Buy Call Options on Stocks That Are Breaking Out—Buyers Are Back

01/14/2015 8:00 am EST

Focus: OPTIONS

Pete Stolcers, of OneOption.com, takes to the charts to study the way the stock market drifted down on Monday and the bounce took longer than normal to find support, but since the rally Tuesday morning looks strong, he explains why he feels more confident buying put options.

The market drifted lower Monday and this bounce took a little longer than normal to find support. Typically, once the 100-day moving average is breached and we move back above it, we are off to the races. That has been the pattern the last six months. Now that we tried to retest and bounced, I feel more confident buying call options.

Stocks look poised to rally on the open Tuesday. If we finish in positive territory, a higher low will have formed and support at $200 will be preserved. This would set us up for a nice earnings rally.

The technical picture has weakened in the last few months, but we should make one more run at the high. I am only forecasting out a few weeks and I am bullish.

Alcoa (AA) kicked off earnings season with a strong number. Earnings season attracts buyers and it is a bullish event. Traders will focus on the here and now and economic activity/credit concerns will take a backseat.

Option expiration has also been bullish the last four months. During the week of options expiration, the market has averaged a gain of 1.5%.

China posted solid trade numbers Monday. This will temporarily ease concerns.

My primary position is January bullish put spreads. I am short closer to in-the-money put options and I am long farther out-of-the-money put options. I sold these options spreads for a credit a week ago and they are in great shape. I did hedge the positions on an intraday basis by shorting the S&P when the (SPY) breached $204. This hedge protected me in the event that we had a meltdown. The put positions did take a little heat yesterday, but the hedge more than offset the losses. Tuesday, I will get relief on those put spreads when the market rallies.

This is a very useful tactic. It allows me to take advantage of time decay and I can control risk. When I have more than a dozen options spreads to manage, I don’t want to buy them all back at the first sign of trouble. I would have to navigate option bid/ask spreads when I buy them back and reestablish them. I would also incur commissions. It is much easier to hedge using one instrument like the S&P futures.

I have weathered the storm and my bullish put spreads will shed premium Tuesday. If the market goes into negative territory, I will hedge and I will use that entry as my stop. The market looks strong and I don’t believe this will be an issue. I will start buying my put spreads back Wednesday. That will lock in profits and released margin.

I am also long February call options. These stocks have broken out and I am using the breakout as my stop (not SPY). I will buy more calls if the SPY closes above $205. That is the high from last week and if we can rally above it, we should be off to the races.

The rally Tuesday morning looks very strong. I believe we will close strong and this looks like a good entry point.

Buy February calls on stocks that are breaking out and use the breakout as your stop.

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By Pete Stolcers of OneOption.com

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