Option Investor

Daily Newsletter, Thursday, 8/25/2011

Table of Contents

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

Market Wrap

Bernanke Watch

by Jim Brown

Click here to email Jim Brown
The markets pulled back on worries over Europe and concerns about the Bernanke speech on Friday.

Market Statistics

The problem started in Germany overnight when the DAX futures fell -4% on worries Germany would also establish a ban on short selling. France, Italy and Spain extended their short selling ban and there were worries it would extend to Germany. For European traders the inability to short on France, Italy and Spain forces them to short futures on the German DAX in order to protect their long positions on the other exchanges. The German ban never materialized and Germany's market ended the day down -1.7%.

There were other European worries on Wednesday when German Labor Party Minister Ursla von der Leyen, called for countries needing bailouts to put up gold as collateral for the loans. Finland secured additional collateral on August 16th to ensure its contribution would be repaid. However, the EU ministers are probably going to reject that deal. The problem of multiple countries asking for collateral shows it is clear they don't expect to be repaid. The bailout loans are more than likely going to be defaulted. Asking for collateral is a show of weakness in the EU plan and the individual countries. Since the eventual plan has to be voted and approved by all the countries concerned it suggests the approval may be in jeopardy. This was causing market concern all over Europe and that indirectly impacts U.S. markets.

However, the U.S. markets shook off the overseas negativity when Bank America announced Warren Buffett had purchased $5 billion in BAC preferred stock. BAC shares spiked from yesterday's close at $6.99 to nearly $9 before falling back as the day progressed to close at $7.65. This was another sweet deal for Buffett. Berkshire Hathaway bought 50,000 preferred shares at $100,000 each. Those preferred shares will pay a dividend of 6%. That may be a good deal in today's low interest market but it gets even better. Berkshire also received warrants to buy 700 million common shares of BAC at $7.14 each. If BAC returns to where it was trading in January at $15 those warrants will be worth $5.5 billion. If Berkshire executes those warrants it would become the largest shareholder in Bank America.

Buffett conceived the idea while taking a bath on Wednesday morning. Buffett called BAC CEO Monynihan with the idea later Wednesday morning using Monynihan's private phone number. Monynihan told Buffett thanks but the bank did not need additional capital. Buffett agreed and said that is exactly why he was calling because he thought the bank was a good long-term investment. With the vote of confidence and capital cloud erased it would be an even better investment. Monynihan thought it over and conferred with advisors and told Buffett on Wednesday afternoon he had a deal. There was no negotiation of the terms. Buffett got exactly what he asked for.

Most analysts believe Monynihan made a very bad deal. With interest rates so low they feel there is almost no way BAC can make money after taxes on what is basically a 6% loan. If they did not need the capital why take on that kind of interest cost? Also, the warrants represent serious dilution to existing shareholders because there is almost no possibility they won't be executed once BAC shares rebound significantly.

I believe BAC did the deal just to remove the capital cloud and they have no plan to let Buffett keep the preferred shares. Once the current cloud over BAC blows away and the bank starts posting larger and larger profits they will buy back the preferreds and the warrants. There will be a cost but once out of the current economic soft patch they will have plenty of profits to make the purchase. I believe Monynihan did the deal simply to erase the capital cloud and halt the decline in his stock price. What is it worth to improve sentiment for the bank and end the daily declines? More than 850 million shares of BAC were traded.

Bank of America Chart

Unfortunately Buffett's BAC purchase helped BAC but it failed to support the broader market. The Dow's morning rally to 11,400 was quickly sold and it declined to within 6 points of 11,100 just before the close.

Another problem for the market was a sharp rise in the weekly Jobless Claims. The weekly number spiked to 417,000. The prior week was revised up from 408,000 to 412,000. On the surface this would appear to be a worsening of conditions but the Department of Labor said the uptick was due to the Verizon strike where 45,000 workers were temporarily out of a job. The Labor Dept said they had identified at least 8,500 new filings that were related to Verizon and there were probably more. They estimated at least 12,500 were Verizon related. The uptick over the last two weeks, even though they were related to the Verizon strike, are pushing estimates for the August Nonfarm Payroll report even lower. Estimates are well below +100,000 private jobs compared to the +154,000 gain in private payrolls in the July report.

