Option Investor

Daily Newsletter, Thursday, 8/5/2010

Table of Contents

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

Market Wrap

The Longest Drum Roll

by Keene Little

Click here to email Keene Little
Market Stats

The first thing I want you all to know is what a dedicated writer I am for you. The Blue Angels have been practicing overhead this afternoon as I write and the urge to drop my keyboard and go watch is almost overwhelming. This is truly cruel and unusual punishment.

The market started the day with a gap down following the release of the unemployment numbers this morning. Really? Since when does the market bother with this report? My first thought was that the market is looking for any excuse to sell (sell first, ask questions later). After they started asking questions many felt it wasn't a good enough reason to continue selling so the rest of the day was spent trying to recover the gap down move. Not surprisingly, the trading volume was very light.

The market appears to be on pins and needles in front of Friday morning's jobs reports. It's kind of fascinating to watch market sentiment. The market seems to get something in its head and can't let go and the current concern is the jobs picture. In the early 1980s it was money supply figures since these would surely tell us how the financial economy was doing. The trade deficit numbers then became the overriding concern because surely that would tell us how well our manufacturing economy was doing and how competitive we were. Now it's the employment numbers because surely that will tell us how well the whole economy is doing. Of course the FOMC announcements have for a long time been important because the market is so convinced the Fed knows what it's doing. If only.

Just as doctors practice medicine I think we should acknowledge the fact that economists are only practicing their trade. Fiat currency, without gold backing (or something tangible besides "faith") has been one grand experiment. The likes of Paul Krugman and the rest of the neo-Keynesian economists, who believe we need to spend our way to wealth, are now doing battle with some who believe in different theories, such as fiscal conservatism and paying down debt, things you and I do when we become concerned about our financial health. But that's the point--the economists are practicing theories. We are the guinea pigs in one grand and global experiment.

So for the market to get hung up on monthly jobs numbers is really a bit silly. For one thing, does anyone really believe the numbers that the government provides us? Is it meaningful if the numbers are revised, sometimes a lot, the following month? But never underestimate the level of silliness in the market that we try so hard to figure out.

Market sentiment in general has turned very hopeful (bullish) and it has done so relatively quickly. One would not get the idea that there's much wrong with the economy if you listen to bubblevision. There are so many bullish pundits paraded in front of the screen (with a token bear now and then so they can make fun of them) that it has turned many traders bullish, which is very typical for the kind of correction we've been in since May. As an example, the bullish sentiment, as measured by trade-futures.com with their DSI (Daily Sentiment Index), was 10% at the July 1st low. It has now increased dramatically to 73% bulls, which is the highest level since May 3rd, which was just off the April high and right before the May 6th flash crash. So from a sentiment gauge the market is vulnerable.

Mutual fund managers have fully bought into this rally, literally and figuratively. Their cash levels are at record low levels as a percent of total assets, lower than where it was in 2000. When redemption requests come in they'll have to sell stocks.

The ISEE call/put ratio has turned in some high numbers recently (meaning a lot more calls than puts). A number over 150 is usually a sign of overly bullish sentiment and it hit 182 last Wednesday and 157 yesterday. As mentioned last week, this is not a timing tool but it does provide a good heads up that bullish sentiment is reaching an extreme and warns of a possible top at any time. The last time the numbers were this high was back in April, shortly before the market high and we're hitting the same levels after only a retracement of the decline.

We have a similar setup as in April when the April 15th high of 185 was followed by a lower ISEE high of 169 on April 26th vs. a higher high for price. Now we've had a high of 182 on July 28th and a lower high of 157 yesterday vs. a higher price high this week. Hindsight will tell us if we have the same setup that leads to the same result as in April. The following chart is from EWI that I've added some notes to.

ISEE Index vs. S&P 500, chart courtesy elliottwave.com

I've received several emails recently asking if we should abandon the short side and get long. We're hearing a lot of positive news on bubblevision, about how the economy is slowly improving (and that the market is predicting it with the latest rally), and the improvements in the ADP numbers, etc. Many are seeing bullish price patterns. And as mentioned above, all of this has completely reversed the bearish sentiment from the low at the start of July.

