Option Investor

Daily Newsletter, Thursday, 10/20/2011

Table of Contents

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

Market Wrap

Bipolar Markets

by Jim Brown

Click here to email Jim Brown
Good earnings and economics are pushing the markets higher but problems in Europe continue to push the indexes lower.

Market Statistics

The Dow declined to triple digit losses this morning when news from Europe said the decision on the comprehensive bailout and recapitalization package would be delayed until Wednesday. The comment out of the Merkel-Sarkozy meeting claimed there would be "a definitive agreement on European banks and the EFSF by Wednesday." A couple hours later news broke claiming that was not the case and there would be a decision on Sunday and the Dow rebounded to nearly a triple digit gain before slipping again as traders wondered which headline was correct.

We clearly remain a hostage to Europe and the EU summit scheduled for this weekend. The bottom line is that nobody knows what will happen or when it will happen and the market hates uncertainty. Until those uncertainties disappear we will continue to have choppy markets. The Dow has alternated between positive and negative closes for the last ten days. The only trend since Oct-11th has been sideways volatility.

I hate to write about the pressures from Europe again because we have beaten this topic to death. So I will only say that our markets for the rest of the month depend on the outcome in Europe this weekend or possibly Wednesday depending on which headline is correct. I am sure I speak for everyone when I say I am less concerned about what they decide than the importance of making a firm decision that does not have to be changed weekly. The markets want them to make a plan, announce that everyone is in agreement and then implement it. Traders can then deal with the consequences, make decisions and the market will again become directional. The direction is of course dependent on the strength and comprehensiveness of the plan.

In the U.S. the economics continue to improve but the data is being overshadowed by news from Europe. The Philly Fed Manufacturing Survey rebounded sharply to a headline number of +8.7 for October from a -17.5 in September and -30.7 in August. That is a dramatic improvement and this report is seen as a proxy for the national ISM that will be released in two weeks. This is great news. The +26.2 gain in the headline number was the largest monthly gain since the early 1980s. That is a +39.4 point gain in the last two months.

The internal components were very strong. New orders rose to +7.8 from -11.3 (-26.8 in August). Backorders rose to +3.4 from -10.4 (-20.9 in August). Capital expenditure plans rocketed higher to 12.3 from 5.5 suggesting hiring would pick up along with equipment purchases. However, employment was the only component that was less than exciting. Employment declined to +1.4 from +5.8 (-5.2 in August). However, the average workweek rebounded from -13.7 to +3.1 meaning workers were getting more hours and that will eventually lead to more hiring. The six month expectations rose from 21.4 to 47.2 and the highest level since April.

There are no signs of a pending recession. On the contrary it appears that the manufacturing sector is picking up speed now that the political problems making the headlines in July and August are now behind us. The problem ahead will be the super-committee deficit cutting report due out on Nov-23rd. That could be a major factor that could derail this recovery if the committee is unable to find a resolution and the entire budget process gets paraded through the daily news again like a huge load of dirty laundry.

Philly Fed Chart

Weekly Jobless Claims declined by -6,000 to 403,000. If that drop sounds strange it is because the prior week was revised higher from 404,000 to 409,000. We have been in the 400,000 range since late September but the numbers keep getting revised higher by 4-5K for each of the prior weeks.

Layoffs are not increasing but they are not declining either. Once we see claims dip under 400,000 and start trending lower the equity markets will begin to believe in the recovery. The jobless claims are the weekly thermometer reading on the health of the economy.

Jobless Claims Chart

Other economics included the Bloomberg Consumer Comfort Index, which rose to -48.4 from -50.8. This is a slow movement index but it has been steadily improving since the low of -53.0 on Sept 25th.

September Existing Home Sales declined slightly to 4.91 million (annualized) from 5.03 million in August. However, August numbers were a sharp increase from the 4.67 million in July so the pace of sales is still improving. Existing inventory is now 8.5 months, down from 9.5 months in July. With inventory declining the sector is heading in the right direction. Thirty year mortgage rates at just over 4% are helping to induce buying.

