Option Investor

Daily Newsletter, Wednesday, 5/12/2010

Table of Contents

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

Market Wrap

Looking Under the Hood

by John Gray

Click here to email John Gray
When the nearly $1 trillion economic stabilization package for Greece (and other troubled southern European countries) was announced on Sunday the markets around the globe roared their approval on Monday with the largest one-day rally in years. In reality, of course, what actually occurred was that all of the day's gains happened in the futures market before the cash market opened. This forced fund managers to buy the stocks in the underlying indexes. Once the huge gap up opening occurred, the markets simply traded flat for the rest of the day. This is not unlike what happened on last Thursday (except in reverse).

Now that the dust has settled it is time survey the landscape and see what really happened and assess the new realities. The problem started with Greece, who economy is about the size of the Dallas/Ft. Worth metroplex (insignificant in the grand scheme of things). Of course it was evident to most intelligent observers that Greece was merely a symptom of a larger malady that affected the entire region. The European finance ministers' decision to monetize the debt did little to address the structural changes that will be necessary (and difficult) to return the region to a sound financial footing. Jim's analogy in last night's Wrap was probably pretty accurate when he said that it was like taking a cash advance on one credit card to pay off the balance on another credit card.

Since the end of WW II most European countries (including England, Ireland, and Scandinavia) have opted for what, I shall euphemistically refer to as a "progressive" form of government. Some might be offended if I called it socialistic. They like 35-hour work weeks; they like two months of paid "holiday' per year; they like to be paid when they don't work; they like free universal health care; they like labor unions because labor unions do what labor unions always do - negotiate contracts that provide more benefits for less work, and make it harder to fire or lay off workers; they like generous pensions that can be taken early. All of these "entitlements" have been woven into the social fabric for decades. It all works well and good until an economic downturn occurs and governmental tax revenues are slashed.

My oldest son heads the internal audit division for a Seattle-based equipment manufacturing business that has plants in Europe, South America, and Australia. His job requires a lot of travel. He complains that when he goes to Europe he is often frustrated because the people with whom he must interact come in late and leave early or are absent because they are on "holiday". The point is that it is going to be very difficult to get Europeans to accept the new reality and do the things necessary to straighten out their mess. I predict widespread social unrest. Witness what is already happening in Greece with strikes, protests, fires, etc.

Australian Treasurer, Wayne Swan, unveiled a national budget Tuesday that forecasts a return to a surplus in two years and retiring the country's debt by 2019. Wow, does Australia occupy the same planet as Europe (or the United States)? Australia has raised interest rates twice.

NEW YORK (MarketWatch)-- Shares of Wall Street investment banking giant Morgan Stanley /quotes/comstock/13*!ms/quotes/nls/ms (MS 27.29, -1.09, -3.84%) fell about 4% on Wednesday morning after the Wall Street Journal reported that federal prosecutors are conducting a preliminary investigation of the firm's mortgage trading business. Morgan Stanley told the paper is has not been contacted by the government regarding a probe, and its Chief Executive James Gorman reiterated that point at a press conference on Wednesday in Tokyo, the paper said. Morgan Stanley shares fell 3.98% to $28.38 in preopen trading.

That's the way they do it in Washington - pile on and kick 'em while they are down. The public outrage over Goldman Sachs has no doubt emboldened Federal prosecutors to launch additional witch hunts.

The U.S. Senate is poised to pass a bill that would direct the GAO to conduct a one-time audit of the Federal Reserve. This would be the first time in the Fed's 95-year history that they have been audited. While the Congress and the American people were fretting and debating about the $700 billion TARP package last year, the Federal Reserve was quietly and secretively loaning out over $2 trillion. They have refused to disclose to whom it was loaned, in what amounts, and the terms for repayment. Congress would like the answers to those questions (and so would I). My only question is, "Why did it take you so long and why limit it to only one audit?"

"A veteran is someone who, at one point in his life, wrote a blank check made payable to the United States of America, for an amount up to and including his life". Now that is honor, courage and commitment. Please don't ever, ever let this country treat its service men and women the way my brothers and I were treated when we returned from Vietnam. They work very hard, for very little pay, in some of the harshest conditions imaginable. They deserve your respect. Remember, they are following orders. If you don't like what they are doing take it up with the people who sent them there.

Gold has gone absolutely bonkers. It makes new highs every day. Presumably, these goldbugs are betting that the shiny metal will protect them from the perceived threat of future inflation coming out of China or the monetization of the European debt. In any event gold has disconnected from the dollar and is marching to the beat of its own drummer. Despite prediction from various talking heads that see gold going to $1500 or even $2000 I would be hesitant to buy at these nose-bleed levels. It could be forming a double top here.