But when you look under the hood of the market you're left to wonder why market breadth and volume do not support the talk. People aren't buying it, literally. The following group of charts shows the new price highs from the July 1st low not being matched by new highs in the advance-decline line and certainly not being supported by volume.

NYSE vs. breadth and volume

While many discount the volume drop to summertime trading, which is certainly a component, the fact is the rally from July 1st is running out steam. The volume drop since the May low is in synch with the idea that we've been in one long correction of the decline from the April high. It's always hard to pinpoint the tippy top of the market but these charts do not inspire any bullishness in me whatsoever.

We'll certainly know more once we get past Friday's jobs reports but in the meantime we can only guess what the reaction might be. The charts are showing what I believe is a near top if it hasn't already been put in. Starting with the SPX weekly chart, there's been no change to my downside projections. Bullishly it has cleared its 50-week moving average and certainly appears headed higher. Of course it didn't work so well for the bulls after it closed the week above the 50-wma back in June.

S&P 500, SPX, Weekly chart

The price behavior, lack of market breadth and declining volume continue to support the rising wedge idea from the July low. The top of the wedge is currently near 1140 so if we get a rally on Friday that's the level to watch for topping. Rising wedges typically get retraced in about half the time it took to build them and that would mean a complete retracement of the July-August rally before the end of the month if it starts down by Monday.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish to 1133-1143
- bearish below 1088

I'll continue to show both a corrective count and an impulsive count to the downside because it's not clear yet to me which one will win out. For the short term it does not matter. Whether we're looking for a 3rd wave down or a c-wave down, both are typically strong moves. It's what happens after the next leg down that should start to provide some longer-tem clues.

Looking more closely at the rising wedge pattern, I continue to see what I consider to be corrective price action in the legs up within the rising wedge. This is one of the things that increases my confidence in the pattern, along with the bearish divergence and declining volume. This week's sideways price action since Monday looks like a bullish continuation pattern and that's why I'm showing another leg up on Friday (meaning a bullish reaction to the jobs reports). I show a target zone of 1133-1143 which is based on some Fib projections, Gann level (1137) and trend line. It would be very typical of this market, which has been full of head fakes, to jump above 1131, nab a slew of bears' stops, suck in some more bulls and then slam the door closed on them, trapping them for the ride back down.

S&P 500, SPX, 60-min chart

But, even though I show an expectation for a move higher on Friday (which might be very short-lived, such as a quick pop higher and then a complete reversal within the first hour), I don't have any money on that trade, not even a hedge against my short positions. I've seen too many of these sideways bullish continuation patterns fail to the downside (and a failed pattern tends to fail hard). Therefore take any selling Friday morning seriously since it could mean the high is already in place. A break of the uptrend line from July 1st, currently near 1107, would be a bearish heads up while a break of last Friday's (July 30) low would confirm we've seen the high.

All the indexes look virtually the same, some looking a little stronger than others. Money has been rotating into the bluest of the blue chips, which I view as a defensive move. While SPX has retraced 50% of its April-May decline the DOW has retraced 62% (and struggling at that Fib level of 10691). Last Friday's low near 10347 is the key level and a break below 10500 would be a bearish heads up. If we get the rally on Friday look for possible topping around 10750-10800.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish to 10750-10800
- bearish below 10347

Creating a parallel down-channel for NDX based on the line connecting the May and July lows and attaching the parallel to the April high shows that price is struggling at the top of this channel. This simply shows the symmetry in the moves and how traders react unconsciously to these symmetrical moves. Whether or not we'll see at least a quick pop above the channel, we'll know quickly on Friday. Like SPX the NDX has retraced 50% of its April-May decline. I consider the price action since the May low as the correction to that initial decline, which is why I'm watching the Fib retracement of the April-May decline instead of April-July. A decline below 1833 would be a break back below its 20-ema, 50-dma, 200-dma and last Friday's low. It would be a significant break and it would mean get short if not already (or add to your position). Until that happens, respect the uptrend.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish to 1935
- bearish below 1833

How the semiconductors trade will tell us a lot about how the broader market will trade (this index and the banking indexes are key to watch). So far I'm not impressed with the bounce off last Friday's low. While the bounce could make it a little higher, especially with a Friday rally, it's very corrective and pointing lower. The July high should stand for a long time to come.

