Is Your Stock About To Break Out? Here's A Simple Options Strategy To Trade It

 
Many stock traders like to play breakouts off of large bases.  Typically they set a stop loss about 6-8% below the breakout entry point, hoping to cut losses short if the breakout fails, while letting profits potentially run to much larger percentage gains over several months. An alternative way to play this type of setup is to deploy an options strategy known as call backspread.

I scanned a number of stocks exhibiting classic “cup & handle” formations and found one, the chewing gum and confectionary product company, Wm. Wrigley Jr. Company (WWY | Quote | Chart | News | PowerRating), which has good technical characteristics, including good relative strength, to use as an example.
 

There are many services that will scan for these patterns if you want to systematically find these types of setups to which you can apply this strategy.
 

As you can see in Figure 1, the chart formation displays a cup and handle setup, with the stock price last closing at 71.88 after recently having experienced a breakout from a large base on above average volume. At this point you might want to put on a call backspread if you expect the stock to breakout from the “handle” being formed. This strategy has limited loss and unlimited profit potential, as seen in Figure 2.



 

Table 1 has the call backspread pricing details. With the stock at 71.88, we would sell an in the money December 65 call and buy 2 in the money December 70 calls. The prices for these options, taking into account bid/ask spreads, would be as follows:
 

 Figure 3

As you can see, we would sell the December 65 for 7.20 and buy two of the December 70s for 3.30 (6.60), leaving a small net credit of $50 in our account (abstracting from commissions, which might run about $5.00 total). This is an in-the-money call backspread, even though typically these are done with the long options out of the money. The $50 credit per backspread means that if the stock ends up experiencing a breakout failure, and falls below 65 before by expiration in December, the position actually makes that much per position. Breakeven is actually at 65.50 on the downside and on the upside the stock needs to finish above 74.50 to make a profit, which is a move of +3.6%.

Remember, these types of breakouts can experience very big moves, which is the intent of the breakout trader. As figure 2 shows, there is unlimited profit potential above 74.50 on the upside should an extended move occur.

As for managing the trade, we could compare the maximum loss on this position, which has a negative position Theta trade (i.e., suffers from time value decay), with say an 8% stop loss typically used for this type of breakout. Interestingly, if you let this trade go to term, the maximum loss is -$450. Yet if you were to use the 8% stop loss rule, you would actually lose $575 if the stop was hit. A nice bonus is that you don’t need to worry about getting whipped out of your position before a potential move higher. And this trade can be simply allowed to go to term without need of intervening since you can only lose $450.

In subsequent articles, I will explain some ways to manage this type of trade, instead of just putting it on and letting it win or lose, such as rolling up the options in the position as it turns profitable.

Good luck with trading.

Cheers!