Option Investor

Daily Newsletter, Wednesday, 7/7/2010

Table of Contents

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

Market Wrap

Banks Lead the Way Higher

by Keene Little

Click here to email Keene Little
Market Stats

James and I swapped wraps so I'll take his tonight and he'll be with you tomorrow night.

Today was a strong rally by most measures. The only real challenge continues to be lower volume during the rallies than the selloffs, including relatively low volume today, clocking in a little lower than yesterday's. As you can see in the table above, advancers handily beat out decliners in both numbers of issues and volume. It was actually a strong 90% up day with NYSE upside volume 94.4% of total volume. Normally that would be a good kickoff to a rally but we've had many 90% days this year, both up and down, which have not had any follow through. It's a manic-depressive market right now and today's rally smelled more like short covering than real buying (almost straight up without much in the way of pullbacks).

The program trading, especially by the quants, tends to drive the market hard in one direction once the bots know what that direction is. They're momentum traders and when the momentum stops they simply swing it the other way. It's one reason why I think we've had so many 90% days that haven't meant much to the longer-term moves in the market. It's simply adding to the volatility which drives traders crazy unless you're able to swing with the market (hard to do when many of the moves start in the overnight futures).

We've seen many times when the market closes on its high or low of the day a tendency for an immediate reversal the next day. I call them mini climaxes as one side or the other rushes to cover their trades, especially into the close like today, and then there's no more to continue in that direction the following day (since the buying or selling wasn't real but instead it was the other side covering their positions). Covering one's position to be flat by the end of the day, which many traders must do, is far different than wanting to buy a rally or sell into a decline but didn't get an opportunity before the close and will do so the next day. And that gives us immediate reversals of the previous day's move and is the setup for Thursday.

I've been wondering lately if opex maneuvering is starting a day earlier than the Thursday prior to opex, which was becoming known as the head-fake or misdirection day. I'm noticing the move that was happening on Thursday is now happening on Wednesday. If this month follows the new pattern then we could find that today was the misdirection day. One thing's for sure, equity options traders were believers in today's rally--the CBOE Equity put/call ratio closed at .52, the same low value that it was at the May 27th high. The previous lower close of .51 was at the May 12th high. The market suffered some strong selling right after those dates.

Helping today's rally were the financial stocks. The banking indexes rallied almost +6% today and much of the credit for that came from Europe. That strong a rally is usually a result of short covering rather than real buying and today's volume suggests the same (today's volume was lower than yesterday's). News of the European bank stress tests is expected to be released soon and while there is concern the stress tests were not stressful enough (sound familiar?), many are expecting the news to be favorable. That would relieve some of the stress that U.S. banks have been experiencing as well and that showed up in today's rally.

State Street bank (SST) also reported favorable earnings and that gave a further boost to banks in general. Too bad we can't trust what the banks are reporting. Peter Atwater at Minyanville wrote an article today (banks' earnings) that does a good job at exploring the problems with the way the banks are (not) reporting their true expenses and thereby fluffing their earnings. It's a joke really and we have no real sense about the banks' true earnings except to know they are not nearly as good as they say they are.

For one thing, the banks continue to be allowed to exclude their credit losses for bad loans, in particular housing loans. The banks have been excluded from the requirement to value loans, CDOs and derivatives at market value for some time now so we don't really know what they hold on their books. Now they're allowed to hide their unrecognized losses in more off-balance-sheet accounting. The hope of course is that the banks will never have to recognize the losses because as everyone knows, "it will come back."

Banks are allowed to defer credit losses for as long as it takes for the housing and employment conditions to improve. The trouble is the conditions are getting worse, not better, and these credit losses are mounting. But the banks don't have to report them. They have a huge liability that's not being subtracted from their income and balance statements and therefore their earnings are a banker's make-believe story for the market's consumption. This is also one reason why bankers have not been too excited about foreclosing on owners (or helping with short sales or remortgages). That would require the bank to disclose the loss on the original loan and take it out of make-believe financing and put it on their for-real balance sheet.

