In Options Trading, Simpler Is Better

Dear SlingShot Trader Subscriber,

Technical analysts often suggest that everything we could know about the market’s fundamentals is present in the price. This means that if perceptions about eurozone credit risk, lower corporate profits or economic troubles worsen, then prices should drop. Similarly, if fundamentals began to improve, then the price trend should, too.

Many new traders are attracted to this kind of analysis because it seems simpler and less ambiguous than fundamental analysis. However, this is a misconception. We find that it’s just as easy for technical analysts to fall into the traps of over-optimization and analysis-paralysis as it is for any other trader. How high is too high? What technical indicator matters most? Should you use a 200 period SMA or Bollinger Bands to establish support? The list can go on and on.

You’ve probably noticed that we typically don’t pile on a bunch of indicators when making our trades. We keep it as simple as possible so that we can concentrate on other factors that we can control. At Slingshot Trader, we fall into the category of analysts who emphasize position sizing and costs over customized parameters — and the raw price action over moving averages or other indicators.

There’s only so much you can do to predict the future. Successful traders keep it simple and put the odds in their favor by making sure that if a trade works out well, it’s larger than the average loss. That’s why we always compare an option’s price before an announcement or other news event with prior prices and volatility levels. It’s also why we emphasize risk-control measures such as appropriate position sizing.

We’ve worked with traders for years and have found that abandoning or minimizing technical indicators is like that first jump off the high-dive board as a child. The water looks deep and a little scary, but despite a few belly-flops, we all survive and learn to swim. Current market conditions are about as deep and scary as it gets. However, the limitations of technical analysis in this market actually can be a benefit by making us more nimble and flexible.

 

The Technicals of the Current Market

For example, the S&P 500 (SPX) has been treating the 1,260 to 1,280 level as firm resistance during the last two months — but do we know why? Is it because the Europeans are bearish, or are U.S. corporate profits not high enough? Both factors probably are true, and we watch them very actively. But from a technical perspective, the raw price data is giving us some very clear signals.

First, this is the bottom of the channel that was in place during the second and third quarter of 2011. Support traditionally turns into resistance once broken on high volume. Those criteria clearly were met after the collapse in August. At this point, it’ll take some significant fundamental changes to push prices beyond that level for more than a few days. It’ll happen eventually, but we know that this level is where fake-outs will occur, and prices are more likely to drop a few times before it does.

We know, thanks to some of the earliest technical analysts more than a century ago (including Charles Dow), that the market moves in semi-regular waves or cycles. These often line up perfectly with traditional support and resistance levels. One of these cycles predicts that, following a strong break (like August 2011), the market is likely to retrace 61.8% of its move before hitting resistance. This level, referred to as “phi,” can be applied with a Fibonacci retracement.

The chart below is a graph of the S&P 500 futures, with the phi cycle level lining up with resistance left over from the prior channel. We included a chart of the futures so you can see the price action from Tuesday night and early Wednesday morning (based on East Coast time) while the New York stock markets were closed. Prices got within shouting distance of this resistance range and then were turned back. This is relevant in understanding why we remain mildly biased to the downside on our trades.

S&P 500 e-mini futures chart courtesy of Metastock

 

This was a long discussion about our method of technical analysis, but we thought it would be helpful to understand why we don’t try to complicate our trading decisions. Ultimately, simpler analysis is better and makes it easier to optimize the factors we can control, such as position sizing, option pricing and diversification on a short-term basis. Because the market is unpredictable, profits are available for risk takers. This is especially true for short-term option traders like us.

To learn a little more about those factors you can control and about how we look for the best pricing on our trades, check out the videos in the Education section of the Resources tab on the Slingshot Trader website and read our PDF report on successful options trading.

 

This Week’s Events

Earnings for the fourth quarter won’t really heat up until the middle of January. With the holiday week ahead of us, we expect volume to be low and the news to be relatively quiet. However, there are some important releases to watch that may create new opportunities even in a slow market such as this one. We’ll discuss these in more detail during today’s weekly webinar at 6 p.m. ET.

12/21 — Bed Bath and Beyond (BBBY) Q3 earnings, after market close

12/22 — U.S. Final GDP, 8:30 a.m. ET

12/23 — U.S. Durable Goods, 8:30 a.m. ET

12/23 — U.S. New Home Sales, 10 a.m. ET

12/27 — Consumer Confidence, 10 a.m. ET

 

The Bottom Line for the Next Seven Days

The market typically gets very quiet during the week between Christmas and New Year’s Day. European markets can be especially slow then, with very low volume. Usually this means that trading ranges will be tight, making new trades more difficult to find. However, this year, the low levels of volume actually could push prices even faster if something unexpected happens.

For example, if European debt levels or a French downgrade by the big rating agencies were to occur next week, we’d get big price moves as sellers react to the data. We’ll be watching the market and individual stocks for trading opportunities if such data looks more likely to be released during the holiday break. It could turn out that we’ll find some great trades during a week that a lot of traders tend to write off.

 

TRADE REVIEW

When it’s time to open or close a trade, we’ll send you alerts via email. You also can sign up to receive text messages regarding our trades. For more info about our SlingShot Trader portfolio, you can read trade alerts here and view our portfolio here. You also can see more trade-specific details by clicking on the trade links below.

 

Positions Opened

These are the SlingShot Trader positions we opened during the past week of trading that we have not yet closed.

Bed Bath and Beyond (BBBY) On Dec. 19, we “bought to open” the BBBY Jan 60 Puts for $1.61. The position is currently flat, and we still like it for new entries this afternoon only if it can be opened at our entry price or less. BBBY releases earnings after the market closes today, and we expect to close the trade tomorrow.

 

Positions Closed

These are the SlingShot Trader positions we closed during the past week of trading.

Walgreen (WAG) On Dec. 20, we “bought to open” the Jan 32 Puts for $1.28. We closed the position this morning following the company’s earnings report for $1.68, for a 31% profit in one day.

Adobe (ADBE) On Dec. 8, we “bought to open” the Jan 27 Puts for $1.29. We closed the position Dec. 16 for 53 cents, for a loss of 58%.

FedEx (FDX) On Dec. 13, we “bought to open” the Jan 85 Calls for $1.80. We closed the position Dec. 15 for $1.47, for a loss of 18%.

Oracle (ORCL)On Dec. 14, we “bought to open” the Jan 30 Puts for $1.31. We closed the trade Dec. 15 for $1.84, for a profit of 40% in one day.

 

Top Trades Now

These are the current SlingShot Trader positions that we still recommend getting into now, assuming you haven’t already bought a full position.

Bed Bath and Beyond (BBBY) See Positions Opened above.

 

Webinar Preview: Join Us Tonight at 6 p.m. ET

Every Wednesday at 6 p.m. ET, we host our live webinar, in which we’ll review this weekly newsletter, discuss coming events in more detail and walk through our Top Trades. We also encourage you to submit your questions live during the session. We want to do everything we can to help you become a successful options trader, which is why you have live access to us for an hour every week.

And if you have any questions or comments you would like to send us in advance of the live session — or anytime during the week — you can write to us at johnandwade@slingshot-trader.com. (Please send any questions about the status of your subscription directly to Customer Service at service@slingshot-trader.com.)

If you can’t attend the session live, you can watch the archived version on our website in the “Live Weekly” section. It’ll typically be posted within about two hours of the end of the live session.

 

Sincerely,

 

John Jagerson and Wade Hansen
Editors
SlingShot Trader