Option Investor

Daily Newsletter, Wednesday, 1/4/2017

Table of Contents

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

Market Wrap

Santa Is Late To the Party

by Keene Little

Click here to email Keene Little
I'm guessing Santa partied a little too hard in the days leading up to Christmas and he was too hung over to help the market rally in the final week of 2016. But he showed up the past two days to finish out the period known as the "Santa Claus" rally. Now we wait to see if he can make up for last week's loss.

Today's Market Stats

The first two trading days of January are typically bullish and this year has been no exception. The "January effect" is off to a good start and if the week finishes positive it will mean we should all buy LEAP calls and come back at the end of the year to collect our money. That is of course said with tongue firmly planted in my cheek since this hasn't exactly been an accurate indicator as of late. The idea is that the first week tells us how January will go and how January goes tells us how the year will go.

The trouble with this "indicator" is that the market is bullish more often than it's not and therefore the year is up more often than it's not. And the first week of January is generally bullish as new-month and Christmas/end-of-year bonus money gets put to work. The combination has been turned into the "January effect." But last January's strong decline was followed by a strong year for the bulls so it didn't work out too well for those who bought LEAP puts last year based on a negative start to the year. While it's fun to play with, like all indicators, don't put too much faith in just one.

The small caps continue to act strong, as can be seen in the table above. The RUT is up +2.3% in the first two trading days of the year while the Dow hasn't cracked +1% yet. SPX is up +1.4% and that's been good enough to drive the VIX down near -8% where it closed below 12 again. You can't time the market on the VIX but when it drops below 12, as it did twice in December, market tops soon follow. I'll show a weekly chart of the VIX further below.

This afternoon's release of the FOMC minutes from December created a little positive response from the market but after an initial reaction the indexes basically went back to sleep. The minutes reflect the fact that the Fed felt the strong post-election rally was a strong factor in the decision to raise rates. One wonders what they would have done if the market had sold off on the election of Trump. The minutes reflected the discussion about the desire of the Fed to steer clear of politics (cough) but that the market was clearly favoring the idea of an increase in the rate.

Following the election the bond market tanked (it had already been selling off since July but sold off hard after the election) and that spiked yields higher. As I've said repeatedly, the Fed doesn't dictate bond rates, the bond market does and the Fed follows. Whenever the Fed hasn't followed, such as with the long-depressed 0.25% rate, they have distorted the market and created bubbles. Today is no different but at least they're finally starting to respond to what the bond market is telling them. Since the low in bond prices around mid-December they've been bouncing back up, including today's rally, which has yields pulling back, and yet the stock market continues to press higher. Hmm, I wonder which one will win this battle...(hint, the bond market is the smarter of the two).

While Trump was not named specifically (there was probably a gag order not to mention his name), apparently the Fed recognized the impact of the election on the markets and the meaning of it for the economy. There's hardly agreement on where the economy is headed next and in their summary of the various economic projections they were clear to note "substantial uncertainty" about what the fiscal policy should be in the coming year. However, the minutes reflected the stock market's rally, saying "Asset price movements as well as changes in the expected path for U.S. monetary policy beyond December appeared to be driven largely by expectations of more expansionary fiscal policy in the aftermath of U.S. elections." In other words, the market expects higher rates so let's meet those expectations.

Part of the reason for further rate hikes is that the Fed believes the market is anticipating "the incoming Congress and Administration would enact significant stimulus measures." There was also concern by the Fed that many of these stimulus measures, such as infrastructure spending, could significantly lower the unemployment rate and that if the Fed did not start raising rates now they'll have to scramble later to raise rates more significantly and faster. In effect they're trying to head off improving conditions before they happen. There's only one problem with this approach -- the Fed has a perfect record of Never forecasting the economy correctly. It continues to baffle me why the market pays any attention to these economic boobs who could not forecast their way out of a wet paper bag, even if the bag was ripped open for them.