But this charade will not be able to continue much longer and therefore the rally in the banks is just another opportunity to unload their stocks and look for shorting opportunities in the sector. As the banks continue to make an effort to hide these credit losses they will be further hampering their own efforts to make new loans to generate income. For as long as these bad loans are on the banks' books (even if hidden) they will not have money, nor the incentive, to provide additional loans.

But foreclosed homes are building up to intolerable levels that even the banks can't stomach. The GSEs (FNM and FRE) have been processing foreclosed properties at an accelerating pace and the rest of the mortgage holders will need to follow suit unless they don't mind being the last one to hold the bag. We will likely see an acceleration of the number of foreclosed properties being reported, prompting many to question why all of a sudden the foreclosure problem seems to be getting worse. It's all part of the deflationary cycle as debt is destroyed and the credit bubble deflated. It's a necessary and healthy step towards improving our financial system to get it ready for the next growth phase in a few years.

So take today's strong rally in the banks with a grain of salt since it's another hope-filled rally that's not based on reality. The hard part for us traders is trying to figure out how long a hope-filled rally can extend and of course we can only guess at that. But we have some charting tools to help us figure out support and resistance levels and watch price action around them. The current bounce should be a correction to the decline and therefore I'm looking for resistance levels where the market could run out of steam and provide another shorting opportunity.

Since breaking below support near 1038 last week SPX has been cycling around this level for the past few days. Today's close back above the broken H&S neckline looks bullish but it's too early to tell whether last week's break down was a head fake and bear trap, like it did back in July 2009, or if instead this week's bounce is going to be a bull trap. By several measures it would appear that it's possible we'll see SPX bounce up to the 1070 area and that's also where the longer-term broken uptrend line from 1990-2002 is located. Once this bounce has finished we should see the market continue on its southbound journey towards much lower lows. Many are looking for the 943 area but if the bearish wave count is correct that level should be no more than a speed bump on the way down to the 860-870 area.

S&P 500, SPX, Weekly chart

The recovery back above the H&S neckline should be considered bullish and will be especially so if it comes back down and uses that level for support now. But as shown with the dashed line, that may only be good for one more leg up for a slightly larger bounce into next week at the latest. At 1074.57 it would close its June 29th gap so anything higher than that would be another sign of bullishness. A drop back below the neckline near 1038 would be a bearish heads up and below 1018 would confirm the next leg down has likely begun.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish above 1075
- bearish below 1048

You can see in the above chart that the 50-dma has crossed down below the 200-dma, which happened on Tuesday, and this is known as the Death Cross. I've heard different takes on this signal and one person even identified it as the bottom of a market pullback on several previous occasions so take it for what it's worth. Many money managers use this signal as their timing method. Some say you should use the ema's for the moving averages and the chart below shows a longer time frame using the 50 and 200-ema's. If you look carefully you can see that it has in fact provided longer-term buy and sell signals so this week's cross will be taken seriously by many.

S&P 500, SPX, Daily chart, 1990-2010 with 50/200 crosses

SPX achieved a 38% retracement of the decline from June 21st, at 1056.87, and looks like it has its sights on the 50% at 1071.07 if the rally continues on Thursday. As currently counted, the bounce off last Thursday's low could be considered complete, which makes it all that more important what the market does tomorrow. Considering the market closed at its high today, a sharp reversal back down could be a kickoff to a serious decline in a 3rd of a 3rd wave down. That's why a break below 1018 could be serious. If there's more work to be done to relieve the oversold nature of the market we could see another down-up sequence into Friday, or early next week, to complete the correction of the leg down from June 21st.

