Monday, September 30, 2013

CSCO: Bearish on the bones of the 'Net.

Update 11/5/2013: CSCO broke above its 10-day price channel on Tuesday, signalling a tactical close to the position. The reward/risk ratio now stands at 92:100, which means I should close rather than hold.

I'm not certain at this point what happened with the Elliott wave count. I'll revisit it and do an update once I've untangled it.

CSCO rose 0.52% over the position's 32-day lifespan, or 6% annualized. That's a move in opposition to my bear position. 

Even so, the options produced a 1.5% positive yield on risk, or 16.9% annualized. Can't complain about that.

Update 10/4/2013: CSCO went on the shelf Sept. 30 after failing confirmation. It broke below the 20-day price channel again today and spent much of today down from its initial price in trading before the opening bell. 

However, it rose above the confirmation level with about two hours to go before the closing bell. It stayed high until the last 10 minutes of trading and in the final five minutes flirted with the breakout level. 

It was a ha'penny below confirmation when my trade was filled with six minutes to go, and closed a penny above confirmation. I'll call it a marginal compliance with the rules. The clock was ticking, the price was moving, and I had to choose.

I've structured the trade as a bear call spread expiring in November. Leverage is 5.3:1. The maximum yield at expiration is 48.2%. The position provides a 2.8% hedge of profitability at expiration above the entry price.

Cisco Systems Inc. (CSCO) broke below its 20-day price channel on Friday and traded still lower today. However, it has since risen back to within the channel and is flirting with the lower boundary. It may end up confirming the breakout; it may not.

The bear signal came at the end of a seven-day decline from $24.80, the culmination of the bull signal that preceded the present very near term downtrend. That peak coincided with the day the bull signal was given and so counts as a whip-saw.

Whether CSCO confirms its present breakout or not, its chart is one of the more interesting that I've worked with of late. To understand it, I had to go back to 2000, the year the Dot-com Bubble burst.

The markets as a whole followed the dot-coms into a decline, although not as severe, but afterwards rose in another major uptrend into 2007, only to collapse again with the advent of the Great Recession, and then to once again recovering to new highs.

CSCO's drummer was tapping out a different beat. The company survived the Dot-com Crash, but rather than moving to a new bull market, it began tracing a complex extended sideways correction.

CSCO 15 years monthly bars (left), 1 year daily bars (right)
In Elliott wave analysis, the correction has taken the form of a zig-zag (A-B-C on the left chart) with an intervening wave down (W) followed by what appears to be a triangle of some sort, although its nature won't be apparent until the conclusion of the present wave D.

The right chart zooms in to show the peak of wave C at $26.49 on Aug. 7 followed by the beginnings of wave D to the downside. As I count the near-term movement, the chart is showing a wave c decline that will be followed by an upside correction, and then further decline toward the lower boundary of the triangle.

The best bearish outcome for this structure would be a descending triangle with a flat base, which would give CSCO downside potential to $13.30, the end of wave B. A symmetrical triangle would have a higher downside target and so less potential.

After wave D in a triangle comes wave E to the upside, concluding below $26.49, and then either a continuation of the wave II correction, or the beginning of a massive wave III to the downside.

It seems likely that the lower-case waves (a-b-c) that I've labeled on the right-hand chart are several time-spans down from the upper-case waves (C), so I would not necessarily expect the present smaller wave c to be the conclusion of large wave D. There's room for waves within waves between the two.

It is in the nature of sideways corrections, such as triangles, that they produce substandard odds because the uptrends and downtrends offset each other. So it is with CSCO.

It failed my one-size-fits-all initial screening over the weekend. (See "Monday's Prospects".) And a closer look tailored to the chart shows that my intial screeing was correct in rejecting it.

CSCO has completed 17 bear signals since the triangle formation began in 2009; eight succeeded for an average gain of 4.3% over 34 days, but nine failed, for an average loss of 7% over 19 days. That's a negative 2.7% yield spread.

The present wave D has produced only one other bear signal so far. It yielded a 1.1% profit over 17 days.

For all of that I consider CSCO to be worth playing because of the structure imposed on the chart by the triangle pattern. It's too large a pattern to play as with an iron condor, which profits from sideways movements. However, the clear targets provided by the triangle increases the chances of success in a directional trade. At the least, my sense of where the price stands is clearer than would be the case in other structures.

Cisco Systems makes networking products that provide the bones of the Internet, which, far from being a damp, amorphous cloud, is a collection of wires and fiber-optic cables running through tubes on poles and underground and under the sea that are hooked up to a menagerie of routers and other devices, many of which are made by Cisco.

The Internet is made of hard stuff that like a skeleton holds our tweets and Facebook likes and birthday wishes and anti-government blog rants into a functioning whole that both binds and frees our thoughts.

An amazing book on the subject is Tubes: A Journey to the Center of the Internet by Andrew Blum, which takes the reader to many of the more interesting places in the infrastructure of the 'Net. Cisco is one of the major global players that has created the stuff of that infrastructure.

Analysts love Cisco. I can't say it any simpler than that. The stock has a wide professional following and most give its prospects top marks, for a collective enthusiasm index of 47%.

The financials, looking backward, support that opinion, with return on equity of 18% and debt amounting to only 22% of equity.

Each of the last dozen quarters has shown a profit, only three of which have shown a decline from the quarter before. The most recent of those, all of which are quite small, was reported in August 2012, and the other two were way back in 2011. Profits have been in a shallow uptrend the last four quarters.

All 12 quarters showed upside earnings surprises.

Institutions own 72% of shares. The price stands at a premium; it takes $2.57 in shares to control a dollar in sales.

CSCO on average trades 38.6 million shares a day and supports a moderate selection of option strike prices spaced a dollar apart. The front-month at-the-money bid/ask spread on puts is 1.3%, which is quite narrow.

Implied volatility stands at 27%, about the middle of the six-month range. It has been on the rise since hitting a six-month low on Sept. 13.

Options are pricing in confidence that 68.2% of trades will fall between $21.58 and $25.28 over the next month, for a potential gain or loss of 7.9%, and between $22.54 and $24.32 over the next week.

Trading in option contracts is heavy today, with calls approaching triple their five-day average volume and puts at double the average.

Cisco Systems next publishes earnings on Nov. 13. The stock goes ex-dividend on Oct. 1 for quarterly payout yielding 2.9% annualized at today's prices.

Decision for my account: CSCO has a good bearish chart. I can live with the odds, which are almost even over the long haul, because of the triangle structure.

As I write this, 4-1/2 hours before the closing bell, CSCO is showing upside momentum that has carried it back within its 20-day price channel. I'll check the charts in the last half hour of trading. If that momentum has reversed to the downside, then I'll open a bear position and update this analysis with my action. If momentum remains to the upside, then I'll add CSCO to my Watchlist and look for a potential reversal.


My trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. StockCharts has a good explainer. The principal practioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

By preference I place my trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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