Monday, March 10, 2014
Harmon, Trading Options
The point of identifying market trend, doing sector analysis, and reviewing individual charts using “classical technical analysis, Japanese candlestick techniques, derived and quantitative methods, and price derivatives” is to find “stock setups that can potentially return 5 to 10 percent or more in two weeks or less for the technical setup.” (p. 121) And then to structure directional option trades that can capture this return.
Harmon explains, succinctly but on balance quite well, some basic option combinations and guidelines for using them. For instance, he suggests buying a call spread “when there is strong defined resistance above a trigger or the cost of the desired long call is prohibitive.” He looks to “maintain the cost of the spread below one-third of the difference between the strikes” and does not “like to sell the upside call to create the spread if the premium from the sale does not give [him] at least 25 percent of the premium paid for the long call.” (p. 149)
In Harmon’s view, “most options combinations start with a directional bias on the underlying stock and with a simple long or short call or put. The rest are added to manipulate leverage and manage risk to the trader’s requirements.” (p. 171) Harmon calls the “simple long or short call or put” the driver and claims that “selecting the driver is the most important decision. It comes from your analysis of the chart and the potential for a move that got you interested in trading the stock in the first place.” The next task is to select the funding options, so called because “they fund or pay for the trade. They lower its cost.” (p. 172) Finally, once the driver and funding options have been chosen, “you must assess the risk remaining in the trade. If necessary, you may need to also select a risk limiter before you are ready to execute.” (p. 173)
Harmon devotes a chapter to detailed trading plans for seven stocks, including two earnings plays. He starts with a macro week in review/preview. His trend analysis of gold, the U.S. Dollar Index, treasuries, the Shanghai Composite and emerging markets, volatility, and the U.S. equity index “gives an upward bias to the market, so individual stock trades should all be biased higher as well.” (p. 191)
By way of example, let’s look at Deckers (a trade idea for the week of July 15, 2013). It “has been moving higher and is approaching resistance at 56.50. … It has support from a rising RSI and MACD for more upside. The short interest can also help at over 29 percent. There is resistance higher at 59 and 60.40 and then free air. Support lower is found at 52.50 and 50.55 followed by 48. There is also a large relative open interest (OI) at the July 57.50 call, which could lead to a pin there Friday. … If it really gets going, there is also large OI at the 65 call well above. … With all that short interest, you do not want to cap the upside on any option trade beyond this week. As an options trade, consider the July/August 57.5 call Calendar ($2.30) or the August 57.5 ($2.60) calls alone. Offset some cost by also selling the August 47.5 put (85 cents, or $1.75 net on the resulting bullish Risk Reversal). The July 56.5/57.5 1X2 ratio call spread (10 cents) is a good way to play for a pin at 57.5. Hedge that bet by also buying the July 58.5 call (20 cents) to turn it into a call Butterfly.” (p. 193)
Harmon’s directional technique is, of course, only one of many possible ways to trade options. But it’s a technique that all traders should understand before they decide on their own personal course.