S&P 500, SPX, 60-min chart

The DOW had done a better job at holding onto its H&S neckline by breaking it only marginally. The strong rebound back above it today looks bullish. If the rally continues even a little higher on Thursday watch to see how the DOW handles its 20-ema, which often acts as support and resistance in a strong move. It will be near 10052 on Thursday (SPX 1067) and is one of the reasons why I have 10055 as a key level to the upside--it will be potentially bullish above that level. Otherwise a move back down below 9659 would suggest the bounce is over and the next serious decline is underway.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish above 10055
- bearish below 9659

NDX had dropped even more significantly below its H&S neckline so today's recovery back above it is even more impressive. Amazing what a little short covering can do. Its 20-ema is a bit higher than the others, near 1810 tomorrow so watch that level if the market rallies a little further. It would close its June 29th gap with a rally up to 1836 and anything higher than that would be potentially bullish.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish above 1836
- bearish below 1719

The SOX rallied hard today, up +5%, and that certainly helped the tech stocks as well as the overall tone of the market. Between a strong SOX and strong banks there wasn't much hope for any bears trying to muzzle their way in today. But the SOX has a very similar pattern and the current bounce looks like a correction to the decline from June 21st. Once the correction is over, which could be today's high or it could be after it fills its June 29th gap at 354, we should see hard selling kick in.

Semiconductor index, SOX, Daily chart

The small caps were not getting much love yesterday or this morning but once traders felt a little more comfortable with the rally they started buying the RUT (and shorts got more nervous and started covering). The RUT is now nearing its H&S neckline again, near 614 (it was resistance yesterday). As shown with the dashed line, we could see a pullback and then another new high into early next week before the next wave of selling hits. I'm showing a slightly different possibility on the RUT than I show on the others, which is for a new low around 560 to finish the leg down from June 21st and then a larger bounce into the 3rd week of July before heading much lower into August. It's a little difficult to reconcile the differences between the RUT and the other indexes at the moment so it will be worth watching the bottom of the channel on the RUT to see if it finds support or not.

Russell 2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 614
- bearish below 596

By the size of today's white candle I don't need to tell you the banks had a strong day today--BKX was up +5.6%. But notice where it stopped--right at its broken 200-dma and the setup is for an immediate reversal back down. It could pull back and then head higher to the top of its down-channel, currently near 49.40. Between that, its price level resistance near 50 and the 50-dma coming down towards 50, it would be some tough resistance if it manages to rally back up to that level.

KBW Bank index, BKX, Daily chart

The Baltic Dry Bulk index, which tracks shipping rates for dry commodities, continues to decline. It has dropped 29 days in a row and fell -5.1% today. This is clearly a sign of economic contraction instead of growth. The slowdown in demand from China is getting much of the blame and the Shanghai Composite index (SSEC) shows there's lots of concern from investors in China's immediate future.

The SSEC has been showing relative weakness since its high in August 2009. In April it broke its uptrend line from November 2008 and declined sharply from there. And then in May it broke below its September 2009 low and found that level to be resistance before dropping lower again. There are some small hints of bullish divergence at the most recent low so we could see a bigger bounce in the Chinese markets. But this chart is telling us the Chinese economy is slowing down and those who have been pinning their hopes on China to support a global recovery are starting to realize it's not going to happen.

Shanghai Composite index, $SSEC, Daily chart

Shipping is slowing down and economies are slowing down so it doesn't take a rocket scientist to realize transportation stocks will likely be heading down. But the short-term pattern for TRAN isn't clear enough to suggest an immediate short play in the sector or to wait and see if we'll first see a larger bounce (dashed line). A drop below yesterday's low near 3872 would suggest there will be no more bounce and the wave count is the same as the others, which calls for a 3rd of a 3rd wave down and therefore hard selling.

Transportation Index, TRAN, Daily chart

The dollar and equities have been inversely related in the past few days and that could continue if the dollar gets a bounce off support (its uptrend line from December) and the stock market starts back down. There are a number of ways a pullback correction in the dollar could play out and I'm only showing two that I consider at least more likely. Once the current leg down from the June high has finished we should get a multi-week rally for wave B of a large A-B-C pullback to correct the November 2009-June 2010 rally.

U.S. Dollar contract, DX, Daily chart

Gold might have finished its leg down from the June 28th high, in which case it should get a bounce back up to at least its 50-dma near 1216 before heading lower again. Or it might first work its way lower to its uptrend line from October 2008 near 1165 before trying for a larger bounce correction, which is what I've depicted on the chart.

