Volatility, Rather Than Direction Can Cue Trades
Although we often think of trends as exiting in just two directions, there are actually three directions for trends. A stock can move up, down or sideways. This has been recognized for at least 120 years, but it is still a fact that can be overlooked by many investors.
Charles Dow was among the first market analysts to write widely about the price action of stocks. He noted that stocks tend to move in one direction for a time although that movement is interrupted by frequent reactions.
In other words, Dow wrote that stocks might move up for a time, fall back by maybe half of the amount they gained, and then resume the up trend. In a down trend, the stock will enjoy brief rallies that interrupt the string of lower prices.
However, at times, there will not be a clear trend. Dow called these periods “lines” because the stock can appear to move in a horizontal line on the chart. Modern day analysts call these price moves “consolidations.”
Some analysts estimate that strong up or down trends are in place just about a third of the time. The rest of the time, stocks are trading in sideways trends, or Dow’s lines. That means traders should have strategies available when they see a stock in a consolidation.
Stocks Can Get Ahead of Themselves
Sometimes, we see a stock consolidate after a sharp move. It could be that the sharp move is created by traders who get ahead of the fundamentals. That could be the case with The New York Times Company (NYSE: NYT) which jumped on Friday only to pull back on Monday.
Friday’s jump came on news that Facebook (Nasdaq: FB) would begin prioritizing “trustworthy” news in its feed of social media posts, using member surveys to identify high-quality outlets in an effort to fight sensationalism and misinformation, Chief Executive Mark Zuckerberg said.
Facebook has been under fire for its part in distributing “fake news” in the run up to the US Presidential election in 2006 and in other elections around the world.
Two years ago, Facebook users saw hoaxes saying Pope Francis endorsed Republican Donald Trump for U.S. president and that a federal agent investigating Democrat Hillary Clinton was found dead. Facebook initially proposed fighting false stories by letting users flag them.
The chief executive outlined the shakeup in a post on Facebook, saying that starting next week the News Feed, the company’s centerpiece product, would prioritize “high quality news” over less trusted sources.
“There’s too much sensationalism, misinformation and polarization in the world today,” Zuckerberg wrote.
“Social media enables people to spread information faster than ever before, and if we don’t specifically tackle these problems, then we end up amplifying them,” he wrote.
Zuckerberg said he expects recently announced changes to shrink the amount of news on Facebook by 20%, to about 4% of all content from 5% currently.
The company will accomplish that by allowing its 2 billion members, not experts or Facebook executives, to determine how news outlets rank in terms of trustworthiness. It also said it would put an emphasis on local news sources.
Analysts believe “The move is likely to send shockwaves through the media landscape in nearly every country, given the ubiquity of the world’s largest social network and how central it has become in some places to the distribution of news.”
News organizations and traders immediately began considering how they would fare in the ranking. The New York Times is well positioned for this challenge. That could explain the rally seen in the stock last week.
However, the stock is unlikely to continue rallying until the company increases its print advertising revenue which fell 20.1% in the third quarter of 2017, following a decline of 10.5% in the preceding quarter.
While waiting for a turnaround, traders should expect short term weakness in the stock.
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 credit spread option 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 NYT
For NYT, we have a number of options available. Short term investment tips options allow us to trade frequently and potentially 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 February 16 $21 call for about $1.15 and buy a February 16 $22 call for about $0.60. This trade generates a credit of $0.55, 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 $55. The credit received when the trade is opened, $55 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $45. The risk is found by subtracting the difference in the strike prices ($100 or $1.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($55).
This trade offers a return of 122% of the amount risked for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if NYT is below $21 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 $45 for this trade in NYT.
These are the type of trading 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.