This Stock Could Be Breaking Out
Some traders try to use indicators in a strictly mechanical way. They might look at momentum indicators, for example. These indicators are usually interpreted in a way that forecasts short term reversals.
So, when a momentum indictor moves higher, these traders will look for ways to sell their positions or even to establish a short position in the stock. Likewise when a momentum indicator declines, they will be watching for a chance to enter a position by buying.
This may not always be the best way to trade. Interpreting momentum indicators ideally includes a view of how the stock behaves, its personality in some ways, and the general market background.
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The chart below is of Micron Technology, Inc. (Nasdaq: MU). Micron is one of the largest memory chip makers but makes just three types of chips known as DRAM, NAND and NOR memory chips. Demand for these chips has been high and the stock price of MU reflects that fact.
The stock has been moving higher after breaking out of a trading range in February. The stock declined, in line with the broad stock market, and now appears to be bottoming.
At the bottom of the chart is the two-period RSI. This is the relative strength index (RSI) but it’s calculated with just two days worth of data instead of the more common value. In numerous books and articles, the trader and analyst Larry Connors has shown that this calculation works better.
Looking at the chart, we can see that the indicator is moving into what could be considered an oversold extreme. This would traditionally be the time to look for a decline in the stock. But, the last four signals indicated that this was a sign of strength.
While Micron was in a trading range, the RSI(2) indicator did highlight reversals. But, now it is trending. The stock is in a relatively strong trend and we should expect a stock to behave differently when it is trending than it does when it is in a trading range.
Based on that analysis, it could be best to establish a position in the stock that benefits from price gains. That could be done, of course, with an eye towards managing the risks in case the stock does reverse quickly. Options allow us to meet these objectives of gaining exposure to the stock while limiting risk.
A Trade for Short Term Bulls
As with the ownership of any stock, buying MU could require 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 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% 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.
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.
This strategy could be especially appealing with high prices stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for MU
For MU, the May 18 options allow a trader to gain exposure to the stock.
An May 18 $52.50 call option can be bought for about $3.40 and the May 18 $55 call could be sold for about $2.20. This trade would cost $1.30 to open, or $130 since each contract covers 100 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 $130.
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 MU the maximum gain is $1.20 ($55 – $52.50 = $2.50; $2.50 – $1.30 = $1.20). This represents $120 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $130 to open this trade.
That is a potential gain of about 90% based on the amount risked in the trade. The trade could be closed early 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.