A reasonable percentage of my posts are about the market, partly because I enjoy it and partly because that is what seems to be consuming everyone these days. I noted in recent newsletter articles that the stock market agains appears to have found the bottom trendline of the channel it’s been in since October 2007. On a weekly chart, the Dow Jones Industrial Average (INDU) indeed seems to have bounced off the channel bottom. It now must test the 200-week simple moving average (SMA), which is at about 11,712:

Note first of all that the upper channel line is almost the same as the (now declining) 50-week SMA. If the market rises that far, it will be simultaneously testing that average and the upper trendline. The prospect of a breakthrough there is not great, as I have discussed. The gray circle on the upper trendline indicates a possible point of intersection for that test. But will the market even advance that far?

The INDU nudged the 200-week average not so long ago and has pulled back. I nevertheless expect a full-on test of the 200 soon, in large part because so many expect it to occur and because a convincing failure there has not yet occurred. If the INDU breaks above the 200, a further advance to test the 50-week average may reasonably be supposed.

The market may, however, pull back to again test the lower trendline, as it did in March, which is noted on the chart above by the green circle. Another leap at the upper trendline is therefore quite likely.

To date, the INDU’s intraday low of 10,827 this year represents nearly a 24% selloff from the intraday high of 14,198. Put differently, the Dow has in less than a year lost nearly a fourth off its all-time high level in October 2007.

A fair question, one on many minds: if the current market is a correction to a major uptrend, when will this correction be over? No one knows, and the technical factors - while helpful - ain’t the whole story. There’s inflation, the economy, and other factors discussed at length by me and many other commentators. I think more selloff is necessary would be necessary to convince everyone that the correction has bottomed - a clear point of capitulation needs to occur.

But truly resuming a new uptrend will require a healthier economy and stronger corporate earnings. Will they be there? If so, the question of whither the market answers itself.

I am bearish now, as most of you know, but the market will in coming months - say by the end of October - make clear whether it is merely correcting a major uptrend still in place or if more bear is to come. I think a resumption of the bull this year or early next year is quite likely, especially given the election. We’ll soon know.

Quick Historical Note:

1. The correction of 2000-02 retraced approximately 38.2%, then later hit 50%, of the rise from 1990. Both are Fibonacci retracement theory numbers. In fact, the Dow declined to previous market top (support) levels from 1998.

2. The current correction already has hit 38.2% of the rise from the bull market’s 2003 beginnings. In fact, the first week of July 2008 saw a fall to 10,827, which is a 50% retracement. The current correction has already hit 2005 support (the INDU’s 2005 top) and has almost hit the 10,752 top from early 2,000.

3. Also on a positive note, the 200-week SMA has not yet turned downward. That downturn will be negative news. should it occur.

Feel better now? I know one thing: the more bearish more people become, the better I feel.

For call writers, of course, all of this is merely an attempt to answer the question of when is best to write covered calls. Right now is good, since the market has hit a (probably) temporary bottom and is gathering for a spring at the upper trendline.

Important Note: If we get another pullback testing the lower trendline, as in March 2008, don’t panic. It is not unlikely. Today’s pullback may indicate a retest of the lower trendline or may just be noise. And don’t forget: we’re in the doldrums time of year, and a lot of traders are on vacation now or not working their hardest.

This post is a little longer than usual, but worth it for me to think things through, and - I hope - worth the read for you. Mark Hulberg, whose newsletter tracks the results of investing newsletters, recently noted that Richard Russell has now turned long-term bearish on the stock market. Russell - no spring chicken - is the editor of Dow Theory Letters, a newsletter distributed since 1958 and is the dean of stock market newsletter publishers. Hulberg interprets Russell’s analysis to be that the market’s long-term trendline has been violated and that the market is headed down until further notice.

While Mr. Russell (who is 84) is a formidable technical analyst, I tend to think this bear market is a correction to the stock market’s long-term uptrend. Let’s take a look at the Dow Jones Industrials (INDU) going back to 1994. We see a long-term uptrend that began in the late 1980s, sharply accelerating from late 1994 to the end of 1999. The bear market of 2000-2002 is clearly delineated and we can see a test of the 100-month moving average at the 2002 correction bottom; then the major uptrend resumes through October 2007.

