Look at Figure 4.9
Figure 4.9
The stock’s primary and intermediate trend lines are clearly moving up; however, the stock has found significant resistance at the
$67.50 level. An attempted breakout at the middle of April and again near the end of the month failed very quickly, which lends even more strength to the resistance at this level. In addition, at today’s close, the stock closed below the support provided by the primary trend line. Even though today’s price action was positive, it failed to rise above the intermediate trend line, suggesting that the stock may now be finding resistance in that price area. The volume three days ago as the stock broke below the 50 sma was quite a bit stronger than the volume of the last week, while the volume for today’s attempted rally was measurably lower than yesterday. All of
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these readings point to an overall bearish current view of this stock.
The factors just described can all be taken as early indications of a bearish trend reversal, at least for a short-term trend time frame.
The stock is presently around $65.71; its most immediate level of support is now around $65. Let’s assume that if the stock closes tomorrow or the day after below the current support at $65, we would want to initiate a put options trade. This would apply a simple price filter to our threshold analysis; we could also stipulate that selling volume continue to be at least as large as the volume shown in today’s upward move to add an extra filter and make the trade even more conservative. We will place our entry price at around
$64.75; if the stock reaches this area, we will buy a put option.
Additional support can be seen around $63 and $60, as
demonstrated by the upward trending primary trend line. Since our entry point is quite close to the secondary support, justification for the trade can only be made if there is strong evidence that the stock will fall to at least $60.
Looking at a risk-reward graph on AFL in Figure 4.10 and projecting 15 days into the future with a predicted stock price falling to $60.00, we buy 10 contracts of the June 65p at $1.85.
According to the risk graph (which considers all the Black-Scholes elements) our puts will be worth $3.37 per share or $3,373.
Our purchase price was $1,850. That is a net profit of $1,523.
Figure 4.10
105 Trying to jump into a put trade on a stock that appears to be on the
verge of starting a new downtrend can be tricky and somewhat hazardous. Naturally, you have to be wary that the downside breakout you are looking at isn’t actually a fakeout; this is why you need to be careful to apply filtering rules to the signals your threshold analysis gives you just as you normally do on bullish trades. The other aspect of downward trending stocks that often makes this a difficult trade to actually place lies in the increased volatility stocks often experience as they initiate a new downtrend.
Look at Figure 4.11.
Figure 4.11
Early in May CCOI began a strong uptrend. However, in the face of disappointing earnings, it gapped down almost five points.
This type of action is fairly common in stocks as they begin a new downward trend. Extreme sell-offs that trigger downward trends often force the stock to exceed its normal daily trading range by a large amount, which produces the gap we see in Figure 4.11. If the gap is large enough, the stock can often find support very quickly at the bottom of the gap space, meaning that if you didn’t get into the put trade before the gap occurred, there isn’t likely to be much downside left in the stock.
One of the mistakes traders will make when they see a move such as this is to “chase the stock”—they will be afraid that if they don’t
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get in as soon as possible, they will miss whatever opportunity might be left. Don’t let an extreme move to the downside ruin your objectivity; a simple way around the problem is to ignore the stock for the rest of the day and see what its movement is like the next day. Be careful to identify the current support and resistance thresholds that apply to the stock now; if it continues to move lower, for example, closing just below today’s low price on higher than average volume, there may still be enough downside room left to afford you an opportunity to trade.
In these situations, you should also remember that although a stock may be poised to experience a significant drop, any positive catalyst—a favorable guidance report, a bullish analyst upgrade, etc.—could also cause the stock to move to the upside and begin a new uptrend. This is why you should make sure to wait until the stock actually does break below support and begin the downtrend.
If it breaks, it could gap lower, which means that you should expect to miss many of these moves. The gaps often mean that your
reward-to-risk ratios in the trade no longer work in your favor. Since your objective is to identify trades with the highest possible odds of success, understand that many of these moves will happen so fast that you won’t be able to take advantage of them, and that is all right. There is always another opportunity. In fact, when you miss moves in stocks that gap lower, your next approach should be to watch for the next setup: stocks that have already begun a downward trend.
Duration of the Trade
Trying to take advantage of the drops a stock makes as it begins a new downtrend can provide opportunities to take greater advantage of the price range of a downtrend than many of the other strategies that can be applied to put options trading.
However, remember that downtrends typically aren’t as easy to sustain for extended periods of time as strong uptrends. Because of this, few downtrends actually last longer than a couple of months. In general, one of the most effective strategies to use when planning a put options trade in a stock that is about to begin a new downtrend is to purchase sufficient time to allow the stock to begin the downtrend and make a large enough move to give you a good profit. But planning to stay in a put trade throughout a downtrend is a risky and expensive trade. Once you have
identified the most immediate support thresholds for the stock you
107 are about to trade, you should be prepared to exit your trade and
lock in your profits at these levels.
Look back at Figure 4.11.
Figure 4.11
CCOI dropped from $32.50 to $30.97 and broke its 50 dma. If you entered the trade here and purchased 10 put contracts, you would be in a favorable position two days later as the stock fell to $28.42 as seen in Figure 4.12.
Figure 4.12
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The eternal question do you take your profit or let the play run?
Assume the put option cost $1 per share. The stock fell in price about
$2.50. The option probably increased in value $1.25. You’ve made over 100% on your investment. You may seriously wish to consider taking the money and running. Frankly there’s not time to perform additional analysis. The stock can stabilize or run the other direction just as quickly as it fell. Reconsider the trade and if the indicators signal re-entry you can get back in, but protect your profit first.
It is common for a stock initiating a new downtrend to breakdown and then find support. However, when it does finally find support, the stock typically will attempt to fill the space between support and those previous highs. Fighting against a new downtrend, the stock will require a greater amount of time to fill a portion of the space before any further action occurs that could continue the downtrend. This rally attempt, and the time it takes, will erode your profits at rates that you may not be able to recover from if the stock does continue its downtrend. The moral of the story is simple: If you are fortunate enough to get into a put trade at the beginning of a new downtrend, be prepared to take your profits as soon as the stock finds support. Thus, you should plan to purchase only enough time to allow the downtrend to continue. Purchasing more than two to three months’ time in this type of put trade is usually more costly than it is effective.