Option Investor

Daily Newsletter, Wednesday, 5/21/2014

Table of Contents

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

Market Wrap

Reversals of Reversals

by Keene Little

Click here to email Keene Little
The stock market is coiling for a big move and no one can say with certainty which way it's going to break. In the meantime we have a choppy consolidation that won't quit and it's frustrating both sides.

Wednesday's Market Stats

The stock market is continuing its sideways choppy consolidation pattern that it's been in for the past 2+ months. Short-term sentiment is swinging daily with the market while longer-term sentiment shows complacency that could get the bulls into trouble if they're not careful. But the bears haven't been able to do anything to scare the bulls yet and with an intact uptrend they haven't felt the need to worry.

It's been very quiet for the markets when looking at geopolitical events and economic reports. This has left the market to bounce around on its own and at the moment it's looking rudderless. The only report today that's worth mentioning was the FOMC minutes that were released at 14:00 and even that didn't move the market much. There was a little downside blip but after 10 minutes the indexes started back up and finished near their highs for the day (the RUT was a little off).

There were no surprises in the FOMC minutes, which simply confirmed what we've already heard. The Fed feels the economic slowdown in Q1 was largely weather related and that economic growth should look better as the year progresses. This could be wishful thinking or it's a way for the Fed to stay on track with its bond-purchase taper program. They know they need to taper their purchases and they're hoping to get it done before the market rocks the boat. The big question in my mind is whether or not they'll make it to October when the last of the bond buying should be completed. Any further threat of an economic slowdown could have the Fed halting their taper program, if not reversing it. This is especially likely if the stock market starts down more earnestly.

The Fed members acknowledged that they believed there could be some risk to the stock market with the low volatility. They believe this represents an increase in investor willingness to accept higher levels of risk and as we know, when the VIX is low it's time to go. Perhaps someone in the Fed meeting mentioned that saying. With the Fed's push to get investors into riskier assets there is perhaps some recognition now that it has made the market more vulnerable to a downside disconnect.

Following the May 13th high, which was a good setup for the completion of the rally, I had expected to see the market start down into what should become a much larger decline than just a "pullback." We got the decline, especially Thursday morning, but the bulls have hardly been scared away. Just another dip to buy as far as they're concerned. It's been such a winning strategy for years and therefore it's not hard to understand why they keep doing it.

But now the bounce off last Thursday's low could be setting up the completion of a correction to the initial decline, to be followed by another leg down. At least that's the bearish setup, but as has been the case for a long time, the bull could still have a rabbit or two left in his hat. Many are now just hoping the market at least continues to float higher into the holiday weekend and then month-end.

But the only way the market is going to make it much higher is for the sellers to stay away. Total trading volume is pitifully low and especially so during rally attempts (today's rally was again lower than yesterday's selling). The pattern since March has generally been weaker volume during rally attempts and stronger volume during declines. Market breadth reamins weak. Looking at today's Market Stats above shows the 52-week highs and lows came in at the same 155. But getting in behind those numbers shows the Nasdaq had 75 news lows vs. 41 new highs and yet the index finished up +0.84%. This is the way the rally has been progressing for some time -- on the backs of fewer and fewer stocks.

As an example of the situation for the tech indexes, NFLX was up big today and finished at its high, up almost 19 (+5.1%) at 390.69. That certainly helped the indexes but what if these same stocks start back down while the weaker stocks simply drop harder? Take a look where NFLX finished today -- up against its broken uptrend line from April 2013, currently near 392. The 2nd leg of a 3-wave bounce off its April 28th low would be 162% of the 1st leg up (to complete an a-b-c bounce correction to its March-April decline) at 392, only a little more than a point above today's high.

Netflix, Inc., NFLX, Weekly chart

From a bearish perspective, this is a back test that will be followed by a kiss goodbye and the next decline could be stronger than the March-April leg down. Some of these big tech stocks are going to be important to watch in the next couple of weeks since without their support it would be hard for the tech indexes to keep the majority fooled about the rally. Keep in mind that while the tech indexes had a marginal pullback into April that wasn't true for the average stock in the indexes. It's the same for the RUT -- the average decline for the stocks in these indexes was more than -20%. If the indexes had done that we would have seen the Nasdaq down to about 3500 (instead of holding support near 4000).

