I figured I would post an article I wrote for our employees this week. This is more of a teaching tool than anything else. It is able to address how to stay alive during market conditions like we have had here recently. Your thoughts are welcome as always...

Weekly Market Commentary 8-7-2006
Jeff Kohler
PHD Coach / Trading Rooms Instructor

It is said that the only constant in this market is volatility. Volatility is a measure of risk based on the standard deviation of the asset return. In English, this really means how much your investment will fluctuate over a period of time. We have all watched the market and individual positions fluctuate in significant amounts recently, which stir emotion and clouds a trader’s judgment of investment quality and market timing. The question now becomes, “What works, and why?”

The market has made some progress, posting slight gains for the last few weeks. But we are still considered to be in a bearish environment. Tomorrow the US Federal Reserve will meet again to discuss the current state of interest rates which can generate plenty of movement within the market. With the market presenting an overall bearish bias, and volatility causing traders to react emotionally, the challenge is to find the strategy that will be profitable in an environment like this. Today we will discuss how to use a credit producing strategy on a high probability trade. Let’s look at Todco (THE).

You can’t ignore the fact that there are big option premiums out there right now. As an option trader one must look at big option premiums as a reason to start selling options and being the recipient of these credits.
Let’s use Todco as our case study. As you can see there is a descending triangle formation that has been created over the last couple months. A few weeks ago we discussed this same price pattern on CYMI. We were expecting a break and had a target of $35 per share which was reached in only a weeks worth of time. The same theory is applied here on THE. The Descending Triangle happens to be a bearish continuation pattern. This means when it confirms, the stock should continue its downward trend. With a bearish posture and with over valued options infecting the market, we will be selling a credit spread instead of buying over priced put options.

In order to create the highest probability of success and give you plenty of breathing room in case the stock starts to rally, we will be selling an out-the-money credit spread for the front month of August. After all, the faster this contract expires, the faster we are relieved from our obligation in this trade. Let’s look at the option quotes to get a price on this trade.

If Todco decides to break support at $33, this support level should wind up becoming new resistance. If resistance holds, then the stock price should not exceed $33. If we were to enter a conservative spread trade on this stock it might look as follows…

Sell THE August 35 Call for $0.85
Buy THE August 40 Call for $0.20

The net difference between these two trades results in a $0.65 credit to your account. Now this might not sound like a huge return, but you also need to consider the likelihood that you will retain this full credit and how much of a cushion this trade presents against a loss. To sum up our expectation of this trade, we want the stock to close below $35 at expiration. As of now the stock is below this value. If this pattern confirms and the stock breaks support, this should present a high probability that we end up watching both options expire worthless and walk away with this full credit.

Why does this strategy work? As a trader one must consider the reward of their risk and the probability of a profitable outcome. Taking a downtrending stock, in a downtrending group, and trading it in a downtrending market will increase the odds of a successful outcome. Combine this with the bearish pattern and the conservative trade setup. Our stock is able to sustain upward movement if it presents itself, while still being able to walk away with a profit.

INVESTools teaches its student base to participate in strategies like this that consistently outperform the market while taking emphasis on risk management. You can learn more about this strategy by participating in my Advanced Options Trading Rooms session every Thursday evening at 8 p.m. Eastern.

Posted by Option Addict on 8/08/2006 at 8:43 AM | Permalink