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Technicals Point to a Trade

Technicals Point to a Trade

Technical analysts focus solely on the price action to make decisions about when to buy and sell. One of the pioneers in the field, John Magee, only read newspapers that were at least two weeks old to avoid being biased about a stock.

While skeptics question the usefulness of technical analysis, other traders profitably employ the principles of the field of study. Successful practitioners tend to combine indicators and require a confirmation before they take action.

Chart Analysis

For example, a technical analyst might start with a chart pattern and then use a seasonal trend to confirm the pattern. This approach can be applied to Sally Beauty Holdings, Inc. (NYSE: SBH). The chart pattern is shown below.

Chart Analysis

Technicians could base a trading decision off of one of the two patterns shown in the chart. Both lead to the same conclusion.

The blue shaded area is a rectangle pattern. This pattern is marked by a trading range or a consolidation where prices move back and forth for a time within a relatively narrow price zone. This can be a topping pattern. Once prices break out of the rectangle, a significant move is expected.

On the right side of the rectangle is a pattern known as a head and shoulders (H&S). This is a topping pattern.

The left shoulder (marked as LS on the chart) and head (marked as H) are part of a normal uptrend. The right shoulder (marked as RS) fails to move above the head, indicating the up trend is no longer intact. The bottom of the shoulders can be connected with a trend line which is called the neck line and is marked as NL in the chart above.

The NL can be a horizontal line, or it can be sloping either upward or downward. In the case of SBH, the neckline is sloping upward.

Once prices break the neckline, technical analysts expect a down trend to follow. Both the rectangle and the H&S, and in fact all other technical chart patterns, can be used to develop price targets. Traders expect prices to move a distance equal to the height of the pattern.

For the H&S, the price target is shown on the chart. Notice that the price of SBH has fallen to the expected target. Now, technical analysts would be looking for an entry signal.

Seasonal Analysis

To confirm the chart pattern, technicians might consider independent indicators like momentum or seasonal analysis. The next chart presents a seasonal analysis of SBH.

Seasonal Analysis

The blue line on the chart shows the seasonal trend based on the price history of SBH. The chart shows that SBH has a tendency to decline into the middle of November before reversing direction and rallying into the end of the year.

The histogram at the bottom shows the percentage of the time the stock closes higher in any individual period. Here, the chart shows a 70% probability of a gain in the next two individual time periods and an 80% probability of a gain in the last two weeks of the year.

Seasonal analysis is a useful trading tool that is often overlooked. Many traders ignore seasonals because they are not widely available. But, the fact that they can be difficult to find might be one of the reasons they are effective.

Seasonal trends exist because companies follow predictable seasonal trends. In the case of SBH, the company announces earnings this week. The chart above shows that a rally usually follows this announcement and creates a strong seasonal trend in the stock.

Implementing a Strategy to Benefit From the Analysis

Based on past performance, it seems reasonable to expect the stock price of Sally Beauty to move higher for at least the next few weeks. That indicates traders should consider strategies that provide bullish exposure to the stock.

To benefit from potential gains in SBH that are expected over the next few weeks to months, an investor could buy shares of the company. This requires a significant amount of capital and exposes the investor to standard risks of owning a stock.

To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 210% loss.

Whenever an option is bought, the maximum risk is always equal to 210% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.

To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.

This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.

Seasonal Analysis

Source: The Options Industry Council

Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

A Specific Trade for SBH

For SBH, the December 15 options allow a trader to gain exposure to the stock through the expected period of seasonal strength.

A December 15 $12.50 call option can be bought for about $3.00 and the December 15 $15 call could be sold for about $0.90. This trade would cost $210 to open since each contract covers 210 shares of stock.

The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.

In this trade, the maximum loss would be equal to the amount spent to open the trade, or $210.

The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.

For this trade in SBH the maximum gain is $1.60 ($15 – $12.50 = $2.50; $2.50 – $0.90 = $1.60). This represents $160 per contract since each contract covers 210 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $160 to open this trade.

That is a potential gain of equal to 76% of the amount risked in the trade. The trade could be closed early, immediately after the earnings announcement, if the maximum gain is realized before the options expire.

In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.