The weakening in the regional manufacturing surveys are suggesting we could see a continued rise in Jobless Claims because the employment components have been worsening.

Jobless Claims Chart

On the positive side of the economic picture the Kansas Fed Manufacturing Survey did not worsen. Given the major declines in all the recent reports this was a surprise. The Kansas headline number for August was +3.0 compared to +3.0 in July. New orders rose to +1.0 from the -5.0 in July. Backorders were less bad at -10 from -19. Even better the capital expenditure plans improved from 8.0 to 13.0 suggesting some improvement in sentiment. The hiring component improved from 4.0 to 8.0.

All of these gains were minimal but they were definitely better than the sharp declines we saw in the other regional manufacturing reports. This was good news on a relative basis.

Kansas Fed Manufacturing Survey Chart

Friday has two economic reports in the GPD revision for Q2 and Consumer Sentiment. The GDP showed +1.28% growth in the first reading but that is expected to decline to less than 1% in Friday's revision. Moody's is expecting a drop to +0.8% growth but several other analysts are expecting less than +0.5% growth.

The Consumer Sentiment fell to 54.9 in the first reading and that is the lowest level since 1980. The -19.2 point decline over the last three months was only exceeded twice in the history of the survey in 1990 and 2005. Friday's number is expected to improve slightly to 56.0.

The big event for Friday is of course the Bernanke speech and everybody with access to a microphone or a keyboard has opined on what he is likely to say. Most believe there is almost no potential for a new program to be announced. Not only is it the wrong platform but there are no programs he could announce that would not rock the boat. Most now believe he will outline the various programs the Fed could use and possibly discuss what events would force the Fed to act. With three dissenters on the FOMC the odds of a QE3 program are about zero.

The one program receiving a little bit of play is the "Operation TWIST" action taken in 1961. Basically the Fed changes its purchases of treasuries from the short-term 2-year durations to the long term 30-year in order to keep interest rates lower for a longer period. Keeping long-term rates significantly lower aids home mortgages, business loans, etc. However, Kansas Fed President Thomas Hoenig said, "I don't see any reason why it would work" to further stimulate the economy. "What is the fundamental problem? Is the fundamental problem a yield curve issue or that the U.S. and world have too much debt?" There is no problem Operation TWIST can solve.

Regardless of what Bernanke says or doesn't say his speech is the focal point for the week. The markets ran up in anticipation of some market-moving announcement and then sold off when the preponderance of the evidence suggests there is nothing he could announce that would benefit the market. He said a very weak payroll number on Sept 2nd could force the Fed to act when it meets on September 20th.

The U.S. sold $29 billion in seven-year notes at a record low yield today. This followed $35 billion in five-year notes at 1.029% and $35 billion in two-year notes on Tuesday at 0.222%, also record low yields. Interest rates do not appear to be a problem.

Doctor Doom, Nouriel Roubini, believes Bernanke will eventually announce QE3 but not at this meeting. Roubini believes we are heading into a global recession and the Fed is running out of policy bullets to slow the U.S. decline. Another QE program is the only hope according to Roubini.

Gold prices rebounded from $1705 to $1777 before easing slightly at the close. The $72 rebound came on the debt crisis worries in Europe and the sharp drop in European markets. Adding in the rise in Jobless Claims and traders bought the -$200 dip from Tuesday's high at $1917. Analysts are unsure whether this is just an oversold bounce or the beginning of a rebound to new highs. The fundamentals have not changed only the perceived risk of being long gold at $1900. Shanghai and Hong Kong both raised margins on Gold earlier in the week and that forced a minor reshuffle by investors in those markets. Investor sentiment in gold was 93% bullish last week and that has only happened once before and it was followed by a -34% decline to push investor sentiment back to 51% bullish before the rebound began.