One of the proposed provisions that are being considered by the Senate as they debate financial regulatory reform is a ban on proprietary trading (trading their own account as opposed to trading their client's account). This primarily would affect the five or so large banks (formerly investment banks). This will probably cause a hue and cry from those institutions because last quarter their huge earnings were largely attributable to massive profits made by their trading desks. I can envision legions of lobbyists being assembled, getting ready to go into battle to thwart this attempt. In my humble opinion Glass-Stegall should never have been repealed.

Boeing Aircraft (BA) unveiled today its latest design for a new UAV (unmanned aerial vehicle). They will call it the "Phantom Ray". It employs stealth technology and uses the "flying wing" design used by the B-2 bomber. The "Ray" will be able to operate at 40,000 feet and travel at 640 mph (Mach .8). Its mission could either be reconnaissance or direct interdiction. Military procurement has dropped off for manned (piloted) aircraft but continues at a high level for UAV's.

Phantom Ray

Last week's blood bath did considerable technical damage to the major indexes. Previous levels of support were easily broken and have now turned into resistance. The first level that SPX must regain and close above is the 1170-1171 area. The 50 DMA and the 62% retracement level reside in this area. If it can successfully conquer this level it will run into heavy resistance again at the 1180-1185 area which had previously acted as support since the first of April. SPX charged boldly out of the chute this morning and headed for its first test. It briefly touched 1169 at 11:06 AM and promptly bounced back and retested it again in the early afternoon.

SPX - Daily

It is rather interesting that a fractal pattern very similar to the one that exists today happened in October, 2008. In that previous instance the market imploded (like Thursday and Friday). It gapped up huge on the following trading day (think Monday) on news of a big bank rescue (I think). What happened after that is what I find interesting (and perhaps instructive). SPX lost almost 300 points over the next month before it began a recovery. I have borrowed one of Keene's charts from yesterday's Market Monitor to illustrate the point.

SPX - 2008

Jim did a masterful job of covering the oil spill in the Gulf in yesterday's Wrap so I won't go into any more details other than to say that the "blame game" has already begun. We could probably tag this as the "Lawyers' Relief Act of 2010". The Goldman Sachs (and now Morgan Stanley) case will enhance the solicitors' bank accounts as well. I smell a new "cottage" in the Hamptons.

Yesterday a friend emailed me a picture of an order that he was contemplating placing with E-trade. I have attached the picture below, but it may be difficult to read. Essentially, he wanted to buy 10 contracts of the March, 2011, 87 put on SPY. He was placing the order as a market order which would mean that he probably will be filled at the "ask" price. He wanted my opinion on the trade. He obviously has a very bearish view of the future. I pointed out to him that there is almost a 100% chance that he will lose his money if he plans to hold it until expiration in March, 2011. However, if he is willing to trade the position at any time he could make some good money if the market took a major dump (like last Thursday).

E Trade

Buying deep OTM options is a crap-shoot, but they can yield huge dividends (percentage-wise) if they make a big move in your direction. I was struck by something that Linda said in her Trader's Corner article last Friday. Since she primarily trades credit spreads and Iron Condors, directional trading is not something she does routinely except that she sets aside 10%-15% of the credit she receives to buy long puts. Now, that's a good plan.

You have heard us preach for months now how market declines can be swift and vicious. If you didn't believe it before, you just witnessed three month's worth of gains wiped out in three days. Sometimes you simply don't have time to do something to protect yourself. You buy insurance for your cars; you buy insurance for your house. Why not buy some insurance for your portfolio? As with your car and your house you hope you never have to file a claim, but it is comforting to know that it's there.

What is mankind's greatest invention? If you answered "The Wheel" or "Beer" I would give you high marks, but that's still not the right answer. For someone who spent the first sixteen years of his life growing up in Florida without air-conditioning, the answer is obvious - A/C. Without it, Florida would still be a steamy, insect and reptile-infested swamp. When the first window units showed up, my parents bought one and installed it in their bedroom. My brother and I had to do with the attic fan. If that were today I would march right down to my local office of Health and Human Services and file a child abuse complaint.

So, where is this market headed? I don't know the answer, but I have an opinion. I think we will see lower (and maybe much lower) before the April 26th high is breached again. The 14-month rally from March, 2009, came too far, too fast (IMO), and was not consistent with the economic realities on the ground. The last leg of the rally was characterized by low volume on up days (like today), and much higher volume on down days. This all suggests waning momentum and a lack of participation by the bulls. If proprietary trading is ever banned (don't hold your breath), the markets will be less manipulated than they are today (maybe). I don't mind telling you that some days (like today) I hate this market, and wish that I were doing something else for a living.

