Tim Bovee, Private Trader: NTAP: An ambiguous bear play

Update 10/31/2014: I've closed my bear position in NTAP. It moved and stayed up, trading above the 20-day price channel today. The stock still remains ambiguous, but the damage grew too great for my taste.

The stock rose by 7.3% over the 22-day lifespan of the position. My short options position, due to expire Nov. 21, produced a 116.13 loss on debit, or -1,926.7% annualized. Nothing ambiguous about that.

The trade produced more loss than it should have because of a flaw in my trading rules. I require confirmation of a sell signal, as I do a buy signal. This multiplies losses if there are a series of non-confirmations, yet the price keeps moving counter the trade.

That's what happened to NTAP: Close above the 10-day price channel on Oct. 24, not confirmed on the 27th (the next trading day), close above on the 28th, not confirmed on the 29th, close above on the 30th and confirmed, finally, on the 31st.

There are several ways to fix this, and I'll roll the problem into a broader revision of my signalling system now underway. But the bottom line is that I gave up an extra $2.25 on the share price as a result of the flaw.

Update 10/9/2014: NTAP has resumed downward momentum and I've opened a position, structuring it as a bear call spread, sold for a credit, short the $41 calls and long the $42 calls, and expiring Nov. 21. The spread has 4.5:1 leverage.

Update 10/2/2014: I'm not satisfied with the degree of upward momentum shown by NTAP today. It has been rising since hitting the day's low shortly before noon New York time. I've also had a hard time constructing an acceptable bear call spread and want to take a day to consider the issue. The risk/reward ratio is awful if I build it for a decent return. The only way to avoid outsized risk is to diminish the potential return to a trivial amount.

So I'll place NTAP on the Watchlist and revisit it on Friday.

NetApp Inc. (NTAP) has an extremely ambiguous chart. Bull trend? Bear trend? There's no way to tell. For the nearer term, however, the ambiguity melts away, giving the chart decidedly bearish cast.

The Chart

The NTAP chart must answer the question: What is the Elliott wave form of the declining wave C {+3}, which began in February 2011. It gives an ambiguous answer, speaking in riddles that defy a definite answer.

The problem can be seen clearly on the right-hand chart, where I've put both my orthodox Elliott wave count and and alternative count with each wave marked by the prefix "Alt:".

Click on chart to enlarge.

NTAP 20 years monthly bars (left), 4 years daily bars (right)

The discrepancy between form and reality occurs in the rise beginning in November 2012, which I've called wave 2 {+1} in the orthodox count. A 2nd wave is always based on three-wave movements, with the waves called A, B and C. Internally, waves A and C can subdivide into five waves at the lesser degree, but the major structure within a second wave is A-B-C, with extensions allowed.

Wave 2 {+1} on this chart has a clear five-wave pattern, but that can be handled by considering some of the waves to be of lesser degree within the basic A-B-C. Ideally, there will be a proportionality among the higher and lower degrees: A high degree movement will cover a wider price range and a longer span of time than will a low degree movement.

The proportionality on this chart is wrong. Wave B lasted for 81 days and covered $4.27 in price. The internal wave that I've labelled in the alternative count as wave 4 lasted 48 days and covered $6.01 in price.

In other words, the alternate-count wave is too long in price and too short in time to be entirely credible.

Elliott imposes no firm rule on proportionality, but it governs the analysis more often than not.

I can make the alternate count work by considering the January 2012 low to be the end of wave C {+3}, rather than a wave of lesser degree within C {+3}.

That solution is disproportionate to the {+3} degree structure because it gives a year-long C wave, but a nine-year-long A wave at that degree. It's not forbidden, but it is certainly not elegant.

The stakes are high over the longer term. The preferred count, showing wave C{+3} to be in progress, shows a strong likelihood that the price will decline below the November 2008 low, $10.39. The alternate count, showing wave C {+3} as having ended last November, has a minimum downside expectation of below $33.34, the end of alternate wave A.

That's a huge difference, but of less consequence for a shorter-term trade. The alternate count provide a 19% decline from today's opening price, which gives plenty of opportunity for profit.

Odds and Yields

NTAP has produced one bear signal since wave 3 {+1} to the downside began in January. It was successful, yielding 7.4 over 77 days.

It has not fared as well at the larger degree, the ongoing wave C {+3} decline that began in February 2011. There have been 15 bear signals in that period, with only a 43% success rate. The six successful signals on average yielded 9.6% over 51 days. The eight unsuccessful signals on average lost 6% over 25 days.

The Company

NetApp, headquartered in Sunnyvale, California, provides companies with electronic data storage and management solutions. It is a NASDAQ 100 company and routinely ranks high on the "Best Places to Work" surveys in the business news media.

It is one of the go-to providers for companies dealing with big data and cloud computing.

Analysts are pessimistic about NetApp's prospects, collectively coming down with a negative 52% enthusiasm rating.

This is despite the fact that the company reports a 20% return on equity, with long-term debt at 39% of equity.

Earnings consistently peak in the 1st quarter each year, and that quarters earnings have been in an uptrend for at least three years. The company has surprised to the upside 11 times in the past three years. The one downside surprise was in 2012.

The earnings yield is 4.57%, compared to a 2.41% yield on the 10-year U.S. Treasury notes. The dividend yield is 1.6%.

Earnings estimates, combined with the dividend, suggest a "fair" price of $30.92, meaning that NTAP is overpriced by 52%. I've marked the "fair" price on the left-hand chart in purple.

The stock is selling at 22 times earnings and also at a premium to sales. It takes $2.10 in shares to control a dollar in sales.

Institutions own 85% of shares.

NetApp next publishes earnings on Nov. 12. The stock goes ex-dividend on Oct. 8 for a quarterly payout of 16.5 cents per share.

Liquidity and Volatility

NTAP on average trades 3.5 million shares per day and supports a very wide range of strike prices spaced 50 cents apart, with open interest running to three figures.

The front-month at-the-money bid/ask spread on puts is 4.1%, compared to 0.3% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

Implied volatility stands at 28% and has been rising since the middle of September, compared to 16% over the S&P 500.

NTAP's volatility is in the 68th percentile of the decline that preceded the present rise, implying that the most successful trades will be structured as short option spreads, sold for a credit and expiring in the front month.

Options are pricing in confidence that 68.2% of trades will fall between $37.89 and $44.65 over the next month, for a potential gain or loss of 8.2%, and between $39.65 and $42.89 over the next week. I've marked the month range on the right-hand chart in blue.

Contracts today are skewed toward calls, with volume running slightly above the five-day average. Puts are running at 31% of average volume.

Decision for My Account

For the shorter term, there's much to like about NTAP. I intend to open a bear position in NTAP with downward momentum continues in the half hour before the closing bell, structuring it as a bear call spread.

If momentum falters, then I'll place NTAP on my Watchlist for later action.

-- Tim Bovee, Portland, Oregon, Oct. 2, 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.

From time to time 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.