This Chart Shows What Resistance Means
There are investors who argue that technical analysis isn’t a useful discipline. Actually, technical analysis is one tool for traders to consider and in the right hands it can be useful. In the wrong hands, it can be a direct path to the destruction of wealth.
To properly use technical analysis, it can be best to use patterns and indicators to react to the market action. To destroy wealth, it could be best to use technical tools to predict the market action.
For example, a prediction might be along the lines of expecting the stock market to decline by 1.618 times the length of the most recent rally. This may very well happen but if it does, it should be considered to be a coincidence.
To use technical analysis as a reactive tool, we could wait for the current rally to end which means we wait for price to start falling. Then, we can use tools to forecast how low prices could drop. This reactive approach will be illustrated in this article.
Resistance Is a Real Problem
Technical analysts often spot price levels they believe will prove to be resistance on a chart. Resistance is a level where a rally is expected to stop, or in effect where prices run into resistance and stop moving higher.
Resistance can develop because investors do like to “get even.” In other words, if they buy and a stock falls, they may sell when they have a chance to get out of the position at a break even level. The level where buying occurred could show up on a chart as potential resistance.
The charts below shows potential resistance in Foot Locker (NYSE: FL). We will start with a longer term chart.
FL was a strong performer in 2016 and investors tend to like to see strong performers stumble. They believe after the price falls from its highs, the stock offers a bargain and they don’t want to miss out on the gains the stock promises the second time it moves up. So, they buy into decline.
The long term shows that FL did fall from its highs. This could have attracted bargain hunters. The daily chart, shown next, indicates where those bargain hunters might have bought.
The daily chart shows gaps, which are large areas where no trading occurs. Gaps tend to be associated with news stories. Let’s consider what could have happened after prices gapped down in May. The news could have attracted the attention of bargain hunters.
The bargain hunter might have thought, “I’ve been to Foot Locker. It’s a good store. I always see customers in the store. People will always buy sneakers so there is no way a store will Foot Locker will remain down. I’ll buy when it finishes falling on the news.”
Well, many of those bargain hunters would have been buying near $48. The chart shows what happened next. The stock fell again and did so with a big gap. Now, let’s go back to our bargain hunter.
This time they are thinking, “I guess I was early. This is a great company and it’ll come back. But, it might take time. So, I’ll sell when I am even and take advantage of other opportunities in bargains with that money.”
A few weeks, later, the stock gaps again, This time to the up side. Now, our investor is at break even and is thinking, “let me take my money out of Foot Locker. After all, it did fall and I don’t want to risk that happening again. I’m even, after all, so I’m selling.”
That explains why the stock is selling off again. Many investors are even and want out. This should place a limit on the short term up side potential of the stock.
The expected short term weakness in the stock creates a trading opportunity.
To benefit from weakness, 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.
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 FL
For FL, 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 January 19 $48 call for about $0.60 and buy a January 19 $50 call for about $0.25. This trade generates a credit of $0.35, 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 $35. The credit received when the trade is opened, $35 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $165. The risk is found by subtracting the difference in the strike prices ($200 or $2.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($35).
This trade offers a return of about 21% for a holding period that is about one week. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if FL is below $48 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 $165 for this trade in FL.
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.