I suspect the stock market's euphoria over expectations for what the Trump Administration and Republican-led Congress will be able to do will turn to disappointment as soon as the sausage-making process of governing makes it clear that there's going to be little change. Do you remember "Hope and change you can believe in" eight years ago? The sentiment in the post-election rally fits as the last hurrah of a long bull market and it's quite likely that the disappointment will settle in quickly and the November rally will turn to dust. But that's just my opinion and we'll let the charts speak for themselves, starting with a weekly view of the VIX.

Volatility index, VIX, Weekly chart

In the final week of December, when Santa was a no-show, the VIX had bounced up to resistance at its broken uptrend line from 2014. This trend line might not be that important, considering the number of breaks and recoveries in 2016, but at 14 it was also the location of the downtrend line from June 2016 and the reversal from these two trend lines looks bearish for VIX, which is of course bullish for the stock market. The risk for the stock market is that previous declines below 12, which is where the VIX closed today, has been followed shortly thereafter by a more significant pullback/decline. But if we are into the last hurrah for the stock market rally I see the potential for the VIX to drop down to its 2005-2007-2014 lows near 10. That would truly be a scary time to be long the market.

S&P 500, SPX, Weekly chart

At today's high SPX once again has tested the potentially important Gann Square of 9 2271-2273. As mentioned for the past few weeks, this area "vibrates" off the 2009 low, for both time and price, and is therefore an important level to see how the index behaves around it. From a weekly perspective, with a 5-wave move up from February, the rally can be considered complete at any time and now it's just a matter of looking at the short-term charts to see if they support further upside or a reversal at any time. If the rally continues into next week keep an eye on two price projections, which are based on the relationships between the waves in the rally from February, near 2285 and 2292. Slightly higher is the top of a rising wedge pattern for the rally from February, near 2300.

S&P 500, SPX, Daily chart

The daily chart shows how SPX has been stalled at the Gann 2271-2273 level since reaching it on December 13th. The highest closing price so far is the December 13th close at 2271.72. For the rally from November 4th, the 5th wave of the move would equal 62% of the 3rd wave at 2289, which lines up with the two projections on the weekly chart at 2285 and 2292. And then as mentioned above, if it can rally up to its trend line along the highs from April-July/August 2016 we could see 2300 next week. Any new highs, or a truncated high here, with a lower MACD high would be a signal to get ready to short it for at least a larger pullback but at the moment it's too early to be thinking short since we could see this rally continue into next week. Just don't be complacent about the upside.

Key Levels for SPX:
- bullish above 2278
- bearish below 2233

S&P 500, SPX, 60-min chart

Last Friday's decline was a drop below a parallel down-channel for the pullback from December 13th (bull flag) but that turned into a head-fake break (throw-under completion to the pullback correction). SPX is now challenging the top of the down-channel as well as the Gann 2271-2273 level. A break above 2273 would therefore be at least short-term bullish and if we get a 5-wave move up from last Friday, as depicted in green, we'd have a very good setup to get short for the coming reversal.

Dow Industrials, INDU, Daily chart

I don't have much in the way of upside targets for the Dow and think it's probably best to watch some of the other indexes to watch for a possible high. One upside target, assuming the rally will continue, is a trend line along the highs from August-December 2016, which will be near 20250 next week. Last Friday's decline was to the 20-dma, currently nearing 19850, and as long as that MA continues to support pullbacks I'd keep looking higher. But a close below its 20-dma would be a bearish sign.

Key Levels for DOW:
- bullish above 19,981
- bearish below 19,718

Nasdaq Composite index, COMPQ, Daily chart

In last week's update I pointed out some significant resistance for the Nasdaq where it's currently trading. But the pattern continues to support the need for one more leg up to complete the rally from November and in turn the one from February. A trend line along the highs from April-September 2016 (the top of a rising wedge for the rally from February) will be near 5615 by the end of next week and it's the upside potential from here.

But the bulls could run into trouble at lower prices -- the uptrend line along the highs from August-September 2016 is where the rally into the December 27th high stopped and that line will be near 5536 by the end of this week. While I show the key level for the bulls to break is 5513 (just above the December 27th high), I would carefully manage long positions with a tighter stop since failure of the rally could happen at any time. Between the trend line at 5536 and the higher one at 5615 (next week) is the top of a rising wedge for the rally from November, which will be near 5565 early next week. It's the middle target, at 5565, that I'm depicting on the chart.

