Option Investor

Daily Newsletter, Tuesday, 10/25/2011

Table of Contents

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

Market Wrap

Earnings Turn Ugly

by Jim Brown

Click here to email Jim Brown
Cancellation of the EU Finance Ministers meeting on Wednesday and a flurry of negative earnings soured market sentiment.

Market Statistics

Tuesday was the day everyone dreaded. All the headlines were bad. EU Finance Ministers cancelled their summit for Wednesday suggesting there will not be a comprehensive plan for resolving the EU credit crisis as promised. In the U.S. there was a flurry of earnings warnings and poor guidance that erased the positive earnings sentiment from last week. U.S. economics also turned negative with the Consumer Confidence hitting a 30 month low. There was no area traders could point to as a beacon of hope and the market decline reflected that loss of confidence.

The European crisis flared up again as various countries refused to go along with the new plan unless other countries agreed to changes. For instance, part of the new plan calls for the pension age to be raised to 67 for anyone born after 1964. Italian lawmakers are kicking back on that provision as well as others and there is fear Berlusconi is in danger of being voted out of office. He has survived prior scandals and multiple confidence votes but should a new vote be triggered today analysts believe it would fail. The fight against the austerity measures have strengthened Berlusconi's political opponents and his key party allies of the Northern League are threatening to withhold support. If a confidence vote was forced and Berlusconi lost power, Italy could be mired for months in the vacuum as rival opponents fought to gain control. This would delay any austerity moves.

The ECB has been buying billions in Italian bonds in an effort to keep Italian borrowing costs low but the rising political confusion and failure to enact the new austerity measures has caused a new spike in interest rates that could eventually create an even bigger problem than Greece.

The broader EU is demanding these austerity concessions from those nations in trouble before the EU leaders will approve the comprehensive plan. With Italy on the brink of disaster and not likely to approve the required austerity measures the EU leaders cannot get the plan approved.

The comprehensive plan was supposed to deal with the debt crisis by writing off more of Greece's debt, raising bank capital levels and boosting the powers of the EFSF. The ten EU countries that do not use the euro currency won't sign off on the move to force banks to raise new capital without the other two parts of the plan in place.

The meeting of the finance ministers was to iron out the details of the plan before the full meeting the EU leaders late Wednesday. When the meeting of the finance ministers was canceled it virtually assured there would be nothing positive coming out of the EU leaders meeting. The market did not like the news after being promised for the last week that a comprehensive plan would be presented today.

Market sentiment was already ugly after some high profile earnings warnings and unexpectedly weak economics. The October Consumer Confidence came in at 39.8 and the lowest level since March of 2009 compared to estimates for a rise to 47.0. This compares to the 46.5 reading in September. The headline number has fallen -20 points in just the last three months.

The present conditions component fell to 26.3 from 33.3 and is approaching the recession lows of 21.9. This is not a good sign. The expectations component fell to 48.7 from 55.1 and the recession lows were 27.3.

There is one caveat that confidence has declined in October in 19 of the last 21 years for cyclical reasons. However, the magnitude of the last three months decline is scary. Those respondents who felt jobs were plentiful declined from 5.6% to 3.4% and a cycle low.

More than half of the responders expect the stock market to be lower a year from now. Those who believe the market will go lower are at the highest since Oct-2008.

This report could be the result in a change in methods that took place earlier this year. By comparison the Consumer Sentiment report only showed a small decline. The Bloomberg weekly index has been trending higher for several weeks and the Rasmussen daily index has been flat.

Consumer Confidence Chart

Mass layoffs for September declined to 1,495 events from 1,587 in August. The workers impacted declined to 153,229 from 165,547. Manufacturing layoffs declined by nearly 10,000. The minor decline in total layoffs is not enough to trigger optimism about next week's Nonfarm Payroll numbers.

The Richmond Fed Manufacturing Survey came in with a headline number of -6.0 for the second month. The unchanged reading was slightly disappointing although the internal components improved. New orders were -5.0, up from -17.0 in September. Any number below zero represents contraction so orders improved but are still declining.

Backorders improved to -15.0 from -23.0 but obviously still significantly negative. The worst component was employment, which fell to -7.0 from +7.0 and the lowest level since Nov-2009. That does imply the Nonfarm Payroll numbers will be weak. The best component was the capital expenditure plans, which rose to 13.0 from 5.0.

