Try This Dead-Cat Bounce Strategy
As an
option trader, putting statistical probabilities on my side is only
half the struggle when looking for trades. I also like to find technical
conditions that lend additional support, to tilt purely statistical analysis
even more in my favor.
Let’s look at the
example of Synaptics, Inc. (SYNA),
which gapped down sharply this past Friday following weaker than expected Q1
revenue forecasts. The computer touchpad technology company’s capitalization was
slashed 25%, as the stock price dropped by $5.17, closing Friday’s
session at $15.85.
The large gap chart is a nice technical condition
to use for setting up a “not likely to go zone†for an option trade. As
primarily an option writer, I like to find zones where stocks are not
likely to go and will select a point just outside that zone to sell an option
spread.
The large chart gap acts as a major technical
break point (resistance), which may be difficult for SYNA to surmount anytime
soon.
Looking at the daily price chart of SYNA, we can
see that the gap lower offers a window of opportunity for selling a call spread,
as indicated in figure 1.
Since the level of 20.21 was the close before the
gap lower, I consider this level will be difficult to reach in the next three
months, so I will select the December 20 call strike to sell, and will cover
that strike with a purchase of the December 25 strike, creating a vertical bear
call spread, a trade that profits from time-value decay.
Ideally, you could wait for a “dead cat bounceâ€
up after the big drop day to put a bear call spread on, but here the close was
off the day’s low enough for me. The strikes and prices for each are contained
in figure 2 below.
As seen in figure 2, we would collect $75 for
selling the December 20 call. The matrix in figure 2 shows bid prices, so we
would actually pay $30 for buying the December 25 call, not $25 (the bid price).
This trade has a maximum potential loss of $455 (difference between the strikes
minus net premium collected of $45, abstracting from commissions), which we can
use as our required capital value for the trade.
If SYNA remains below 20 in the next 140 days and
expires worthless on December 17, we keep the $45 in net premium we collected
for the spread, a potential return of +9.8%.
The profit zone, shown in figure 3, extends to
zero, but the upside risk (not entirely shown here) is limited at $455, with
breakeven at 20.45.
This trade, however, needs to be managed
properly. Our stop loss rule is two-fold, exit if the spread price doubles, or
if the short strike is touched. Simple! This way we will usually keep maximum
losses to twice potential profit on each trade, which can potentially pay off in
the long run in terms of keeping drawdowns under control.
Bear call (credit) spreads are one of my favorite
setups, whether trading stocks or stock index options. The trick to making them
pay off in the long run with stocks, is to keep a large portfolio of them, so that
you keep your capital diversified. I like to keep no more than 5% in any one
position.
I’ll keep my radar screen up and running in the
weeks ahead for similar setups like the SYNA gapper to help to keep your plate
full.
Cheers!
John Summa
Past performance is not a guarantee of future
profits. Trade with risk capital only.
John F. Summa is Founder and President of
OptionsNerd.com,
and a registered Commodity Trading Advisor (CTA) with the National Futures
Association (NFA). Founded in 1998, OptionsNerd.com offers trading
seminars and tutorials to options traders, futures and option trading
advisories and managed futures and options CTA account services.
Mr
Summa’s trading articles have appeared in Technical Analysis of Stocks &
Commodities magazine, as well as Active Trader Magazine, Options Trader
Magazine, Futures Magazine, Stock, Futures & Options Magazine, and Investopedia.com. He coauthored
Options on Futures: New
Trading Strategies and Options on Futures Workbook (John Wiley & Sons, 2001) and more recently wrote the groundbreaking
book,
Trading
Against The Crowd: Profiting From Fear and Greed in Stock, Futures and
Options Markets (John Wiley & Sons,
2004), which includes Mr. Summa’s innovative quantitative bear and bull
news-flow Contrarian indicator.
Mr. Summa is a PhD-trained economist
and operates a
delta-neutral options trading CTA program.