Gold Chart

Apple shares rebounded to close only slightly negative after yesterday's announcement by Steve Jobs and his resignation as CEO. The stock traded down to $350 overnight but erased most of those gains by the close. Steve did not give any reason for his resignation other than he can no longer perform the CEO duties. Everyone assumes it is health related since he is regularly photographed entering and leaving medical offices. Steve was immediately elected as Chairman of the Board so he is not leaving Apple only leaving the day to day operations. In that position, one that has been vacant for some time, he could assume the role as Chief Visionary. Jobs recommended COO Tim Cook and acting CEO in Steve's absence, be promoted to permanent CEO and the board immediately acted on Steve's wishes.

Apple shares have risen +6,760% since Jobs was rehired as CEO in 1997. Steve grew Apple from a startup but was kicked out because of his insane focus on detail and the desire to make the absolute best products possible. He rescued Next Software and grew it to the point where Apple acquired the company giving Jobs a second fortune. Jobs gained control of Pixar Animation and grew it to the point where it was acquired by Disney and Jobs took home another monster payday. To say this many has been instrumental in some of the biggest technology innovations on the planet would be an understatement.

Apple Chart

Hurricane Irene is moving up the east coast with hurricane warnings from South Carolina all the way past New York. The storm is being compared to several hurricanes that caused billions in damage and serious loss of life in decades past. Fortunately Irene is only a category 3 at present and could weaken to a category one by the time it reaches New York. One thing it is producing is a significant amount of retail sales all up the coast from food stores and builder supply stores like Home Depot. You can expect to see a boost in retail sales for August when the numbers are reported in mid September. There is a silver lining in almost every cloud. Tropical storm ten has formed off the coast of Africa and is heading towards the Bahamas for next week.

Hurricane Irene

Tropical Storm Ten

The S&P failed at short-term resistance at 1175 and finished the day right in the middle of its recent range. Effectively the market found a neutral level where it is neither overbought nor oversold ahead of the Bernanke speech. Support is 1120 and major resistance at 1200-1205. The odds are very good one of those levels will be tested on Friday.

S&P-500 Chart

Like the S&P the Dow finished in the middle of its recent range and in a neutral position ahead of the speech. Only two components were positive and those were BAC and AXP. CAT and MMM both lost over $2.

Support is now 10,800 and resistance 11,500.

Dow Chart

The Nasdaq benefited from the +25 point rebound in Apple to also close in the middle of its recent range and just above light support at 2400. Strong support at 2335 and strong resistance at 2550. Despite today's -48 point day this was a nothing day. Traders took profits and headed to neutral ground.

Nasdaq Chart

Russell Chart

Thursday was a return to neutral for the markets. This was what the TV reporters have been calling as a risk off day. Early week profits were captured and traders moved to the sidelines to wait for the Bernanke speech. It was as simple as that. Throw in the Europe mess and rising jobless claims for economic color and a few headlines about Apple and Bank America and you have a quick synopsis of the trading day. Nothing material happened and nothing is likely to happen ahead of the Bernanke speech. After the speech is a different story.

Post speech, regardless of content, the market is likely to be volatile. Traders looking to sell the news will sell and those hoping for a dip will buy. It will be a giant tug of war and there is no telling where we will end up. Unless there is something unexpected that causes a spike in bullish sentiment I would expect we have a greater chance of a decline to support than a rally to resistance. This is August and we have people like Doctor Doom preaching recession on every channel and every newspaper. While I think they will be wrong it does not matter what I think. It only matters what the majority of traders think and that will depend on how good Bernanke does as economic cheerleader on Friday.

Jim Brown

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New Plays

Once Again, It's Up to Ben

by James Brown

Click here to email James Brown

Editor's Note:

The financial world will turns its eyes and ears toward Jackson Hole, Wyoming tomorrow. Federal Reserve chairman Ben Bernanke will share his speech on the "Near- and Long-term Prospects for the U.S. Economy", which begins at 10:00 a.m. ET tomorrow. Most analysts are not expecting Bernanke to announce QE3 but he could announce some other sort of stimulus or hint at some other policy moves to help stimulate the struggling U.S. economy.

