Tim Bovee, Private Trader: DOW: An ambiguous breakout

Update 6/30/2014: DOW broke below the 10-day price channel on June 27 and confirmed the exit signal the next trading day. The same crossing also broke below the 10-day channel, meaning DOW won't go on the Roll Shelf.

The share price declined by 1.1% over the 32-day life of the position, or negative 12.4% annualized. My options position produced a 15.2% loss, or negative 172.7% annualized.

DOW's price peaked on June 24 at $53.35, ending the rise, wave 3 {+1}, that began April 17, 2013 from $29.81. The wave 4 {+1} correction is now underway.

Although there is no way to forecast for certain how deep the correction will be, Fibonacci retracement levels give us some likely scenarios.

Shallow correction, typical of a 4th wave, might well stop at the 23.6% retracement level, or $47.79. Deeper stopping points are 38.2% ($44.36), 50% ($41.58), and 61.8% ($38.80).

To avoid getting too lost in the Fibonacci weeds, I think of it as meaning that DOW will spend some time down in the $40s, and perhaps even the $30s.

The duration of the correction is also impossible to predict. At the {+1} degree, the 1st wave lasted 2-1/2 months and the 3rd endured for 14 months.

Click on chart to enlarge.

DOW 30 days hourly bars

Update 5/29/2014: DOW has resumed upward momentum and I've opened a bull position, structuring it as a bull call spread, long the $50 calls and short the $55 calls and expiring in September. The leverage is 7:1, with a potential maximum yield on risk of 100%.

Update 5/27/2014: DOW failed to show upward momentum at the end of the day, failing to challenge the high it set in morning trading of $39.93. I'll move it to the Watchlist for further consideration.

The Dow Chemical Co. (DOW) has broken to a new high, but not all new highs are good news. DOW's rise from April 15 is filled with ambiguities, and what appears to be happy days for the bulls may in fact be an occasion that will satisfy the bears.

The Chart

DOW's break above its 20-day price channel on Friday also carried the price above its previous high of $50.96, attained on March 25. Today's confirmation suggests that the uptrend that began April 17, 2013 from $29.81 remains in force.

Using Elliott wave analysis, I've labeled the rise of the past year as wave 3 {+1}, the middle portion of a rise that began in November 2012, wave 3 {+2}. In fact, the Elliott wave framing shows DOW to be in 3rd waves at all degrees from {+1} up to {+4}, which be in March 2009 from $5.89. Wave 3 {+4} began in July 2010 from $22.42.

From the March 25 high, DOW faltered a bit, declining to $46.56 on April 15 before rising again.

The question this chart must answer is the nature of the rise from April 15: Is it a downside correction that showed an excess of enthusiasm in an upside retracement, or is it indeed the beginning of a new rise, wave 5 {-1}, the last leg of the last leg of wave 3 {+1}?

Double click on chart to enlarge.

DOW 2 years daily bars (left), 30 days hourly bars (right)

The right-hand chart gives a detailed count of what I've labeled wave 5 {-1} to the upside. My analysis concludes that April 15 was indeed the end of wave 4 {-1}, and the labeling reflects that conclusion. The churning following the April 23 peak of $50.64 is a 2nd wave correction, wave 2 {-2}

Wave 2 {-2} is a flat, the sort of structure within Elliott that I find to be extremely ambiguous.

Therefore, an alternate reading is also allowed under the Elliott wave rules. It would see Friday's higher high is the beginning of a continued sideways correction, a continued wave 4 {-1}. A decline below $50.64 would suggest that the bearish alternate reading is the correct one.

One argument in favor of the bearish case is that 2nd waves tend to be simple zigzags rather than flats. That's a tendency not a rule, however, and 2nd wave flats are certainly not unheard of.

At any rate, wave 5 {-1}, when complete, will also mark the end of wave 5 from Dec. 5, 2013 and will signal the beginning of the wave 4 {+1} correction, which will take back a portion of the 725 rise from April 2013.

