BHI Credit Spread reversal for breakeven

At long last, the much mentioned post on the BHI credit spread gone bad, gone good.

But first, today's market. WOAH, Bessie! What a blood bath! I hope everyone had their stops set out there. I'm not going to try to get into it, but looking at the weekly chart of the SPX, it looks to me like the uptrend is CLEARLY over and it would be very reasonable to look for a move back down to 1300 in the near future.


Now for the BHI trade. The purpose of sharing this is not only to show the possibility of "reversing a trade" when doing credit spreads, but also that it's not quite so simple because there are further risks taken on when doing so.
One of the handy aspects of a vertical spread trade are that the maximum profit and maximum loss potential are clearly defined. On a 5 pt. credit spread, whatever credit you take in up front is your maximum profit and 5 - that credit is the maximum loss potential.
So you plan your position size for the amount of risk you are comfortable assuming. Let's say your account size and your rules have determined that you will risk no more than $1000 in any trade. If you want to put on a Credit spread 5 dollars wide that brings in a credit of $1.30, you have $3.70 at risk. You can sell 2 spreads. 3.70 x 100 x 2 = $740. Selling that third contract would put you over the limit of your risk tolerance.

So you're now comfortable within your risk tolerance and happy with the entry. The market or stock suddenly changes drastically and moves in the wrong direction. The magic line is broken, the position is turning into a loser and you no longer want to be in the trade. You can close the spread entirely for a loss, probably less than the maximum potential loss. You can hope it'll turn around and start going in the right direction again(which is the choice we should NOT get in the habit of making - Say no to hopium), or you can try to reverse the trade.
Sounds complicated, but it's not. You just buy back the short side of your credit spread. If you have a bear-call spread, you've sold a call and bought a call at a higher price. If you buy back the sold call, you're now in a long call which is bullish. If you're in a bull-put spread you have sold a put and bought a put at a lower strike price. If support is broken, you can buy back the short put and you're then holding one long put which is bearish.
So the million dollar question has to be, "Has this new turn of events reversed my stance on this stock or index?" That's a big call. In most cases, you will not go from bullish to bearish or vice versa. But sometimes you will. Drastic news and major volume can be very convincing for a decisive change.
But the trickiest part of all is that if and when you do decide to reverse the trade and buy back the short option, you have changed your risk exposure. In many cases, you will be opening the possibility to lose more money than you would have on the original max loss potential of the spread and certainly more than you would if you just closed the spread on the first break of the magic line or sign of major trouble.
Let's look at my trade finally. (Somebody shut the guy up and show us some action!)
Here's what the stock looked like as I was watching it for a move above resistance at 75.

It popped in a pretty convincing way over that level, but I didn't catch it close enough to 75 to feel good about holding through a pullback to that level. With a potential play up to resistance at 90, the risk/reward is actually there for a reasonable trade to be made, but not for the risk I'm comfortable with options in my little account.

Watching for a pullback and successful test of support, I was satisfied with the next support on 12/28. The prior two days formed a Harami and the 28th was a higher day for confirmation. When I entered the trade, the stock was higher for a more convincing "higher" close than where it ended the day.

As discussed in this post on Dec. 28th, I entered a Jan 70/75 Bull-Put spread. Perhaps it was the potential weakness in the Oil Services charts(OIH), the whole market all together, or maybe that I just wanted a "conservative" trade, but I decided to do a bull put spread rather than a long call. The call would certainly have a much greater profit potential, but the bull put spread would have a higher probability of success since the stock only needed to close above 75 for the maximum profit.
I placed the trade in two accounts. One filled at a credit of $1.30, the other for $1.35.
On the Jan 3, the first trading day of the year, the trade went very wrong. BHI plunged through the 75 support area in a pretty dramatic way.

With one account, the more conservative one, I didn't want to risk taking a bigger loss than I had to. So I bought back the whole spread. That one I sold originally for $1.30 on the 28th and bought it back on the 3rd for $2.95. A $1.65 loss not including commissions.
Here's what I did with the spread in the other account.