If Bernanke does not soothe the markets then stocks could see another sharp sell-off. I would anticipate the market to be quiet and trade sideways up to the ten o'clock hour but Friday morning probably depends on how Europe's markets are doing. Day traders may want to consider some sort of market neutral strategy (like a straddle or a strangle) at 10:00 a.m. ET tomorrow to catch any post-speech volatility.

We are not adding any new plays tonight. There is no way to predict what direction stocks might move on Bernanke's comments. We could rally or stocks could see a sell-the-news sort of move even if he offers some sort of stimulus.

I suspect that stocks could see another dip toward their recent lows. Here's a small list of stocks I'm watching for potential entry points:


- James

In Play Updates and Reviews

Prepare For The Dip

by James Brown

Click here to email James Brown

Editor's Note:
There is a decent chance that stocks decline on Friday no matter what Bernanke says in what could be a "sell the news" type of move. We've adjusted our entry points on DIG and SLX. Meanwhile we've locked in some gains on ALXN, AUXL and RLD.


Current Portfolio:

BULLISH Play Updates

Alexion Pharmaceuticals - ALXN - close: 52.99 change: -0.52

Stop Loss: 49.45
Target(s): --.--, 57.00
Current Gain/Loss: + 4.5%
Time Frame: 2 to 5 weeks
New Positions: see below

08/25 update: Our plan was to sell half of our stock position at the open today. ALXN opened at $53.49, then immediately bounced between $54 and $52 before settling in to hover around the $53 level. If Bernanke disappoints the market tomorrow then we could see ALXN retesting $50 soon. I am not suggesting new positions at this time.

Our plan was to keep our position size small to limit our risk.

Current Position: ALXN stock @ $50.67

- or -

Long SEP $55 call (ALXN1117I55) Entry $1.40

08/25 Sold Half @ 53.49 (+5.5%) -stock only, not the option
08/24 new stop loss @ 49.45
08/24 Take profits now. Sell half at the open tomorrow. ALXN is currently up +5.6% (stock only). We'll leave our option position unchanged. Current bid is $1.40 (+0.0%)
08/15 new stop loss @ 47.90
08/12 trade is open.
08/11 open positions if ALXN and S&P500 are positive Friday morning
08/09 new entry point strategy, new stop loss, new targets.

Entry on August 12 at $50.67
Earnings Date 10/20/11 (unconfirmed)
Average Daily Volume = 1.7 million
Listed on August 8, 2011

Auxilium Pharma - AUXL - close: 17.07 change: -0.19

Stop Loss: 15.25
Target(s): --.--, 19.75
Current Gain/Loss: +5.8%
Time Frame: 6 to 8 weeks
New Positions: see below

08/25 update: The short-term trend in AUXL is up but I'm worried shares are looking a little overbought here. The plan today was sell half of our position at the close tonight to avoid any potential weakness on Friday. The option closed with a bid of $0.60 (+33.3%).

I am not suggesting new positions at this time. More conservative traders may want to raise their stop loss. Our final target remains $19.75 but AUXL will have to chew through some resistance to get there.

Given the market's recent volatility we do want to keep our position size small.

Current Position: Long AUXL stock @ $16.13

- or -

Long SEP $17.50 call (AUXL1117I17.5) Entry $0.45

08/25 Planned exit to sell half. AUXL @ 17.07 (+5.8%)
sold half of Sep. $17.50 call, bid @ 0.60 (+33.3%)
08/24 Take profits (sell half) Tomorrow at the close
08/24 new stop loss @ 15.25
08/23 new stop loss @ 14.95.
08/23 added 2nd target at $19.75


Entry on August 22 at $16.13
Earnings Date 11/03/11 (unconfirmed)
Average Daily Volume = 1.4 million
Listed on August 20, 2011

Avon Products Inc. - AVP - close: 21.37 change: -0.36

Stop Loss: 19.95
Target(s): 23.50, 24.40
Current Gain/Loss: - 2.4%
Time Frame: 6 to 8 weeks
New Positions: see below

08/25 update: AVP rallied to short-term resistance near $22 and reversed this morning. The stock closed down -1.6% and erased yesterday's gains. I am not suggesting new positions at this time. Any significant market weakness tomorrow could see AVP retesting the $20.50-20.00 zone.

