Tomorrow's News Today

01/19/06 02:26:46 PM

by David Penn

A positive stochastic divergence in the hourly chart of the NASDAQ 100 prepared traders for an "up" morning the day before January options expired.

Security: $NDX, QQQQ
Position: N/A

Summing up a few ideas about trading options in a book called The Guts & Glory Of Day Trading: True Stories of Day Traders Who Made (Or Lost) $1,000,000, trader Teresa Lo suggests:

Buy options that are in the money and within one or two weeks of expiration. This minimizes the premium you pay for the option's time value. If your position moves against you by a couple of strikes, sell the option. Don't ride it to zero.

These thoughts echo those of options guru Larry McMillan who, talking about trading options in the short term (that is, one to two weeks before expiration), also suggests in-the-money (ITM) options as the best play.

So if you're talking short-term trading with options (for very short-term trading, McMillan suggests you are often better off with the straight futures) and you're talking ITM options, what options play would have suited this "buy the panic" setup in the NASDAQ 100 this week?

FIGURE 1: NASDAQ 100, HOURLY. A positive stochastic divergence and a piercing pattern anticipate an interruption — if not an end — to the selling in the NASDAQ 100.

Graphic provided by: eSignal.

Truth told, it was the Standard & Poor's 500 that I was looking at after the close on Wednesday, January 18, when I spotted this positive divergence in the stochastic (Figure 1). But having just talked about the positive stochastic divergences that supported the bullishness of a cup with handle pattern in the S&P 500 ("The Emini S&P's Cup With Handle Bottom," Traders.com Advantage; January 18, 2006), I wanted to take a look at another popular market, the NASDAQ 100, to see if similar opportunities were brewing over there.

I was especially curious about the possibility of picking up a few points in these days before expiration, having arrived at the January 2006 rally a little late for decent profits. As of the close on January 18, the January 128 SPY calls (SPY AX) and the January 42 QQQQ calls (QQQ AP) both were trading at 0.45. Generally speaking, I'm looking for at least a double when buying options. But given the proximity of expiration — a mere two days away — I decided first that I wouldn't be greedy and would take whatever the market gave me.

Unfortunately, my second decision was to avoid the play altogether. This close to expiration, I feared, it was possible that a breakdown in the market, a sudden loss of confidence, could send those 0.45 calls plummeting in a nanosecond.

The road not traveled, then, resembles this: the SPY calls opened at about 0.55, the QQQQ calls at 0.45. Focusing on the QQQQ (the exchange-traded fund that tracks the same NASDAQ 100 shown in Figure 1) and the $NDX, the cash $NDX gave a buy signal on January 18 between 10-11 am Pacific time with a bid at 1717.71, which was hit in the next hour. The maximum drawdown was to 1714.03. As of this writing, the $NDX is at 1737.97.

Taking the options play would have involved buying January QQQQ calls sometime around 11:15 am PT. Assuming a purchase price at least as good as the January 18th close, put a trader long, say, January 42 QQQQ calls at 0.45. As of this writing, those calls are trading at 0.85 bid. That 89% gain in 24 hours isn't the "double" that many if not most options traders consider a minimum profit requirement. But in a market that has been as difficult as this one, such a gain might be enough to encourage at least some profit-taking on the part of options traders savvy (and courageous) enough to trade in the teeth of options expiration.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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