Option 101 Classic:
Article originally written 12.11.2002
Over the past week, we've been talking about the importance of confirmation in selecting trades, especially in the option world. Due to the strongly positive flood of reader email from the last two installments, I thought it would be useful to extend the concept a little further.
One of the central points I was trying to make last week was that there is no magical, works-all-the-time indicator. All of technical analysis boils down to pattern recognition and degrees of confirmation between various indicators. There are no guarantees. As technicians, our job is to correctly apply the tools of our trade to pick solid entry points on high-odds targets. We've already spent a fair amount of time covering the technical aspects of what makes a good trade in a given stock. Where I think we ought to focus our attention today is on picking winning trade candidates.
I've had a number of readers write in recently, asking about how to find solid trade candidates in the first place. My answer is always, "They are where you find them". I'm not normally so flip, but there's a reason for my response. I think you can pick ANY stock and find trading opportunities on a regular basis. It's all about getting familiar with the way that stock trades. There's an old saying about familiarity breeding contempt, but in the trading world, it is my opinion that familiarity breeds profits. In fact, I think any accomplished trader can make a steady income stream from only a handful of stocks that the trader follows closely.
The reason I want to talk about this aspect of trade selection today is that I think there are a lot of traders that are constantly searching for that perfect stock to trade, scanning innumerable possibilities on a regular basis. To me, that endeavor is akin to trying to find the perfect, can't-lose technical indicator. Since a picture is worth a thousand words, let's spend the rest of our time looking at an example, and I think you'll see what I mean.
Up until recently, I frequently would use generic stock symbols like ABC or XYZ for hypothetical examples in my articles. But then a couple weeks ago, I noticed that there was a new put play listed on the OI site on ABC. Much to my surprise, I found that it was a real stock symbol for the company AmerisourceBergen Corporation. I've never traded the stock before, but I can recognize high-odds setups on the chart when I see them.
Throughout September and October, ABC was banging into solid resistance in the $74-75 area, but was completely unable to break through. There wasn't any trading signal available at that point, but the lack of an ability to break through resistance hinted at weakness in the future. The first confirmation came in mid-October, when the stock traded down to just below $70, generating the first PnF Sell signal in close to a month. Since that column of O's came to rest right on the bullish support line, I would have shied away from entries on weakness right there. But another failed rally near the $75 level would be just the ticket for a low-risk/high potential reward bearish trade.
Sure enough, the last week of October had ABC rallying to and failing right at the $75 level before the bottom fell out in early November. Then the stock took out support at the 200-dma and then the $65 level before a big gap down on November 19th that took the stock down to roughly $56. For traders with a longer time horizon, that would have made for a great 3-4 week trade. Buy a put on the rollover near $75 and then exit on the rebound from $56. I doubt there are many traders that would have held on through all the intervening volatility, but the point is that there was a $19 range in which to capture a profit. I don't know about you, but that's more than enough for me!
Alright, that's water under the bridge though. OI initiated coverage of ABC as a put on November 14th when the stock was trading at $63.80 and closed out the play on the 19th when the stock rebounded back to the $59 level. What I really want to talk about here is how to capitalize on future opportunities in the stock. We've covered a lot of ground here without the benefit of a chart, so let's delve into one now.
Daily Chart of ABC - 12/02/02
This is the picture that ABC presented us with as of the close of trading last Monday. The second solid bounce off of the $56 level reinforces it as strong support in my mind, so I don't want to try shorting a breakdown until I see a trade at $55, which would create a new PnF Sell signal and give us a new price target from the vertical count of $46. But that's not the most likely scenario that would have jumped out at me. I see the top of the mid-November gap as a price magnet that will likely be touched sooner than later. But there are a lot of traders that got trapped on that big gap down and will use a return to the $63-64 price level to get out. That means significant overhead supply. At the other end of the near-term price spectrum, I see $56 as pretty strong support.
That gives me two actionable levels over the near term, if I wanted to trade ABC. Buy puts on a rally failure in the $63-64 area is my favorite trade. But a close second would be buying calls on another rebound from the $56 level. Both of these trades present very favorable risk/reward ratios. The put trade would have the stop set at $65, and my target to the downside would be $56-57. The call trade can be managed with a tight stop at $55, targeting $63-64 to the upside. In both cases, we would be risking $1-2 to potentially make $6-8. I'll take odds like that every day of the week and twice on Sunday! So let's see what would have happened.
Daily Chart of ABC - 7 Trading Days Later
Sure enough, the second bounce from the $56 level actually stuck and ABC clawed its way up to the $63 level by early December. The stock gave us 3 great entry opportunities, with intraday trades up to $63.50, $63.75 and $63.80 before daily Stochastics finally rolled over and led to another big decline. Just taking the most recent entry opportunity provided on Monday morning would have yielded more than a $6 drop in the stock in just 3 days time. Note that the stock was right back at the $56 support level on Wednesday. Is this a good entry opportunity to the long side? I really don't know, as the declining Stochastics make me a bit nervous. A quick look at the PnF chart though, shows a Buy signal still in effect, with a $75 target currently in play. We'd need a trade at $55 in order to invalidate that target, so I'd probably go with the odds and take the trade. There's $2.15 of downside risk, with the likelihood of another trip to the top of the gap ($6-7 upside potential) over the near term and then up to $75 ($18 potential upside) over the longer term.
The point I'm trying to make (and hopefully I succeeded) is that it doesn't matter what stocks you decide to trade. Just like it doesn't really matter what selection of technical indicators you elect to use. This should all fit into your business plan -- select in advance what you are going to trade, and how you are going to trade it. Rest assured that if you select equities or indices that have liquidity and volatility, then the solid trading opportunities will come. Our job is to exercise the necessary patience while waiting for the high-odds opportunities to arrive. Put another way, pick your targets and then pull the trigger when they drift into range.
Traders that can put this habit into consistent practice will be successful, whether their chosen trading vehicle is options, stocks, or futures. I can tell you this. Waiting for my targets to wander into range is certainly a lot easier than trying to charge through the forest of optionable stocks, trying to catch the one that looks to be moving right now. Look at any stock trading above the $20 level with an average weekly range greater than $2-3, and I'm willing to bet there are a couple of solid trades that set up each and every month. Build a stable of 6-8 stocks to follow, and you should never suffer from a lack of solid trading opportunities.
So coming back to the title of tonight's article, I don't think there is a "right target". A more appropriate endeavor is to pick YOUR target and then patiently wait for it to come to you. I hope that helps in your trade selection process!
Have a great week!