• Facebook
  • Twitter
  • Podcast

Hope Is Not the Best Strategy for this Stock

Hope Is Not the Best Strategy for this Stock

Source: Deep Water.com

Many traders have a strategy and they buy or sell based on that strategy. They might decide to buy if a stock is undervalued and sell when it is overbought. Or, technical indicators could lead them to buying when a stock is oversold and selling when it is overbought.

Of course, other traders base decisions on tips and hope. When trading tips, a trader might hear about a stock from an acquaintance and buy the stock. Or, the trader might see that a stock has been falling and hope that it will recover.

Hope can be driven by the fact that a stock once traded at a significant price. Some investors anchor their thinking about the stock’s value on that high and presume a decline presents an opportunity to purchase the shares at a discount to that value.

Hope can also be driven by a belief that the company is in a business that is ultimately destined for success. This can create the illusion of a bargain and lead to a decision to jump into a stock because the trader believes “the industry will survive and prosper in the long run.”

Hope Creates Volatility

One potential indicator of hope in a stick can be seen in a chart. Volatility can increase, as we can see in the chart of Transocean Ltd. (NYSE: RIG).

RIG daily chart

Notice the high degree of volatility recently as the stock reached new six month and even twelve month highs.

RIG chart

For many investors, this was a sign the stock could get to its all time highs which were near $130 a share in 2008.

Some traders believe the stock must be worth a higher price simply because it traded at such a high price in the past.

Last week’s activity did have some important implications for traders.

Immediate selling after a rally is a sign of weakness in a stock. It indicates there are traders looking to sell into strength and they can push prices lower quickly. This is called resistance because their presence in the market leads to resistance against higher prices.

The second important implication is that rapid sell offs result in increased volatility. The increased volatility leads to higher options premiums and that could be useful for traders who use strategies that involve selling options.

Those strategies can benefit from increased volatility by capturing higher than average premiums generated by the higher than average volatility.

A Trading Strategy While Awaiting Better News

To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.

In this case, with a bearish outlook, a call option should be sold.

Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.

The risk profile of this trading strategy is summarized in the diagram below.

bear call spread

Source: The Options Industry Council

The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.

The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.

A Bear Call Spread in RIG

For RIG, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.

In this case, we could sell a June 22 $13 call for about $0.45 and buy a June 22 $14 call for about $0.15. This trade generates a credit of $0.30, which is the difference in the amount of premium for the call that is sold and the call.

Since each contract covers 100 shares, opening this position results in immediate income of $30. The credit received when the trade is opened, $30 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $70. The risk is found by subtracting the difference in the strike prices ($100 or $1.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($30).

This trade offers a potential return of about 42% of the amount risked for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if RIG is below $13 when the options expire, a likely event given the stock’s trend.

Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $70 for this trade in RIG.

These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.