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Support and Resistance Can Be Frustrating or Profitable

Support and Resistance Can Be Frustrating or Profitable

Traders often find the concepts of support and resistance to be useful. The idea is that resistance forms near old highs and support forms new recent lows.

In practice, the concepts are intuitive. Traders who bought at those old highs suffered losses as the stock price pulled back. Many will then say that if they can just break-even they will sell. The selling pressure coming from investors thankful to break even creates resistance.

Support comes from bargain hunters. Many investors will be watching a stock and believe it is worth a certain price. While waiting for a pull back to their ideal buy point, the stock might not cooperate and the stock could rally.

Traders creating resistance drive the price back down and now traders who thought a lower price seemed important will buy at previous lows. This creates support. That concept can be seen in the chart below.

TGT daily chart

In this chart of Target Corporation (NYSE: TGT), the price has been moving between support and resistance for some time. The current price is near a resistance level and the stock could begin to sell off again, headed towards support.

In the stock market, this pattern will not continue indefinitely. It will often end when a company announces earnings and pushes the price out if the range. In the case of Target, that could come in August, the next scheduled announcement.

Until then, the stock is likely to remain in a trading range, a relatively boring pattern for long term investors and a frustratingly risky pattern for short term traders trying to sell resistance and buy support.

Rather than attempting to do that, traders could use a relatively low risk strategy with options. There are strategies using options that can strictly define the level of risk a trader accepts, something that is impossible to do with stocks.

There are also options strategies specifically designed to benefit from a trading range that do not require buying support and selling resistance, and accepting the high level of risk that can develop when the stock finally breaks out of the trading range.

A Strategy to Benefit From a Calm Market Environment

For Target Corporation, there is a relatively high likelihood of a relatively narrow trading range. One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.

To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.

In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.

The risks and potential rewards of the strategy are shown in the following diagram.

iron condor

Source: The Options Industry Council

The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.

Opening an Iron Condor in Target Corporation

For Target Corporation, the trade can be opened using the following four options contracts:

Target Iron Condor

As you see, all of the options expire on the same day, Friday, June 15.

The difference in the exercise prices of the calls or puts is equal to $1.50. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $150 less the premium received when the trade was opened.

Selling the options will generate $0.60 in income ($0.20 from the call and $0.40 from the put). Buying the options will cost $0.30 ($0.10 for the call and $0.20 for the put). This means opening the trade will result in a credit of $0.30, or $30 for each contract since each contract covers 100 shares.

The maximum risk on the trade is equal to the difference in strike prices ($1.50) minus the premium received ($0.30). This is equal to $1.20, or $120 since each contract covers 100 shares. Many brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $120 in capital.

The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.30 or $30 per contract.

The potential reward on the trade ($30) is about 33% of the amount risked, a high potential return on investment for a trade that will be open for about one week. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.

This trade could also be closed out early to reduce the potential risks of the trade. It could still deliver its maximum gain even if the position is closed before the expiration date of the options.

The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.

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