Because the break was drastic enough for me to turn bearish on the stock, I weighed the possibilities and decided to "reverse the trade" to a bearish trade, buying back the short 75 put and holding on to the long 70 put. If you add it all up, you'll see that in the end I made .05 or $5 dollars on the trade. Including commissions, it comes out to a loss of $1. Not bad. No big deal, right?
Well, consider the decision making process in reversing the trade. I could have closed the the whole spread like I did with the other one for a loss of about $1.60(since I got better fill to open this one). In reversing the trade, I bought back the 75 put, originally sold for $1.80, for $4.20. That locks in a loss of $2.4. But I am then still holding the 70 put that I paid $.45 for. So definite loss is 2.4 while the potential loss is still $2.85. Expiration is in 11 trading days and in order to come out at break even at expiration, I need the stock to be at $67.60 to assure that the intrinsic value of the 70 put equals the loss I took on the selling and buying of the 75 put.
Meanwhile, there is time value still left in the Out-Of-The-Money 70 put that is ticking away every day more and more.
At this point, all I wanted to do was break even and get out. I added the loss on the 75 put to the original cost of the 70 put plus a little spice for commissions to come up with a limit sell order of $4.90.
Luckily the stock did continue to drop the next two days and my order filled on the morning of the 5th. It all worked out very nicely and seemingly easily, so of course I wished I had done the same with my other "conservative" account. However, the stock could have just as easily not continued down and gone back up or lingered between 70 and 75 while the unrealized gains on the 70 put were ticking away rapidly in time value. I would have then taken on a bigger loss than if I just closed out the whole spread all together in the first place.
Playing this game is very much like walking a tight rope. This one worked out for me. But I've definitely blown a few of these in the past. My impression is that more often then not it's best to just close down the spread as one trade for whatever loss is there assuming it is less than the max loss on the spread. The probability oriented people at thinkorswim who almost exclusively sell time in the form of vertical spreads and others would not even think about doing such a risky and chancy maneuver.
Mike Coval and some Investools people will promote the great prospect of reversing a trade and make it seem easy. It's not. It may be advisable to do in some cases, but my impression is that that it is usually not.
So there it is. My BHI trade. All that work, sweating, blogging and even your reading....just for a breakeven trade. I hope it was worth it. ;-)

VPRT review and setup

Hello all,

Sorry to leave so much time between posts lately. Rehearsals have got the best of me right now and I'm just not finding enough time to look at the market intelligently, much less make worthwhile blog posts. The BHI credit spread post will have to wait too since it will take more brain power for me to put together.

Boy, whoever wrote the last post on this blog sure had it wrong about the channel being broken. Amazing strength the past few days. But let's not forget that the Nasdaq is still not quite above resistance. And while the SPX is somewhat out in the clear, the OEX hasn't quite gotten there. The Russell 2000 looks like it's not quite ready to make the charge.
The NDX looks like it could even be working on the right shoulder of a head and shoulders pattern. A move down to and through the 1760 area would be the confirmation of that pattern. It may well be shattered soon, though, to the upside.


Don't get me wrong. The market is clearly bullish right now and it will be so until it turns around, which it hasn't yet done. I just want to point out some of the things that aren't quite as rosy looking as the Dow Industrials. Going into the three day weekend, I would expect to see some profit taking, unloading a bit of risk going into the three day weekend.

I wanted to share this chart of VPRT that I just mocked up for a friend. I mentioned this stock some months ago at a meeting or two and mentioned before that I have a paper position on it. I've gotten the impression that Jim has mentioned the idea of buying on a "close above the high of the low day." This is a good way of buying pullbacks, particularly in conjunction with a stock that is coming into likely support.

I really like the looks of this stock. The fundamental scores are really nice. It seems that the P/E could be a touch high and some cause for concern, but if they're really growing at a rate of 34% annually, then people are apparently willing to pay up for it.

There is a good looking Cup and Handle pattern here. I bought on a pullback to old resistance/new support in anticipation of a forming handle for the cup already in place. Indeed, the stock did move up and through the buy point(.10 above the high of the right side of the cup) and with a big volume spike. On a pullback to new support, I added 1/2 again the size of the first position. Normally, I wouldn't want to buy right before earnings, but with a buffer zone of profits already and some degree of confidence in the consistency of earnings reports, I was comfortable taking the chance.
(click it to see it bigger)

Notice that the stock has consolidated and pullback a bit to what was old resistance. This could be a very nice "close above the high of the low day" buy on a bounce off new horizontal support as well as the MA.

I'm sure it doesn't quite work out like this every time, but assuming that this stock does do very well from here on out, I've built a position in an ideal way. I may add one more time, but we'll see. Now it's just a matter of sitting back and letting the trend do its thing. I will give it some room to breathe along the way in the interest of making this an intermediate to longer term play. Might even do some covered calls on it if it looks like it's not ready to move higher just yet.

