Several of my close friends in the investment field have recently admitted to me in whispered tones that they have suffered significant losses this year not only in their personal portfolios but their professionally managed ones as well. These are serious people who make stock selections based on fundamentals and hold on to them through thick and thin, provided the reasons that they bought them in the first place don’t change. Whenever I happen to toss in a polite comment such as “Your favorite stock just broke major support and I strongly recommend dumping that stinker,” I receive reactions that range from rolling eyes to actual nose scrunching, as if I just presented them with a plate of Limburger.

The financial field is divided into two camps, much like the Republicans and Democrats–the technicians who see the world as it is and the fundamentalists, like my friends, who insist on viewing the world through rose-colored glasses. In general, the fundamentalist camp lumps technical analysis in with voodoo and elven runes and therefore since they don’t know anything about it, it must be evil. Frankly, we technicians don’t give a damn what they think as long as they leave us alone.

But sometimes miracles do happen.

It’s amazing how a contraction in one’s financial security can change a person’s point of view, for in fact, a couple of my friends have recently admitted that they wished they had understood the basics of technical analysis. I accept their hidden apologies and in the spirit of their recent enlightenment, today’s article is dedicated to them and all other beginning chartologists.

Note: Seasoned technicians need not proceed any further.

What am I looking at?
Before one can even begin to dissect a stock chart, one needs to understand the difference between a linear and a logarithmic scale. On a linear scale, all whole numbers are equidistant from each other. In other words, the distance between, say, one and two is the same as the distance between one hundred and fifty-nine and one hundred and sixty. Simple, right?

A logarithmic, or log, scale is very different. Here, the numbers are not equally spaced distance-wise; rather, they are equally spaced percentage-wise. For example, the distance between 5 and 10 is the same as the distance between 10 and 20. What this means on a stock chart is that a price bar representing a 50% gain will be the same size no matter where it appears. In this case, a picture is probably worth a thousand words. Below are two charts of Excel Maritime, EXM—one linear and one log.

Comparing these two charts, you can see that the log scale puts an equal weight on each price bar making today’s 42% move that much more dramatic. Most technicians prefer a log price scale for this very reason, but it’s okay if a linear scale makes more sense to you. Just know the difference.

A few other technical tips
You might notice a few things from examining the above charts. For one, you can see that the price tends to “bunch up” at the decade intervals, i.e. 10, 20, 30, etc., and to a lesser extent, at the 5-levels, i.e. 5, 15, 25, etc. These are called support and resistance levels. For EXM, you can see that it spent a good month bouncing off the $10 level in October which became a level of support because it was, in fact, “supporting” the price.

You’ll see this support was violated on November 11th followed by another down day. This was a strong indication that the buyers had thrown in the towel and the sellers were now in charge. The price plunged. Its recent $3.50 low could be the bottom as evidenced by two factors: 1. The past two days of strong price movement have been accompanied by much heavier than normal volume (not shown on the charts above), meaning that the shorts are probably covering and the bulls are regaining power; and 2. Today’s price bar has filled the gap set on November 20th. Once a price gap is filled, chances are good that it will continue moving in the direction of the fill.

Notice that the previous $10 support level is now a resistance level. This is a psychological barrier for traders and will be the stock’s next hurdle to upward progression. If it manages to break through it on heavy volume, further upside movement is highly probable.

Well, that’s the long and the short of log and linear scales. I hope this mini-chartology lesson has whetted your appetite for further study into the beauty of technical analysis. Tomorrow, I’ll continue our education with a few other interesting and useful chart-reading tips.

Note: All of the major web-based financial sites–MSN Money, Google, Yahoo!–offer both linear and log charts. MSN Money also offers a log base 2 scale, not that I’m sure how to use it.

Whether Congress’s proposed temporary bailout of Detroit combined with Obama’s stimulus plans to create jobs by repairing our aging infrastructure was the engine that fueled today’s broad-based rally is immaterial to market technicians who, like me, are getting excited over the forming chart patterns. Not only are today’s break-outs and bullish gaps displayed by many individual stocks (most notably the best-of-breed companies in the infrastructure and basic material sectors such as water transport, coal, construction, and steel as well as some tech stocks and electronic stock exchanges) but for me, the most exciting and possibly telling pattern could be forming in the the S&P 500 index itself.