Richmond Fed Chart

The Case Shiller Home Price Index for August improved slightly from -4.1% to -3.8% relative to the prior three month period. This is a lagging report and was ignored.

The economic calendar for the rest of the week still contains some critical events. The EU leaders summit on Wednesday is going to be a letdown but that was priced into the market today. The GDP on Thursday is going to be important with whisper numbers near +3%. That could be a real disappointment.

Economic Calendar

A real problem for the market was the sudden flurry of negative earnings announcements and guidance. Everything was working so well last week but that has suddenly reversed.

Texas Instruments (TXN) reported earnings of 60-cents compared to estimates of 57-cents but issued a warning for Q4. The company said global economic uncertainty would hurt Q4 results in almost every market segment. TXN predicted earnings in Q4 of 28-36 cents and analysts were expecting 54-cents. That seems grim except TI said those earnings reflect a 15-cents charge for acquisition related costs. That changes the forecast to 43-51 cents but still well below analyst estimates. TXN shares only declined -2% for one of the least declines of the day.

Netflix (NFLX) was the poster child of the early decliners with a -35% drop to $77 on news it had lost 800,000 subscribers as a result of its price change and conflicting strategy announcements. Netflix ended the quarter with 23.8 million subscribers after it bungled a switch to billing separately for the DVD service and the streaming service. Numerous analysts slashed price targets from highs in the $225 range to numbers in the $75 to $95 range plus changing their recommendations to neutral or sell. Netflix also warned on Q4 saying earnings could range from 36-70 cents compared to analyst expectations of $1.05. NFLX actually posted earnings of $1.16 for Q3 compared to estimates of 96-cents so the dual billing was actually a plus for earnings but the execution failures were the highlight.

Netflix Chart

Broadcom (BRCM) posted earnings of 48-cents but then warned revenue and profits would decline in Q4 due to "industry softness." Revenue is now expected to be $1.7-$1.8 billion compared to prior analyst estimates of $2.0 billion.

BRCM Chart

3M (MMM) posted earnings of $1.52 per share compared to analyst estimates of $1.61 and shares declined -6% on the news. MMM was responsible for more than 40 points in the Dow's decline. 3M also warned on sales and profits for Q4 and for 2012 so it is a miracle it was not down -20%. The company said the global economic environment was "challenging" and the debt crisis had impacted exchange rates and disproportionately impacted 3M because of their international exposure. 3M predicted full year 2011 earnings of $5.85-$5.95 compared to its prior forecast of $6.10 to $6.25.

3M Chart

AK Steel (AKS) posted strong earnings of 72-cents compared to estimates of 55-cents but they warned for Q4 because of weak economic conditions and the uncertainty in Europe. Today was a market where you did not want to show any weakness and despite their blowout earnings the stock was crushed for a -13% loss.

AKS Chart

After the bell Amazon (AMZN) reported earnings of 14-cents compared to estimates of 24-cents and earnings of 51-cents in the year ago quarter and the stock was crushed in afterhours trading. Amazon also warned on Q4 earnings and said they could post a loss. Q4 revenue projections declined to $16.34 to $18.65 billion from analyst estimates of $18.15 billion. In Q3 sales rose +44% compared to +51% in Q2. The new forecast for Q4 suggests sales would only grow +27% to +44% and this is their busy quarter.

Amazon said it could post a $200 million loss in Q4 as it spends money on building the Kindle Fire tablets. Analysts were looking for $374 million in profits. The company said it was building 17 new fulfillment centers this year, two more than originally planned. They are also increasing the production of the Kindle Fire by "a few million units" citing strong demand. Jeff Bezos said preorders had more than doubled any prior Kindle launch.

Amazon shares declined -4% intraday to close -$10 at $227 but were crushed after the announcement to trade as low as $184.50 before rebounding to end trading at -203 for a -$34 loss for the day and that was +18 off the lows.

Amazon Chart

First Solar (FSLR) shares were crushed after the company announced "CEO Rob Gillette is no longer with the company." They would not say if he was fired or left on his own accord only he was no longer with FSLR. The company recently said it sold more solar panels in Q3 than the year before but profits had declined -62% because of lower prices received. First Solar is being killed by the $30 billion in subsidies China is providing to its solar companies to enable them to compete around the world. FSLR shares declined -25% on the CEO news.

First Solar Chart

It was a bad day in the market and the list of losers was full or major declines. Here are the top 15 decliners on the NYSE and Nasdaq.