While on the subject of the techs, I'll show the Nasdaq's daily chart to show a bullish setup if tech stocks like NFLX can keep going. I get a different interpretation using NDX, which I'll show next. The COMPQ has been trading sideways in a narrowing coil, the top of which is near its 50-dma, which will cross near 4146 on Thursday, about 13 points above today's high. A rally above 4146, that holds above (not just an intraday break above it to catch the stops), would be bullish. But if it heads back down and drops below the bottom of the triangle, near 4040, it would be bearish for another leg down to at least match the March-April decline.

Nasdaq Composite index, COMPQ, Daily chart

As I've been showing for NDX, it has a little different pattern since the April 15th low, one which looks more bearish. It's a rising wedge pattern and as you can on the chart below, today's rally brought NDX right up to the top of the wedge. Possibly a pop higher Thursday morning for a little throw-over and then a key reversal to the downside -- that's what the bears need to wish for here. If it rallies above 3640 and stays above that level it will be a bullish breakout from a bearish pattern and failed patterns tend to fail hard (so a strong rally). Regardless of how weak the rally had been so far, a rally above 3640 would have me looking to buy the dips rather than sell the rallies. In the meantime we've got a bearish setup here.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 3640
- bearish below 3542

If the bears take over from here there's considerable downside potential for NDX, which I show on the chart. First, there's the potential for a H&S top, with the left shoulder in January, head in March and now completing the right shoulder. The downside objective out of the pattern (neckline near 3425) is to about 3112. If the 2nd leg of the move down from March achieves 162% of the 1st leg down we'll see it drop to 3100 (3300 would be two equal legs down). Needless to say, it's decision time for the techs and as they go so will go the broader market.

The wedge pattern for NDX is shown in more detail with the 60-min chart below. You can see today's rally into the close is up against the top of the wedge pattern. I'm showing a possible 3-wave move up from April 15th (labeled w-x-y) and two equal legs points to 3639.28, less than 3 points above today's high. This is why a slight pop higher Thursday morning followed by a drop back inside the wedge would give us a sell signal (stop above the morning high). MACD shows bearish divergence, which supports the idea that the rally is going to fail here but price is king so follow it. This is what I'll be watching closely in the morning (looking to get short if the bearish pattern follows through).

Nasdaq-100, NDX, 60-min chart

Looking at SPX weekly chart, the first thing that jumps out, other than the tangle of uptrend lines, is the bearish divergence since December. The market has chopped its way higher but as discussed ad nauseum since January, the waning momentum and a slew of market breadth indicators tell us the rally is on its last legs. The bull has run its marathon and is crawling to the finish line on bloodied knees. Somebody needs to shoot the poor thing and put it out of its misery.

S&P 500, SPX, Weekly chart

While the weekly perspective of SPX looks like it could, and should, fail at any time now, the choppy pattern to the upside might not be finished. The sideways consolidation that we've been in for the past 2+ months could resolve to the upside, in which case I'd be looking for a rally up to at least the 2000 area. First I'd want to see it get through 1920-1930 before betting on the long side but if you're short the market you need to see the upside potential. There are signs confirming a top is already in place but until it drops below its April low near 1814 the bulls will still have a fighting chance for higher highs.

As I said, I liked the setup for a top on May 13th, which missed a price projection at 1904 by only 2 points. The sharp decline following that high also supports the idea it was an important high. The bounce off last Thursday's low is so far a correction to the decline that has run into trouble at the broken uptrend line from April 11th, which stopped Monday's rally and will be near 1892 Thursday morning. If SPX pushes much above 1892 we'll probably see new highs whereas a drop below last Tuesday's low, near 1868, should lead to a move down to at least test 1850 support.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1900
- bearish below 1862

The 60-min chart below shows another reason why 1892 is an important level for the bulls to break through -- two equal legs up from last Thursday, for an a-b-c bounce correction to last week's decline, points to 1891.78. That crosses the broken uptrend line from April 11 - May 7 (which fits as the bottom of the rising wedge pattern up from April 11th to complete the last leg of its rally into the May 13th high) early Thursday morning. This makes it possible we'll see a quick high Thursday morning followed by the start of a stronger selloff. In other words, don't get sucked into a bullish start to Thursday since it could be a bull trap.

