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KELTNER CHANNELS


For Lubrizol, Time To Take A Break?

10/01/09 09:06:16 AM
by Donald W. Pendergast, Jr.

Picking tops and bottoms in the market can be a very dangerous prospect, but sometimes there are tell-tale indications about a warning of a trend reversal well in advance of the actual event.

Security:   LZ
Position:   N/A

Lubrizol (LZ) common stock has had a tremendous trend move since the remarkable marketwide reversal that occurred last March. The stock has tripled in value, obviously making at least a few of the value investors of the world extremely happy. But why would anyone even want to consider selling out now, considering that the stock has a favorable intermediate-term earnings growth projection? The weekly chart (Figure 1) may tell us why preparing for some sort of a trend reversal and/or pullback may be a very wise course of action. Then we'll examine a low-risk option trade, one that may enable traders to cash in, should the stock reverse to the downside.

FIGURE 1: LZ, WEEKLY. Sometimes, the convergence of dissimilar technical dynamics at a common time/price zone has to be taken seriously. This may be one of those unique market moments, this time in shares of Lubrizol.
Graphic provided by: MetaStock.
Graphic provided by: Various WB EOD indicators from ProfitTrader.
 
Sometimes, the convergence of technical dynamics on a single chart is nothing less than astounding, and this particular chart of Lubrizol might just qualify for the term "amazing," especially for those who doubt the existence of a very real time/price order in the financial markets.

Starting from the dead low of March 6, 2009, LZ rose by 95.16% in a nine-week period (highlighted by the first green rectangle on the chart, from point A to point B), after which it went into a narrow-range consolidation pattern (blue rectangle on chart) lasting 10 weeks. The stock launched higher from the consolidation, tacking on 59.52% in an 11-week period (the second green rectangle on chart, from point C to point D). I find it amazing that the ratio between the percentage gains from each rally comes out to be very close to a major Fibonacci ratio:

59.52% / 95.16% = 0.62547

That's not too far from the famed 0.618 Fibonacci ratio that many technicians work with every day. Now, consider the fact that even as this near-perfect Fibonacci ratio between the swings was finalized, the price of LZ peaked and then reversed just as it hit a key Fibonacci 162% extension ratio, even as it came into contact with the extreme outer Keltner band (set at 7.5 standard deviations from a 45-week exponential moving average [EMA]). Note also that the detrend oscillator had already confirmed that the latest upthrust was already losing momentum, warning of a possible reversal to come -- one that in fact may already be under way.

Adding more fuel to the validity of the time/price theory of markets, note that the long-term money flow (the Chaikin money flow [CMF][144]) also reached a peak at the same time as all of the above technical factors converged. Yes, 144 is also a Fibonacci number. Now, of course, all of this could just be pure coincidence, and maybe I'm a bit biased on the time/price theory of markets, but I've seen situations like this time and again over the years and it is uncanny at how accurate such convergences usually are at calling significant reversals in stocks, exchange traded funds (ETFs), and commodities. Regardless, what we need to know now is if there is a low-risk way to play the potential for trend reversal follow-through in this particular stock.

FIGURE 2: BEAR CALL SPREAD. Imagine, getting credit without having a credit card. It's no wonder that so many traders are selling equity options instead of buying and selling stocks.
Graphic provided by: ThinkorSwim LZ bear call spread.
 
The following option spread is only for aggressive traders who also happen to subscribe to the time/price theory of market mechanics. Anyone taking this trade needs to be willing to quickly close out the trade in case the reversal doesn't materialize as quickly as anticipated. Here's the trade plan:

Sell 1 November 2009 LZ $75 call option (LZKO)
Buy 1 November 2009 LZ $80 call option (LZKP)
----------------------------------------------
Net credit received: $1.25 or better

This is an out-of-the-money [OTM] bear call spread, one that will capitalize on this likely weekly peak in LZ, as long as the stock fails to close in the money ($75.01) by November 20, 2009. Between now and option expiration, the spread will continue to lose time value, which is all it's composed of anyway (remember, OTM options have no intrinsic value, only extrinsic value). If LZ bumbles around for a few weeks near the low $70s, the spread will still be losing time value, which is the major edge of every option/option spread seller.

Only if we see a continued rise (it may happen) in LZ will the spread start to lose money -- that is, it will cost more to close it out than the amount of the credit we initially received to sell it. If you get $1.25 in credit for the sale, consider closing it out if the spread doubles in price to about $2.50. If LZ starts to move lower, just sit back and enjoy the ride south -- you'll be profiting from the twin joys of ever-decreasing option deltas (as the options move farther OTM) and ever-increasing amounts of time decay. See Figure 2.

Really aggressive traders might even want to scale in to this trade, should LZ move a dollar or two higher on light volume; you'll likely get even more cash for each spread you sell, which is a big plus. Just make sure that the overall technical picture still points toward a significant trend reversal, should you decide to go this route. If the stock keeps going up, close the trade on a doubling in value of the spread and just wait for a less-demanding trade setup to materialize.



Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title: Writer, market consultant
Company: Linear Trading Systems LLC
Jacksonville, FL 32217
Phone # for sales: 904-239-9564
E-mail address: lineartradingsys@gmail.com

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Date: 10/02/09Rank: 1Comment: 
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