Gold continuous contract, GC, Daily chart

No surprise, the gold miners look similar to gold which looks similar to the other stocks. GDX did find support at its uptrend line from February and could make it up to its 50-dma or 20-ema near 51 before rolling back over.

Gold Miners, GDX, Weekly chart

If the bounce in oil can get a little higher it should find resistance near 75 where it will run into its 20-ema and then 50-dma. Once the current bounce finishes it should start down in earnest as a 3rd of a 3rd wave down unfolds (just like stocks).

Oil continuous contract, CL, Daily chart

There were no significant economic reports this morning and tomorrow's reports are not likely to have much of an effect on traders' moods. The market is expecting a sharp drop in consumer credit which is all part of the credit collapse that's in motion. Once the stock market participants really start to understand this, the selling will come in stronger waves.

Economic reports, summary and Key Trading Levels

Other than some minor differences I see in some of the charts, such as between the RUT and the blue chips, most indexes remain in synch. After the decline from June 21st it appears we're bouncing to correct that decline. Internal market measures are strong but volume remains tepid at best. Volume picks up when the selling begins so this remains a caution flag out on the field. Bulls are just trampling over the flag at the moment but the ref will not take kindly to that.

Whether the bounce finished today or finishes early next week (after a pullback and then another leg up), it's important to understand the very bearish wave count setup that we currently face. If the bearish wave count is correct then we'll soon start down in multiple degrees of 3rd waves. The 2009-2010 rally was a large 2nd wave, and then the bounce into the June 21st high was another smaller 2nd wave and now today's bounce is another smaller 2nd wave. These are pointing to a 3rd of a 3rd wave within a larger developing 3rd wave. It sounds confusing but the bottom line is we're about to see some serious selling once the current bounce completes.

Since 3rd waves are the strongest of a 5-wave impulsive move, having nested 3rd waves about to unfold means a really strong move is coming. I could be very wrong about the wave count and that's why I have the key levels to the upside--above those levels could mean something at least short-term bullish playing out and I'd want to see how the pattern develops before getting all bearish again. But as of now, the bearish setup is there so be looking for shorting opportunities until the market proves otherwise. Playing the long side right now is to trade against the current and you'll need to keep 'em tight. Downside surprises are right around the corner now.

Good luck and I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 1075
- bearish below 1048

Key Levels for DOW:
- cautiously bullish above 10055
- bearish below 9659

Key Levels for NDX:
- cautiously bullish above 1836
- bearish below 1719

Key Levels for RUT:
- cautiously bullish above 614
- bearish below 596

Keene H. Little, CMT

New Plays

Short Index Play

by Scott Hawes

Click here to email Scott Hawes

PowerShares QQQQ Trust - QQQQ - close 43.96 change +1.36 stop 46.90

Company Description:
PowerShares QQQ Trust, Series 1 (the Trust) is a unit investment trust that issues securities called PowerShares QQQ Index Tracking Stock. The Trust holds all of the component securities of the Nasdaq-100 Index (the Index). The Investment objective of the Trust is to provide investment results that generally correspond to the price and yield performance of the Nasdaq-100 Index. Invesco PowerShares Capital Management, LLC is the Sponsor of the Trust and The Bank of New York Mellon is the Trustee.

Target(s): 42.55, 41.80, 41.05
Key Support/Resistance Areas: 46.77, 45.20, 44.46, 43.50, 42.50, 41.00
Time Frame: 1 to 2 weeks

Why We Like It:
QQQQ had a monster truck rally today but I believe this will be short lived. The ETF is nearing an important resistance level at $44.46 and has all of its SMA's and plenty of congestion overhead to act as resistance. The rectangle on the chart represents a gap that I suppose could get filled so conservative traders may consider waiting to enter at $45.00. I'm just not confidant the gap will get filled. Today was a relief rally and we may get a little more but I think the selling will resume again and QQQQ should easily retest its lows and possibly break them. Let's use a trigger of $44.30 to initiate short positions. Our stop is $46.90 and I do not see QQQQ trading up to this level prior to breaking down again.

