Thursday, February 13, 2014

IP: A contrarian chart

International Paper Co. (IP) gave a bull signal on Thursday that awaits confirmation by the price continuing to trade above the upper boundary of the 20-day price channel.

The chart, however, is in a formation that suggests that the bull signal is the culmination of a rise, not its beginning, and that the smarter strategy for trading IP is contrarian.

The Chart

Elliott wave analysis shows IP as tracing out a symmetrical triangle beginning from $50.33 on July 25, 2013.

Triangles in Elliott counting are composed of five bounces, labeled a through e, alternating between the upper and lower boundaries, with each bounce composed of  three waves.

My count shows IP has having broken above the upper boundary on Dec. 18, 2013 and continued on a ways, overshooting the goal for wave b.

Ahead lie waves c to the downside, d to the upside and e to the downside, each tracing a series of lower highs and higher lows at their turns.

Click on chart to enlarge.
IP 5 years 6 months 2-day bars (left), 180 days 2-hour bars (right)
Triangles are sometimes malformed; they respect the trend lines forming their boundaries with the unruly surliness of a seventh grader in Middle School. That's what happened on Feb. 11 when wave b {-1}, a subwave of wave c to the downside, overshot the boundary.

If it turns quickly and proceeds to the final wave c {-1} to the downside, completing wave c, then my count is correct. If it moves up to a new high, above the wave b peak of $49.52 set Dec. 18, 2013, then my count is wrong and something else is going on with the chart.

The triangle is a fourth wave within a pair of third waves at degrees {+3} and {+4} within wave A {+5} of wave B {+6}, the latter two having begun from $3.93 on March 6, 2009, the Great Recession low.

IP has plenty of upside potential once the triangle is complete. The question is whether there is money to be made over the next few months as the triangle traces out its path.

And I believe there is, on the bear side. The triangle formation means that the break above the triangle sets up a retreat back to the lower boundary. This is a case where the contrarian case is persuasive, even for a trend follower like me.

A reasonable downside target for wave c is between $43.75 and $44 along the lower boundary of the triangle.

There's no way to say for sure that the boundary and price won't meet at a higher level because the time it will take for wave c to complete its decline can't be estimated. A month or so would match the other waves in the triangle and so seems reasonable.

The overshoot, however, presents a problem, since there is no way to know that it won't continue upward and break the triangle pattern. So the cautious money will wait until the price retreats back within the triangle boundary before opening a bear position.

The upper boundary as of Thursday's close was about $48.57, and the re-entry into the triangle will have to happen fast if my present count is to retain its credibility.

Odds and Yields

IP has completed three trading signals since the triangle began in July 2013, one bull signal and two bears.

The bull signal was successful, yielding 3% over 34 days. The two bear signals were unsuccessful, on average losing 2.9% over 24 days.

The numbers tell me that IP has been prone to whipsaws during the triangle formation, especially to the downside.

The Company

International Paper, headquartered in Memphis, Tennessee, is a global pulp, paper and packaging company, the largest in the world. If you're using paper -- and who isn't, even in these digitally dominate days? -- then the odds are good that International Paper had a hand in it.

Analysts collectively come down at a 34% enthusiasm rating regarding IP's prospects. That's a fairly high level of optimism.

The company reports 18% return on equity with debt about 7% above equity.

Earnings tend to peak in the third quarter. In 2013 that quarter was well above its year-ago counterpart, as were all quarters in 2013.

Earnings have surprised to the downside three times in the last year, twice in 2013, including the most recent quarter reported, and once in 2012. The other quarters all surprised to the upside.

The company's earnings yield is 6.15%, higher than 68% of other paper and paper products companies. The annual dividend yield at today's price and rates is 2.85%, just a bit less than half of earnings.

The stock is selling at 16 times earnings, and also at a discount to sales. It takes 74 cents in shares to control a dollar in sales.

Institutions own 84% of shares.

International Paper goes ex-dividend in June for a quarterly payout of 35 cents and next publishes earnings on April 28.

Liquidity and Volatility

IP on average trades 4.4 million shares a day, sufficient to support a wide selection of option strike prices spaced a dollar apart at $50 or less and $2.50 apart above $50.

The front-month at-the-money bid/ask spread on puts is 2.9%.

Implied volatility stands at 23%, in the 11th percentile of the one-year range, and has been in a downtrend since hitting a peak of 31% on Feb. 3. It stands 16% below historic volatility.

The low level of volatility suggests that a long bear options position, such as a bear put vertical spread, would have the greatest chance of success.

Options are pricing in confidence that 68.2% of trades will fall between $45.85 and $52.35 over the next month, for a potential gain or loss of 6.6%, and between $47.54 and $50.66 over the next week.

Remember that a move above $49.22 would invalidate my chart analysis, and the volatility analysis puts the odds of that occurring within one standard deviation of Thursday's closing price.

Call contracts were traded actively on Thursday, running 26% above their five-day average volume. Puts were running at 83% of average.

Decision for My Account

Based on the chart analysis, I'll want to see IP move back within the triangle before opening a trade. I'll add it to my Watchlist with an eye toward opening a bear position to profit from the downward retreat.


My shorter-term 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. The principal practitioner 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

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

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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