Why Options Are the Best Tool for Trading a Trend Reversal

11/18/2010 12:01 am EST


by: Tyler Craig

The futility of bottom and top picking is a favorite verse to those preaching technical analysis. The ranks of those professing to have accurately picked a bottom are filled primarily with three groups of traders: those who conveniently forget to mention their previous ten failed attempts, out-and-out liars, and those struck by a rare occurrence of dumb luck.

When it comes to strategy selection, I contend that options are far superior to stock when attempting to trade against the prevailing trend.  The difficulty with stock lies in the fact that you have little margin for error.  Fortunately, options open the door to a much wider profit zone, thereby, granting additional breathing room. As opposed to shorting an uptrending stock expected to reverse, traders may opt instead to sell an out-of-the-money call spread or call ratio spread. In the event the stock continues to rise further over the next few days, the option spreads are generally more forgiving and easier to manage.

This explains in part why call ratio spreads are a strategy of choice when attempting contrarian plays in gold.  Suppose on November 9 with the potent reversal experienced by GLD and other commodities, we decided to bet against the entrenched uptrend by selling a Dec 41-44 1×3 ratio spread for $2.10 credit. Consider the following two graphics comparing a simple short position to the call ratio spread. Take special note of the difference in the profit zones.

Click to Enlarge

Click to Enlarge

The “extra buffer” section of the ratio spread graph illustrates the additional profit zone that traders acquire when taking the option route over stock. Admittedly, there are other trade-offs between both approaches worth exploring, but we’ll leave those for another day.

Those engaging in contrarian trades may consider adding options to the mix to exploit some of the benefits outlined.

Tyler Craig is a trader and blogger at TylersTrading.com.

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