Below is a daily chart of the SPX. To me, it sure looks like it is in the process of forming an inverse head and shoulders pattern. For the chartologically challenged, a head and shoulders formation is a very powerful chart pattern that is coveted by many traders because it is so successful. (For a closer look at these patterns and some examples, see my March 5th and 6th blogs.) Let’s look at this chart more closely.

You can see that the left shoulder was formed from the beginning of October to the beginning of November. The neckline, or the new level of overhead resistance, is at 1000. The top of the shoulder is at 850. The head was put in two weeks later and occurred at the 750 level, one hundred points below the shoulder. The last several trading sessions have touched the 850 level again and today’s gap up is a strong indication that a right shoulder is beginning to form.

If this pattern is indeed in the formation process, what can we expect from here? As my arrows on the chart indicate, we should expect to see the SPX retest the neckline level at 1000 in the next week or so. The index will then reverse, and head back down to the 850 shoulder level probably some time in the beginning of January. If this level is successfully retested, then the only thing left to complete the pattern is for the S&P to rise back up again to the neckline. If it manages to break through that on heavy volume, we can easily expect it to rise at least another 250 points which is the magnitude of the distance between the neckline and the top of the head.

Of course, these are a lot of ifs. Trading mavericks can play each leg of this formation as it develops; for the gun-shy, I’d recommend waiting until the entire pattern is formed and then taking a bullish position if and only if the index decisively breaks through its neckline level which will most likely happen in the middle to the end of January.

If this pattern does play out as I’ve indicated, it would do a lot to boost the confidence and morale of the retail investor which, I believe, have been more badly beaten up than the market itself.

Apparently in my fever-induced haze yesterday, I misunderstood Cramer. I thought he was looking at potential takeover targets in the drug sector only but obviously that isn’t the case given his picks today.

He proposed that Illinois Tool Works (ITW) acquire Manitowoc (MTW) (which, by the way, he mispronounces but I’ll cut him some slack since he’s not a Cheesehead) and Nike (NKE) for Under Armour (UA). Both look good to me, especially a Nike/Under Armour merger and am rather surprised it hasn’t happened already. If you like it, too, and are looking for a cheap, conservative way to play it, I’d suggest the July 25/30 bull-call spread at a $2 debit. The maximum loss here is $2 (the debit amount) with a maximum gain of $3 (the difference between the strike prices less the debit).

Yesterday on CNBC’s Fast Money show, it was noted that Big Pharma companies are sitting on piles of cash (read: billion$ and billion$) fueling speculation that M&A activity in the drug sector will probably happen and soon due to the depressed stock prices of many of the companies in the sector. Not only did Jim Cramer pick up this ball, but he ran with it in his show. He said that he was going to identify five companies that he feels are ripe for the picking. In a blatant attempt to boost his ratings, he only mentioned one candidate yesterday—Pfizer targeting Allergan—and will give his next two picks today and the other two tomorrow.

I decided that I would try to second guess Cramu (as he used to call himself in his newsletters years ago) and have come up with my own candidates. What I did was run a screen on the biotechs with EPS 5 year growth rate > 8%, average daily trading volume > 150,000, and market capitalization > $1B. Out of the top 25, I then hand-picked those that had positive cash flows and high sales per share. I whittled the list down to the seven listed in the chart below.

Of this seven, I looked at those that had robust drug pipelines as well as many drug collaborations. [Note: Genentech (DNA) is supposed to be in the process of being acquired by Roche but rumors are flying that Roche many not be able to come up with the money. If not, Genentech will be back on the block but with a market cap of $775B it’s not going to be a cheap date.] I don’t claim to be a specialist in the drug sector and can only make recommendations based on my short amount of research, but I do think the following are attractive take-over targets:

Biogen-Idec (BIIB): The company already has many drugs on the market and many in development, mostly in the areas of MS, non-Hodgkin’s lymphoma, leukemia, and rheumatoid arthritis. It collaborates with many other biotech firms including PDL BioPharma, Elan, and Schering AG. Technically, the stock is down 50% from its all-time high put in a little over a year ago and is sitting on major support at $40.

Gilead Sciences (GILD): The company engages in the discovery, development, and commercialization of therapeutics for the treatment of life-threatening infectious diseases including hepatitis B, HIV, and the flu (you’ll recognize Tamiflu). It has many research collaborations including Abbott and Novartis and commercial collaborations with GlaxoSmithKline and Bristol-Myers Squibb, to name a few. The stock price has survived better than others in this group, down only about 18% from recent highs so it might not be a
a great bargain especially considering its large market cap.