S&P 500, SPX, 60-min chart

Coinciding with a potential top for the stock market is a VIX level down in the weeds. Complacency is obvious with the VIX banging on 12, a level that has been support since August 2013. The VIX is also now down to the bottom of a potential bullish descending wedge from its February 3rd high and the combination looks like a bullish setup. That would of course mean a bearish setup for stocks.

Volatility index, VIX, Daily chart

The DOW sold off 155 points yesterday and rallied 158 today. Will the real market direction please stand up. Yesterday's low below the March 15th low (as opposed to the higher low for the other indexes) was a bear trap but now the question is whether today's rally is setting a bull trap. Like SPX, the DOW is bouncing back up toward its broken uptrend line from April 11 - May 7, near 16600 Thursday morning (so a little further away relative to SPX). While it's a different shape, the bounce off the May 15th low nearly achieved a price projection at 16549 for its completion with a high near 16545 this afternoon. So its bounce, if it's to be just a correction to the decline, might have finished this afternoon or could finish with a minor pop higher Thursday morning. A rally above 16600 would look more bullish and that would point to at least a test of its May 13th high at 16735.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 16,735
- bearish below 16,340

The RUT was a bit whippy today and then finished near the middle of its range, leaving a doji day to ponder. As I look at its daily pattern I get a bullish impression. It has been nothing but a choppy move down since March and that has it looking like a corrective pullback. The bullish divergence since April also adds to the bullish impression. As long as it holds above 1080 it's hard to turn bearish but the bears have in their favor the fact that it's in a down trend (lower highs) and its recent bounce attempt into Monday's high was rejected by its broken 200-dma (and descending 20-dma). The bulls need to break the downtrend line, currently near 1120, in order to at least turn the pattern neutral.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 1137
- bearish below 1080

I usually show the TNX (10-year yield) chart but tonight I'm showing the TYX (30-year yield) chart since it bounced off support last week where it should and the bullish interpretation of the pattern calls for the bounce to turn into a rally. The bond bears need to keep selling in order to get TYX up over 3.5%, the May 12th high, in order to confirm a breakout of its down-channel from March 7th and a larger one from December 31st, currently near 3.49%. The bullish divergence since February supports the bullish perspective and selling in the bonds could support a rally in the stock market, which is the reason I'm watching this carefully. But if the bond bulls keep up their buying and drive yields lower, a break below support near 3.3% would be significant. Two equal legs down from December 31st and the uptrend line from 2012-2013 would then be broken and a failed bullish setup could fail hard.

30-year Yield, TYX, Daily chart

The Trannies have been stronger than the DOW Industrials this year, consistently putting in new highs for the year after December's highs while the DOW has lagged behind in that regard. But the TRAN's days could be numbered here if the rising wedge pattern off the April 14th low is going to be the conclusion to its longer-term rally, which is how it's currently fitting. It fits as the c-wave (ending diagonals are common for the final 5th or c-wave) of an a-b-c move up from February 5th and two equal legs up projects to 7963. The 5th wave of the move up from April 14th would be 62% of the 3rd wave (common in an ending diagonal) at 7952. The top of the rising wedge will be near 8000 next Tuesday (Monday is a holiday) so we've got an upside target zone of about 7950-8000 for a final high. A drop below 7700 would confirm the final high is in place.

Transportation Index, TRAN, Daily chart

Last week I mentioned I was looking for a pullback in the U.S. dollar and following its quick high Thursday morning we've seen more of a consolidation than a pullback. There's still the potential for a slightly larger pullback but in any case it should head higher once the pullback/consolidation completes.

U.S. Dollar contract, DX, Daily chart

Gold has continued to chop sideways in the coil I showed last week and came close to the bottom of it today, currently near 1281. A break below that level would be a bearish heads up but it needs to break below its April 24th low at 1268.40 to confirm it's breaking down. The downside objective, assuming it will head lower, is 1194 but there is lower potential. It takes a rally above 1310 to put the gold bears back on their heels and then above 1340 to turn the pattern bullish.