After the bell the SEMI book-to-bill ratio for September came in at 0.75, a decline from 0.80 in August. That is the lowest reading in more than two years. New orders fell -15.3% and shipments declined -9.8%. The BTB ratio is the dollar value of orders received compared to the value of orders shipped. In September manufacturers only received $75 in orders for every $100 in product shipped. This was the sixth consecutive month of declines. The drag is related to the slowdown in PC sales, European uncertainty and weak global economy.

The only reports due out on Friday are the Regional Employment and the ECRI Weekly Leading Index. Neither are market movers.

The only economics that matter are the decisions made or not made by the EU finance ministers on Sunday. If that decision is postponed to Wednesday it will just prolong the agony.

Earnings continue to be the short term focus and Microsoft was the big dog on tap for Thursday. Microsoft posted a +7% increase in revenue at $17.37 billion. Profits were $5.7 billion or 68-cents and that was in line with analyst estimates. Sales of Windows rose only +2% to $4.87 billion and slightly below the pace of new PC sales at 3.2%. The online division (Bing) lost -$494 million, down from -$558 million in the year ago quarter. Online revenue rose +19% to $625 million. Microsoft is hoping its $8.5 billion acquisition of Skype to improve its online offerings. Shares of Microsoft were flat after the close.

Microsoft Chart

SanDisk (SNDK) rallied after the close after reporting earnings of $1.20 that beat street estimates of $1.06. The company said robust demand in smartphones, tablets and e-readers was keeping chip volume tight. Revenue rose +15% to $1.42 billion. Shares rallied about $1 in after hours.

SNDK Chart

Chipotle Mexican Grill (CMG) reported profits that rose +25%. Earnings of $1.90 beat the street estimates of $1.85. Chipotle raised prices by +4.5% in 80% of its stores in an effort to recover higher costs for chicken, beef, cheese and sour cream. Food costs rose to 33.1% of sales, a +2.5% increase. This lowered gross margins to 26.7% from 27.7%. Same store sales rose +11.3% compared to analyst estimates of +9.6%. Chipotle has 1,100 restaurants and plans to open 160 more in 2012. They appear to be doing everything right and the stock continues to rise even with a forward PE over 35 for 2012.

CMG Chart

Ingersoll Rand (IR) reported earnings of 81-cents that beat estimates of 79-cents but the shares were hammered for an 8% loss on weak guidance. The maker of things like Trane air conditioners and Schlage locks said the weak housing market continued to weigh on profits. Revenue rose +5% to $3.93 billion despite declining sales in the USA. Ingersoll predicted earnings of 54-70 cents for Q4 and analysts were expecting 70 cents. IR also plunged after the Q2 earnings in July for a $15 loss over the following month.

IR Chart

Southwest Airlines (LUV) rallied +4% after reporting a +35% rise in revenue even though the company posted a loss for the quarter. Southwest would have earned 15-cents or $122 million and a penny better than analysts expected but fuel hedges turned against them. The airline lost $140 million when fuel prices plunged during the quarter and their fuel hedges went against them. It was the first quarterly loss in two years and the lost before that was also due to hedges going negative when oil prices crashed after the 2008 oil bubble. This compared to a loss of -$162 million by American Airlines (AMR) and its fourth straight quarterly loss and 14th in the last 16 quarters.

Southwest Chart

Despite the high profile hits and misses in earnings the numbers are still good. According to S&P 102 S&P-500 companies have reported Q3 earnings and 82 of them have either met or exceeded expectations. Considering the economy was undergoing a softpatch in July/August this is a testament to the previous cost cutting and restructuring as the country recovered from the recession. When the economy actually begins to accelerate the earnings are going to be huge.

The markets are trading with a bipolar personality as we wade through the earnings and wait on a "definitive and comprehensive plan" (wink, wink) out of Europe. The S&P closed at 1215 and has created a new trading range between 1200-1225 while we wait.

