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Some Trades

January 6, 2007
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I know I said I’d do a look at some of the sector indexes, but with an erratic and short first week of 2007 behind us, I’d rather wait until we have another full week under our belt to get a more settled look at what’s doing in the market. In the meantime, the first three days of trading in 2007 were quite jumpy and on considerably higher volume than the holiday period. We talked about the relative weakness in the Nasdaq and particularly the Nasdaq 100. Yet those indexes actually gained on the week, the NDX(Nasdaq 100) getting back above the broken support line….

…while the SPX and Dow both were down. What is most striking to me is that the SPX closed right at the horizontal and diagonal support lines that I’ve had drawn on my chart since the prior week. It’s just weird when that happens. If this 1410 area is broken, this will be bad news for the short term. We already have lower highs and lower lows on an intraday basis, but on a closing basis, this would be a clear lower low. After 1410, I would see the 1380 area as very important support for the intermediate time frame.
(click for bigger picture)

All this is to say that the markets are still giving us pretty mixed signals and though we may be on the verge of something significant, we haven’t broken yet. A crucial thing to watch will be the VIX index. “When the Vix is low and starts to turn up, it’s time to go.” The weekly action on the VIX shows a doji star with a fairly wide range but small body. It closed up somewhat for the week, but still hasn’t broken above the very significant level just under 13. If that is broken while the SPX breaks 1410, I would see this as a blatant signal to turn bearish, at least in the short term.

This article is an interesting look at the sell-off in commodities as a signal for economic slow down. The basics of it make sense and its nice when big talk on the economy makes sense to the average civilian like me. Also, it’s worth mentioning that the Wall Street Journal pointed out this morning that we haven’t seen healthy correction (10% pull back in a bull market to keep it from overheating) in the Dow or SPX in several years.

One member mentioned at the meeting that we spent a little too much time on the market posture rather than looking at individual stocks. It’s a reasonable comment. Of course, what matters most is what is going on with the individual stocks that we have our money in or want to put our money in. But it is crucial to always stay in tune with the broad market indexes because when they are at potential turning points, if they do turn, each individual stock will drastically change its tune even if it has been performing very well. Strong stocks on the verge of breakouts and further advance will, at the very least, wait longer to make their move. At worst, they’ll see profit taking as people want to reduce their risk. I try to think of the market as a bunch of people standing in a room watching what each other is doing. When the selling gets going, most people will join in and follow the crowd. Look at the run up and sell off in GROW. I think it’s fair to say that this was all the momentum of people piling on to the buy side of a super hot stock and then all bailing out as the momentum swung back to correct the move.

Here are a few trades I’ve done recently on our list.

COH December bull call spread. Purchased on October 30 for 3.80 with the stock at 40.08.
This chart from that day shows my analysis and entrance was made on the most current daily candle of this chart. The mention of short sellers is because I’d seen that short interest had decreased over those months.
(Click image to see it bigger)

I rarely do a debit spread but am realizing their appeal more and more. Credit spreads, of course, have great appeal, but they serve different situations. I did this one because a credit spread only makes sense to me if there is a support level between the short strike and the price at the time. In this case, I did the bull call spread because I saw a potential pull back to one of two support levels between 35 and 40. If it would pull back enough to make it worthwhile, I planned on buying back the 40 call for a profit and then hold the 35 call for the expected bounce back up. That’s also why I bought the December spread, to give myself a bit more time in the long call if I went that route. It ended up not pulling back very much and I never bought back the 40. Of course, when the stock started moving, I wished I wasn’t in a capped profit position, but I was happy to just let time decay for the position as long as it stayed above 40.

On 12/4, I sold the position for 4.85 because I realized that even the max profit on the 1 contract spread would not justify the commissions for exercising the options. It was more profitable to take slightly less than the max potential profit and pay only the small commission for closing the position. I could have waited a couple weeks longer and maybe gotten .05 more, but I was happy to just close it and move on. (Think about it. What market maker is going to by a $5 spread from me for $4.95 for a profit potential of .05?) In the end, I made $.99 or a 26% return on $3.80 investment including commissions on a stock that didn’t have to do anything but go sideways or up from where I initiated the position.