New Plays

Bearish Play on Small Caps

by Scott Hawes

Click here to email Scott Hawes


iShares Russell 2000 - IWM - close 71.62 change +2.13 stop 73.10

Company Description:
iShares Russell 2000 Index Fund (the Fund) seeks investment results that correspond generally to the price and yield performance of the Russell 2000 Index (the Index). The Index measures the performances of the small-capitalization sector of the United States equity market. The Index is a float-adjusted capitalization-weighted index of equity securities issued by the approximately 2,000 smallest issuers in the Russell 3000 Index. The Fund invests in a representative sample of securities included in the Index that collectively has an investment profile similar to the Index. The Fund’s portfolio of sector includes consumer non-cyclical, financial, industrial, consumer cyclical, technology, communications, utilities, energy and basic materials. BlackRock Fund Advisors serves as the investment adviser for the Fund. (source: company press release or website)

Target(s): 69.05, 68.05
Key Support Areas: 70.25, 69.75
Key Resistance Areas: 72.10, 72.60
Time Frame: About 2 weeks

Why We Like It:
The snap back rally from last week's plunge has been nothing short of incredible. But I believe it is time for a snap back down and I suggest readers take advantage of it by initiating short positions in IWM. The ETF is has already made it back up to its 20-day SMA from below and has also retraced over 61.8% of the decline from the April 26 highs of $74.66 to the May 7 low of $64.64. I threw out the long bottom wick from Thursday's plunge because it may or may not have been "real." In any event, anyone who has held positions throughout the past couple of weeks has to be thinking about selling positions now that the retracement back up has come so far. And if they were stopped out they are probably hesitant to jump back in the market right now. In addition, IWM is approaching a primary downward trend line and for options traders volatility has been sucked out of the option premium over the last several days. An increase in volatility will be good for option traders. I believe now is a good time to initiate PUT positions at current levels or a failed rally into the $72 area just overhead. This also gives us a good reference point to place a stop at $73.10 which is above the downtrend line and the 20-day SMA. I will be surprised if IWM can break through this congestion but if it does we will have a relatively small loss. The trade also sets up a good 2:1 risk reward ratio. We are risking about $1.30 to make $2.60. Our stop is $73.10.

Suggested Position: Short IWM stock at current levels or a failed rally into the $72.00 area.

Option Traders:
Suggested Position: Buy JUNE $72.00 PUT, current ask $2.45

Annotated chart:

Entry on May xx
Earnings Date More than 2 months (unconfirmed)
Average Daily Volume: 79 million
Listed on May 12, 2010

In Play Updates and Reviews

Long Hits Target

by Scott Hawes

Click here to email Scott Hawes
Current Portfolio:

BULLISH Play Updates

Dr. Pepper Snapple Group - DPS - close 37.87 change +1.09 stop 32.49

Target(s): 36.80, 38.80
Key Support Areas: 35.75, 34.75, 32.70
Key Resistance Areas: 36.80, 37.45
Current Gain/Loss: N/A
Time Frame: Several weeks
New Positions: Waiting for trigger

DPS kept on going today and made new 52-week highs again. I am not chasing the stock at these levels but will be interested if the stock pulls back to the $35 area. This is just above its 50-day and 20-day SMA. After several weeks of slowly consolidating lower and sideways DPS broke to the upside and now we must wait until it turns back to retest the broken resistance which should now act as support, along with the aforementioned SMA's. We think DPS will pull back to the $35.00-34.50 zone before moving higher. Therefore we are suggesting a trigger to open positions at $35.00 with a stop loss at $32.49. Please keep your position size small since the market has been so volatile.

Suggested Position: Long DPS stock if it trades near $35.00

Entry on: May xx
Earnings Date: More than 2 months (unconfirmed)
Average Daily Volume: 1.9 million
Listed on: May 8, 2010

Titanium Metals - TIE - close 17.07 change +0.71 stop 14.70

Target(s): 16.95, 18.00
Key Support Areas: 16.00, 15.50, 15.00
Key Resistance Areas: 16.00, 16.70, 17.25
Current Gain/Loss: Unopened
Time Frame: Several weeks
New Positions: Waiting for trigger

TIE had a huge day and is running away from our trigger to enter. I expect TIE to eventually make a trip down to its 50-day SMA and 20-day SMA which are near each other. I would like to move up our trigger slightly to $15.75 which is between the two SMA's. If TIE gets down here it would also create a bullish inverse head and shoulders pattern on the daily chart. I'll leave my comments from the new play that was released. TIE reported earnings on May 5th of 9 cents versus about 3 cents estimates. The stock reacted favorably even though the overall market plunged late last week. The stock has been consolidating in a bull flag for the past month and I suggest readers take advantage of any pullback in the stock to the $15.60 area. This is just above the 50-day SMA and the midpoint of the bull flag, which I think TIE will eventually break out of to the upside. This sets up a good risk reward trade: we are risking $1.05 to make $1.20. If triggered we our looking for the stock to trade back up $16.95, which would garner a nice +7.6% gain. Our second more aggressive target is $18.00 which is near highs from May 2008. Note, it may take several days to a week to get filled on this trade but I wanted to list the trade in case there is significant weakness in the coming days.