About the only sure thing we can count on is a major move once the plan is announced. We are either going to breakout and race to the July highs at 1350 or retrace to the October lows at 1190. I seriously doubt there will be any middle ground.

The chief analyst at JP Morgan believes we will break to the upside regardless of what the plan entails. Just having a new plan and eliminating a lot of the uncertainty will cause institutional traders to buy stocks. He said the improving economics, strong earnings, anticipated record profits in 2012 and the very high short interest could produce a significant rally. He said hedge funds were still significantly short and not expecting a favorable conclusion in Europe. However, in just the last week he said the JPM trading desks had seen a sharp pickup in institutional orders for financial stocks. If financials are moving back into favor then the rest of the market should follow. Let's hope he is right.

S&P Chart

The daily range on the Dow is actually shrinking as we move closer to a decision in Europe. The Dow has closed alternately positive and negative for each of the last ten trading days. This is a clear example of the uncertainty confusing the markets. 11,625 remains resistance and 11,400 is support. The Dow rallied back from a -144 point drop before lunch to close positive and right in the middle of that range. I expect a major move over the next couple weeks.

Dow Chart

The Nasdaq closed negative again thanks to continued losses in Apple, now down -6% from its pre-earnings level. Other major decliners today included WYNN -7.15, NVEC -9.27, HITT -6.60, PLCM -5.75, PCLN -5.18 and CYMI -4.30. Google and Amazon both closed slightly positive. Without the leadership from Apple the techs appear lost.

The Nasdaq dipped to an eight day low at 2557 before rebounding to close at prior support at 2600. The after hours earnings should have given techs a positive spin for Friday's open and the Nasdaq futures are moving higher late this evening. Resistance is now 2665.

Nasdaq Chart

My guidance for Friday would be to strangle something. We are profiling a Russell 2000 ETF strangle tonight using November options. A strangle involves buying a put and a call with different strike prices on a specific security. Normally the trader chooses a strike price just out of the money on either side of the stock price. This compares to a straddle where you buy a call and a put at the same strike price.

In a strangle we are betting on a major move in the market over the next couple weeks that will push the price of the underlying well above or below the strikes purchased. I think that is the perfect strategy for the current environment.

The European calendar as of tonight is as follows:

Friday/Saturday: EU finance ministers meet.
Saturday: Merkel and Sarkozy meet.
Sunday: EU leaders meet to discuss EFSF plan.
Wednesday: Definitive agreement on banks and EFSF.

The potential for a major case of foot and mouth disease from multiple EU leaders is about 100%. The odds of them getting through six days of contentious meetings without saying something they shouldn't is about zero. The market will be hanging on every word spoken and every headline posted.

Just getting past Wednesday is the first challenge. The following Monday, Oct 31st, is the fiscal year end for most mutual funds. They will have to make their final buy-sell decisions by Friday the 28th for them to be effective for the current year. That means we could have some additional volatility even after the European circus concludes.

Bottom line for me is to either wait patiently on the sidelines or strangle something.

Jim Brown

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New Option Plays

Major Headline Risk

by James Brown

Click here to email James Brown

Editor's Note:

The stock market is chopping sideways in a range as investors wait for some sort of deal/no deal headline out of Europe this weekend. There is a LOT of headline risk for both bulls and the bears. Stocks could see a big move either direction based on what happens in Europe this weekend.

We are going to try and take advantage of this volatility with a market neutral option strategy called a strangle. You could also try a straddle (buying a call and a put at the same strike) although I usually find that straddles are too expensive.

Instead of using the IWM small cap ETF you could also try a strangle on the S&P 500 ETF (SPY), Dow Industrials (DIA), the midcap ETF (MDY), the NASDAQ-100 ETF (QQQ) or you could try this strategy on similar double (2x) ETFs.