Gold continuous contract, GC, Daily chart

Oil has also reached an inflection point by rallying up to resistance at its current price near 104, at its downtrend line from August 2013 and its broken uptrend line from January 9 - March 17. Slightly higher, near 104.75, is a shallow downtrend line from the two previous highs in March and April. This could be the top of what will become a bullish sideways triangle, which needs one more trip down to the bottom of it (the uptrend line from March 17th) in order to complete the triangle. Oil would be bullish above 105 but currently looks like a setup for at least a pullback, if not something more bearish with a triple top here.

Oil continuous contract, CL, Daily chart

Tomorrow's reports include existing home sales for April, which are expected to be about the same as March. The market is looking for signs of improvement in home sales as evidence for improved 2nd quarter growth.

Economic reports and Summary

Stock indexes have hit an important point where the bulls need to keep the rally going (and hopefully add some oomph behind it) whereas the bears need to reverse it now. A slight pop up Thursday morning should be followed by immediate selling if the bears are going to take over. Or it could start down immediately, depending on what the futures do in the pre-market session. How Thursday goes could set the market's direction for the next couple of weeks so don't get caught on the wrong side.

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

Keene H. Little, CMT

Be who you are and say what you feel, because those who mind don't matter and those who matter don't mind. - Dr. Seuss

New Plays

Can The Big Caps Carry the Small Caps?

by James Brown

Click here to email James Brown

Editor's Note:

The S&P 500 index and the Dow Jones Industrial Average both delivered a decent bounce and look like they want to retest their recent highs. Meanwhile the NASDAQ composite and the small cap Russell 2000 index are still stuck under an intermediate trend of lower highs. However, it almost feels like the big cap indices might slowly drag the small caps begrudgingly higher.

We are not adding any new plays to the Premier Investor newsletter tonight. Keep an eye on the Russell 2000 and resistance near 1120 and its 30-dma and 200-dma. A breakout there could be a turning point for the market.

In Play Updates and Reviews

Stocks Rebound With Widespread Gains

by James Brown

Click here to email James Brown

Editor's Note:
The U.S. market rebounded following yesterday's decline. Big cap indices outpaced the small caps.

Current Portfolio:

BULLISH Play Updates

American Airlines Group Inc. - AAL - close $38.32

Stop Loss: 37.25
Target(s): to be determined
Current Gain/Loss: unopened

Entry on May -- at $--.--
Listed on May 17, 2014
Time Frame: 9 to 12 weeks
Average Daily Volume = 10.3 million
New Positions: Yes, see below

05/21/14: AAL was little changed today. The fact that shares did not participate in the market's widespread rally is a little bit surprising.

I do not see any changes from our weekend newsletter's new play description.

Earlier Comments:
AAL is in the services sector. AAL is the merger between US Airways and American Airlines (AMR). The new company, American Airlines Group, is the largest carrier with nearly 6,7000 flights a day, over 330 destinations, to more than 50 countries, with over 100,000 employees worldwide.

This $17 billion merger was threatened by the U.S. Justice department last year. Regulators tried to block the merger on fears the new company would be too big, hold too much power, and reduce competitiveness and thus pricing for consumers. A U.S. district judge just recently approved a settlement worked out between AAL and the Justice Department where the new company agreed to sell certain assets to competitors. Getting the legal hurdle for its merger out of the way it's one more worry that investors can forget.

The airlines would also like to forget about winter. The 2014 winter season was brutal for the airline industry. In January and February the Bureau of Transportation Statistics said 6.05% of all domestic flights were cancelled. That number dropped to 4.6% of all flights cancelled in March. Put them all together and you have the worst winter cancellation rate in 20 years. Yet this news has failed to stop the rally in airline stocks. Granted AAL did consolidate sideways for a few weeks but now it is only a couple of points away from new eight year highs.

AAL just recently released data on April. Their revenue passenger miles for April were up 4.7 percent to 18.1 billion in 2014 versus April 2013. Odds are this number is going to improve since summers tend to be more bullish for the airline business.