Key Levels for COMPQ:
- bullish above 5513
- bearish below 5371

Nasdaq-100, NDX, Daily chart

While I'll continue to give the bulls the benefit of the doubt I do want to highlight a bearish setup on NDX. I show upside potential to the 5000 area (back to the top of a parallel up-channel for the rally from November) but first I want to see it can get above resistance just below 4950. This is where the trend line along the highs from July-October 2016 is located, as well as the broken short-term uptrend line from December 16th. The two lines crossed today near 4945, which is where today's rally stopped. The bounce off last Friday's low is only a 3-wave move and as such it could be just an a-b-c bounce correction to what is a new downtrend off the December 27th high. If long the tech indexes I think it's a good idea to tighten your stops.

Key Levels for NDX:
- bullish above 4950
- bearish below 4885

Russell-2000, RUT, Daily chart

Today's rally for the RUT had it breaking its downtrend line from December 9th, currently near 1374, and the setup continues to look good for a rally up to its trend line along the highs from 2007-2015, currently near 1405. This is the top of what appears to be a large megaphone pattern since 2014, which fits as a bearish topping pattern. The top of a parallel up-channel for the rally from February crosses this trend line along the highs next Tuesday at 1405. Above 1410 would be a bullish breakout and considering MACD is rolling up from the zero line we have to consider the bullish potential for that to happen. But if we see the 1405 area tested and hold as resistance it would produce a higher price high with a lower MACD high (bearish divergence) and that would be a good setup to trade the short side.

Key Levels for RUT:
- bullish above 1410
- bearish below 1355

20+ Year Treasury ETF, TLT, Weekly chart

Keeping an eye on the bigger picture for bonds, the TLT weekly chart shows the bounce off support at its uptrend line from 2011-2013 and is now approaching its steep downtrend line from September-November 2016, currently near 121.20 (today's high was 120.24, so another point higher). Its bounce has TLT back-testing its broken 200-week MA at 120.21. The pattern of the bounce supports the idea that we'll see another leg down for the selloff in bonds and perhaps we'd see a test of the June 2015 low at 114.88.

But with the weekly MACD turning up from oversold (and the daily MACD climbing above zero) it continues to be a good setup for at least a higher bounce for bonds. The longer-term pattern continues to support the idea that the long-term bull market is not over yet and now that the uptrend line from 2011 has been tested, and held, we're starting the next leg up in the bull market. Upside potential is to the top of its long-running rising wedge, which is the trend line along the highs from 2008-2012. That line will be near 146 around mid-year. That's not a prediction (yet) but it's the upside potential if you're short TLT (perhaps through an inverse bond ETF, such as TBT) and willing to hold on through the bounce.

KBW Bank index, BKX, Weekly chart

The banks continued to show relative strength yesterday and today and with yesterday's and today's higher highs it has continued to make new all-time highs by pushing above its December 8th high at 93.65. The consolidation off that high looks complete at last week's low and now we could see a rally up to a price projection at 97.07 and maybe up to just above 100 by next week. The 97.07 price projection is where the 5th wave of the rally from 2009 (the leg up from February) would equal the 1st wave but it's not a clean wave count for that projection so it's just a level of interest. The broken uptrend line from February-April 2016, which was broken in June, is where the rally into the December 13th high stopped and by the end of next week that line will be near 100, which makes for a good projection (nice round number at the century level as well).

Transportation Index, TRAN, Daily chart

While the Dow struggles to test its December highs (19985 on December 21st) the TRAN has barely been able to get a bounce started. It made a lower low for its pullback yesterday and while it did OK today (+1%) it's nowhere near its December 9th high. So at the moment we have small bearish divergence between the two and if the TRAN is unable to climb back above its November 2014 high at 9310, which would have it back above its two parallel up-channels, from January and June 2016, it's going to keep the TRAN more bearish than bullish.