The current market appears to be another major correction to the long-term uptrend. If so, we can reasonably expect the market to continue its oscillations within channels down to the long-term trendline, which also happens to be the 100-month moving average - right where the red circle is drawn.

Of course, when the market tested that average in 2002, the trend line could not have been drawn where it is now; since it is drawn across bottoms, the bottom must clearly have occurred in order to draw it. However, the test of the 100-month average did occur and the market passed the test.

Will the market find support again at the 100-month level (also roughly the trendline) at about the 10,500 level? The odds are good that it will, because at that point all the players except perhaps the public are ready for a reversal and help make it come about. In this view, we are not in a secular bear market, strictly speaking, but a major correction to the major trend. Ditto for the 2000-2002 bear market.

Points to ponder:

1) The market is testing the 50-month average now. While it could find support there and stage a major recovery, it seems unlikely, given the state of the economy, inflation, etc. As I recently noted in a newsletter issue, the market is at the bottom of a declining channel on a weekly chart and likely will rise to the upper channel line, a normal and expected (by me, at any rate) oscillation. Then it will almost certainly resume plumbing for the major trendline down about 10,500.

2) The 100-month average is going negative (curling over and pointing down). If the 50-month follows suit, expect a test of the 200-month.

3) If the market fails at the 100-month average, the next major INDU support level is at about 7,750, the 2002 correction bottom. That would be about a 45% selloff from the highest close at 14,164. By this I don’t mean a 45% retracement; it would mean a loss of nearly half the Dow’s value. That seems a little extreme. Possible, but not so likely.

The Retracement Perspective:

Retracement theory posits that a market, after a rise with no major correction, will correct - retrace - much of the move up. Many, including myself, rely on the Fibonacci sequence. In the early 2000s bear market, the market retraced almost a perfect 50%, as shown in the next chart.

A 50% retracement in the current bear movement (10,889) would take us almost to the 100-month average and the trendline. But heck, we almost hit that on July 15th. A trip down to the 7,750-level on the INDU would be a 100% retracement (they happen). The chart below demonstrates the Fibonacci levels for both the 1999 and 2007 peaks (the green line is the 100-month average again):

Note how much sharper the selloff has been this time than in the 2000-02 correction. The contrast is a bit unsettling. I think this market is ginning up a greater than 50% correction, since we almost touched that in July. At the very least, it will test the 100-month average. While anything could happen, there is no reason to think the correction is done. There simply is nothing to break the downtrend’s progress.

I’m in Palm Coast, Florida, for the week, though we have broadband and can get phone messages.

The question on everyone’s mind: whither the market? Let’s see, the dollar’s tanking, the subprime mortage mess hasn’t even warmed up, the housing market is in trouble and it’s getting worse, the economy is cooling (that’s why the Fed cut the rate), etc., etc. None of these things fuel a bull market. I have been saying for some time, as have many others, that this bull market (now nearly 5 years old) will end when corporate earnings deteriorate, since earnings - driven by a good economy - is what starts a bull market to begin with. After all, why would anyone pay market-top prices arrived at during a strong economy once the economy cools and earnings ain’t what they used to be? Exactly! Actually, the market will tank ahead of the real earnings slide as the economy begins to cool in earnest.

But we don’t really want bull markets to end, thus they are tenacious. Does the chart tell us anything? Following is a daily chart of the DJIA. Note that in July the market went from an uptrend into a range as it corrected, the range being marked by horizontal lines - the range is actually kind of classic. But a range is often a congestion pattern, which could indicate an uptrend ahead. Have a look:

TREND
The red trend line could well indicate that the medium-term trend is continuing. Notice how it was thoroughly tested, twice in August, once in September, making higher lows. In this analysis, the market has pulled back again to test the trend line in late September and last week, the low of last week’s test being a tad higher than October’s test low - important because successive tests of an uptrend line should be higher. The Dow pulled back to the 200-MA in August, but except for that, the 200-MA has been out of the action, so it is not very reactive with the Dow.

TRIANGLE?
Note also how the trend line and the top range line indicate that an ascending triangle could be forming, which is generally a bullish sign. The Dow peeking above the range line does not necessarily invalidate the triangle, though it certainly is not a “perfect” ascending triangle. But, the Dow has made consistently higher lows, a hallmark of the AT. Note also how volume fell off as the high was reached in October, also a good sign for the AT.