Semiconductor index, SOX, Daily chart

The RUT was much weaker today and might have been simply a result of traders cutting their risk in front of Friday's reports. If the market sells off on Friday it will be harder to get out of the small caps. So while the RUT was down -1.2% today the DOW essentially broke even. Money was running from the small caps into the large caps. Whether this is a harbinger for more selling on Friday we'll know soon enough. I'm using a Fib retracement from the July low because of the slightly different wave count I'm trying on this index. It has retraced 50% of the April-July decline but only 38% of the April-May decline so relative to the others it is clearly weaker. A lack of animal spirits in the small caps is not a bullish omen.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 670
- bearish below 639

Looking at the financial sector ETF this week shows how it has been struggling with resistance near $15, which is where it has peaked out 3 times previously in May, June and July. Will the 4th time be the charm? So far no. It has a slightly different pattern than the broader averages but if it does make it a little higher it could finish a smaller rising wedge pattern from the July 20th low. As it stands now the move up from July 1st counts well as completed a-b-c bounce. Today it broke its uptrend line from July 20th and then bounced back up to it by the end of the day, which also happens to be where its 200-dma is located. A selloff tomorrow would leave a kiss goodbye following the retest of resistance and would be a sell signal. Follow the money if that happens.

Financial sector ETF, XLF, Daily chart

The TRAN has been struggling at 4515 resistance for over a week now. I see an upside target only marginally higher near 4537 but at this point the pattern counts well as a completed a-b-c bounce off its July 6th low and has met the objective for two equal legs up. It just needs the starting gun to race to the downside.

Transportation Index, TRAN, Daily chart

Earlier I reported on the DSI sentiment reading for the stock market and how it quickly ran from 10% bulls at the beginning of July to 73% bulls currently. Just the opposite has happened for the dollar, although over a slightly longer stretch of time. From a 98% bullish reading at the June high it has now slipped to 6%, which is even lower than where it was at the November low. So the reversal in sentiment has now been completed along with the 57% price retracement of the dollar's November-June rally, setting the dollar up for its next rally leg.

The dollar dropped down to a Fib projection at 80.549 (the low was 80.555), its 200-dma and the bottom of its parallel down-channel from June. As I had mentioned earlier in the week on the Market Monitor, now is a good time to be looking to nibble long on the dollar (UUP is a good vehicle). A rally above 82.50 would be confirmation we've seen the low. If it drops a little lower first then watch for support near 79.93, its 62% retracement.

U.S. Dollar contract, DX, Daily chart

Commodities have not followed the dollar tick for tick and commodity stocks have been more in synch with the stock market than the commodities themselves but each looks ready for a reversal. The commodity related equity index also sports a rising wedge pattern for its bounce off the July 1st low and also supports the idea we'll see a little higher before it finishes. A little throw-over above the top of the wedge would be a typical finish although it could be finished as of today's high.

Commodity Related Equity index, CRX, Daily chart

Gold was dropping for most of July but has now retraced 38% of its decline from June. The pattern is not clear as to its next move but whether it makes it a little higher, pulls back first and then bounces again or simply heads lower from here, the longer-term trend for gold should now be down.

Gold continuous contract, GC, Daily chart

Oil made it a little higher than I thought it would and pushed back above its broken uptrend line from July 2009. If it continues to use that trend line for support we could see the oil rally continue. But the shorter-term parallel up-channel from July 6th may be showing us it's gone as high as it's going to go. A drop back below 80 would indicate the top of the bounce is probably in. Below 75.90 would confirm that. The bigger picture says the bounce off the May low is a correction and therefore I'm looking for the longer term trend to be down (back below the May low).

Oil continuous contract, CL, Daily chart

Drum roll please...what you've all been waiting for, brought to you by your government, the one, the only, the nonfarm payrolls report. Yea (as Kermit the frog would say it). With all the hype around this report I can't help but wonder if we'll have a sell-the-news reaction no matter what the number is. But expect some wild gyrations at least in the early morning. The initial pre-market direction may certainly not be the direction for the rest of the day. Other than the employment reports we'll also get the consumer credit report in the afternoon. Unless this number is scary bad, as in a deeper contraction than last month's, it should not be a market mover.

