Option Investor

Daily Newsletter, Thursday, 10/20/2011

Table of Contents

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

Market Wrap

Bipolar Markets

by Jim Brown

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

Market Statistics

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

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

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

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

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

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

Philly Fed Chart

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

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

Jobless Claims Chart

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

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

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

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

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

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

Microsoft Chart

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

SNDK Chart

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

CMG Chart

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

IR Chart

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

Southwest Chart

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

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

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

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

S&P Chart

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

Dow Chart

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

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

Nasdaq Chart

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

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

The European calendar as of tonight is as follows:

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

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

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

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

Jim Brown

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New Plays

Stops Can Help

by James Brown

Click here to email James Brown

Editor's Note:

The stock market is oscillating sideways as investors wait for October options to expire after Friday and while they wait for the EU summit this weekend. Investors are expecting some sort of deal that will limit the damage from a Greek default and protect the EU banking system from collapse (from said default). There is no guarantee of a deal but there are certainly growing expectations for one.

This makes for a dangerous trading environment especially if you only go long or short stocks (or ETFs). If you bet the wrong way and the news this weekend goes against you then Monday could be very painful. Yes, stop losses can mitigate your risk but the equity you're trading can gap open several points the wrong way and exacerbate your loss.

The Premier Investor newsletter currently does not have any bearish positions because for the most part stocks have been trending higher in the month of October. The rally has stalled recently as investors look for some sort of rescue in Europe. We are not suggesting any new trades tonight but readers may want to consider some sort of hedge. If you trade options then consider buying some puts either on your individual positions or on the major indices before the closing bell on Friday.

Keep in mind that if there is a deal and stocks rally on Monday then your puts are going to drop in value. It's an insurance policy in case things go really poorly but you don't get your insurance premium back if there isn't a disaster (although if you're quick you might be able to sell them fast and reduce your expense if stocks rally on Monday morning).

Option traders may also want to consider some sort of market neutral strategy like a straddle or a strangle. That way you do not care what direction the market moves as long as it moves big.

Summary: No new positions for Premier tonight. I would expect a quiet, sideways market tomorrow but you never know. There could be a new rumor out of Europe to move stocks on Friday.


In Play Updates and Reviews

Financials Outperform

by James Brown

Click here to email James Brown

Editor's Note:
The banking stocks were some of the market's best performers on Thursday after traders bought the midday dip. Our XLF trade was opened this morning.

If your portfolio is mostly long the market (bullish on stocks) then you may want to consider buying some sort of hedge tomorrow (maybe puts on the SPY) just in case the news out of Europe this weekend is bearish and the market plunges on Monday.


Current Portfolio:

BULLISH Play Updates

Adobe Systems - ADBE - close: 26.02 change: -0.74

Stop Loss: 25.45
Target(s): 29.50
Current Gain/Loss: -3.8%
Time Frame: 6 to 8 weeks
New Positions: see below

10/20 update: Tech stocks were showing relative weakness this morning. ADBE dipped to $25.50 before paring its gains and actually edging into positive territory. If the market opens positive tomorrow I would be tempted to open new bullish positions on the bounce. We will inch up our stop loss to $25.45.

Current Position: Long ADBE @ 27.13

- or -

Long NOV $27 call (ADBE1119K27) Entry $1.27

10/20 new stop loss @ 25.45
10/18 new stop loss @ 25.35, today's bounce looks like an entry
10/14 ADBE gapped higher at $27.13

Entry on October 14 at $27.13
Earnings Date 12/15/11 (unconfirmed)
Average Daily Volume = 7.1 million
Listed on October 11, 2011

Autodesk, Inc. - ADSK - close: 31.27 change: +0.31

Stop Loss: 29.75
Target(s): 34.00
Current Gain/Loss: +3.0%
Time Frame: 6 to 8 weeks
New Positions: see below

10/20 update: I have been suggesting that readers look for a dip near $30.00 as our next entry point. The tech weakness this morning provided that dip. Shares of ADSK fell to $30.05 before rebounding off round-number support and closing up +1% on the session. If the stock market opens positive tomorrow I would still be tempted to open new positions at current levels. Investors need to be aware that this weekend holds significant event risk for the market.

The plan was to keep our position size small since ADSK is short-term overbought here.

*Small Positions*

current Position: Long ADSK stock @ 30.35

- or -

Long NOV $32 call (ADSK1119K32) Entry $1.60

10/20 ADSK provided another entry point on the dip to $30.00
10/15 new stop loss @ 29.75, adjusted target to $34.00

Entry on October 12 at $30.35
Earnings Date 11/17/11 (unconfirmed)
Average Daily Volume = 4.5 million
Listed on October 11, 2011

Bristol-Myers Squibb - BMY - close: 32.44 change: +0.09

Stop Loss: 31.75
Target(s): 33.50
Current Gain/Loss: +3.8%
Time Frame: 6 to 8 weeks
New Positions: see below

10/20 update: BMY continues to churn sideways inside the $32-33 range. I would expect tomorrow to be more of the same as investors wait for October options to expire (and the EU summit this weekend). I am not suggesting new positions at this time.