NOW WHAT?
If the AT is valid, the market needs to break through the upper range line to new highs and hold them, which might not happen until 2008. Will the market continue to fight the increasing weight of negative expectations?

A breakdown below the trend line would invalidate both the trend and ascending triangle analyses. A breakdown would be a series of closes below the trend line indicating that the major uptrend is over and the market is moving into a range; or worse. If this breakdown happens, the market needs to find support at either the 200-MA or the range bottom at 13,000. Not holding the 200-MA would be bad, and a breakdown below the range bottom would be very bad news. One trip down to 12,500 was a correction; another one would be, well, disaster.

So we wait and see. The real question is whether there is enough residual bullishness to move the market higher, especially since the falling dollar isn’t exactly drawing foreign players like bees to honey.

Ah, it’s Halloween, the time of year when the “Halloween Effect” - sometimes known as the Sell-in-May-and-Go-Away Effect - is about due to begin. Stocks very frequently begin rising on November 1st or thereabouts right through the end of April or sometime in May. It is a pretty consistent phenomenon, about which I’ve written before. Will we get the Halloween Effect this year? It would be nice if Messr. Bernanke and the rest of the FOMC committee would give us a 25-basis point rate cut today, which wouldn’t hurt the Halloween Effect one little bit. But like little kids waiting for Halloween to come, we have to wait and see.

Well, since it IS Halloween, let’s look at something really scary and dangerous. It’s real and it’s out there waiting for you. It doesn’t get little kids, though, gentle reader, it is looking for yoooouuuuu… the Witch Hat.

In years of writing covered calls and doing other types of trading, and years of seeing what CallWriter members have done, one thing sticks out: the Witch Hat. It is the sudden price spike that does not hold, but comes back down as fast as it went up, making a chart pattern that looks like a Witch Hat. It whipsaws unwary covered call writers (and other traders), spraying blood on the walls. OK, enough bloody metaphors, but the following chart provides a blood-chilling example:

Unsuspecting covered call writers sometimes see a violent up-move like this and rush to get in before it’s too late, perhaps buying the stock and writing calls to get in on the move, maybe rolling the short calls up if they’ve already written the stock. [Cue scary music] But only TOO LATE do they realize… the Witch Hat has gotten them. As the GM chart above indicates, bad things often happen to those who write price spikes, like the horror-movie teenagers who slip into the dark woods to neck… we already know what’s going to happen to them, don’t we?

I could show you other examples, but you get the “point.” Make the stock prove itself by holding the higher price; make sure it wants to live in the new trading range before getting in or rolling up. How much proof you want (how many closes at the new level) is up to you, but make sure you aren’t writing, or rolling up to, a Witch Hat. Keep your blood in your veins, where it belongs. (Whoops) They are out there every day of the year.

Continuing in this spooky vein, what is Microsoft doing now?

Witch Hat, or new higher trading range justified by the latest earnings release? Has the mother of all like-watching-paint-dry stocks finally become a tad less boring? [Hint: The premium is lousy, so it doesn’t matter.]

Watch out for all kinds of Witch Hats today, and happy trick or treating!

On April 23rd, I wrote a blog post on Alcoa (AA) which pointed out the different readings from the daily (showed an uptrend that may have topped out) and weekly (showed stock possible failing at the range top of a long-term channel) charts. I pointed out that the key was for Alcoa to find support at the 50-MA on the daily chart, which it may have done, and break the range top. Note the following daily chart:

(Click on chart to enlarge it)

The stock held the 50-MA and today spiked up on news that Alcoa is looking to sell lackluster units. Alcoa opened on a nice gap up today above the 50-MA and then traded down to fill the gap and back up, piercing the upper Bollinger Band on news. Note that whenever Alcoa broke above the upper band briefly, a pullback occurred soon after, except for the break in mid-January, which was a very slight rupture almost too small to be called a break. It is of course too early to tell if today’s break above the upper band signals another pullback or a new surge in the stock.