Genzyme (GENZ): The company develops and distributes treatments for renal, kidney, and thyroid diseases, osteoarthritis, and provides reproductive testing and genetic counseling among other services. The company has a collaboration agreement with PTC Therapeutics and a strategic alliance with Osiris Therapeutics. The stock has slumped 27% from recent highs and is threatening support at $60.

The rest of the companies in the above chart are not primarily involved in drug development (most of them make biotech supplies) and I must confess that I don’t know enough about this space to make an educated guess as to who might want to acquire them.

Well, these are my candidates in the biotech area. Let’s see if Cramu thinks so, too.

Dr. Kris is–achoo!–feeling a bit under the weather. She tried to put out a blog today but quickly chucked it for a nice warm bath. She’s currently snuggled under a fluffy down comforter alternately sipping chamomile tea and dozing off to Turner Classic Movies.

She’s hoping to return to her blogging duties as soon as possible.

It looks like today’s market gobbled up the gains of the Thanksgiving rally. It was to be expected since the Monday following Black Friday is historically a down day. (See last Wednesday’s blog, “The Turkey Effect,” for further details.) Last week’s rally sparked hope of a market bottom; I, however, do not share that hope as evidenced by the following charts of the the VIX and the S&P 500.

What the charts are saying and how we can profit from them

The volatility index, the VIX
The chart of the VIX, the market volatility index, shows that it’s been trading in a horizontal range for the past two months. The lower support level is around 55 (you could argue the case for support around 47 as well). Upper resistance is defined by the 80 level. A bottoming tail formed on Friday and today’s gap up further emphasized this turn-around in direction. (Remember that the VIX and the markets move counter to each other.) So, is there any way one can profit from this channeling behavior?

Well, you can’t actually buy the VIX but there are options on it with good liquidity at many strike prices. One conservative options play is to sell bull-put credit spreads on a day like today when the VIX is bouncing off lower resistance. Try the December 55/50 put spread (sell the 55 strike and buy the 50 strike) or the December 50/45 spread if you’re of a more conservative bent.

This is a directional play and as such you don’t want to wait for the price to move against you so I’d recommend closing out the spread when the VIX gets near upper resistance at 80. When it shows signs of heading back down, I’d reverse the process by selling an at-the-money (ATM) or slightly out-of-the-money (OTM) bear-call credit spread.

Nothing channels forever, so you may only get to do this a couple of times, but it could be worth your while. If the trade does happen to move against you, close it out or roll down the strike prices. I’d recommend setting your stop-loss at the break-even (B/E) price. For a bull-put credit spread, the B/E is the lower strike price less the net credit; on the bear-call side, the B/E is the price of the higher strike plus the net credit.

The major market indexes
The chart below shows the daily price action of the S&P 500. (I chose the S&P because it’s the benchmark index for most comparison purposes but all of the other major indexes look similar.) You can see that it’s found a new trading range bounded by a downwards sloping channel. For reference, I also included the 30 day exponential moving average as it seems to coincide with the upper price channel boundary.

We can play this in several ways using equities and options. (This channel is also a handy reference for index futures traders, too.) First, there’s the tracking stocks—the SPY, DIA, QQQQ, etc. along with their double and triple long/short ETF counterparts. You can buy these when the index turns up from its lower channel boundary, sell when it reaches the upper boundary, and then take a short position (by either shorting the tracking stock or buying the short equivalent) when the index begins to head back down.

Options players can play the options on either the indexes or the tracking stocks. Options on the latter are cheaper and generally more liquid than the former. Possible options strategies include the above-mentioned credit-spreads, debit-spreads, or straight calls and puts. Because of the time decay factor inherent in options pricing, I prefer buying options with strikes that are at least 6 months out if I plan on holding them for more than a day or two.

A note on currencies

The Greenback
The long US dollar tracking stock, the UUP, has been trading in the $26-$27 range for the past six weeks. A definitive break on either side will likely continue in the same direction—just a heads up to you currency traders out there. (There are no options on the UUP, alas.)

The Yen
The Japanese yen is the only currency (with a tracking stock) that is bucking the buck. It’s tracking stock, the FXY, has been rising steadily since its October 6th breakout and is less than $2 away from hitting its yearly high at $108.79. This tracking stock is optionable and selling the December 105 cash-secured put when it next takes a breather (maybe as soon as tomorrow) would be a nice way to ease into a long position. Note that many of its options are thinly traded and you can’t buy any further into the future than June 2009.