with PCYC's gap open higher @ 52.21

Entry on November 19 at $52.21
Average Daily Volume = 1.0 million
Listed on November 17, 2012


PUT Play Updates

Carpenter Tech. - CRS - close: 45.73 change: -0.47

Stop Loss: 48.05
Target(s): 42.50
Current Option Gain/Loss: +13.4%
Time Frame: 3 to 6 weeks
New Positions: see below

Comments:
11/20/12: Tuesday proved to be a quiet session for CRS. The stock churned sideways near the $46 level most of the day.

We still have half a position open. I am not suggesting new positions at this time.

Earlier Comments:
Our multi-week target is $42.50. CRS can be somewhat volatile so readers may want to limit their position size to reduce risk.

- Suggested Positions -

Long Dec $45 PUT (CRS1222x45) Entry $1.15

11/19/12 sold half at the open. unfortunately CRS gapped open higher at $45.94
exit half @ 45.95, option @ $1.20 (+4.3%)
11/17/12 new stop loss @ 48.05, sell half of our position on Monday morning
11/14/12 new stop loss @ 49.05

Entry on November 12 at $48.23
Average Daily Volume = 460 thousand
Listed on November 10, 2012


Dow Jones Industrial Average (ETF) - DIA - close: 127.71 change: +0.08

Stop Loss: 128.15
Target(s): 125.25
Current Option Gain/Loss: -26.8%
Time Frame: 3 to 4 weeks
New Positions: see below

Comments:
11/20/12: The stock market faltered midday but managed to claw its way higher the rest of the afternoon. The DIA is still hovering just under resistance at $128.00. I am not suggesting new positions at this time.

- Suggested Positions -

long DEC $125 PUT (DIA1222x125) entry $1.79

11/17/12 new stop loss @ 128.15
11/14/12 new stop loss @ 129.15
11/13/12 new stop loss @ 130.15
11/08/12 new stop loss @ 130.60

Entry on November 08 at $129.18
Average Daily Volume = 5.3 million
Listed on November 7, 2012


iShares Russell 2000 ETF - IWM - close: 79.26 change: +0.14

Stop Loss: 80.15
Target(s): 75.50
Current Option Gain/Loss: -22.8%
Time Frame: 4 to 6 weeks
New Positions: see below

Comments:
11/20/12: The small cap ETF churned sideways as investors digested news of France's credit downgrade and Ben Bernanke's comments about the fiscal cliff today. I am not suggesting new positions at this time.

- Suggested Positions -

Long 2013 Jan $75 PUT (IWM1319m75) entry $1.53

11/17/12 the IWM looks poised to bounce
11/14/12 new stop loss @ 80.15
11/13/12 new stop loss @ 81.05

Entry on November 08 at $79.85
Average Daily Volume = 36 million
Listed on November 7, 2012


Lockheed Martin Corp. - LMT - close: 90.18 change: -0.30

Stop Loss: 90.65
Target(s): 84.25
Current Option Gain/Loss: -50.0%
Time Frame: 3 to 4 weeks
New Positions: see below

Comments:
11/20/12: Lack of follow through on yesterday's big bounce in LMT is somewhat encouraging. Yet our trade remains in trouble here. LMT rebounded sharply from its midday lows and looks poised to rally tomorrow, which will likely see the stock hit our stop loss at $90.65. Readers may want to abandon ship.

Earlier Comments:
We do want to keep our position size small because LMT has produced a new breakdown on its daily chart but it has not yet broken below potential support on the weekly chart. It is possible the stock could bounce off the trend line displayed on the weekly chart but I doubt it given the market's broader weakness.

- Suggested *Small* Positions -

Long Dec $85 PUT (LMT1222x85) Entry $1.60

Entry on November 15 at $88.02
Average Daily Volume = 1.6 million
Listed on November 14, 2012


Vornado Realty - VNO - close: 74.77 change: +0.41

Stop Loss: 75.25
Target(s): 72.50
Current Option Gain/Loss: Dec75p: + 3.5% & 2013Jan$75p: +10.5%
Time Frame: 3 to 6 weeks
New Positions: see below

Comments:
11/20/12: The oversold bounce in VNO continues. It looks like the stock may hit our stop loss at $75.25 before it hits potential resistance at the simple 10-dma (75.50). More aggressive traders may want to adjust their stop loss appropriately. I am not suggesting new positions.

- Suggested Positions -

Long DEC $75 PUT (VNO1222x75) entry $1.40*

- or -

Long 2013 Jan $75 PUT (VNO1319m75) entry $1.90*

11/16/12 sold half of our position to lock in gains.
1/2 exit Dec $75 put @ $2.55 (+82.1%)
1/2 exit 2013 Jan $75 put @ $3.10 (+63.1%)
adjust the stop loss down to $75.25
11/15/12 SELL HALF of our positions to lock in gains tomorrow morning,
move the stop loss down to $76.25 for the rest
11/14/12 readers may want to start taking profits now
new stop loss @ 78.05
11/12/12 trade opened on gap down at $76.89
*option entry price is an estimate since the option did not trade at the time our play was opened.

Entry on November 12 at $76.89
Average Daily Volume = 1.1 million
Listed on November 10, 2012