Find the Stock, Trade the Options

03/09/2011 5:01 am EST

Focus: OPTIONS

Analysis turned out a nice-looking set-up, but a trader's work is far from over. Here, one trader considers several different option strategies and must choose just one to act on his latest idea. 

By Greg Harmon 

Every weekend, the entire trading community spends their time avoiding their families and friends while looking for the next big trade. If you are a technical trader like me, that means looking at charts. One stock I found this weekend, mattress maker Tempur-Pedic International (TPX), looked primed to break through a double top and extend higher.  

For a charts guy, finding stocks going to new highs is better than a six-year-old getting their favorite toy on their birthday! You can't wait for the market to open for a chance to play with it. But finding the stock is just the first step. 

Here are five methods to consider when deciding how to enter a set-up like this one. The first three methods can be used if you have a non-margin, or cash account, and methods four and five apply if you have a margin account. The chart I used this weekend is shown below along with my analysis.

chart
Click to Enlarge

Tempur-Pedic is pressing on the ceiling at $48.80 for the second time in a month. If it can get over $48.80, then it has a measured move target of $54.50. The relative strength index (RSI) is bullish and the Moving Average Convergence/Divergence (MACD) indicator is improving and about to cross higher, supporting further upside.

Five Methods for Trading This Set-up

  1. Buy the stock: Pretty straightforward; if it breaks resistance, you buy the stock

  2. Buy call options: Also pretty straightforward. Buy either the March or April 49 strike, at the money calls, when the trigger occurs, giving upside exposure at a much cheaper cost and limiting the downside risk to the premium paid. The March 49's closed at $1.05 and the April 49's at $2.25

  3. Buy vertical call spreads: This is a variation of method two. Here you additionally sell an upside strike call (the 55 strike in this case), against the option you bought to reduce your cost on the trade. The 55 strike was chosen because of the expectation that the stock would move to $54.50, where it will expire worthless. This works best on options with April expiry, as there is more time value in those options, and it would reduce the cost by 50 cents, or 25%

  4. Buy calendar call spreads: This entry is through selling the near month above-the-money call and buying the next expiry call of the same strike. For example, sell the March 50 call for 80 cents and buy the April 50 call for $2.00, or a net debit of $1.20. This is also a bet on the timing of the move higher, as you are betting that the stock will not be above 50 on the March expiry, or you will be able to buy back the option for less than what you sold it. This is betting on a slow rise

  5. Sell puts: You could also bet on a fast rise by selling the March 55 puts for $6.80 or April 55 puts for $6.90 with the expectation that you will be able to buy them back on or before expiry at or near 50 cents. If the stock closes below 55 you would be forced to buy the stock at $55 but then your basis would only be 48.10, using the April puts

By Greg Harmon of DragonflyCap.com

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