Economic reports, summary and Key Trading Levels

As I had mentioned at the end of the day on the Market Monitor, if a gun were held to my head and I was forced to make a trade to hold into Friday morning I would have traded to the long side. The charts show a little more upside potential and we've had a potentially bullish sideways consolidation pattern this week. But I would also cover any long trade almost immediately on Friday, win or lose. Given how close I think we are to a top I would not want to be long much of anything right now.

But I had also mentioned that if the gun were removed from my head before today's close I would have immediately covered my trade and gone home flat. I've seen enough of these bullish consolidation patterns head south in a hurry and I just didn't think it was worth the risk for either side in front of what is clearly an emotional moment for the market. With light volume and high emotions it's a formula for whippy price action. Let the dust settle in the morning to see if a direction gets established.

If after the first 30-60 minutes of trading we get an initial move, a correction of that move and then a continuation of the move I'd say there's a good chance the continuation will be the direction to trade. If that continuation happens to be down then I think holding a short position through the weekend makes sense (know your risk). If the continuation is to the upside and hits some of the upside targets I've mentioned (SPX 1133-1143), I'd think seriously about profit protection and maybe nibbling on some shorts. A rally above those upside targets would be a reason to be at least short-term bullish.

Good luck tomorrow and be careful. Remember, flat is a position. I'll be back with you on Monday as Todd and I will be switching nights next week.

Key Levels for SPX:
- cautiously bullish to 1133-1143
- bearish below 1088

Key Levels for DOW:
- cautiously bullish to 10750-10800
- bearish below 10347

Key Levels for NDX:
- cautiously bullish to 1935
- bearish below 1833

Key Levels for RUT:
- cautiously bullish above 670
- bearish below 639

Keene H. Little, CMT

New Option Plays

Reload Your Watch List

by James Brown

Click here to email James Brown

Editor's Note:

Look at the last four days in the market. Aside from the spike higher on Monday morning stocks have gone nowhere. Investors are waiting for the results from the July jobs report. It will take a better than expected jobs report to keep this rally alive and even that won't guarantee we won't see some sell-the-news reaction. On the other hand a disappointing report could easily spark some major profit taking after a +7% rally in July. Since the report comes out Friday morning before the opening bell I am not adding any new plays tonight. Odds are extremely high the market (and most stocks) will gap open one way or the other on Friday.

Next time we find the market in this situation, with stocks in a narrow range ahead of a major economic report (almost guaranteed to move the market) and option expiration is only two weeks away - I would consider market neutral strategies like a straddle or a strangle to capture any volatility following the report. They don't always work but sometimes we can catch a significant move. Unfortunately, it's too late for us to launch those positions tonight.

Just because we're not adding new positions tonight doesn't mean we can't prepare for tomorrow. I'm listing several stocks on my watch list. These might be potential trades soon.

INFY: still has a positive long-term bullish trend. A breakout past $64.50-65.00 would be bullish.

ILMN: this stock is breaking out from a six-week consolidation and looks ready to rally. Unfortunately there is long-term resistance in the $47.50-48.00 region. If ILMN fails under $48 look for a dip and bounce back near $45.00. Otherwise look for a breakout.

GS: The stock is up more than $25 from its July lows. Shares are clearly short-term overbought. I would wait for a pull back into the $150-145 region before considering new bullish positions. Look for resistance near $160 and its 200-dma.

IBM: This technology bellwether stock is inching closer and closer toward major resistance in the $132-134 zone. A breakout over $134 could herald the beginning of a major leg higher.

TGT: Traders responded well toward TGT's same-store sales data today. The stock looks poised to rally but there is resistance near $53.00 and its 100-dma (near $53.50).

MTD: This medical device/supply company looks ready to run toward its highs near $130. It might be a buy on a positive jobs report. Otherwise wait for another dip near $115 and its 50-dma.

RMD: This is another medical-related stock that appears to be breaking out from a multi-week consolidation. There is resistance near $70. A stock to watch.

NEU: This stock broke out over resistance several days ago and has been consolidating sideways since. If the market rallies this stock could see a run toward its 2010 highs near $125.

MICC: Shares are sitting near one-year highs. I would prefer to buy a dip or another bounce near $90.00.

OXY: This oil-related stock has been underperforming. A breakdown under $74 could herald a very significant correction lower. Potential put play.