- small bullish positions -

Suggested Position: Long AVP stock @ $21.91

- or -

Long SEP $23 call (AVP1117I23) entry $0.50

08/20 new stop loss at $19.95

Entry on August 17 at $21.91
Earnings Date 10/27/11 (unconfirmed)
Average Daily Volume = 5.1 million
Listed on August 15, 2011

Ultra Oil & Gas ETF - DIG - close: 39.09 change: -1.90

Stop Loss: 35.45
Target(s): 48.50
Current Gain/Loss: unopened
Time Frame: 2 to 6 weeks
New Positions: Yes, see below

08/25 update: I was surprised to see that our play did not open today. DIG was showing strength this morning and gapped open higher at $41.38. The S&P500 was pushing higher on strength in the financial sector. Yet the opening print for the S&P500 was down. Thus our trade here was not open. Maybe that's a good thing. The market reversed and DIG lost -4.6%.

I am adjusting our entry point strategy. The market could sell-off on disappointing comments from Bernanke tomorrow. If that happens then DIG could retest its lows near the $37-36 area. The August 9th low was $35.78. I am now suggesting we buy a dip at $36.00. More aggressive trades could buy a dip near $37.00 instead. If triggered at $36.00 we'll use a stop loss at $35.45. I have updated our option strike. We want to keep our position size small.

New Strategy: Buy the dip at $36.00

Suggested Position: buy this ETF @ at $36.00

- or -

buy the SEP $40 call (DIG1117I40)

08/25 New strategy: buy a dip at $36.00 instead, new stop loss at $35.45
08/24 Readers may want to wait on launching new positions until after we see the market's reaction to Bernanke's comments on Friday.

Entry on August xx at $ xx.xx
Earnings Date --/--/--
Average Daily Volume = 1.4 million
Listed on August 23, 2011

Giant Interactive Group Inc. - GA - close: 8.17 change: +0.27

Stop Loss: 7.55
Target(s): 9.30
Current Gain/Loss: - 3.4%
2nd position Gain/Loss: +3.1%
Time Frame: 4 to 8 weeks
New Positions: see below

08/25 update: GA displayed some relative strength today with a +3.4% gain. The rally stalled at short-term resistance near $8.20. I am not suggesting new positions at this time. Let's wait and see how the market performs on Friday.

Earlier Comments:
Readers should consider this a higher-risk, more aggressive trade. We want to keep our position size small to limit our risk.

Current Position: Long GA stock @ $8.46

- or -

Long SEP $7.50 call (GA1117I7.5) Entry $0.95

- Add 2nd position - entry on 08/24/11

Second Position (small): Long GA stock @ 7.92

Long SEP $7.50 call (GA1117I7.5) Entry $0.65

08/23 new stop loss @ 7.55
08/23 adding a 2nd position
08/20 new stop loss @ 7.38

Entry on August 15 at $ 8.46
Earnings Date 11/16/11 (unconfirmed)
Average Daily Volume = 1.3 million
Listed on August 13, 2011

Sturm Ruger & Co - RGR - close: 31.22 change: +0.13

Stop Loss: 27.25
Target(s): 33.75
Current Gain/Loss: + 3.2%
Time Frame: 6 to 8 weeks
New Positions: see below

08/25 update: RGR was still drifting higher but most of the action was sideways. Investors could choose to sell the news tomorrow so we're not suggesting new positions at this time. Nimble traders could look for a dip near the $29.00 or $28.00 levels as a potential entry point should RGR see a pull back. Cautious traders may want to raise their stop loss.

