The Myth of the "Perfect" Entry

03/11/2011 3:01 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

A recent options trade on Apple illustrates that there is no "perfect" trade entry point. Success is achieved by finding a valid entry on the charts and relying on discipline and careful trade planning.

By Josip Causic

One of the most common questions that we Online Trading Academy instructors get from our students is in regards to a "perfect entry." Though there is no perfect entry, valid entries do need to be determined from the charts. When one is found, then the correct option strategy can be selected so that you may benefit from the leverage of options on the trade.

It is a well-known saying that a picture is worth a thousand words; and so is the case with the valid entry. Figure 1 below displays a chart of Apple, Inc. (AAPL), one of the most loved stocks trading on the US market. The reason why I have selected a black background with western bars instead of the usual candlesticks on a white setting is as follows: There are four points on any candle or bar (high, low, open, and close), yet due to the thickness of candles, more focus is placed on the distance between the open and close than on the actual range. By having a bar chart, the range (distance between high and low) becomes more obvious.

Now let's move on to the discussion of AAPL's price action. After reaching its highest point at $365, AAPL rapidly declined over a period of three trading sessions. Observe that the $340 zone has acted as a kind of area of support that has prevented AAPL from going lower. Meanwhile, the general market, including the Nasdaq, has made a lower low.

(In fact, I made reference to this very point a week ago in my last article, "6 Steps to Profitable Option Trading.")

chart
Click to Enlarge

Going back to the chart, once AAPL touched the $340 zone, it stayed in that area, consolidating or simply going sideways, while the market went lower. It is a well-known fact that AAPL represents 20% of the Nasdaq weighting. This makes it possible to conjure that if AAPL is one of the leaders and the leaders have stopped going lower and started going sideways, this short-term bearishness may have ended. Next, the question becomes: If this set-up is not bearish, does it mean that it is instantly bullish? The answer to that question is "no."

Looking at the chart objectively, when would we have the highest level of certainty that AAPL is breaking out of the consolidation range? Evidently, when the price action surpasses the highest of the three consecutive recent highs in this consolidation range; so in order to alert myself, I have utilized an alert with $345.50 as the trigger.

Now, let us turn our attention to the option strategy that we could select once the alert is triggered and price action lifts above $345.50. Again, I wish to offer two choices: Either a bull put spread or a bull call spread. Taking into account that AAPL is one of those unusual stocks that has weekly options listed, I have selected a bull put spread.

chart
Click to Enlarge

The table above lists the specifics of the trade, and faithful readers are familiar with what the specifications are. Basically, the sold 340 leg should be viewed as my willingness to own AAPL at $340, while at the time it was trading at $345.60. Certainly, no one in their right mind will force me to deliver on my obligation/willingness to buy at $340 when it is trading $5.60 higher. Moreover, just to ensure that $34,000 of my capital is not tied up, I selected to purchase the lower leg. Now it is only $500 of capital that is needed for this trade. In fact, as long as AAPL stays above the sold 340 put, I could receive about 28% on my money invested. I only need to be correct on my technicals for a week.

The graphic below shows verification of my trade entry (please forgive the tiny numbers). As of the writing of this article, I have a buyback on the short leg order for a nickel that I am anticipating will get filled before Friday expiry.

chart
Click to Enlarge

I have discussed the concept of selecting a valid entry. Once the chart told us what to do, the implied volatility as well as the availability of weekly options helped us to determine an appropriate option strategy. Once we are in the trade, active monitoring needs to be done. Even though we have sold premium, follow-up action of buying back our obligation is highly advised. Be disciplined and do not get greedy. It is alright to get most of our maximum profit instead of squeezing out every drop of it.

Lastly, as we say at Online Trading Academy, "Plan the trade and trade the plan." Have a great weekend!

By Josip Causic, instructor, Online Trading Academy

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