In Play Updates and Reviews

Waiting to Exhale

by James Brown

Click here to email James Brown

Current Portfolio:

CALL Play Updates

ProShares UltraShort 20 YR Treasury - TBT - close 36.61 change -0.31 stop 35.55

Target(s): 36.90(hit), 37.50 (hit), 38.00, 39.25, 40.50
Key Support/Resistance Areas: 42.00, 41.00, 39.70, 38.25, 37.55, 34.65
Current Gain/Loss: +9.7%
Time Frame: Several Weeks
New Positions: Yes

8/5: Both stocks and bonds are holding their breath for the Friday morning jobs report. If the report comes in strong it will help alleviate fears about the U.S. economy slowing down. This could inspire investors to sell bonds to raise money and buy stocks. On the other hand if the jobs number disappoints then investors will continue to seek shelter in the bond market, which is bad for our call play, since this is the ultrashort bond ETF. I would expect the TBT to gap open one way or the other tomorrow.

8/4: TBT is showing signs of life and I expect it move higher from here. This ETF (short bonds) is a good hedge against our short DIA position. After the big sell-off in TBT on Friday we offered a lowered target of $36.90 which was hit today. Options positions are now up nearly +10% and I am looking for TBT to trade to at least $37.50 which is below the 50-day SMA and still a valid target. I suggest tightening stops at this level. I suggest tightening stops at these levels to see if we can get more out of the trade. A break above the 50-day SMA should easily send TBT towards our more aggressive targets. We plan to tighten the stop in the coming days when we have a better reference point.

8/3: After a brief dip in early trading TBT recovered nicely. Prices are coiling on its intraday chart and a breakout should happen tomorrow or Thursday. If TBT breaks above today's highs it should easily trade to our first two targets which are both below the 50-day SMA. I suggest tightening stops at these levels to see if we can get more out of the trade. A break above the 50-day SMA should easily send TBT towards our more aggressive targets.

Current Position: Long September $37.00 CALL, entry was at $1.23

Entry on July 26, 2010
Earnings N/A (unconfirmed)
Average Daily Volume: 3.8 million
Listed on July 24, 2010

PUT Play Updates

SPDR DJIA ETF - DIA - close 106.88 change -0.08 stop 108.75

Target(s): 106.25, 105.25, 104.30, 103.65
Key Support/Resistance Areas: 108.00, 107.00, 105.90, 104.75, 104.20, 103.50
Current Gain/Loss: -8%
Time Frame: 1 week
New Positions: possibly

8/5: Stocks are drifting sideways in a very narrow range. The market is waiting for the results from July's jobs report. A strong, better than expected report "should" produce another move higher. On the other hand, if the jobs number disappoints, stocks could see some serious profit taking, especially after the +7% rally in July. Odds are really good that the DIA will gap open tomorrow morning. I would look for a move under $105.00 as a potential entry point although nimble traders could use a move under $105.50 as an entry. I would not surprise me to see the DIA trading near $100 in the next several days if the jobs data disappoints.

8/4: The markets melted higher again today despite an early attempt to sell-off. Our main goal with this trade is to fill the gap higher from Monday which is near 105.25. This is the area where readers should tighten stops, or use a trailing stop, to see if the selling intensifies or if buyers step in. The drop could happen fast so simply taking profits is also a smart move. A drop to this area will produce a winning trade and for options traders it should be a +20% gain. We are at resistance points so this is a logical place for the DJIA to turn lower to regain some energy before possibly moving higher. For readers looking for a quicker exit $106.25 could be considered which is near this week’s lows as the DJIA is stubbornly hanging onto the gap.

8/3: It was an inside day for DIA in that it traded within yesterday's high/low price range. DIA closed just about where it opened so we are currently breakeven on the position. I've raised the first target to $105.15 so that it is just above Friday's high as opposed to its closing price. A trip down to this level could happen fast and it is a good place to consider tightening stops or taking profits. For options traders this level should produce a +20% gain. Our next target is $104.30 which just above the 200-day SMA.

Current Position: Long September $106.00 PUTS, entry was at $2.70

Entry on August 3, 2010
Earnings: N/A (unconfirmed)
Average Daily Volume: 14 million
Listed on August 2, 2010