Options are pricing in confidence that 68.2% of trades will fall between $47.95 and $53.83 over the next month, for a potential gain or loss of 5.8%. I've marked those levels on the right-hand chart in blue.

The 1st wave of the {-1} degree lasted about a month, so as a thought experiment lets assume $54 as the peak of wave 5 {-1}, using the range implied by options prices.

If DOW follows the tendency of corrections to end at Fibonacci retracement levels, then the 38.2% level, $44.76, would mark the end of a shallow correction, the 50% level, $41.91 of a steeper one and the 61.8% level, $39.05, a major downward correction.

Fibonacci retracement levels are a tendency, not a rule. In my experience, corrections will stop where they please.

Odds and Yields

DOW has completed five bull signals since wave 3 {+1} began in April 2013. Four were successful, on average yielding 4.6% over 33 days. Two were unsuccessful, losing 6.6% over 13 days. The magnitude of the losses creates a negative win/lose yield spread, -2% in this case, never a good thing.

However, arguably, DOW's tendency to avoid whipsaws, with its 80% success rate, goes far to overcome the negative spread.

The Company

Dow Chemical, headquartered in Midland, Michigan, is the second-largest chemical manufacturer in the world by revenue, which operations in 160 countries.

Half of its market capitalization comes from performance plastics, many of them destined for automotive and construction applications.

Analysts are less than optimistic about Dow Chemical's prospects. Collectively they come down with a negative 50% enthusiasm rating.

This is despite a respectable return on equity of 16%. Debt is a bit higher than I like, at 71% of equity.

Dow Chemical's earnings yield is 7.5%, compared to 2.53% on the 10-year U.S. Treasury notes. Its dividend yields 2.91%.

The 1st and 2nd quarters tend to be Dow Chemical's biggest earners. they dropped off in 2012 from the prior year's peak but recovered to higher levels in 2013 and the 1st quarter of 2014 has moved still higher.

Earnings have surprised to the downside five times in the last three years, most recently in the 3rd quarter of 2013. The seven other quarters in that period have surprised to the upside.

The stock is selling for 13 times earnings but at near parity to sales. It takes $1.05 in shares to control a dollar in sales.

The earnings growth rate, when adjusted for the dividend, implies a "fair" price of $37.27, suggesting that DOW is overpriced by 37%. I've marked the "fair" price on the left-hand chart in purple.

Institutions own 67% of shares.

Dow Chemical next publishes earnings on July 23. The stock goes ex-dividend on June 26 for a quarterly payout of 37 cents per share.

Liquidity and Volatility

DOW on average trades 1.2 million shares a day and supports a wide selection of option strike prices spaced a dollar apart at most levels, with open interest running mainly to three figures.

The front-month at-the-money bid/ask spread on calls is 2.9%, compared to 0.7% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 20% and has been on the decline from 29% since April 11. By comparison, the S&P 500 index has volatility of 12%.

DOW has just bounced slightly off of its low of the past year and stands in the 1st percentile of its one-year range. That low level implies that positions structured as long options spreads, bought with a debit and expiring in September will have the best chance of success.

Option contracts today are heavily skewed toward calls, which are running 43% above their five-day average volume. Puts are trading at 30% below average volume.

Decision for My Account

I intend to open a bull position in DOW under my shorter-term rules, structuring it as bull call spread. I'll make the trade if DOW shows upside momentum in the half hour before the closing bell.

True, the recent uptrend is ambiguous. This is overcome in part by DOW's excellent 80% success rate. It doesn't whipsaw often.

Moreover, DOW's options allow me to open a hedged position. That and strict adherence to my stop/loss rules will provide added protection.

As I write this, 2-1/2 hours before the bell, DOW has fallen off its peak of $1.28 set around 10:40 a.m. New York time. My entry rule requiring upside momentum before opening a position provides a third level of protection.

-- Tim Bovee, Portland, Oregon, May 27, 2014

References

My shorter-term trading rules can be read here. My longer-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 shorter-term 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.

Disclaimer

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 decisions for his or her own account, and take responsibility for the consequences.