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Taking some heat and needing a plan

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Believe it or not, I've gotten quite a few e-mails from traders that shorted some stocks and they've rallied "further" than imagined and some serious heat is being taken in account. If you trade long enough, and even if you haven't, we've all been in this situation at least once. The mistakes are common. Too many trades on and can't monitor them all, perhaps some complacency and sometimes just an extreme oversold bounce that can turn a trade upside down and seriously impact the account.

One subscriber made some very nice gains in biotech IDEC Pharmaceuticals (NASDAQ:IDPH) $41.67 +4.2% from the $37 to $23 level. Then when the stock rallied back near $31.50 a new short position was put on. Since then the stock has exhibited strength and a once flourishing account now feels some heat. I'm not talking about a 100 share short position either. There's some size involved and suffice it so say, I'd be doing a little sweating too and looking for some type of hedge near-term.

The trader doesn't understand or use point and figure charts, so I'm going to take some things from the point and figure chart, overlay it on the bar chart and use retracement to try and begin understanding some various levels.

The "basics" and the obvious are found from the retracement highs and lows. The MARKET wanted to sell at $71.39 (upper retracement) and buy at $20.76. It sure looks like recent support at $30.43 is a level from retracement where market makers found a "buy side" bias and they and their institutional clients liked the stock as an accumulation level.

Look for market makers to now be measuring order flow and the $40.10 level. For the trader short at $30.50, any type of decline back near $35 would most likely be welcomed. A break back above the relative high of $42.50 puts the bear at further risk for a bullish move to $46, where I'd think market makers would have more of a "sell bias" in the stock as it relates to inventory bought at $30.43 and perhaps right near here at $40.10.

IDEC Pharmaceuticals Chart - Daily Interval

Shares of IDPH are showing some bullishness and it's a good thing that a bearish trader from $31.50 is at least showing some concern. With a bullish vertical count of $67, that's the longer-term risk a bear currently needs to understand.

If this were my position, the first thing I'd do is ask myself at what level would I be "thankful" for a pullback to where I could get this trade back under control. Right now, that would be at the $37 level.

A break above the recent relative high of $42.50 most likely see further bullishness to $46 and that could only make things worse.

For now, I'd do nothing, but get a plan in place for a break above $41.50 (consign the loss) and stop or "pay up" with a protective call option.

On the downside, first goal is to get hedged at $40, while bringing up my short cost basis as much as possible.

Right now, I'd simply work from the stop at $42.50. Yes, I'm going to confess a $12.00 loss per share, but if I'm trading equal dollar amounts as when I shorted from $37 to $23 (37% gain) I'm at a fractional account loss (39% loss) in the account and that is the most important thing to control!

If I can get a light volume pullback, perhaps get some volume on a downward move, then I'd have a plan in place and look at selling some August $35 puts (IDKTG) which are currently bid $1.25, but would mostly likely rise to around $2 on a decline to the $37 level should that take place in the next several days. This would get my cost basis in the short at $31.50 up to $33.50.

The question posed right now is "do I wish I would have simply covered before at $33?" If the answer is "yes" then the selling of the $35 puts for $2 is a confirming type of trade.

But I'm still not "hedged." If I want to get "hedged" at $40, I could then take the $2 premium received from the puts and turn to the $40 strike calls that gives me the RIGHT, to buy the stock at $40. Right now, the August $40 calls (IDKHH) are offered $3.90, but should the stock come down to $37-$38 then I'm guessing the price of these calls would be $2 or less.

Lessons learned from this e-mail: I'm not degrading this trader, but some comments this e-mail are things I've tried to warn against in the past.

One "reason" this trade has gotten away from the trader is that they had too many trades on and simply couldn't monitor the account properly.

On Monday, July 15th, the biotech bullish % from Dorsey/Wright and Associates was at 10% and "bear confirmed". That compares to this Tuesday's reading of "bull alert" at 20.12% after turning "bull alert" at 16%. IDPH gave a "buy signal" at $37, which contributed one buy signal to the sector's bullish %.

I'm "hoping" the trader has a trading discipline that states a certain MAXIMUM and consistent dollar amount that can be put into each trade. My assumptions of a net 3% loss in the account as it relates to a past short and current short in IDPH is based off of a disciplined trading strategy where the trader may have shorted $100K previously, and shorted the same $100K recently. The account "status" might be entirely different if 1000 shares were shorted initially and 2000 shares shorted recently.

Special Note: The above is EXACTLY why options or derivatives as they are called were created. They were created to allow INSTITUTIONS to control risk in their holdings, NOT as a tool to OVERLEVERAGE and SPECULATE with as is often thought by options traders.

If you're an equity trader, OPTIONS can save your hide and reduce risk in a trade. Even when things start getting a little heated.

Jeff Bailey
Senior Market Technician
Option Investor

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