The Volatility Trader
105 W. Monument Street
Baltimore, MD 21201
Friday, September 15, 2006
Email – #181
Dear Volatility Trader Member,
We’re ending the week with a bang. This alert contains three main sections:
1. Trade action to take for this morning
2. Current position update
3. Market update
i. Today’s CPI numbers and what they mean to the market
ii.Treasury yields are declining
iii. The long-term Dow chart is bullish
iv. In the Short-Term, the Dow Could Pull Back
So let’s get right to it…
E-Trade and TXU Corp On The Trading Block
The following trades are specifically designed to capitalize on current market momentum. With the banks and brokerages staging a breakout that will likely propel the market higher, the trend is looking up. So our first investment is in E-Trade (NYSE: ET).
You have two options. First, on the long side:
1. Buy E*Trade October 2006 $25 Calls (ETAE.X) at no more than $1.50. If the stock closes below $21.75, exit the position immediately.
2. Buy the underlying stock long at current levels. If the stock closes below $21.75, exit the trade immediately.
Now for the short trading side:
We’re going to buy put options on TXU Corp (NYSE: TXU) in order to capitalize on energy sector weakness. The Energy Select SPDR (AMEX: XLE) has completely lost momentum, and looks as if it could dump even further. Some of the stocks in the sector have yet to decline… but they will.
Here’s what to do
1. Buy TXU Corp January 2007 $55 Puts (TXFUK.X) at no more than $1.40. If the stock closes above $67.50, exit immediately.
2. Short the underlying stock at current levels. If the stock closes above $67.50, exit immediately.
Update On Current Volatility Trader Positions
Chaparral Steel Company (Nasdaq: CHAP): Continue to hold your put options. The stock showed poor relative strength yesterday, and could begin a massive drop within the next few sessions. The company reports earnings on September 20, so I’ll update you the day prior to the release.
Dow Diamonds (AMEX: DIA): If you’re still in this position, hold until further notice. If momentum continues on the upside, these positions could quickly be stopped out. THIS POSITION IS A HEDGE, should the market fall. However, if the Dow shows significant strength, and moves above 11,540 – AFTER THE FIRST 30 MINUTES OF TRADING – close this position immediately.
Market Update
Over the past week, the major indices have displayed incredible strength, something that is hard to stomach when you’re not in bullish positions. However, there are a few components missing to this rally, which need to line up, before we can feel completely comfortable from the stance of bulls.
Unless something catastrophic happens, most of the data is pointing to a big rally in 2007. But right now, we’re going to trade on momentum, not hype. Thus, we will not take a long position in any of the indexes yet, but will stick to individual “sector correlation” stock plays.
What Today’s CPI Numbers Mean For The Market
Overall, today’s numbers are very bullish for the market. The seasonally adjusted CPI accelerated 0.2%, with the decline in energy prices proving to keep inflation in check. The core index climbed 0.2%, which should also keep inflation hawks at bay. This report shows steady growth with tame inflation.
The question of the day will be whether the market buys the CPI, or if this becomes a case of “buy the rumor, sell the news.” However, the data indicates that there will NOT be another rate hike in the next meeting, something the market should react to favorably.
Traders look for guidance can watch market momentum for the first 30 minutes. Futures are trading up, which could be a “gap and trap” scenario, meaning that the indexes open up, and sell of the remainder of the day. This would occur, if traders decide to take profits after bullish trading this week. You get around this “trap” by waiting for the first 30 minutes of trading to pass by. If the Dow continues to climb after the first 30 minutes, the momentum is for real, and the index will likely continue to move higher throughout the day.
Treasury Yields Are Declining
Interest rates are a key component to any rally, and right now, the 10-Year Treasury Bond Yield (TYX) is sitting at 4.747… and has been trending lower over the past month and a half. The yield curve remains inverted, which over the last 50-years has always indicated trouble for the economy.
The 3-Month T-Bill Discount Rate is at 48.10, and has been in a free-fall for 9 of the last 11 sessions. A decline here promotes a market rally. But while the 3-Month could bounce, the overall trend is down, and I expect it to fall into the 4.7 area, within the next 30 days. We are only now beginning to see the first cracks in the Discount Rate.
The key here is that while there is trepidation in the current economy, it will eventually recover. The 3-Month has topped out, and it should begin to decline from here. At the same time, the 10-Year should show more relative strength, thus creating an upward sloping yield curve! This would be bullish for stocks… but we’re not there yet.
Long-Term Dow Chart is Bullish
Looking at a monthly chart of the Dow Jones Industrial Average, it’s setting up for a break above 12,000. But the current uptrend has taken place on lower volume. A pullback is in the cards, letting sectors like retail and banks cool off first.
The chart below shows that the Dow isn’t “overbought,” but is trading off its 50- and 200-month moving averages. Though the index will travel higher, the market internals must catch up first.
In the Short-Term, Be Careful of a Pullback
While the long-term fundamentals point to a larger Dow rally, the short-term picture indicates a pullback. Retail and financials have begun a run upwards, and could slow a little in the coming weeks. (In the case of today’s E*Trade position, the risk to reward is in our favor, even if the market does pull back).
You do not have to understand how P&F charts work to see what I’m talking about in the chart below. All you need to recognize is that the Dow has staged a major run from the 11,250 area, without stopping for air. Even bulls have to catch their breath once in a while.
Ideally, I would like to see the Dow decline to the 11,250 area before going “market” long. Buying right now would be an instance of the “Greatest Fool Theory,” which means that to buy here, you’re expecting some fool to buy at a higher level. We don’t want to be the greatest fools. We will let the market come to us, not move to it. Instead of buying the Diamonds (AMEX: DIA), we are instead taking on E*Trade, which is not pushing highs yet, while shorting energy, which is falling out of bed.
Oil And Commodities Still Declining
With oil prices currently around $63.12, we could easily see a fall to $60. Obviously, a further decline would be bullish for stocks.
Gold has fallen to $574 an ounce, and will likely decline into $550. The decline in gold is not over yet.
The U.S. dollar index (NYBOT: DX) is rallying, and will most likely try to break above 86 cents. Though it will have trouble moving above 87 cents, the move above 86 cents will be bullish for stocks in the near-term.
Exit is everything,
Mark Whistler