I should note that the big chart ranking on this one is not good. But the group's chart itself looks quite strong. One real bit of concern is the fair amount of recent insider selling. But with a stock that has been so strong, perhaps it's natural for them to want to take a little bit off the table. I'm sure they have kids in college or whatever else that the rest of the world has to worry about too.

I hope you're all taking your share out of this market. Enjoy it while it lasts. Check out this IBD article, Distribution Days Can Signal Market Top.


Have a great weekend.

Credit Spreads for a weakening market

If I had to make a prediction, I would say that this channel on the SPX is about to be broken. MACD and Stochastic are clearly rolling over. After a week of trying to hang onto the 1450 level, the market gave up and retreated south. The 1430 level now represents the convergence of the 30 day MA, the rising support line from the Channel since November, and potential horizontal support from a recent line of resistance. Breaking that area and the recent channel would be a major red flag. Breaking below the 1420 area would be an official lower low.

The Nasdaq isn't any prettier with what looks already like a lower high.


This weekly chart of the VIX isn't all that scarey looking. 12.50 remains the level beyond which we know there is a major change in progress. (I'm setting an alert for my own personal, instant newsflash.) The last week of action on the VIX doesn't look too bad, but it is noteworthy that the entire range of this weekly bar, shadows included, was made on Friday.


So it seems that at the very least, the uptrend is in jeopardy. If we are going to be headed generally sideways if not down, selling calls and doing credit spreads will be more suitable than going long stock and calls. In addition, if the market does begin to break down and VIX begins to rise, this will be accompanied by a rise in implied volatility which factors into the time value of options, making them more expensive. If they become more expensive, it is more advantageous to be an option seller.
If you have stock positions that look to be peaking or going sideways, consider selling March calls on them. Right now we're right in that window of 20 to 40 days before expiration. This time period is where we want to be selling calls in order to capitalize on the last month and more rapid decay of their time premium. (Of course, the proper analysis must be done for each individual position and you must be comfortable with getting called out of the stock or buying back the short call early.)
But let's talk credit spreads. In short, a credit spread is a position made of selling one option and buying another creating a hedged, defined risk position in which the net cost of the two "legs" brings in a credit. Let's use the SPY.

If we owned the SPY, we could sell calls at 145 for $1.40. As long as the stock is not at or higher than $146.40 at March expiration, we will make more money on the position than we would on just the stock. (Note the January post in which I mentioned selling Feb 144 calls.) But what if we don't own the stock? Sell the 145 calls naked? We could do that, but it would require a lot of margin and would theoretically have unlimited risk because the the SPY could take off like a rocket and never stop. Let's make a credit spread out of it.

We can sell the March 145 Call $1.40 and take on the obligation to sell shares of SPY at 145 if "called out." In order to limit our loss and define our risk, we can buy a higher strike price as a form of insurance. Since those calls at a higher strike price will cost less than the ones we sell, the net position will be a credit. I'll choose the March 147 call which we can buy for .65.
The total position then would be a "vertical" spread, March 145/147 for a total credit of .75. It is often referred to as a "Bear-Call" Spread, because it is a bearish position that benefits from the stock going down and it is made of calls. (Bull-Put Spread is the other type over Vertical credit spread.) In the worst case scenario, the stock would fly higher than both sides of our position. In order to fulfill our obligation to sell someone the stock at 145 we could use our right from the purchased call to buy the stock at 147 no matter how high the actual stock price. This makes for a max risk of $2. But with the credit that we took in on the position, we actually are only risking $1.25. The potential return on risk here is .75/1.25=60%.

I should note that I am not going to trade this position. As the name implies, it is a bearish position(even if it makes money in a sideways market too). I am not yet bearish on the market. I think the position is actually not such a bad idea and could work out very nicely. But it's more a matter of what kind of trader you are and how you will manage your risk and where this fits into your portfolio.

The example is more for the purpose of at least attempting to introduce the concept of a credit spread before refering to them further. I have mentioned a trade on BHI that I intend to recount for you, but felt the need to do a general intro to what a credit spread is first. Also, because people seem to be more comfortable with calls than puts, I figured it'd be best to use a call spread as an example.

What I will get into on the next post is the prospect of reversing a trade. In short, if you put on a Bear-Call Spread and then the stock or index moves very aggressively bullish, you can close the short side of the spread by buying back the 145 calls for a loss. But by keeping the 147 long calls, you would then be in a position with unlimited profit potential. In doing this, we switch our position from a bearish one to a bullish one. This should not be done flippantly. I'll discuss further in my coming post on the BHI trade. (Sorry, I know I've mentioned it a number of times already and haven't done it yet. I just don't want to write any more at the moment.)