Losers List

Gold rallied to a new six week high with a +55 gain in regular trading and another +8 after the close to $1708. After weeks of holding just over support at $1600 the sudden breakdown in expectations in Europe and the flurry of negative earnings guidance on weak economic expectations suddenly made gold a safe haven play once again. Open interest in gold had been declining as equities rallied but that investor interest came roaring back when the earnings turned negative.

Gold Chart

Given everything I reported above you would expect the markets to trade down again on Wednesday. With the $30 drop in Amazon and the earnings miss and warning from Broadcom you would expect the Nasdaq futures to be deeply negative. Surprise, the S&P and Nasdaq futures are both positive at 9:PM ET. If you are looking for logic don't look in the stock market.

I suspect fund managers are contemplating buying the dip to get one more bounce before their fiscal year end closes on Friday. Maybe some investors are still hoping for a miracle in Europe with the EU leader summit but I suspect they will be disappointed.

I told James to hold off on adding any new plays tonight because tomorrow is a coin toss and anything is possible. There is no reason to trade when there is no valid expectation of a specific move. The market is significantly overbought despite the -207 point drop today. It can always become more overbought but a bad headline from Europe could easily knock off another 400 points in just a couple hours.

The S&P topped out at 1256 on Monday and declined to close at 1220 today. That is well over strong support at 1200 but initial support at 1225 could be in jeopardy. Today's close is still more than 150 points (+14%) above the Oct 4th lows. That represents a major move without any material profit taking.

Because I think the overall U.S. economic picture is improving and today's flurry of earnings challenges are not in line with those reported in the first 30% of the cycle, I would buy a dip to 1200. A break under 1200 I would avoid until we found a trend. The last two months of 2011 could be positive because fund managers need to make some money fast. If the economics continue to improve I think they will pile on the market longs. That is just an opinion and not a fact. Hindsight is always 20:20 but foresight is always a guess.

Volume has been light at 7.6 billion shares on both Monday and Tuesday. There was no conviction to the upside on Monday or the downside today.

S&P Chart

The Dow rallied to strong resistance at 11,925 on Monday but failed at that level at least temporarily. Initial support for tomorrow will be 11,625 and the prior resistance from last week. The Dow was handicapped by the 3M earnings warning. Ten Dow components declined more than $1 and only Cisco was positive.

Dow Components

Dow Chart

The Nasdaq had a successful test of the 200-day on Monday but huge earnings misses on some high profile names knocked it back to a possible test of support at 2625. Futures are positive tonight despite the Amazon miss so anything is possible for tomorrow.

Nasdaq 2600 should be a level that holds unless the negative surprises continue.

Nasdaq Chart

Apparently the closing flush today was overdone with the futures positive overnight. I still believe there is a better chance of a negative headline out of Europe on Wednesday than a positive result. Maybe the market has already priced it in with today's drop but we won't know until the closing bell.

If we get a dip I would probably be a buyer because the worst that can happen in Europe is nothing. We have had 13 summit meeting with no material result over the last two years so one more will not be a major surprise. All the facts point to a meeting that ends without anything other than a promise of things to come so nothing new. Funds will focus on positioning for year end on Friday and that could produce buying.

Jim Brown

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New Option Plays

EU Meeting Tomorrow

by James Brown

Click here to email James Brown

Editor's Note:

The U.S. stock market retreated lower today following disappointing earnings news and word that the EU finance ministers had canceled their meeting tomorrow. The 27 leaders of the EU nations will still meet tomorrow but without their finance ministers no one expects there to be any significant resolutions. The natural reaction was to take profits after the market's recent rally.

Unfortunately there was a lot of expectation for tomorrow's EU summit meeting. Those expectations are likely to sour. Now add some disappointing earnings news like Amazon.com's (AMZN) tonight, and tomorrow morning could be a bearish one for stocks.

We want to see how the markets react to tomorrow's meetings in Europe and wait to see if there are any significant headlines out of the EU before adding any new trades to the newsletter. Thus, there will be no new additions tonight.

Potential buy-the-dip candidates:


- James

In Play Updates and Reviews

Reversal At Resistance

by James Brown

Click here to email James Brown

Editor's Note:

The major indices ran out of steam near resistance. Most of the market experienced some profit taking following recent gains.

The U.S. market looks poised for more weakness tomorrow morning. Nimble traders may want to consider buying calls on a dip near support in their favorite stocks.