Current Position: Long RGR stock @ 30.25

- or -

Long SEP $30 call (RGR1117I30) Entry $1.95

08/22 RGR gaps open higher at $30.25 (entry point)

Entry on August 22 at $30.25
Earnings Date 10/27/11 (unconfirmed)
Average Daily Volume = 310 thousand
Listed on August 20, 2011

RealD Inc. - RLD - close: 14.61 change: -0.58

Stop Loss: 13.25
Target(s): 18.00
Current Gain/Loss: + 4.0%
Time Frame: 6 to 10 weeks
New Positions: see below

08/25 update: Ouch! It looks like we should have taken profits at the opening bell instead of the closing bell. I was concerned that RLD might see some profit taking tomorrow (Friday) so the plan was to take some money off the table tonight at the close. Unfortunately, RLD gave up -3.8% and settled on its lows for the day. I did not see any news behind this relative weakness. It's probably just profit taking after the strong move from the $12 area. The Sep. $15 call ended the day with a bid at $0.90 (+50%).

I am not suggesting new positions at this time. We'll keep our final target at $18.00.

Earlier Comments:
We want to use small positions to limit our risk. NOTE: If you trade options you may want to use the November instead of Octobers but the spreads are a little wider.

current Position: Long RLD stock @ $14.04

- or -

Long SEP $15.00 call (RLD1117I15) Entry $0.60

08/25 planned exit to sell half at the close.
RLD +4.0%, option @ $0.90 (+50%)
08/24 Prepare to take profits early and sell half tomorrow at the closing bell.
08/24 new stop loss at $13.25
08/22 gap open entry at $14.04

Entry on August 22 at $14.04
Earnings Date 11/02/11 (unconfirmed)
Average Daily Volume = 1.4 million
Listed on August 20, 2011

Steel ETF - SLX - close: 51.03 change: -1.19

Stop Loss: 49.40
Target(s): 55.75, 59.75
Current Gain/Loss: unopened
Time Frame: 2 to 6 weeks
New Positions: Yes, see below

08/25 update: Our trade is still not open yet. The SLX opened strong but the opening print on the S&P500 was down. It looks like the SLX will test support near $50.00 soon. We will adjust our strategy. We'll plan to buy a dip at $50.00 and tweak our stop loss to $49.40. I would still keep our position size small.

New Strategy: Buy a dip at $50.00

Suggested Position: buy this ETF @ open

- or -

buy the SEP $55 call (SLX1117I55)

08/25 new strategy: buy a dip at $50.00, new stop 49.40

Entry on August xx at $ xx.xx
Earnings Date --/--/--
Average Daily Volume = 126 thousand
Listed on August 23, 2011

BEARISH Play Updates

Nordic American Tanker - NAT - close: 17.12 change: -0.29

Stop Loss: 18.55
Target(s): 12.75, 10.50
Current Gain/Loss: - 0.4%
Time Frame: 6 to 12 weeks
New Positions: see below

08/25 update: The morning rally failed and NAT ended the session down -1.6%. I would still consider launching new bearish positions at current levels. Just remember to keep our positions small. You may want to consider using put options instead since your risk is limited to the cost of the put you purchase.

- small positions -

Current Position: short NAT stock @ $17.05

- or -

Long OCT $15 PUT (NAT1122V15) Entry $0.75*

08/24 NAT provides another entry point with failed rally at $18
08/22 gap open entry @ 17.05
* option entry is an estimate. option did not trade today

Entry on August 22 at $17.05
Earnings Date 11/07/11 (unconfirmed)
Average Daily Volume = 583 thousand
Listed on August 20, 2011

Overseas Shipholding Group - OSG - close: 15.05 change: -0.44

Stop Loss: 17.55
Target(s): 12.50, 10.25
Current Gain/Loss: + 3.0%
Time Frame: 6 to 12 weeks
New Positions: see below

08/25 update: So far so good. The morning rally attempt in OSG failed at the $16.00 level. Shares closed on their lows with a -2.8% drop for the day. OSG looks poised to breakdown under support at $15.00 soon. A new relative low under $14.75 could be used as another entry point. I would keep positions very small to start.

- Small Bearish Positions -

Current Position: short OSG stock @ $15.52

- or -

Long OCT $14 PUT (OSG1122V14) Entry $1.50

08/22 gap open entry at $15.52

Entry on August 22 at $15.52
Earnings Date 11/02/11 (unconfirmed)
Average Daily Volume = 981 thousand
Listed on August 20, 2011