Wall Street seems keen on shares of AAL. Goldman Sachs recently put a $46 price target on the stock. In the latest 13F filings it was revealed that Paulson & Co had raised their stake in AAL from 8.5 million shares to 12.2 million. Meanwhile David Tepper is the hot fund manager everyone loves and his Appaloosa Management has AAL as its second largest holding. In the last quarter Appaloosa increased their AAL stake by 22.5%.

On a short-term basis shares of AAL are sitting just below resistance at $40.00. I am suggesting a trigger to launch bullish positions at $40.25. We'll start with a stop loss at $37.25, just under this past week's low. I'm not setting an exit target yet but probably somewhere in the $45-50 zone.

Trigger @ $40.25

Suggested Position: buy AAL stock @ (trigger)

- (or for more adventurous traders, try this option) -

Buy the Aug $40 call (AAL140816C40)

option format: symbol-year-month-day-call-strike

Arrowhead Research - ARWR - close: 10.93 change: -0.37

Stop Loss: 10.75
Target(s): to be determined
Current Gain/Loss: unopened

Entry on May -- at $--.--
Listed on May 19, 2014
Time Frame: 6 to 8 weeks
Average Daily Volume = 1.3 million
New Positions: Yes, see below

05/21/14: It was another volatile day for ARWR. If this trade opens we're going to need to wear a seatbelt.

There is no change from the Monday night new play description.

Earlier Comments:
ARWR is in the healthcare sector. The company is in the biotech industry. Biotech stocks peaked in early March as investors started selling momentum and high-growth names. ARWR was definitely a target for profit taking after a rally from $2.00 a share back in July 2013 to over $25 in March 2014.

Biotech analysts believe ARWR has a lot of potential. The company is working on a treatment for hepatitis B and should have new data available in the third quarter this year. If successful the hepatitis B treatment could be a multi-billion drug as there are over 300 million patients around the world. ARWR currently has a market cap of about $600 million but a Deutsche bank analysts believes ARWR's market cap could surge to $4-to-$5 billion if its hepatitis B treatment is approved. ARWR is also developing new treatments on its RNAi technology.

Make no mistake, this is an aggressive trade. ARWR is an early stage biotech firm with no revenues. Any investment is a belief they will bring successful clinical data and eventually get FDA approval for its drugs in development.

Technically after a drop from $25 to $10 most of the air has been let out of the prior bubble. As investors return to risk on trades we think ARWR could outperform.

Tonight we're suggesting a trigger to open bullish positions at $12.05. We'll start this trade with a stop loss at $10.75.

Trigger @ $12.05

Suggested Position: buy ARWR stock @ $12.05

- (or for more adventurous traders, try this option) -

buy the Sep $12.50 call (ARWR140920C12.5)

Delta Air Lines - DAL - close: 38.34 change: +0.51

Stop Loss: 36.45
Target(s): to be determined
Current Gain/Loss: + 1.8%

Entry on May 05 at $37.65
Listed on May 03, 2014
Time Frame: 6 to 8 weeks
Average Daily Volume = 13.5 million
New Positions: see below

05/21/14: The sideways consolidation in shares of DAL appears to be narrowing. If you look closely you can see a trend of lower highs and higher lows. This could last a few more days before we see DAL breakout again.

More conservative traders may want to adjust their stop higher. I am not suggesting new positions at this time.

Current Position: long DAL stock @ $37.65

- (or for more adventurous traders, try this option) -

Long Sept $40 call (DAL1420i40) entry $2.20*

05/12/14 new stop @ 36.45
05/07/14 new stop @ 35.75
05/05/14 triggered @ 37.65
*option entry price is an estimate since the option did not trade at the time our play was opened.

BEARISH Play Updates

Aegerion Pharma. - AEGR - close: 31.71 change: +1.36

Stop Loss: 32.55
Target(s): to be determined
Current Gain/Loss: unopened

Entry on May -- at $--.--
Listed on May 20, 2014
Time Frame: 6 to 8 weeks
Average Daily Volume = 1.4 million
New Positions: Yes, see below

05/21/14: AEGR almost completely erased yesterday's losses. The stock shot higher right at the open with a sprint towards $32 before stalling. I didn't see any company-specific news behind today's show of relative strength (+4.4%). We might drop AEGR as a bearish candidate if we see it close above its 10-dma.