U.S. Dollar contract, DX, Weekly chart

The US$ has been struggling with the 103 area, which I've been discussing the past few weeks. A 127% extension of its previous decline (March 2015 - May 2016) is at 103.27 and the 2nd leg of the rally from May 2016 is 162% of the 1st leg at 103.33. There have been multiple attempts over the past 13 trading days, including today, to get over this level but the highest close so far is 103.26 on December 20th, 103.23 on December 28th and 103.22 yesterday. It's either a bullish sideways choppy consolidation since December 15th or it's topping and we'll see at least a larger pullback and potentially something a little more bearish into April-May. But if the dollar can close above 103.33 I'd turn at least short-term bullish

Gold continuous contract, GC, Daily chart

With today's high at 1168.60 gold has back-tested the bottom of a parallel down-channel from last July's high. Oftentimes we'll see price bounce back up to the bottom of a broken down-channel (or pull back to the top of a broken up-channel) for a back-test and then resume the trend (down in this case). Slightly higher is price-level S/R near 1180 and gold stays bearish below that level.

Oil continuous contract, CL, Daily chart

Tuesday morning oil popped up in the pre-market session but then sold off sharply when the cash market opened. The day produced an outside down candle as it engulfed the previous week's price action, which has it looking like a bearish reversal. Yesterday's higher price high was met with a lower MACD high. One reason I say we could be looking at an important reversal back down is because the early-morning high achieved a price projection near 55 (with a high at 55.24) that I've mentioned the past few weeks. A 127% extension of its previous decline (June-August) is at 55.06 and two equal legs up from August is at 54.94. Both cross the top of a parallel up-channel for the rally from August this week. So the bearish reversal yesterday has the potential to mark an important top. That makes today's bounce a shorting opportunity with a stop just above yesterday's high.

Economic reports

Thursday morning will be a little busier for economic reports but probably not market moving. The ADP Employment Change report for December is expected to show a decline from November but nothing drastic. Other than the unemployment claims data we'll also get the ISM Services report, which is expected to be flat from November. Crude inventories, announced later in the morning could move crude prices and since it's looking like prices are set to drop we'll see if we got an increase in inventories that are more than expected. Friday is the big day with the NFP report but again, no big change is expected from November so it would take a significantly lower number to start lips babbling about the Fed not being able to raise rates any more, etc. We'll also get reports on Factory Orders (expecting a decline) and housing starts and permits (expecting flat to lower).


The S&P 500 index is up +1.4% for this week and that shows us Santa at least arrived for the conclusion to the Santa Claus rally period. Now we wait to see if the typical swoon following this period will hit the market with selling. The rallies the past two days have not been impressive because they were created largely during the overnight sessions and then not much, if anything, added during the regular trading hours. This gives it the appearance of distribution instead of accumulation.

The chart patterns support the potential for the rally to continue into next week. Using SPX as our proxy, if it can close above 2273 I see upside potential to 2285-2295 and maybe 2300. But it's important to recognize the fact that we should be into the final leg of the rally from November, which will complete the final leg of the rally from February. It's going to be an important high and that's what makes it very important not to get caught long by ignoring stops. It's too early to get short but we're in a position where we need to protect long positions rather than be aggressive on the long side. It's a good time for caution by both sides.

Assuming we'll get at least a larger pullback once the rally completes in the next week or so (if not already complete) we'll have time to evaluate the pullback to see if it's looking more like a correction to the rally or something more bearish. Future trades will then be planned based on that analysis. Both sides have time to evaluate the price action over the next couple of weeks before establishing a trade for a bigger move, which means risks should be kept small for now.

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

Keene H. Little, CMT

In the end everything works out and if it doesn't work out, it is not the end. Old Indian Saying

New Plays

Bears Baffled

by Jim Brown

Click here to email Jim Brown
Editor's Note

The markets rebounded to resistance completely baffling those who expected a sudden decline in January. The first two days of January are part of the Santa Rally period because of the end of year retirement fund inflows. The majority of that money has now been invested. We still need to wait another day or two to see if this is just a fund flow event or something that can continue. There is no compelling need to be long the market. There is always another buying opportunity in the future.