Current Portfolio:

CALL Play Updates

Abercrombie & Fitch - ANF - close: 73.47 change: +0.47

Stop Loss: 67.45
Target(s): 77.25
Current Option Gain/Loss: Unopened
Time Frame: 2 to 3 weeks
New Positions: Yes, see below

10/25 update: Our new trade on ANF is not open yet. The S&P 500 opened flat and ANF opened down before rising toward the $75.00 level. It looks like the stock market might be poised for some profit taking tomorrow. We will adjust our entry point strategy on ANF. The new plan is to buy a dip at $70.25 with a stop loss at $67.45.

I am labeling this as an aggressive trade. ANF can be a volatile stock and we have a wide stop loss. I would launch small bullish positions tomorrow but only if both ANF and the S&P 500 index both open positive. Please note we do not want to hold over the mid November earnings report. Our exit target is $77.25.

FYI: Traders will want to take note of the fact that the most recent data listed short interest at 8% of the 85.8 million share float. Plus, the Point & Figure chart for ANF is bullish with a $98 target.

buy-a-dip at $70.25, stop loss $67.45

- Suggested Positions -

buy the NOV $75 call (ANF1119K75)

Entry on October xx at $ xx.xx
Earnings Date 11/16/11 (unconfirmed)
Average Daily Volume = 2.1 million
Listed on October 24, 2011

Bed Bath & Beyond Inc. - BBBY - close: 61.02 change: -1.21

Stop Loss: 58.90
Target(s): 64.75
Current Option Gain/Loss: -26.6%
Time Frame: 2 to 4 weeks
New Positions: see below

10/25 update: BBBY hit some profit taking today with a -1.9% decline. Shares look headed for the $60.00 level, which should offer some round-number support. If you're looking for a new entry point I'd wait for a dip or a bounce near $60.00.

*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

Costco Wholesale - COST - close: 83.23 change: -1.25

Stop Loss: 83.75
Target(s): 97.50
Current Option Gain/Loss: Unopened
Time Frame: 4 to 8 weeks
New Positions: Yes, see below

10/25 update: COST also experienced some profit taking today. Shares fell under short-term support at $84.00 and closed near its lows for the session. Nimble traders may want to consider buying calls on a dip near $82.00 with a relatively tight stop loss.

At the moment our plan is to buy calls at $86.50. However, if we do see COST find support or bounce near $82.00 we'll probably update our entry point strategy tomorrow.

Earlier Comments:
If triggered at $86.50 we'll use a stop loss at $83.75. Our multi-week exit target is $97.50. Cautious traders will want to consider an exit near $90 or $94 instead. Keep positions small.

Trigger @ $86.50 (small positions)

- Suggested Positions -

buy the NOV $85 call (COST1119K85)

- or -

buy the 2012 Jan $90 call (COST1221A90)

Entry on October xx at $ xx.xx
Earnings Date 12/07/11 (unconfirmed)
Average Daily Volume = 2.9 million
Listed on October 22, 2011

iShares China 25 index ETF - FXI - close: 34.73 change: -0.55

Stop Loss: 32.95
Target(s): 39.50
Current Option Gain/Loss: Unopened
Time Frame: 3 to 6 weeks
New Positions: Yes, see below

10/25 update: Our trade on the FXI is not open yet. The S&P 500 opened flat and FXI opened down. There is now a good chance that the FXI might fill the gap with a dip toward the $33.50 area. Nimble traders may want to consider buying a dip or a bounce near this level.

Given the U.S. stock market's decline today and what could be a negative open tomorrow morning, we are going to take a more cautious approach to new positions. I am temporarily removing the newsletter's entry point to buy calls on the FXI and we'll re-evaluate tomorrow.

No Entry Point Tonight. Wait and Watch. We will re-evaluate tomorrow.

Entry on October xx at $ xx.xx
Earnings Date --/--/--
Average Daily Volume = 30 million
Listed on October 24, 2011

Goldman Sachs - GS - close: 100.44 change: -3.54

Stop Loss: 97.95
Target(s): 114.00
Current Option Gain/Loss: -41.8%
Time Frame: 4 to 6 weeks
New Positions: see below

10/25 update: Ouch! Financial stocks were some of the worst performers on Tuesday. News that the EU finance ministers had canceled their meeting tomorrow does not bode well. Suddenly there is no chance for a comprehensive solution to the problems in Europe happening tomorrow.

