A frustration that has long plagued traders is the Breakout/Pullback Blues-sometimes this malady leaves us black and blue from the whipsaw beating received. Traders at every level have experienced initial satisfactions of buying a recommended or discovered equity (I will stick to bullish thinking although the principles apply inversely as well), and shortly after watched their path to fortune fall clumsily to a depressing level.
A tactic employed to beat the “Blues” is a combined study of support and resistance levels of the equity of interest integrating this knowledge with the writing of put options. Selling options generates immediate capital gains, it cost nothing save commissions, the income earned reduces the price of the stock when and if it is put to you, a firm entry price is established, the option can be repurchased at anytime, if it is not exercised at or by the expiry date it expires worthless with you keeping all the premium, constant adjustment of buy on stop orders and other wiggles are eliminated.
There are some simply rules which have to be observed:
You have to have a margin account and option privileges (talk to your broker).
Never write a put on a stock that you do not wish to own.
The capital necessary to cover your written position must be available for immediate use up to the date that the option expires. Equities can react with incredible rapidity and volatility to internal corporate hiccups and general market knee jerks-preparation to damage control is necessary. (Charting, experience and general risk management will allow for latitude here: initially follow the rule.)
You cannot write or buy puts in an RRSP account. (Stupid!)
Charting, both daily and weekly movements, of the stock will be of immense help (I would not use this tactic without this knowledge) determining support and resistance, trend as well as writing points.
An example is worth a thousands words as goes the wisdom. So the example we will use is RCI.B ( Rogers Communications).
Rogers appears to be forming a complex inverted Head and Shoulders formation with a neckline at or about $45.46. The stock has increased almost 40% from its March 20,08 low of $32.92. The stock reached a high of $45.99 but failed to close above the $45.46 resistance level on May 02, 2008, as of this writing the stock has fallen $1.05 for the week. Conformity is usually inherent in technical patterns of heavily traded large caps. And if this is true, then Rogers should form a second right shoulder somewhere between $43-41. Several short term indicators on the daily chart are starting to turn over-expect a pullback.
Price support exists in the $39-40 range and there are the beginings of a triple moving average bullish crossover just above $41 on the weekly chart. Rogers has only given short term buy signs not confirming a totally bullish trend. It would have been less than conservative to purchase the stock after the size of the run up in just eight weeks on the assumption that it would power through $45.46 and keep going without a pull back to catch its breath.
All indications are that Rogers should be an issue to own but at the right price. Based on the support levels as previously noted, 10 Jan 42 put options were written @ $2.65 for a capital gain of $2,650.00 (minus commission of $22.45). A shorter time period could have been selected, however the January puts were accompanied by a good premium(greedy buggar) and should the stock muddle about breathing space is not a worry.
Should the stock make its second right shoulder as expected and launch into the bull trend the option can be left to expire, it can be bought back at a lower price since with the passing of time its value will decrease or it can rolled upward into to a new put strike price and expiry date. Nobody is going to put the stock to you if it is trading above $42.
Conversely should the price patterns break support the option can be bought back (there is a $2.65 cushion which is somebody else’s money), you can hold the position having the stock put to you should the belief exist that this is a minor set back.There are further option scenarios which can be brought into play as well.
If we do not have another financial or political tsunami spiking the market it is unlikely that the negative side will be seen in this play. Remember the tactics employed here were accomplished with no expenditure of personal capital. The investor was able to buy at a more favourable level (buy low) and did not have to experience the anguish of having 45K earning a 2% dividend while on a downhill bias.