Be carefully out there. Choppy waters.

CRDN signal

CRDN is giving a fresh 3rd green arrow today. But what I like even more is that it has formed a higher high and higher low for a newly established uptrend in the short term. That move above resistance at 55(a significant level at many times over the last year) could also be seen as a miniature inverted head and shoulders pattern.


An exit on a move back below the MA or below 55 could be reasonable, but to give it room, you might look at 52.50 as established support. With that, the former high of 62.50 would be a nice target. That makes for a good risk/reward ratio.
The stock's group isn't great looking on the big chart, but you can see that in reality the group is still looking strong by its chart.


What's even more attractive is to look at the long term chart of CRDN. After a year of virtually sideways action, it could be ready for the next leg up.



The selloff from the recent high was on an analyst downgrade. Today's move was on an analyst upgrade. Can we really rely on these people? I'd prefer to see what the crow is doing on the charts.
The conviction behind the sell off just didn't seem very convincing. Now that our commitment to the war is being extended and with a strong proposed 2008 budget for defense, as today's analyst noted, it would seem that a the number for the 2007 and 2008 earnings estimates on CRDN would be likely to increase as they get more military orders like the ones they got at the end of last month.
Using today's price of 55.52 and the earnings estimate for 2007, it has a forward looking P/E of 11.4 compared to the group P/E(probably trailing twelve months) of 22.44. And with an annual estimated growth in the coming years of 16.67%, that makes for a PEG of .68. That's VERY low.
Earnings come out February 26. There could well be a nice run up into the earnings announcement which could give a nice buffer of profits to hold through earnings. Otherwise, an options play could be nice, particularly considering the implied volatility still has room to go higher.

Because the movement of implied volatility affects ATM and OTM options the most, I will look to buy March Calls and plan on selling them before the announcement. The Implied volatility will likely stay around the same or go up 'til then. But with the announcement, good or bad, the IV is likely to come out of the options quickly. And then, of course, there's the risk that the announcement will go bad, which would hurt options a lot more than the stock.

Any thoughts? Am I missing something?

List Performers

Since this post followed so quickly after the last one, I just wanted to point out that Jim left an insightful comment in the comments area for the last post on Oil. Check it out. And don't be shy about leaving your own.

So far, the 40/45 March Bull-Put spread on COH I suggested a few posts ago is looking good. I'm not going to claim victory just yet, as there's plenty of time before expiration, but it's nice confirmation when things begin to work as predicted from the start of a trade. (I'm paper trading it, so I'll let you know how it comes out.)
COH has put in a new high now and while it may keep firing higher, it would be prudent to look for a cleaner entry. The MACD and Stochastic have yet to turn lower, but I would imagine one or both will in the coming week as the stock regroups for further upside. With 5 up days in a row, it is reasonable to think there might be a bit of a healthy pull back needed. Also, I like to keep old trend lines on charts for a while to see how the stock reacts to the backside. You can see that the stock is coming right to the underside of the recently broken 5 month trend support. Given the angle of the line, I don't see it as some scarey point of reversal. It just seems a healthy reminder that stocks aren't supposed to go Parabolic and this one could use a few days rest. If it pulls back toward the MA and puts in a higher low, that would be a great entry. I will look to 45 for new support.
(Click for a larger view)


CRDN is in a group seemingly trying to fight its way out of the red. Notice that the Group Rank in Phase 1 is showing 64. After not a lot of follow through on selling after an analyst downgrade, we see a potential double bottom reversal pattern which would give a nice buy signal in a move above 55. This would also be very close to a fresh third green arrow on the MA. With earnings on Feb 26, this could be a nice short term trade up to 60 or so.


Earnings coming out tomorrow on CTSH and the chart looks very healthy. Of course buying on a pull back would be ideal. There's very nice, clear support at 82.50. Use this to define your risk and position size.


I'm feeling good about replacing ISE with ICE. Friday marks a new high for ICE on above average volume while ISE had a down day to erase much of its rally attempt the prior day. We'll see what earnings this week bring for these stocks.


The homebuilders have been doing very well lately and our KBH has been moving right along with the pack with a new high for the last 8 months on Friday. It's not quite ideal to buy after a week of very strong action. But the strength serves as confirmation that people are continuously embracing these stocks again. A target of 60 seems inevitable in the coming months. The trick is to get the entry correct.