Earlier Comments:
Our final target is $33.50.

current Position: Long BMY stock @ $31.15

- or -

Long 2012 Jan. $30 call (BMY1221A30) Entry $2.26

10/17 2012 Jan. $30 call open (bid) @ 2.90 (+28.3%)
10/15 new stop loss @ 31.75
10/15 Plan to take profits on the call, sell half on Monday
10/10 new stop loss @ 30.95
10/04 new stop loss @ 30.75
09/27 new stop loss @ 29.90
09/26 trade opened

Entry on September 26 at $31.15
Earnings Date 10/26/11 (unconfirmed)
Average Daily Volume = 13.6 million
Listed on September 22, 2011

Lowe's Companies - LOW - close: 21.52 change: +0.48

Stop Loss: 19.75
Target(s): 22.85
Current Gain/Loss: + 3.7%
Time Frame: 4 to 8 weeks
New Positions: see below

10/20 update: LOW displayed some relative strength with a bounce from the $21.00 level. Shares closed up +2.2% on Thursday and poised to make a run at resistance near $22.00.

More conservative traders may want to raise their stop loss to breakeven at $20.75. I am not suggesting new positions at this time.

Earlier Comments:
The $22.00 level might be resistance but I'm listing our exit target at $22.85. I would keep our position size small.

current Position: Long LOW stock @ 20.75

- or -

Long NOV $21 call (LOW1119K21) Entry $0.85

Entry on October 10 at $20.75
Earnings Date 11/14/11 (unconfirmed)
Average Daily Volume = 16.7 million
Listed on October 08, 2011

EnPro Industries - NPO - close: 31.46 change: -0.43

Stop Loss: 29.80
Target(s): 34.00
Current Gain/Loss: + 1.4%
Time Frame: 2 to 4 weeks
New Positions: see below

10/20 update: NPO dipped to a new low for the week before paring its losses in the last few hours. Volume was average on today's move although I couldn't find any news or events to account for the surge in volume. I am not suggesting new positions on NPO at this time.

Earlier Comments:
We want to keep our position small to limit risk.

(Small Positions)

current Position: Long NPO stock @ $30.87

10/19 exit Oct. $30 calls, bid @ $1.25 (-28.5%)
10/18 plan to exit Oct. calls tomorrow at the close
10/17 October options are running out of time. Consider an early exit
10/15 adjusted target for stock to $34.00
10/15 adjusted target for option to $33.00
10/10 new stop loss at $29.80

Entry on October 07 at $30.87
Earnings Date 11/03/11 (unconfirmed)
Average Daily Volume = 282 thousand
Listed on October 06, 2011

VeriFone Systems - PAY - close: 38.40 change: -0.31

Stop Loss: 37.95
Target(s): 44.85
Current Gain/Loss: unopened
Time Frame: 6 to 8 weeks
New Positions: Yes, see below

10/20 update: There is no change from my prior comments. PAY is still bouncing around the $37.50-40.00 zone. Whether or not PAY breakout past resistance and begins a new leg higher or breaks down and retests the October lows may depend on the market reaction to the EU summit this weekend. This is not a market fueled by individual company fundamentals.

Our plan is to open bullish positions at $40.50.

Earlier Comments:
We will aim for $44.85 as our exit target. More conservative traders may want to exit near the 200-dma. FYI: The Point & Figure chart for PAY is bullish with a $59 target.

Trigger @ 40.50

Suggested Position: buy PAY stock @ $40.50

- or -

buy the NOV $42 call (PAY1119K42)

Entry on October xx at $ xx.xx
Earnings Date 12/01/11 (unconfirmed)
Average Daily Volume = 2.3 million
Listed on October 13, 2011

Rackspace Hosting - RAX - close: 38.46 change: +0.37

Stop Loss: 37.25
Target(s): 43.25
Current Gain/Loss: unopened
Time Frame: 4 to 6 weeks
New Positions: Yes, see below

10/20 update: Hmm... RAX did not escape the tech sector weakness this morning. Yet shares did bounce back into positive territory by the close. I remain optimistic on RAX but I'm not quite ready to pull the trigger. More aggressive traders may want to buy RAX (or calls) on a rally past $38.50. The newsletter will continue to wait and watch with no entry point for one more day and we'll make a decision this weekend.

Entry Point Removed. Re-evaluate Tomorrow Night.

10/20/11 Not ready to pull the trigger. Wait for one more day
10/19/11 Temporarily remove entry point plans, no trade
10/19/11 trade not opened.

Entry on October xx at $ xx.xx
Earnings Date 11/07/11 (unconfirmed)
Average Daily Volume = 1.6 million
Listed on October 18, 2011

Financial Sector ETF - XLF - close: 12.80 change: +0.19

Stop Loss: 11.95
Target(s): 14.45
Current Gain/Loss: +0.7%
Time Frame: 6 to 8 weeks
New Positions: see below

10/20 update: I do not know why the quote services I check list the XLF opening at $12.61 today. Looking at an intraday chart this ETF appears to have opened at $12.71. Combine that with a positive open for the S&P 500 and we have a new bullish entry point in the XLF. Traders bought the dip near $12.45 midday and the XLF displayed relative strength with a +1.5% gain at the close.

I would still consider new positions tomorrow if the S&P 500 opens positive. Or more conservative traders can wait for a breakout past resistance at $13.00 instead.

Investors need to be aware that the XLF could see a HUGE move next week as the market reacts to news from the EU summit this weekend on Greece and protecting the major EU banks. That huge move could be up or down. If you are the hedging type then consider buying a put to protect yourself here.

Currently we have a stop loss at $11.95 and our target is $14.45.

current Position: Long XLF @ $12.71

- or -

Long NOV $13 call (XLF1119K13) $0.42

11/20 trade opened. XLF at $12.71
11/19 try again. New stop loss @ 11.95


Entry on October 20 at $12.71
Earnings Date --/--/--
Average Daily Volume = 125 million
Listed on October 18, 2011

BEARISH Play Updates

None. We do not have any active bearish trades.