I went through my list of potential plays and there was nothing that simply had to be played today. There were two kinds of charts. Some small caps had 5% to 10% spikes over the last two days and took themselves out of contention for a new play in an overextended market. The second type was the S&P-500 clone. Like the chart below they had rallied back to resistance but then stalled.

I know it is boring not to have any new plays but we need to be patient. When the market does not move in the expected direction, a lot of people begin to get nervous and I am sure we are seeing some short covering from those impatient shorts. I am not going to recommend anything for Thursday because 2017 is only 2-days old. There is no "must trade by date" and we need to be patient.


No New Bullish Plays


No New Bearish Plays

In Play Updates and Reviews

Major Change

by Jim Brown

Click here to email Jim Brown

Editors Note:

The Russell 2000 exploded higher by 31 points to close right at the prior resistance high. If the Russell blows through the 1,390 level the bearish case for an imminent decline in January will evaporate. The Russell is the market sentiment indicator and today's rebound was very bullish. It still has to punch through to a new high.

The Dow failed to penetrate the prior resistance at 19950-19975 and was the percentage laggard at only +0.3% compared to the +2.3% gain on the Russell. If the market continues higher on Thursday there will be a lot of short covering.

Current Portfolio

Stop Loss Updates

Check the graphic below for any new stop losses in bright yellow. We need to always be prepared for an unexpected decline.

Profit Targets

Check the graphic below for any profit stops in green. We need to always be prepared for a profit exit at resistance.

Current Position Changes

VXX - VIX Futures ETF
The short position remains unopened until a trade at $29.50.

If you are looking for a different type of trading strategy, try these newsletters:

Short term Calls and Puts on equities = Option Investor Newsletter

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BULLISH Play Updates

No Current Bullish Plays

BEARISH Play Updates

AKS - AK Steel - Company Profile


No specific news. Strong rebound with the market but dead stop at resistance.

Original Trade Description: December 17th.

AK Steel Holding Corporation, through its subsidiary, AK Steel Corporation, produces flat-rolled carbon, stainless and electrical steel, and tubular products in the United States and internationally. It produces flat-rolled value-added carbon steels, including coated, cold-rolled, and hot-rolled carbon steel products; and specialty stainless and electrical steels in sheet and strip forms. The company also produces carbon and stainless steel that is finished into welded steel tubing, which is used in the automotive, large truck, industrial, and construction markets; buys and sells steel and steel products, and other materials; and produces metallurgical coal from reserves in Pennsylvania. It sells its flat-rolled carbon steel products primarily to automotive manufacturers and to customers in the infrastructure and manufacturing markets, including electrical transmission, heating, ventilation and air conditioning equipment, and appliances; and coated, cold-rolled, and hot-rolled carbon steel products to distributors, service centers, and converters. The company sells its stainless steel products to manufacturers and their suppliers in the automotive industry; manufacturers of food handling, chemical processing, pollution control, and medical and health equipment; and distributors and service centers. It also sells electrical steel products to manufacturers of power transmission and distribution transformers, as well as for use in the manufacture of electrical motors and generators. Company description from FinViz.com.

The steel sector rallied on expectations for Trump to place additional tariffs on imported steel and make American steel more competitive. While I am all for fair trade changes, that is likely to take many months if not a year or more to implement any changes what will help the U.S. steel companies. It will be months or quarters after that before the changes actually begin to show up in the earnings of these companies.

Earnings January 24th.

AKS rallied from $4.93 before the election to $11.39 for a +131% gain. Shares faded somewhat last week but still closed at $10.38 on Friday. When the post election balloon bursts, this stock could decline significantly. I would expect that to happen in the first week in January. I definitely do not expect the stock to be making higher highs.

Position 12/19/16:

Short AKS shares @ $10.17. See portfolio graphic for stop loss.


Long Jan $10 put @ .69 cents. No initial stop loss.

IWM - Russell 2000 ETF - ETF Profile


Monster rebound on the Russell with a +31 point gain but it did stop just below the resistance highs. It is either poised for a breakout or another resistance failure.

Original Trade Description: December 10th

The IWM ETF seeks to track the investment results of the Russell 2000 Small cap Index.