RIMM has been moving sideways lately with some very toppy signals to it. The recent earnings announcement was met with a heavy volume and huge bearish engulfing pattern. Then a rally attempt at new highs was harshly batted down from resistance on big volume again. A few noticable up days this week look like another attempt is being made, but the volume has been less than average on those days. I won't have a whole lot of hope for this stock until it can convincingly break through the 140 area. Until then I will be looking more closely for a potential bearish position here. Obviously a bounce down off the 140 area for a triple top pattern would be a nice entry.
Paper Trade: On December 22, the day after the earnings announcement, I used the bearish engulfing as a signal that sentiment on this stock was changing. With a lower high also in place, I sold a January 140/145 Bear Call spread for a credit of $1.47. It expired worthless for a return of 41% in 4 weeks. The first week of January was a bit worriesome, but I held because it had not broken the resistance yet.


WCC had a stellar earnings announcement accompanied by news of a $400 Million stock buy back program. The market obviously liked this with some heavy volume gains. Notice that the day before earnings were announced was already an optimistic move. At this point a pullback would be a better place for an entry. 62.50 would be a good support level or maybe the MA will come up to provide support somewhere else. A move above the 69-70 area will be the real signal that this stock is going places.



ZMH is pulling back for a nice entry. 80 would be the most obvious, perhaps strongest support to look for now. But an entry on a bounce of the 82.50 level, the low of the day it gapped up, would be nice and clean. Don't forget the big volume spike that accompanied the gap. This is a major sign of sentiment on this stock.



But don't forget to look at the long term chart on ZMH. The 90 area appears to be potential resistance. What I'm thinking is that it might be nice to buy stock or a deep ITM, Long term call option here around 80 or 82.50 and then sell 90 calls as it approaches that level if it struggles with resistance there.


Have a great week.

Checking the Oil

For starters, I want to take a look at Oil. The oil industry groups are ranking on the very bottom of the Big Chart. If they start to make a comeback to market leading status, we want to be jump on the ride early on.

Oil has been moving downward ever since mid summer when the recent stock market rally began. This chart for Weekly crude shows a clear downtrend with lower lows and a lower high. The past two weeks have shown a strong bounce in Crude which we should pay attention to. The general belief, correct or not, is that if oil goes up the market goes down.
There is a Bullish divergence between the lower lows in the price of oil and higher lows in the MACD. The rally the last two weeks has been pretty impressive with this week's candle being bigger than most. But it is far from out of the woods. Even if it does break above the 60 area, with the 40 Moving Average (in this case the 40 week MA, equivalent to the 200 day MA) rolling over, it seems like getting past 65 will be a major feat for crude.


In turn the oil services index is looking pretty non-commital with a generally sideways chart for the year and it is approaching the underside of the 50 and 200 MA, likely points of resistance. It's got a short term uptrend in place, but in the intermediate to long term it is hard to put a finger on much more than wandering sideways action. With the MACD and Stochastics high, it's hard to get excited about jumping into this group. Our BHI looks very similar.


But it's interesting to look at the index for integrated oil companies. There is the same short term uptrend, but the longer term is also more clearly in a healthy uptrend and the current price is above all the 20, 200, and as of a few days ago, the 50 MA. (As a side note, there are two oil indexes, $OIX and $XOI. I can't quite figure out if there's a really signficant reason to use one over the other, but it doesn't seem to make much of a difference. Click on the links to see their components. Mostly the same.) Remember, to play this index as an ETF, the closest thing is the XLE.



I did a Global Search of the entire Energy sector with the only requirements being a minimum F/E score of 3.25 and minimum price pattern score of 2.5. Amazingly enough, only 20 stocks showed up. Our UNT was one of them. It's showing a weaker Estimates score than ideal, but the underlying numbers are still attractive even if with a few black marks.
The chart is still not quite screaming for a buy, but it looks like it is moving toward taking out some of the first obstacles. First up is the long term downtrending resistance line. Though this longer term resitance line is somewhat daunting, we do have a short term uptrend in play and have put in a higher low on the intermediate time frame. It has just broken above the 50 MA and will likely find resistance at the 200. As it breaks the downtrend line and struggles with the 200, the 50 may well come provide it with support in the coming weeks or months to begin the building of a new intermediate term uptrend. Notice how the volume on the more recent selloffs hasn't been terribly high(I'm dismissing Jan 3 as new year's craziness) while the volume has been ramping up somewhat in the strength of this last week. Sentiment on this one may well be shifting.
Keep on eye out.


More on our list soon.