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Is It a Coincidence or an Opportunity?

By Jeff Clark
Tuesday, July 24, 2007

The canary may be ready to start chirping again.
 
Shares of Merrill Lynch (MER), Wall Street's version of the canary in the coal mine, led the market lower last week with an 8% decline. The selling started on Tuesday, when the investment bank announced record earnings that blew away analysts' expectations.
 
At first the stock traded higher – gaining almost $2 over Monday's closing price. But the shares quickly reversed and ended the day in the red.
 
MER shares continued lower on Wednesday and Thursday after Bear Sterns announced losses in their hedge funds caused by problems with subprime loans. The fear is that those problems aren't unique to Bear Sterns and that the entire brokerage sector will suffer a similar fate.
 
Then, on Friday, MER dropped a whopping $2.66 per share as the stock closed just a few pennies above $80. That large, one-day drop basically wiped out all of the value of the July 80 call options – of which there were many – and padded the pockets of option market makers who were short those contracts.
 
Last month, I wrote about the tendency of MER shares to close option-expiration day within a few pennies of an important option strike price. I even went so far as to correctly predict that MER would end last month's option expiration day around $90 per share. That was the strike price with the largest open option interest.
 
The stock closed at $90.23.
 
I didn't make any such prediction this month. But given the large number of expiring options at the $80 strike price, it wasn't too surprising that MER closed at $80.04 last Friday.
 
There's another unique tendency of MER shares that, if history is any sort of a guide, suggests we could see some strength this week...
 
MER tends to be very volatile during the week following option expiration. And that volatility is skewed in the direction in which the stock closes on Monday. For example, if the stock closes higher on the Monday following option expiration, it typically goes on to make further gains. If the stock closes lower, then investors can look forward to bigger declines.
 
That's been the case for seven of the past eight months. Take a look...
 
Exp. Month
Price on
Exp.
Direction
on Mon.
One-Week Change
Nov 06
90.87
down
-1.80%
Dec 06
91.56
down
-0.70%
Jan 07
95.87
up
-1.40%
Feb 07
92.79
down
-3.98%
Mar 07
79.90
up
+5.26%
Apr 07
92.02
down
-1.50%
May 07
94.17
down
-2.11%
Jun 07
90.23
down
-6.13%
Jul 07
80.04
up
?
 
In every case but one (January 2007), MER continued in the direction in which it closed on the day following option expiration. It didn't matter how large or small the move was on Monday. In most cases, it's just a matter of a few pennies. But those small initial moves often lead to large weekly percentage moves.
 
And, while I don't show it in the table, in every month except one (January 2007), MER reversed its direction from the previous week.
 
So, if this trend holds true, then yesterday's $0.01 gain in MER could be the start of a reversal of last week's losses.
 
Of course, all of this could be nothing more than mere coincidence. And if that's the case, investors might find some comfort in knowing they're buying a high-quality blue chip at just eight times earnings, and that those earnings are growing more than 37% year over year.
 
Traders won't care. We'll be out of the stock by Friday.
 
Best regards and good trading,
 
Jeff Clark




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