Certainly, the metals industry is quite strong, and should not be lightly bet against. Yet for Alcoa’s 2007 uptrend to be considered still in place, we need to see some closes above the $36 level to break the long-term range top and then continued movement upward. It could well pull back from this spike - too early to tell.

Interestingly, implied volatility (IV) and therefore premium has not spiked along with the stock price, because speculators are not jumping on Alcoa. Thus to write the MAY 35 (1.40) or 37.50 ((0.35) Calls would bring in depressingly little time value premium - and June is not much better. The punk amount of time value available, which indicates low IV, indicates that long calls on Alcoa may be a better deal than writing calls. The low IV makes AA a poor buy-write candidate, though even if long the stock those call premiums aren’t much more enticing.

What about those of you already long AA who expect it to pull back again? Writing a price spike like this on a great company that you enjoy owning can be rewarding, because the short calls can be repurchased at a profit if the stock pulls back. But the lack of time value in the Alcoa calls means that all of the profit on a pullback would have to come from the pullback itself, since there is no IV to collapse.

However, only an ITM call will pull back with the stock at anything close to a dollar-for-dollar delta, and the amount of time value in the ITM premiums is so low that you’d better be right about a pullback coming.

Alcoa Inc. (AA) illustrates the importance of looking at weekly as well as daily charts. On a daily chart, it was in a reasonably strong uptrend through early April, when it quit making higher highs and lows and appears to have gone into a range. AA is pulling back to the 50-MA, which tends to act as support at the trendline, suggesting a possible resumption of the earlier move up if it bounces off that support level.

Now let’s look at a weekly chart for AA, and we see in a very different light the uptrend that began in October:

(click on charts to enlarge image)

Note that what looks like an uptrend on the daily chart appears on a weekly chart to be merely an up-leg in a long-term trading range, with the stock now pulling back from resistance at the $36 range top. We would normally expect Alcoa to continue downward to the main or even extended range bottom. But - stocks don’t range forever; every range ends sooner or later. Note that the 50-MA is not very useful on the weekly chart, though it rules on the daily.

The careful observer will note that AA might be forming an ascending triangle, often a bullish sign, since conventional wisdom suggests any trend in place will continue as the triangle resolves at the tip. Yet triangle is as triangle does. If Alcoa finds support again at the 50-MA/trendline and makes another run at resistance, the case for an ascending triangle will be strengthened, and a couple more runs at the range top would forecast even more strength, but it is too early to tell. A bounce off support would be somewhat bullish but far from conclusive, given the strength and depth of the long-term range.

This is not an in-depth article about how to trade or time Alcoa, of course. I’m just making the point that it’s very common for daily and weekly charts to show different things; sometimes radically different things. The point is to check both charts and make sure of what you’re dealing with.

The metals industry is strong, and an announcement confirming takeover rumors about Alcoa would move the stock up, thus bears should proceed with caution.

It is too early to buy puts or take other bearish action (bear call spread, naked call, etc.); we need to see a convincing breakdown below the 50-MA and trendline on the daily chart. If it convincingly breaks that support level, though, it is bear food.

Covered Calls:
Covered call returns on AA are poor at this time, so it is not a good buy-write candidate. If you already own it, consider waiting to see if it holds support before writing it again. If it bounces off the 50-MA, write it higher and perhaps further out for larger premium. But if it breaks support as discussed above, writing deeply ITM calls on portfolio shares might be in order to pocket as much as possible of the pullback. Or in the event of a breakdown below support, consider buying a long-term put, which would free you to write calls and pull in premium income, leaving you eventually with the choice of exercising the long put or flipping it and keeping the stock.

A member this morning pointed out a trade on our Pharmaceutical lists of the highest-returning covered call plays: Dendreon Corp. (DNDN), a biotechnology company. On this morning’s April expiration list DNDN was shown at $21.78 earlier and it was possible to write the APR 20 Call for 2.90 in premium (5.1% return) and the APR 22.50 Call for 1.80 (8.2% uncalled, 11.6% called). Nice returns with only 12 days left until April expiration on 4/21. [The stock has moved almost 2.00 in the time it took to write this post, so many of the numbers in this post may be really old.]

But not so fast, let’s take a closer look.