Suggested Position: Short QQQQ stock if it trades to $44.30

Options Traders: August $45.00 PUTS, current ask $2.08, estimated ask at entry $1.90

Annotated chart:

Entry on July xx
Earnings N/A (unconfirmed)
Average Daily Volume: 100 million
Listed on July 7, 2010

In Play Updates and Reviews

Waiting Patiently For Short Entries

by Scott Hawes

Click here to email Scott Hawes
Current Portfolio:

BULLISH Play Updates

PowerShares DB Agriculture Fund - DBA - close 24.43 change +0.54 stop 23.80 *NEW*

Target(s): 24.60, 24.95
Key Support/Resistance Areas: 25.00, 24.70, 24.40, 23.55, 23.40
Current Gain/Loss: +2.22%
Time Frame: Several weeks
New Positions: Yes, preferably on weakness

7/7: We are long DBA as of the open today. The stock printed a bullish engulfing candlestick on its daily chart and closed above its 100-day SMA. The ETF maintained its upward trend line and also made a higher high. DBA is gaining momentum and I am expecting our targets to be hit, possibly this week. In addition, the stock has now closed above and broken two downtrend lines. My only suggestion is to protect profits if DBA continues higher. I'm going to tighten the stop to $23.80 which is below yesterday's low.

7/6: DBA has broken a downtrend line that began on 1/6/10. The ETF has struggled with a secondary downtrend line but I think its only a matter of time before DBA makes another push higher and breaks through it. DBA also appears to be forming a higher low on its daily chart. Today the ETF sold off to its 20-day SMA from above. I am expecting this support hold and for DBA to make a run up towards its 200-day SMA which is currently just over $25.00. Our most aggressive target is $24.95 while our first target is $24.60. We will use a tight stop at $23.25 which below May's lows.

Current Position: Long DBA stock, entry was $23.90

Suggested Position: August $23.00 CALLS

Entry on July 7, 2010
Earnings Date N/A (unconfirmed)
Average Daily Volume: 792,000
Listed on 7/6/10

BEARISH Play Updates

Informatica Corporation - INFA - close 24.96 change +0.57 stop 26.10

Target(s): 23.82, 23.00, 22.75, 22.15
Key Support/Resistance Areas: 25.35, 24.60, 23.80, 23.25, 22.60, 22.00
Current Gain/Loss: -1.67%
Time Frame: 1 to 2 weeks
New Positions: Yes, on bounces

7/7: INFA shot up to $25.00 this morning and stalled while the broader market continued to march higher. The stock still has to contend with its 20-day and 50-day SMA's if the bounce continues. My feeling is we may see an intraday bounce but I also feel it will be sold into so I suggest we be patient and see how things play out this week.

7/6: INFA traded up to its 200-day SMA today and then backed off. It remains below all of its major SMA's which should keep any bounces in check. I'm going to list another target of $23.82 which is near Friday's closing price. If INFA trades down here prior to bouncing I suggest we take profits on this trade, or at least tighten stops to protect against a reversal. 7/3: INFA is a volatile stock and has been barely hanging on to its 200-day SMA since the flash crash. The stock has been whipped around and has now closed below its 200-day SMA for the fourth consecutive day. I expect INFA to bounce up to retest the 200-day SMA from below before falling to retest its February lows, which is near our 2nd target of $22.75. Considering the recent price patterns over the past few months one may think INFA could bounce higher, but I'm not counting on it bouncing too much higher than the 200-day SMA considering the bearish tone of the past two weeks. But we may need to exhibit some patience once in the position. Let's use a trigger of $24.55 to initiate short positions. Our primary target is $22.75 but I have also listed $23.30 which is a good place to consider tightening stops. We'll use a wide stop of $26.10 which is above the 20-day, 50-day, and 100-day SMA's but it will be adjusted once we are in the position. I will be surprised to see INFA much higher than $25.00 anytime soon. $24.88 is the 38.2% retracement from the stock's recent high to Thursday's low which will also converge with the declining 20-day and 50-day SMA's.