Suggested Position: Long TIE Stock if it trades down near the $15.75 area

Entry on xx at xx
Earnings Date 8/4/2010 (unconfirmed)
Average Daily Volume: 3.8 million
Listed on 5/10/10, 2010

BEARISH Play Updates

Sina Corporation - SINA - close 35.11 change +1.35 stop $36.80

Target(s): 33.25 (hit), 32.50, 30.50
Key Support Areas: 32.50, 30.50
Key Resistance Areas: 35.30, 36.00, 37.60
Current Gain/Loss: -.5%
Time Frame: 1 week
New Positions: Yes, but only as a quick trade

SINA rallied today and closed +4% higher. After being in positive territory yesterday our position is now slightly in the red. My technical comments are mostly the same. The stock remains below broken support near $35.30 and is also below all of its major daily and weekly SMA's. The 50-day SMA crossed below the 200-day SMA which is a bearish signal that confirms our outlook for this stock. I expect the overhead resistance and SMA's to hold. Our stop has been moved down to $36.80 to protect capital if SINA somehow manages to continue higher from here. SINA is approaching earnings on May 17th so we plan to be out of the trade on or before this date. I urge readers to book gains or tighten stops as SINA approaches $32.50. Our target is just above the low from Friday.

Current Position: Short SINA stock at $34.95

Option Traders:
Suggested Position: JUNE $35.00 PUT

Entry on May 4,2010 at $34.95
Earnings Date May 17, 2010 (unconfirmed)
Average Daily Volume: 1.1 million
Listed on May 1, 2010

USG Corp. - USG - close 22.46 change +1.06 stop 23.25

Target(s): 19.25, 18.25
Key Support Areas: 20.75, 20.00, 19.25
Key Resistance Areas: 22.25, 23.00
Current Gain/Loss: -2.55% Time Frame: About 2 weeks

New Positions: Yes

Why We Like It:
USG opened and immediately traded up to the $22 area. We recommended opening positions at a failed rally into the $22 area. At about 10:30 the stock made a double top and quickly reversed. So we are short USG stock at $21.90 in the portfolio. After the weak hands were shaken out the stock reversed at $21.63 and was bought the remainder of the day. When looking at the daily chart USG has rallied into a downtrend line from the April 30th and is approaching resistance. USG has also retraced just about 61.8% of the plunge from last week (see Fibonacci lines on the chart). USG traded up to $22.75 today and the 61.8% retracement is $22.88. I like to use 50% retracements (which is where USG reversed yesterday and my basis for releasing the play last night) and 61.8% retracement levels as potential turning points in stocks after large moves. This is the thesis for shorting this stock. Nothing always works in our set-ups, but these are some of the indicators we look for when entering trades and that have been successful in the past. If it fails we will step aside and look for better opportunities. *NOTE: Please use small position due to the volatility in this stock and to limit risk. I also want to point out that I incorrectly listed purchasing a call option in the new play release last night. It should have been listed as a put option. I apologize for the error and it has been corrected.

Current Position: Short USG stock at $21.90

Option Traders:
Suggested Position: Buy JUNE $20.00 PUT

Annotated chart:

Entry on May 12, 2010
Earnings Date More than 2 months (unconfirmed)
Average Daily Volume: 7.5 million
Listed on May 11, 2010


IMAX Corporation - IMAX - close 19.24 change +0.73 stop 17.15

Target(s): 19.25 (hit), 20.95
Key Support Areas: 18.45, 17.75, 16.95, 50-day SMA
Key Resistance Areas: 19.25, 19.72, 21.30
Current Gain/Loss: +4.05%
Time Frame: 1 to 2 weeks
New Positions: No

The bounce in IMAX continued again today. IMAX gapped open higher and quickly rallied to $19.72. Our target was hit so we closed the position for a gain of +4.05%. Sellers soon stepped in sending the stock over $1 lower. But it did recover and closed near our target. I urge readers to be careful here with the stock's recent volatility and protect capital. A tighter stop could be placed at $18.45, which is below recent intraday support and today's low. I am leery of this snap back rally so please be careful. Use the support and resistance areas above to guide your exit if you still have positions.

Closed Position: Long IMAX stock at $19.25, entry was at $18.50

Annotated Chart:

Entry on May 5th
Earnings Date More than 2 months (unconfirmed)
Average Daily Volume: 1.9 million
Listed on May 4, 2010