Option 101 Classic:
Timing Is Everything
As option traders, we know that the timing of our entries and exits is crucial to our long-term success. Options are a wasting asset, as the time value we purchase when we open a new position decays over time. So just picking the right trade and direction is not enough. We also need to enter our trades when the underlying security is ready to move in our favor.
Not only do we need to pick the right time for entries and exits, but we need to know how long the anticipated move should take to come to fruition. Have you ever entered a trade, "knowing" that you had the direction correct, only to watch your purchased options expire worthless just as the move you were expecting got started? Or am I the only one? When that happens to a trade, we need to ask ourselves where we went wrong. Did we pick the wrong direction, or the wrong timeframe? Why? Could it be that the charts we used for picking the trade were too long or short in their timeframes? In an effort to highlight the important factors involved in picking the right entry, timing and timeframe, I'd like to look at our potential Put play on eBay (NASDAQ:EBAY) today. Care to join me?
We added the stock to our Watch List a couple weeks ago, based on emerging weakness in the longer-term charts. Given the stock's rich valuation and my expectation for more economic weakness in the months ahead, it seemed like an attractive bearish play. Let's review what the charts looked like at the time.
Traders with stronger intestinal fortitude than I could have entered LEAP Put positions near the then-current price of $56.75, due to the developing weakness on the weekly chart and the well-established downtrend on the monthly chart (not shown). But the daily chart clearly showed that a better entry would materialize later, due to Stochastics just beginning to emerge from oversold territory. Sure enough, they would have managed a solid profit over the near term as EBAY got slammed early the following week due to poor reception of the company's annual analyst meeting. The stock sold off sharply, as shown in the daily chart below, dragging EBAY down to test the $52 support level. Support held again, allowing the bulls to take control, pushing back towards the $60 resistance level.
So why did I go through this repeat analysis on the EBAY chart, which we have already analyzed to death over the past 2 weeks? Simply to point out the importance of timing. While we are looking to initiate a long-term position, the shorter-term chart MUST be used if we want to achieve a lower-stress entry point.
It all goes back to defining our trading objectives. For LEAPS plays, the weekly and monthly charts determine the trend that we want to capitalize on, but the daily is used for entries. The other important factor is trade duration. Judging by the time between troughs and peaks on the weekly chart, we can see that a move from overbought to oversold should take on the order of 2-3 months. Judging from the past trading of EBAY, the monthly oscillator takes from 8-10 months to fully transition from one extreme to the other. The monthly trend is half-way through its current decline, while the weekly appears just about ready to start down.
That gives us a reasonable target for the duration of the play from 2-5 months once the daily chart gives us that clear entry signal. Since we want to avoid the effect of time decay in our play, we want to use option contracts that will still have a minimum of 9 months until expiration when we expect the play to come to a reasonable close. That leads us to the conclusion that we can reasonably use 2003 LEAPS, with an expiration in January 2003.
Since we began looking at the stock a couple weeks ago, the daily Stochastics oscillator dropped near oversold, bounced from support and is nearing overbought territory again, while still remaining below resistance. Short-term traders can choose to take advantage of these near-term moves, but their entry/exit triggers will come from the intraday (60-min/30-min) charts. For those traders, the daily chart defines the "longer-term" trend from which they want to profit. Since they are looking to play trends that last for a few days to as much as a couple weeks, they can profitably use shorter-term options. Ideally they will choose those options with 60-90 days until expiration to shield their trade from the effects of time-decay that accelerates as expiration day draws near.
But for us, the moves on the daily chart only portray near-term "noise" that will eventually set us up for our long-term play. We utilize LEAPS for the simple purpose of profiting from a longer-lived trend, with lower time-decay risk. The price we pay is that the LEAPS are significantly more expensive (because we are buying more time), so our annualized rate of return will be lower than what can be achieved by the accomplished swing trader. We pay more up front and reap a lower percentage gain, but do so with less stress (and I believe, less risk) due to the fact that we have more time to be right, and to a certain extent can ignore the fluctuations on the shorter-term charts.
So let's see what we have learned about EBAY that can guide us into a profitable put play. The monthly chart is about halfway through its move towards oversold and the weekly chart is just beginning to roll over. This gives us a reasonable duration of the play of from 2-5 months, guiding us towards a selection of the 2003 LEAP Puts. We can reasonably expect the daily chart to go through numerous overbought/oversold cycles throughout the duration of the play, and is one of our best tools for determining our trade entry trigger.
So long as the $60 resistance level remains intact, the next rollover of the daily oscillator is likely to be our high-odds long-term entry. Then we place our stop just above resistance and settle in to ride the stock lower over the months ahead. Using the weekly Stochastics as our guide, we can ride the long-term trend south, taking defensive action (tightening our stop or closing the play completely), as the oscillator bottoms in oversold again and begins to show signs of life. Depending on developments between now and then and how long the next weekly cycle lasts, we might even get a chance to play EBAY to the downside again before the monthly chart reaches the end of its downward move. Only time will tell...
With the weekly Stochastics rolling over, the 50-dma now crossing below the 200-dma again and a formidable downtrend in place on the price chart, it appears that we are getting close to confirmation that we are on the right side of the long-term trend. Look for increasing bearish pressure to drive EBAY decisively below the $52 support level, as that will be an important confirmation that we are right.
I hope this little discussion helps you to better understand the important factors involved in trade selection, based on your time horizon and the maturity of the trend from which you wish to profit.
Have a great week!