3 Costly Put-Buying Mistakes

05/31/2011 11:15 am EST

Focus: OPTIONS

Thomas Aspray

, Professional Trader & Analyst

Traders playing the short side must be sure to avoid some common pitfalls. See what they are and discover several heavily shorted stocks that seem poised to move higher.

The explosion in options volume over the past few years has made buying put options the favored trading method for those who think a stock is going to move lower. Historically, selling a stock short was the more common approach, and it is still a force in the market.

One readily available piece of information that put buyers and short sellers often ignore is the short interest data, which is published on a regular schedule and provided for free by Nasdaq.

Ignoring this information is a common put-buying mistake, and I have also found that most sell a stock short or buy a put based on fundamentals, as opposed to technical analysis. They either read something negative about a stock that convinces them that it “must” go down, or they form an opinion that the company’s business has no future.

One good example from several years ago was Pfizer Inc. (PFE), as the loss of the company’s patent on Lipitor was expected to doom the stock, yet it rose from a 2009 low under $12 to over $20 recently.

Failing to conduct an objective technical appraisal is the second most common put-buying mistake. In my early-March article titled “Four Stocks You Shouldn’t Short,” I took a look at four stocks that had high short interest, but whose charts suggested that shares were going to move higher, not lower.

Those stocks were EMC Corp (EMC), Alcatel-Lucent (ALU), Rock-Tenn Company (RKT), and Hormel Foods Corporation (HRL). Since the close on March 1, they have shown the following percentage changes: EMC, up 6.9%; ALU, up 19.7%; RKT, up 17.6%; and HRL, up 7.2%.

Put-buying mistake number three is failing to use any type of stop on put positions, because once it starts going against the buyer or the premium disappears, it turns into a “hope” trade. Having a firm stop in mind based on a daily closing level for the stock or closing it out if the put drops 50% would improve the performance of many option traders.

One of the original stocks looks like a good buy now, and two other companies with high short interest are also recommended on the long side.

NEXT: See the Charts for Today's Picks

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Chart Analysis: Rock-Tenn Company (RKT) broke through major resistance, line a, in early 2011 on heavy volume, which was a very bullish sign. As of the most recent short interest report, there are still 10.5 million shares short with a short interest ratio of 14.9. This is calculated by taking the short interest and dividing by the average daily volume. It means that it would take almost 15 days of average volume to cover the short position.

  • RKT retested the breakout level in mid-March, dropping to a low of $62.32 before turning higher
  • The recent trading range was completed last week, as RKT was up sharply with next upside targets from the chart formation at $82-$86
  • The weekly on-balance volume (OBV) staged a major breakout in January, overcoming resistance at line b
  • Initial support for RKT is now at $73.50-$75 with much stronger support in the $67.50-$69 area

The weekly chart of EMC Corp (EMC) shows an upward-sloping trading channel, lines c and d. There are 76 million shares on the short side for EMC, but given the high daily volume, this would only take about four days to cover.

  • The strong close last week suggests an upside breakout above the $29 area with further targets at $30.50
  • The weekly OBV did break out to the upside two weeks ago and continues to look strong. The daily OBV (not shown) is also positive
  • There is short-term support now at $27.70-$28.30 with further support at $26.60-$26.80 (line d)

NEXT: 2 Heavily Shorted Stocks to Buy on the Long Side Instead

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Veeco Instruments Inc. (VECO) is a $2.7 billion company that is part of the semiconductor materials and equipment industry group. The short interest for VECO is 11.8 million shares, which is over 30% of the float. The short interest ratio is 10.2.

  • The weekly chart shows the completion of a major triangle formation, lines a and b. This has long-term targets in the $70-$76 area
  • The weekly OBV has confirmed the price action by also surpassing major resistance at line c
  • There is initial support now in the $53.50-$54 area and then more important support at $50-$52. The weekly uptrend, line b, is now at $48

Blackboard Inc. (BBBB) is a $1.5 billion company that provides software applications and related services to the education industry. Its short interest stands at 9.7 million shares with a short interest ratio of 15.2.

  • The daily chart shows that BBBB has corrected sharply from the highs above $50, closing last Friday at $42.58. The 50% support has been broken with the 61.8% support at $40
  • BBBB had surged 29% on April 29 after the company reported that it has received unsolicited takeover offers
  • This is reflected by the massive volume on the chart, as the OBV rocketed through the resistance at line d. Prior to the takeover news, the short interest ratio was a sky-high 53

What It Means: As I noted last week, the bearish sentiment has continued to grow, which when combined with the predominantly bearish headlines, favors higher—not lower—prices ahead.

As a result, I would expect that many have been establishing short positions over the past two weeks, and if you are playing the short side, I hope you are not making any of the three mistakes that I previously highlighted.

How to Profit: For EMC Corp (EMC), buy at $28.14 with a stop at $26.56 (risk of approx. 5.6%). Sell half the position at $30.22 and raise the stop on the remaining position to $27.08.

For Veeco Instruments Inc. (VECO), buy at $53.52 with a stop at $50.68 (risk of approx. 5.3%). Sell half the position at $58.42 and raise the stop on the remaining position to $52.76.

For Blackboard Inc. (BBBB), buy at $42.12 with a stop at $39.41 (risk of approx. 6.4%). Sell half the position at $47.30 and raise the stop on the remaining position to $41.88.

Portfolio Update

Previous buyers should be long Rock-Tenn Company (RKT) in the $62.33-$63.92 area. Raise the stop on this position from $58.52 to $68.62, sell half the position at $83.60, and raise the stop on the remaining position to $74.90.

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