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Option expiration is a tough day to hang your trading hat on as you're never certain if the market action is truly depicting the broader view of economics or if the action in the major indexes is reflecting some positioning around major strike prices due to options expiration.

Over the years, I've seen some wild gyrations simply due to option expiration and try to avoid trading NASDAQ stocks on an option expiration day. Once I witness shares of PSFT jump from $25-$30 in a 30-minute time frame when having shorted the stock earlier in the day at $26. I was stopped out at $30.25 and the following Monday the stock dropped to $26 if memory serves me correctly.

It still becomes important to monitor levels as previously identified.

One level we're seeing broken to the downside is our 50% retracement level on the Dow Industrials (INDU) at the 9,105 level. Seven sessions ago, the Dow Industrials broke above this level (October 9th), but today's dip back below follows the S&P 500's recent break back below the 1,082 level from Wednesday. The S&P 500 has not stopped that decline and currently trades at a session low of 1,058.

On Wednesday, we thought the breaking of the 1,082 level in the SPX brought the 1,050 level into play (October 5-9 lows) and further risk for bulls down to retracement of 1,011. Currently that scenario looks to be unfolding.

Getting yourself out of a fix

We've all heard the saying, "I'd rather be lucky than good." Recently I got an e-mail from a subscriber regarding a bearish trade in eBay Inc. (EBAY) that had gotten away from them when having shorted the stock at $46. The subscriber firmly believed that the stock was "overvalued" and would fall. We turned to the technical on October 11th to try and help the subscriber deal with the stock at the $60 level and outlined a hedge strategy.

Now what would I be doing as the stock has fallen back to the $52 level? Let's take a quick look at the account (based on 100 share short position) assess things and put together a strategy. Goal at this point is to try and get back to break-even after having been down 26% at one point.

eBay position based on strategies

The top two positions represent a short (red s) in 100 shares of EBAY at $46 and the Oct. $60 call (QXBJL) may have been bought on 10/11/01 as a hedge against further upward move to our retracement bracket of $62.86. Whew! The stock did rally to $63.48 on October 16th and that call option bought as a hedge had the trader more "calm" than perhaps he/she would have been had they still only been holding the stock short. Remember, the call option was bought as a HEDGE (insurance until today's option expiration) and was a cost of doing business to help a bearish trader in case of further upward move in underlying stock. I've subtotaled those two trades to depict what account would look like (at time of screen capture). Well... an 18.6% loss isn't that comforting, but its better than what was a 26% loss a couple of days ago.

Now I've added the SALE of a put option in the November $45 put (QXBWI). What this trade does is OBLIGATE me to buy back 100 shares of EBAY at $45 (remember, the account is already short 100 shares at $46 and we have to buy that stock back at some point). By selling the Nov. $45 put here, I'm basically obligating myself to buy the stock back at $45 minus the premium received of $2.15 or $42.85.

My thinking here is... when the stock was at $63, I would have been more than happy to be able to have pretended this trade never happened! Today I have the opportunity to perhaps do just that. Yes, the stock could rally again, but I've at least worked off some damage by selling the put contract.

Here's the technicals and there are some other strategies we can work into a bearish trader's scenario to help further.

eBay Chart -

Looking back, a bearish trader in EBAY may have been wise to take a loss at $49.60 if short at $46 on the break back above 50% retracement. I always want to look back and perhaps find "what I should have done" then compare to what I've seen happen and where I'm at now. Today, the stock has dropped back below the $54.61 level (38.2% retracement, another stopping point that could have been honored by a short) and has traded right down to the 200-day MA (another point where a bearish trader may have stopped out on the break ABOVE this moving average).

A trader that is short at $46 and has ridden thing out this far can now easily understand and assess risk to $63 (been there, done that) and limit risk from here with a stop just above the 38.2% retracement level of $54.61 (nice correlation there with the 50-day MA at $54.91). By selling the put option outlined previously, you can see we're obligating ourselves to buy back the 100 share short position right below our 61.8% retracement bracket, which is very near the reversal higher back in late September where "smart money" covered.

Been there and done that

Do you get the feeling that the above strategies were fairly well thought out? I know of these strategies not from "reading about them," but having to have implemented them in the past. Yes, I've been in the same boat and learned that when I make a mistake, it's best to admit it early with stops. Sometimes conviction about "valuation" overrides the mind and we hang on to the trade.

Fact is..... the trader that shorted EBAY at $46 was WRONG as outlined in our trading account on September 26th. WRONG because the stock didn't go down that much and ended up at $63. A trader still short at $46 is no more right than he/she was at $46, but the recent decline has given him/her a second chance to further reduce some damage.

I'm not being critical of the subscriber that shorted EBAY at $46. Please don't get me wrong. This is the way I think of my own trading when a trade moves against me. I did the same thing in Amazon.com (NASDAQ:AMZN) at $20 on its way to $100. However, I did cover that MISTAKE at $25 on a break to 52-week highs and glad I did. I would have never gotten the pullback opportunity until 2-year later (last October of 2000). Yes, I was right about valuation concerns regarding AMZN back in October of 1998, but it took two years for the MARKET to come up to speed. Just goes to show, the MARKET is never wrong and why I now trade levels and let the MARKET tell me when I'm right or wrong.

Jeff Bailey
Senior Market Technician
Option Investor

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