I mentioned in this post a BHI bull put spread I placed. I’ll follow up on this one in coming days, since I reversed it and went through the whole dicey process of trying save a bad trade. This will take a whole post in itself, so I’ll leave it out for now.

On the second post of this blog, I did a detailed analysis of ZMH and proposed a trade on it. Two days later, I opened a paper trade.
On 12/7 in the 11 o’clock hour at 75.03, I bought a Jan 70/75 bull call spread with a fill at $3.58. Again, I did a bull call instead of a bull put credit spread because I saw the possibility of a slight pullback and prefer credit spreads when
there is clear support between the price and the short strike. But with my analysis of the stock and the healthy trend, I was comfortable to get in, let time(theta) decay, and trust that it would close above 75 at Jan expiration. A break of the uptrend support line would have been a good place to exit for a minimal loss. I say minimal because as the 70 call would lose value, so would the 75 call, offsetting each other to a good degree. But let’s say the trend line was broken and we got out of the position with the stock at 73. The position as a whole would still have had $3 intrinsic value and time value on top of that. So I think it would be a minimal loss, definitely no more than .58.

I sold the spread on January 3 when the market was selling like crazy and this stock showed a severe looking bearish engulfing pattern. Even at the time, I realized that it had not yet broken the uptrend support line, but I didn’t like the smell of the market and didn’t want to risk giving up any more profits than I had to. I was happy to close it for a decent gain. 23% return on investment not including commissions.

Last month I mentioned a potential bull put spread on ISE in this post with accompanying chart on a bounce off the trend support line. I paper traded this Jan 45/50 bull put spread entering the next day, 12/18 at noon for a credit of $1.65 with the stock at 49.78. This is a bit unusual for me, since the short strike was in the money, but with the trend line so close I knew it’d be either up above 50 or would break the support line in a very short order. Therefore this issue should be resolved fairly quickly. I failed to see the high volume selloff before the bounce as a warning signal. Or maybe I did and that’s why I only paper traded it. I’m generally less on top of my paper trades than real trades and didn’t close this for a couple days after the support was broken. In any case, with a debit of 2.85 to close, the loss was $1.20. The positions was sized for the max loss potential of $3.35, so this was well below my maximum acceptable loss.

One of the difficult realities of spread trading is that they have a much higher probability of success, but a much lower profit potential. So one must understand and strike a balance between these two aspects in order to be profitable in the end of a number of spread trades.

For those of you still new to the market and trading, I strongly recommend sticking to getting a strong grasp of basic fundamental and technical analysis of stocks and learning how to plan and manage simple directional stock trades first. If you don’t know what you’re doing with basic stock analysis, you definitely won’t have a clue how to deal with the stock’s movement affecting a more complicated spread trade.

Another paper trade still in progress is a regular stock purchase on VPRT, a stock I’ve mentioned at a meeting or two. Bought on 12/11 a 32.52, I was anticipating the formation of a handle to complete a cup and handle pattern before the stock powers through the official buy point above the highest point on the right side of the up. That is where there would be no more “overhead supply” or sellers. So let me be clear that this was not yet an official buy according to the O’neil teaching on cup and handles. But if it does clear the buy point, the target would be roughly 47.50, using the depth of the cup as a target distance from the buy point.

But aside from the potential cup and handle pattern, it was in an intermediate term uptrend and bounced off of old resistance, confirming new support. My stop was set just below the round number of 30 at 29.95 and the position was sized for that distance. The support was breached, but not in a convincing way to me with volume decreasing on the selloff and I thought the intermediate trend line, the potential pattern, and the well received earnings report in October deserved the benefit of the doubt. Notice the big volume selling day on the 15th has a good sized lower shadow indicating buying pressure as a significant part of that volume.

As of right now, the intermediate trend is still in tact and I will get out on a convincing break of the uptrending support line, particularly if the broader market continues to look weaker. It is worth noting that it is perhaps expensive here with a PEG of around 2.

That’s all for now. I’ll try to get that BHI trade a maybe a few others up in the near future. I the meantime, please leave any questions or thoughts about what I’ve written here in the comments section just below. Hope you’re enjoying the beautiful day today.

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