After being essentially flat for two years and seldom being above $5 in the last year, this stock went up in late March like a bottle rocket, leaving anything resembling support (including moving averages and trendlines) far behind. There was a huge gap from about $5 to $12, and the last couple of days’ upmove has occurred on decreasing volume (although if volume continues at this rate, it might make a liar out of me), as the chart below shows:

(Click on the above chart to enlarge it)

DNDN moved up on an FDA panel’s endorsement of Provenge, Dendreon’s prostate cancer drug, although some have questioned the propriety of an FDA approval. Given the uncertainty of better news on this stock (and even with better news, does it have much further to go?) and the fact that it has spiked so far above support, it is a dangerous covered call write. See my archived newsletter on writing price spikes for more thoughts in this vein.

It is a small pharmaceutical company that loses money undergoing extreme current volatility, which breaks just about every rule of conservative covered call writing. The cost of protective puts for a covered call position is quite high, and the spread on the puts is enormous - the MAY 22.5P was 5.60 x 6.10 as I write, a bid/ask spread of 0.50. The stock is moving fast enough that it is hard to get option quotes consonant with the same stock price!

The stock may well not be able to hold this price level without more good news, like moving toward closer to FDA approval, which is uncertain. It may even fall on further good news in view of all the speculators who have already bought the rumor. I see this stock as a short - a straight put buy isn’t indicated because they’re far too expensive. Even the OTM MAY 20P is going for 4.90. Sell high premium, buy low premium, remember?

Speculators are having a field day. Putting a covered write on this stock is a real gamble. It might work, but your fingers will be crossed (and your knuckles likely white) waiting for April expiration.

After a 416-pt. selloff on Tuesday, the Dow Jones Industrial Averages ($INDU) sold off this morning down to 12,059, then ralled on good news from the manufacturing front to close at 12,234, down about 34 points. I’m encouraged by the market’s ability to recover this afternoon. But… tomorrow is Friday, and a lot of traders will want to be flat going into the weekend, which could provoke a selloff, in which case we could see a good morning tomorrow then a bad afternoon as traders get flat.

I always stress to covered call writers to look at the weekly chart as well as the daily. The following weekly chart for the INDU illustrates why. Note how, despite the stellar gains since June 2006, volume has been declining since April.

Also note the MACD - the fast and slow lines have been essentially flat since late October and the MACD histogram has been declining since August. Thus despite the DOW’s impressive runup since July, we are seeing some bearish divergences.

Notice how the 50-day MA is still a long way away - about at the 11,715 level, which is very close to the 11,730 50% Fibonacci level discussed in my Black Tuesday post. This suggests to me that the DOW is looking for the 50-day average.

The whole question is whether the worst is over or, as I suspect, we’re not through with the correction. The bigger question is why the selloff in the Shanghai market caused a selloff worldwide; this doesn’t exactly scream bull market to me. It could be that the bull market still has legs and this week’s action is just a needed corrective. It’s too early to tell, but I think the correction is not over and the market will find a Fibonacci level. In fact, we have almost hit the 12,000 (38%) level already, so I would think the 50% level is a more likely target. (I don’t know if a major bear market is beginning, and neither does anyone else.)

For longs and covered call writers, keep a close eye on the market and your stocks. If further weakness is demonstrated, consider buying protective puts, closing the positions or rolling the calls down and out (using multiple rolls, if necessary).

Some people are buying OTM puts for April or May on the logic that they protect against a serious market slide and, if the market recovers without much more hiccupping, the puts will still have enough time value in a couple of weeks to not produce a loss on selling the put. (This is why March puts make less sense - time decay will really kill you between now and March expiration if there is no further market decline.)

Protect Yourself:
In a sense, this correction comes at an opportune time. If you are truly concerned about handling this correction, you should be at my Orlando, Florida Prosperity Powerhouse Covered Call Seminar being held on March 10th and 11th - next weekend! We will be talking about how to react to this and other situations when good trades go bad. Truly, you don’t want to miss it. Details here…

There are two seats left, and they will be gone soon. Call us at 352-377-3500 if you have any questions. There may not be another opportunity this year to get this seminar. If you are concerned about this week’s market action - you need this seminar.

Now, a final thought about puts: the beauty of long puts is that, on a stock decline, you can always decide to keep a stock you think will recover and take profits by selling the puts.