As a proponent of Fib-based pattern trading, I’m constantly watching for reversal plays that offer solid opportunities on a swing and intermediate-term basis. However, just because a pattern is spotted, it doesn’t necessarily mean there’s a trade worth executing. In order to gain an edge, I also generally need to see some secondary confirmation, as well as being able to select an option that is appropriate as it relates to the pattern and the stock itself. The last part of that statement is important for directional trading. Not only is a stock’s historical price volatility important, but when dealing with the short-term directional swing, it’s equally key to know the tendencies of the stock fit the pattern we're looking at.
Historical volatility relates to the amount of movement, up or down, that a trader might expect to see over a calculated period. However, many stocks also exhibit certain tendencies, such as the ability to follow-thru on certain technical triggers. Factors like what type of person is trading the product (i.e. fast money), capitalization and if it’s a growth story, can all play a part in the tendencies of a stock. Another factor is if we are looking at a commodity or a sector proxy that has been making the headlines. Not only can these products trend strongly when in motion, they also have the capacity to be equally quick when putting in countertrends and pattern tops. One such product which offers these characteristics is the Oil Service HOLDRs (OIH). It also recently triggered out of a bearish Butterfly top and is the subject of this lesson.
Figure 1: OIH Butterfly High
In the above daily chart of the OIH we can see the price action through the close of trade on 12/14. The chart shows the second part of a Butterfly structure (wing 2 labeled) that began at the very end of September. During the past several sessions this reversal pattern started to set up into an awareness zone, but it wasn’t until Tuesday’s session that there looked to be an actual trigger for reversal swings. On that day, the OIH reversed, after putting in an All-Time-High, and closed in an engulfing bearish bar. Since price action first moved into the awareness (resistance) zone, Tuesday’s candlestick close was the first such trigger of note. Confirming the potential reversal, secondary indicators such as MACD and momentum were showing relative weakness as the price of the underlying moved higher. With a history of following through off similar technical triggers, but also having a history of showing quick, decisive confirmation, it was time to look for an appropriate option.
Figure 2: OIH December Puts End of Day 12/13
With the OIH delivering a daily chart signal, its ability to turn on a dime and three days left in the December option cycle, the strikes surrounding the, then current action, were the two strongest candidates for this particular trade (see Figure 2). When and if the OIH confirms on the weekly chart, traders’ that employ this pattern in their own trading might investigate some back month options to explore the directional trade. In this corner that would mean looking for an appropriate spread (versus an outright) suitable with one’s risk tolerance.
In the December Put matrix above, the 135s are the stronger of the two choices. With essentially no extrinsic premium to speak of, one could participate as a short in the stock and profit nearly as well as a trader who might have shorted the proxy outright. If proven wrong though, the buyer of the puts has a much stronger limited risk position with a maximum loss of less than 2% of the underlying stock price.
The slightly out-of-the-money 130s were seen as the second vehicle of choice. While the OIH does have the very real tendency to move quickly, as a directional trade the hard delta of the in the money’s and the already low associated dollar risk, relative to the OIH, makes for the slightly better play. If the 130s were used, more purchased contracts, up to an equal dollar equivalent, would be seen as a viable alternative.
As mentioned, the OIH is a product that typically lets traders know very quickly whether a swing reversal will be a profitable endeavor and Wednesday’s action dashed those directional expectations. While the daily high hasn’t been taken out, looking at the last several months and all of the turning points in the OIH, we can physically see if the trigger bar isn’t confirmed handily by the next session, then our short-term, swing trade is best served by exiting quickly. It would be nice if every well-conceived entry could be a profitable one, but until that day comes, money management, risk reduction and keeping those high probability, percentage plays just that, does continue to come in handy.
Chris Tyler
Staff Writer & Options Strategist
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