At the moment I do not see any changes from the Tuesday night newsletter's new play description.

Earlier Comments:
AEGR is in the healthcare sector. The company is a biotech firm that develops treatments for rare diseases. This stock delivered a tremendous rally from October 2012 to October 2013. That's when shares revered at the $100 level and it's been down hill ever since. Exacerbating AEGR's decline has been the company's earnings warning. They lowered guidance back in January and they lowered guidance again when they reported earnings on May 7th.

The stock gapped down sharply following the May 7th report and there has been no oversold bounce. Wall Street was expecting revenues of $33.6 million for the quarter. The company only reported $27 million.

AEGR seems to be facing challenges with its only marketed product, Juxtapid. This is an oral treatment for homozygous familial hypercholesterolemia. This is a genetic disorder characterized by extremely high levels of cholesterol, especially the LDL (bad) cholesterol.

Most of the company's sales are in the U.S. Last quarter a large chunk of its sales in Brazil evaporated with a -70% decline due to an investigation into anticorruption laws in Brazil.

There are concerns that AEGR may have to lower the price for its Juxtapid treatments, which currently cost in the $250,000-$300,000 a year range. There are competing treatments for a lot less money. There is also a worry that there may be fewer customers than previously believed. There were some claims that Juxtapid might have the potential to treat 3,000 patients in the U.S. Yet homozygous familial hypercholesterolemia only affects one in a million people. That means there are closer to 300 potential patients in the U.S.

The company is also facing an investigation from the U.S. Department of Justice for comments made by AEGR's CEO when he appeared on CNBC's Fast Money program last year.

The company seems to be facing a lot of negatives and is clearly in a bear market with lower as the path of least resistance. Currently shares of AEGR are testing round-number support at $30.00. We want to wait for a breakdown below $30.00 and launch bearish positions at $29.50. If triggered we will try and limit our risk with a stop loss at $32.55.

Traders should consider this an aggressive, higher-risk trade. Not only can AEGR see big intraday swings but there is a risk of a short squeeze. The most recent data listed short interest at 30% of the small 28.39 million share float. So far the shorts have been right.

We're not setting an exit target tonight but the $20.00 level looks like it could be significant support.

Trigger @ $29.50

Suggested Position: short AEGR stock @ (trigger)

- (or for more adventurous traders, try this option) -

Buy the Sep $30 PUT (AEGR140920P30)

Financial Engines, Inc. - FNGN - close: 39.86 change: +1.08

Stop Loss: 42.25
Target(s): to be determined
Current Gain/Loss: - 2.9%

Entry on May 14 at $38.75
Listed on May 13, 2014
Time Frame: 6 to 8 weeks
Average Daily Volume = 567 thousand
New Positions: see below

05/21/14: Now might be time to worry about FNGN. The stock erased yesterday's reversal. Shares outperformed the market with a +2.7% bounce and a close above its 10-dma.

FNGN still has short-term resistance at $40.00 and at $42.00. Currently our stop loss is at $42.25. More conservative traders may want to lower their stop tonight.

I am not suggesting new positions. (FYI: getting stopped out at $42.25 will be a -9.0% loss)

Earlier Comments:
FYI: The most recent data listed short interest at about 13% of the 50.4 million share float.

current Position: short FNGN stock @ $38.75

05/14/14 triggered @ 38.75

Jacobs Engineering Group - JEC - close: 53.05 change: +0.13

Stop Loss: 56.15
Target(s): to be determined
Current Gain/Loss: + 2.6%

Entry on May 15 at $54.48
Listed on May 14, 2014
Time Frame: 6 to 8 weeks
Average Daily Volume = 1.4 million
New Positions: see below

05/21/14: JEC delivered a quiet session on Wednesday. The stock underperformed the major indices with a +0.2% gain. The stock remains oversold and due for a bounce.

I am not suggesting new positions at this time.

current Position: short JEC stock @ $54.48

- (or for more adventurous traders, try this option) -

Long Jun $55 PUT (JEC140621P55) entry $1.65**

05/17/14 new stop @ 56.15
05/15/14 trade opened at $54.48
**option entry price is an estimate since the option did not trade at the time our play was opened.
*I've provided the more standardized option symbol format.