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Issue No. 63 – January 23, 2006 Prescott, Arizona Systems@WiserTrader.com
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(Delayed issue containing some additional watchlist entries)
1.0 Trading
The first month of earnings season has been down for six out of the last eight quarters.
1.1 Retracement
The breakout of the S&P 500 from the rising wedge formation was premature, as seen in Figure 1. If the rising wedge pattern continues, we will face another critical point in April when the S&P 500 reaches support at around 1,225. The S&P has declined the first month of the new quarter for six out of the last eight quarters, as illustrated by the rectangles.
FIGURE 1
© 2005 Desert Mountain Systems, LLC. Members of wisertrader.com are neither licensed brokers nor licensed advisors. Trades discussed represent recommendations made by the editor for the wisertrader.com portfolio. The newsletter and web site are for information only and should not be considered as personal advice. While it is believed that the posted information is factual, mistakes can be made in transcription. Investors should trade stocks only after verifying all information and consulting with a licensed broker or adviser. Desert Mountain Systems markets third party trading systems but has no other affiliation with trading system companies.
1.2 Options
Options are highly volatile, making it possible to gain or lose money very quickly. While they are not for everyone, they have distinct advantages when continuously monitored. As most of you know, an options contract grants the right to buy (call option) or sell (put option) 100 shares of an underlying stock at a specified strike price by a specified expiration date. Option contracts are traded just like stocks for a price known as the premium. An option’s fair value is based on the underlying stock price, the stock’s volatility, the time to expiration, the risk free interest rate and the difference between the stock price and the strike price. The value of an options contract falls to zero after expiration. This brief discussion is not meant as a tutorial. Key words are italicized for later lookup.
Many comparisons between trading stocks versus options can be made. A trader needs to consider how much profit will make a trade worth the investment. If the target profit is, say 25%, he has to ask how long it will likely take. On average, it took about 9 months for the S&P 500 to increase 25% during the bull market run up from 1996 to 2000. A trade involving 100 shares of a $60 growth stock would tie up $6,000 in capital.
Compared to trading stocks, options have a lower entry cost with a shorter holding time. For an underlying stock priced around $60, the average at the money option premium is $6.00. This makes the average 100-share contract cost $600, a factor of 10 lower than the cost of buying 100 shares of the actual stock.
For a given percentage price move in the underlying stock, the percentage change in an option’s price is 5 to 10 times greater. This means the stock needs to move only 2½ to 5% to provide a 25% profit on the contract.
The 9-month trading period for the S&P 500 would have been shortened proportionately. One can be in and out of several profitable options trades in the time it takes an underlying stock to move 25%.
Moreover, it is much easier to predict a 2½ to 5% price move over a short period than it is to predict a 25% price move over a longer period. It is true that some penny stocks offer similar returns as options. Like penny stocks, options need to be carefully watched. However, given the choice between trading a penny stock versus an option on a proven $60 stock, with prospects for the same percentage return, it is not too difficult a decision to make. A small price move in a high quality stock is easier to predict than a large price move in a penny stock.
It is strongly recommended that when doing any kind of trading, options or otherwise, that an established trading system be used with a working knowledge of chart analysis. As long as this is followed, the trading of simple put and call options requires little more effort than trading stocks. After one has established a 70% or so success rate in predicting the direction of price movement, it would pay to consider trading options.
2.0 Market Analysis
Choppiness for the first three weeks of earnings season is an understatement. Expectations are for earnings to be up about 14% over the previous year but with lowered projected earnings for 2006. With 20% of companies reporting so far, only half met or exceeded expectations, compared to the normal 75%. It is still early. Precious metals and energy are still expected to be near term leaders due to geopolitical concerns and colder weather. Conditions imply a continued flat to downward bias for the broader market, as seen for the past week.
Key industry ETF’s in Table 2A are Biotech and Semiconductors, which confirm the NASDAQ. Transportation confirms the Dow Jones Industrial Average according to Dow Theory. Banking and Financials are confirming indicators for the S&P 500. Gold and Real Estate are respective indicators for the inverse health of the currency (inflation) and the capacity for consumer spending.
Table 2A
Indices, Key Industry ETF’s and Sector SPDR’s
|
|
1 month |
1 wk ago |
2 wks ago |
3 wks ago |
4 wks ago |
|
Dow Jones Industrial Index |
-2.0% |
-2.7% |
0.0% |
2.3% |
-1.5% |
|
NASDAQ Composite Index |
-0.1% |
-3.0% |
0.5% |
4.5% |
-2.0% |
|
NYSE Composite Index |
-0.6% |
-2.0% |
0.2% |
3.0% |
-1.6% |
|
S & P 500 Index |
0.8% |
-1.5% |
-0.1% |
3.6% |
-1.1% |
|
Russell 2000 Index |
2.6% |
-0.5% |
1.3% |
3.9% |
-1.9% |
|
GLD, GOLD |
10.1% |
-0.4% |
3.2% |
4.1% |
2.9% |
|
RKH, Banking |
-4.3% |
-3.5% |
-0.7% |
2.2% |
-2.3% |
|
IYT, Transportation |
-3.2% |
0.0% |
-1.7% |
0.2% |
-1.7% |
|
SMH, Semiconductors |
-1.1% |
-5.2% |
-0.5% |
8.2% |
-3.1% |
|
BBH, Biotechnology |
-4.4% |
-1.6% |
-1.4% |
0.5% |
-2.0% |
|
IYR, Real Estate |
2.5% |
-0.3% |
-0.1% |
4.8% |
-1.8% |
|
OIH, Oil |
14.8% |
6.6% |
1.7% |
8.7% |
-2.5% |
|
XLE, Energy |
10.1% |
3.6% |
1.9% |
6.3% |
-1.8% |
|
XLU, Utilities |
2.7% |
1.6% |
0.1% |
2.5% |
-1.4% |
|
XLB, Materials |
-1.3% |
-1.5% |
-2.6% |
3.7% |
-0.8% |
|
XLI, Industrial |
-2.8% |
-2.1% |
-0.5% |
1.1% |
-1.3% |
|
XLK, Technology |
-0.6% |
-3.9% |
0.6% |
5.3% |
-2.3% |
|
XLV, Healthcare |
-1.0% |
-1.5% |
-0.3% |
2.6% |
-1.8% |
|
XLF, Financials |
-2.7% |
-3.7% |
0.2% |
2.5% |
-1.6% |
|
XLP, Consumer Staples |
-2.1% |
-1.3% |
-0.1% |
0.9% |
-1.6% |
|
XLY, Consumer Discretionary |
-0.4% |
-1.8% |
0.7% |
2.1% |
-1.3% |