Current Position: Short INFA stock, entry was at $24.55

Option Traders: August $25.00 PUT

Entry on July 6, 2010
Earnings 7/22/2010 (unconfirmed)
Average Daily Volume: 1.72 million
Listed on July 1, 2010

Lululemon Athletica Inc. - LULU - close 37.58 change +1.53 stop 43.10

Target(s): 35.25, 34.05, 33.00
Key Support/Resistance Areas: 42.25, 39.75, 37.00, 35.16, 32.75
Time Frame: 1 week

7/7: LULU rallied +4.24% higher today and is getting closer to our short entry trigger at $39.25. If the stock trades to this level I feel comfortable suggesting a short position as it will be the first time the stock approaches its 50-day SMA since breaking it on 6/25. The 20-day SMA is also overhead, along with a downtrend line which will provide even more resistance. I think patience will pay off for us on this trade.

7/6: LULU came within 15 cents of hitting our trigger to enter short positions today, and then reversed down. The stock has faced a barrage of selling recently and is coming into a prior support/resistance area near our first target of $35.25. If the stock keeps testing this area the support should eventually break. I only wish LULU and the market were not so oversold. I am expecting this stock to bounce, maybe even up to its 50-day SMA which is near $40.00. Considering the conditions I would like to raise our entry back to $39.25 (below the 50-day SMA). If we are patient and get a good short entry it should pay off.

7/3: This is an example of a stock not letting shorts in for swing trade. It may be wishful thinking to expect LULU to bounce all the way up to $39.25 after the selling pressure on Friday. It would be ideal to see LULU make a run up towards its declining 50-day SMA which would be the first time testing it from below since it was broken on 6/28. But I doubt that will happen so I suggest we lower our trigger to enter to $38.40 which is just below Thursday's high. In the end, I think LULU trades down to its 200-day SMA but if it keeps declining prior to bouncing we may lose our chance. For readers who trade intraday LULU provides some good opportunities and if things are moving fast (up or down) this is a good stock to consider trading.

Suggested Position: Short LULU stock if it trades up to $39.25

Option Traders: Buy August $35.00 PUTS if LULU trades to $39.25, current ask $2.05, estimated ask at entry $1.55

Entry on July xx
Earnings 9/9/2010 (unconfirmed)
Average Daily Volume: 1.89 million
Listed on July 1, 2010

Starbucks Corp. - SBUX - close 23.61 change -0.73 stop 26.31

Target(s): 23.70, 22.55, 21.30
Key Support/Resistance Areas: 26.50, 26.00, 25.25, 24.80, 24.00, 23.60, 22.50
Time Frame: 1 to 2 weeks

Why We Like It:
7/6: SBUX came with 6 cents of our trigger to enter short positions and then proceeded close down -3.04%. I'm expecting SBUX to bounce with the broader market so I suggest being patient and ready to short the stock if it trades to our trigger of $24.75.

7/3: Last week SBUX broke below a trend line that began in October 2009 and collapsed below it 20-day, 50-day, and 100-day SMA's. These SMA's (in particular the 100-day SMA) have been key areas where the stock has bounced during its rally over the past year. And now that the stock is below them it has probably seen its best days, at least for awhile. I would like to use a trigger of $24.75 to enter short positions which is below the stock's 100-day SMA, the underside of the broken trend line, and the recent steep downtrend line, all of which are converging (see oval on chart). The $25.00 area could also be considered an entry point but I chosen $24.75 because it is near Friday's highs which could possibly form a double top on the intraday charts. Our primary target is $22.55 but I have also listed $23.70 as area to consider tightening stops. It is above the 200-day SMA which SBUX has not touched in over a year.

Suggested Position: Short SBUX stock if it trades to $24.75

Options Traders: August $25.00 PUTS, current ask $1.61, estimated ask at entry $1.44

Entry on July xx
Earnings 7/21/2010 (unconfirmed)
Average Daily Volume: 10 million
Listed on July 3, 2010