The Russell is up +232 points or 20.1% in the last 22 trading days. It is grossly over extended and many small cap Russell stocks are up 30% to 40%. I understand the bullish sentiment that believes the economy will be better in 2017 but it will not be because of President Trump. His proposals will take months to get through the House and Senate and there is likely to be some major battles. Obamacare will not go away until 2018 or longer because it takes a long time to plan and execute a change that big. Lower taxes will not happen until 2018 because it will take months for both houses to vote on an acceptable tax bill. I seriously doubt they will change rates in the middle of the year. Any change will not occur until 2018.

I could go on but you get the picture. Typically, there is a honeymoon phase after a new president is elected. This phase has run its course. There are 14 trading days left in 2016 and any new highs are likely to be made before Christmas. After Christmas, investors may begin to worry and once into January and a new tax year, the selling could be dramatic. Do you remember January 2016? The market was not nearly as overextended as it is today and the Dow fell -2,150 points in just two weeks. Entering into a new tax year allows traders to capture profits and invest that money for another year before paying taxes.

Dow - January 2016

We also have the potential for a really messy inauguration or even a terrorist attack at the event. That potential will give cautious investors another reason to take profits in January.

I am recommending a long put on the Russell ETF. There is no stock vehicle we can use other than the VXX to capitalize on a market sell off. The VXX is flawed and while it may go up, it may not go up enough to make it worthwhile and it is volatile from day to day. I chose the Russell ETF because the premiums are cheap and the volatility should work in our favor. If you cannot use options then I suggest you buy the VXX shares at the first sign of market weakness after Christmas.

There is also another trigger factor to consider. The Dow is approaching 20,000 and that could be a massive sell the news event given the big gains. Since the Dow could hit that level this week I am recommending we initiate our long put position in advance.

Because the market could still rise, I want to follow the IWM higher and enter the position only when the ETF rolls over.

The ETF has short-term support at 137.75 and again at $137.25. I am recommending we enter the position with a dip to $137. If the Russell continues higher, I will continue raising the entry point as needed.

Position 12/12/16 with an IWM trade at $137.00

Long Feb $134 put @ $3.38, see portfolio graphic for stop loss.

VXX - Volatility Index Futures - ETF Description


Another big drop in a bullish market but it can reverse just as quickly if the sellers appear. No harm, no foul because we are not yet in the position. This should be just a temporary event. Be patient.

Original Trade Description: December 28th

The VXX is a short-term volatility product based on the VIX futures. As a futures product it has the rollover curse. Every time they roll to a new futures contract, they have to pay a premium and that lowers the price of the ETF. It is a flawed product with a perpetual decline built in from the monthly roll over in the futures contracts.

As evidence of this flaw, they have now done four 1:4 reverse stock splits. The last four reverse splits occurred at $13.11 (11/2010), $8.77 (10/2012), $12.84 (11/2013), $9.52 (8/8/16). The prospectus says it can reverse split anytime it trades under $25 for a prolonged period and the splits will always be 1:4.

After the August split the ETF moved sideways for four weeks at $36. I think everyone was waiting for the typical August volatility. When it did not show up and the market rallied on Friday that support broke. And the decline began.

We exited the last short at $26.65 for a $7 gain back on December 13th. I am expecting the January volatility to lift the VXX back to $30. That will give us a great entry for the expected market rally in Feb/Jan where the VXX will crash again.

Unfortunately, put options are expensive with a volatility instrument at this price level. The only recommendation is to short the ETF and forget it. This will be a long-term position. This is not a 2-3 week play. I can guarantee you, if history holds, we can play this until it splits 1:4 again at $10. We may have to rotate in and out a couple times but it will eventually go to $10. Once we are in the position and profitable I will put a trailing stop loss on it. If the stop is hit we will take profits and then look for a bounce to get back in. We could keep this play in the portfolio on a trading basis permanently.

I am putting an entry trigger on the position at $29.50, a level we saw on December 1st. I would expect this to be hit in early January. The VXX could rise well over $30 if the market really corrects so I am not putting a stop loss on the position until the correction is over.

With a VXX trade at $29.50

Short VXX shares, currently $24.62, no initial stop loss.

No options recommended because of price.

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