- James


iShares Russell 2000 ETF - IWM - close: 69.62 change: +0.19

Stop Loss: n/a
Target(s): To Be Determined
Current Option Gain/Loss: +0.0%
Time Frame: 3 to 4 weeks
New Positions: Yes, see below

Company Description

Why We Like It:
The U.S. stock market is churning sideways as investors wait for some sort of deal out of the EU summit this weekend. High-level talks actually start tomorrow but the official EU summit in Brussels is on Sunday. Then there is the deadline for some sort of deal on the EU banks by next Wednesday. The next few days carry a lot of headline risk for both bulls and the bears. One of the biggest risks is that these meetings actually get postponed. That was a problem this morning with rumors the EU summit might get pushed back.

If there is any sort of deal then stocks could rally higher and breakout past major resistance. If there is no significant deal then stocks are likely to plunge and drop toward their August or October lows. Whatever happens there is a good chance that stocks will see a significant move over the next several days.

We are suggesting that traders launch a neutral strangle position on the IWM tomorrow (Friday) morning with November options.

FYI: A strangle involves buying both an out of the money call (OTM call) and an out of the money put (OTM put). The expectation is that the underlying equity (IWM in this case) will move enough to make one side profitable and cover the entire position and then some.

- Suggested Position -

Out-of-the-Money Call option:
Buy the NOV $72 call (IWM1119K72) current ask $1.94

- and -

Out-of-the-Money Put option:
Buy the NOV $68 put (IWM1119W68) current ask $2.81

Annotated Chart:

Entry on October 21 at $ xx.xx
Earnings Date --/--/--
Average Daily Volume = 89 million
Listed on October 20, 2011

In Play Updates and Reviews

Intraday Tech Weakness

by James Brown

Click here to email James Brown

Editor's Note:

Technology stocks underperformed this morning and the NASDAQ failed to bounce back into positive territory.

Overall investors seem to be content to just run down the clock as we wait for the week to end and for the weekend EU summit to begin. There was some profit taking this morning but the major indices pared their losses and the S&P 500 index closed in positive territory. The Dow Transportation average looks poised to breakout, which would be bullish for the overall market.

Unfortunately, with the tech weakness today, we did see HPQ, QQQ, and the SMH all get stopped out.


Current Portfolio:

CALL Play Updates

Bed Bath & Beyond Inc. - BBBY - close: 59.71 change: -0.47

Stop Loss: 58.90
Target(s): 64.75
Current Option Gain/Loss: -37.3%
Time Frame: 2 to 4 weeks
New Positions: see below

10/20 update: The first half of today was fueled by profit taking but BBBY bounced at $58.98. That was almost low enough to hit our stop loss at $58.90. If there is any follow through lower tomorrow we will most likely get stopped out. Bears could argue that Monday and Wednesday's session have produced a short-term bearish double top pattern. I am not suggesting new positions at this time.

*Small Positions*- Suggested Positions -

Long NOV $62.50 call (BBBY1119K62.5) Entry $1.50

Entry on October 14 at $61.00
Earnings Date 12/21/11 (unconfirmed)
Average Daily Volume = 3.4 million
Listed on October 12, 2011

iShares Transportation ETF - IYT - close: 84.39 change: +1.31

Stop Loss: 81.30
Target(s): 90.00
Current Option Gain/Loss: Unopened
Time Frame: 3 to 4 weeks
New Positions: Yes, see below

10/20 update: The transports were showing some relative strength on Thursday. The $TRAN index (and the IYT) advanced +1.5%. The IYT looks poised to breakout past resistance at $85.00 soon. Currently the newsletter is suggesting a breakout trigger at $85.20 to buy calls.

Earlier Comments:
The 100-dma and exponential 200-dma could be potential resistance but we're aiming for $90.00. Readers will want to keep our position size small since the transports are short-term overbought given the huge bounce from its October lows.