Shares of GS fell -3.4% and dropped toward round-number support at $100.00. If both GS and the S&P 500 index open positive tomorrow, then I would consider new bullish positions but I doubt that will happen. We have a stop loss at $97.95. More conservative traders might want to consider a tighter stop loss.

Earlier Comments:
We want to keep our position size small to limit our risk. Our target is $114.00. More conservative traders may want to exit near $110 instead.

(Small Positions) - Suggested Positions -

Long NOV $110 call (GS1119K110) Entry $1.84

Entry on October 24 at $102.65
Earnings Date 10/18/11 (confirmed)
Average Daily Volume = 8.2 million
Listed on October 22, 2011

iShares Transportation ETF - IYT - close: 85.75 change: -1.93

Stop Loss: 82.45
Target(s): 90.00
Current Option Gain/Loss: - 2.3%
Time Frame: 3 to 4 weeks
New Positions: see below

10/25 update: The transportation averages gave up -2.2%. The IYT managed an intraday bounce near $85 this morning. The $85.00 level is the first line of defense for the bulls. The next level of short-term support would be the simple 10-dma near $84.25. More conservative traders might want to raise their stop loss closer to the $84.00 level.

Nimble traders could try and buy calls on a dip or a bounce near $84.25 (10-dma).

Earlier Comments:
Readers will want to keep our position size small since the transports are short-term overbought given the huge bounce from its October lows.

(small positions)

- Suggested Positions -

Long NOV $87 call (IYT1119K87) Entry $2.15

10/22 new stop loss @ 82.45
10/21 Gap higher entry @ 85.33

Entry on October 21 at $85.33
Earnings Date --/--/--
Average Daily Volume = 662 thousand
Listed on October 18, 2011

Rockwell Automation - ROK - close: 64.60 change: -3.80

Stop Loss: 62.40
Target(s): 71.75
Current Option Gain/Loss: -30.3%
Time Frame: 3 to 4 weeks
New Positions: see below

10/25 update: ROK was a big underperformer today with a -5.5% decline. I didn't see any specific news or catalyst behind the stock's relative weakness. The close under $65.00 is definitely short-term bearish. More conservative traders may want to consider an early exit now or at least consider raising your stop loss. We are raising our stop loss to $62.40.

Earlier Comments:
Let's keep our position size small. Our exit target is $71.75. FYI: The Point & Figure chart for ROK is bullish with a $91 target.

(Small Positions)- Suggested Positions -

Long NOV $70 call (ROK1119K70) Entry $1.65

10/24 new stop loss @ 62.40

Entry on October 24 at $66.62
Earnings Date 11/08/11 (confirmed)
Average Daily Volume = 1.7 million
Listed on October 22, 2011

SPX Corp. - SPW - close: 52.73 change: -2.69

Stop Loss: 51.75
Target(s): 57.75
Current Option Gain/Loss: - 5.5%
Time Frame: 3 to 4 weeks
New Positions: see below

10/25 update: Be careful here with SPW. The stock has completely erased yesterday's gain with today's -4.8% decline. The move suddenly looks like a potential bull-trap pattern. The next level of support should be $52.00 and if that level fails we'll be stopped out at $51.75. I'd wait for a bounce from $52 before considering new bullish positions.

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

10/24 new stop loss @ 51.75
10/20 trade opened at $51.80
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.

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

PUT Play Updates

Currently we do not have any active put trades.

Market Neutral Play Updates

iShares Russell 2000 ETF - IWM - close: 71.36 change: -2.06

Stop Loss: n/a
Target(s): To Be Determined
Current Option Gain/Loss: - 5.7%
Time Frame: 3 to 4 weeks
New Positions: see below

10/25 update: After yesterday's bullish breakout it was disappointing to see the small caps give back so much of their gains. The IWM fell -2.8%. The $71.00 area "should" be short-term support but there is no guarantee stocks will bounce.

We are not suggesting new positions at this time.

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.

- Strangle Position cost: 4.55 current value: 4.29 (-5.7%)

Out-of-the-Money Call option:
Long NOV $72 call (IWM1119K72) Entry $2.30, current bid $2.53

- and -

Out-of-the-Money Put option:
Long NOV $68 put (IWM1119W68) Entry $2.25, current bid $1.76

Entry on October 21 at $70.57
Earnings Date --/--/--
Average Daily Volume = 89 million
Listed on October 20, 2011