Trigger @ $85.25 (small positions)

- Suggested Positions -

buy the NOV $87 call (IYT1119K87)

Entry on October xx at $ xx.xx
Earnings Date --/--/--
Average Daily Volume = 662 thousand
Listed on October 18, 2011

SPX Corp. - SPW - close: 51.04 change: -0.63

Stop Loss: 49.15
Target(s): 57.75
Current Option Gain/Loss: + 5.5%
Time Frame: 3 to 4 weeks
New Positions: see below

10/20 update: Our trade on SPW is now open. Both the stock and the S&P 500 opened higher today. Unfortunately SPW was unable to build on its morning strength and the stock underperformed with a -1.2% decline for the session. Nimble traders could try buying calls on a dip or a bounce near the $50.00 mark. More conservative traders may want to wait for a breakout past $53.55 as their entry point instead.

Earlier Comments:
This is an aggressive trade so we want to keep our position size small. FYI: The Point & Figure chart for SPW is bullish with a $78 target.

(Small Positions)- Suggested Positions -

Long NOV $55 call (SPW1119K55) Entry $1.80

10/19 Trade still not open. Try again.
10/18 New entry point on this bounce. See entry details above
10/17 Trade not open. Remove entry point for 24 hours, then re-evaluate.

10/20 trade opened at $51.80


Entry on October 20 at $51.80
Earnings Date 11/02/11 (unconfirmed)
Average Daily Volume = 701 thousand
Listed on October 15, 2011

PUT Play Updates

Currently we do not have any active put trades.


Hewlett Packard - HPQ - close: 24.98 change: -0.63

Stop Loss: 24.45
Target(s): 29.50
Current Option Gain/Loss: +35.5%
Time Frame: 8 to 12 weeks
New Positions: see below

10/20 update: Technology stocks were some of the worst performers today. HPQ slipped to a new two-week low and hit $24.27 midday. Our stop loss was hit at $24.45.

- Suggested Positions -

2012 Jan. $24 call (HPQ1221A24) Entry $2.14, Exit $2.90 (+35.5%)

10/20 stopped out at $24.45
10/17 HPQ could gap open lower tomorrow on IBM's earnings news
10/15 new stop loss @ 24.45
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

PowerShares QQQ ETF - QQQ - close: 56.59 change: -0.28

Stop Loss: 56.45
Target(s): 59.25
Current Option Gain/Loss: -33.9%
Time Frame: 3 to 4 weeks
New Positions: see below

10/20 update: The Qs retreated lower this morning and our stop loss at $56.45 was hit prior to lunchtime. This ETF dipped under its 200-dma and bounced back to pare its losses to less than -0.5%. Bears could argue that the QQQ has produced a very short-term bearish double top this week.

(Small Positions)

NOV $58 call (QQQ1119K58) Entry $1.74, Entry $1.15 (-33.9%)

10/20 stopped out at $56.45


Entry on October 19 at $57.71
Earnings Date --/--/--
Average Daily Volume = 87 million
Listed on October 18, 2011

Semiconductor ETF - SMH - close: 30.24 change: -0.26

Stop Loss: 29.45
Target(s): 33.45
Current Option Gain/Loss: -49.2%
Time Frame: 3 to 4 weeks
New Positions: see below

10/20 update: Xilinx Inc. (XLNX) reported earnings last night. They beat the bottom line but then guided lower going forward. This negative guidance weighed on the semiconductor sector. The SMH gapped open lower at $30.10 and eventually hit our stop loss at $29.45 before bouncing near its simple 50-dma. Our play is closed but I would keep the SMH on your watch list for a breakout past $31.00 or its 100-dma as a bullish entry point.

Earlier Comments:
I would keep our position size small.

(small positions)

- Suggested Positions -

NOV $31.50 call (SMH1119K31.5) Entry $0.63 Exit $0.32 (-49.2%)


Entry on October 19 at $30.75
Earnings Date --/--/--
Average Daily Volume = 12.7 million
Listed on October 18, 2011