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OPTIONS TRADING


Deere Offers Low-Risk Credit Spread

09/28/09 09:24:51 AM
by Donald W. Pendergast, Jr.

The old saying says, "Take care of the pennies and the dollars will take care of themselves." Here's a near-term option credit spread that might make sense, allowing option traders to turn those pennies into dollars.

Security:   DE
Position:   Sell

Deere & Co. (DE) is one of the world's largest manufacturers of agricultural machinery, with solid market penetration on every continent. The stock got hit pretty bad in the 2007-08 bear rout, but it has had a healthy rebound since March 2009. The stock is at a very interesting and important technical crossroads right now, one that might allow option traders to capitalize with a fairly low-risk spread trade.

FIGURE 1: DE, DAILY. Two setups -- one bullish and one bearish --exist on this chart, but the overall technicals favor the bearish case in the near term.
Graphic provided by: MetaStock.
 
Here's the daily chart for DE (Figure 1); one of the first things you'll note is the large inverse head & shoulders pattern, one that has been forming since May 2009. The top of the pattern can be connected with a slightly downsloping trendline that covers the range from $48 to $47 and should offer substantial resistance (as it already has on several occasions), should there be another breakout attempt. Of course, if such a breakout were successful, prices could carry significantly higher, and that is something every trader in this stock should be aware of. Nevertheless, given the rapidly deteriorating money flow in the stock (as evidenced by the Chaikin money flow (CMF)(34), not to mention the fact that DE has just made two straight daily closes below its Gann swing sell line (blue line on chart), the near-term direction in the stock may continue to trend lower.

DE also has a six-month and 12-month correlation with the Standard & Poor's 500 of 0.73 and 0.80, respectively, meaning that there is a high probability that DE will not likely bottom out on its daily price cycle until about October 7-12, 2009 (along with the S&P 500 and Russell 200 indexes), meaning that those who believe that DE shouldn't break out of its overhead resistance anytime soon may profit by selling an out-of-the-money option credit spread. That's what we'll take a look at next (Figure 2).


FIGURE 2: CREDIT SPREAD. With massive overhead resistance residing between $47-$48 and the daily and weekly price cycles moving lower, selling this OTM credit spread appears to make a lot of sense.
Graphic provided by: ThinkorSwim DE option prices.
 
One of the first tasks for any trader wishing to sell option credit spreads is to determine if there is a significant area of resistance just beyond the short strike price of the spread that he or she intends to sell. In DE's case, given the massive resistance area between $47 and $48, we'll consider selling a November 2009 $48/$50 bear call spread, collecting almost $50 for every spread we sell. As long as DE doesn't expire in-the-money at November options expiration, all of the credit received will be ours to keep, unless we choose to close the spread out early at a profit or a loss. Here are the key details:

Sell 1 Nov 2009 DE $48 call
Buy 1 Nov 2009 DE $50 call
----------------------------------------
Net credit received of $0.47 or better ($47 in dollar terms)

I like the general risk-reward outline of this trade; the most a trader could lose is $200 less the amount of the credit received, hopefully $47 or more. That's only $153 in maximum loss, not including commissions. But since the stock appears to have a major resistance area (as mentioned before) and also looks like a solid bet to move lower into its next daily cycle low in early October, there looks to be a very good chance that DE will move lower before it moves higher. If we see a fairly quick drop to $40 by October 11, 2009, the spread could likely be bought back for only $0.12, netting a profit of about $35 per spread originally sold.

If the stock simply meanders back and forth, remaining below $48, time decay is also eating away at the value of the spread, also tipping the scales in the seller's favor. The biggest danger is in a fast move up to or even beyond $48, and, if that happens, the spread should be bought back immediately, without question.

As always, traders should deal with brokers who charge low commissions on options in order to maximize profits and minimize losses.




Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title: Writer, market consultant
Company: Linear Trading Systems LLC
Jacksonville, FL 32217
Phone # for sales: 904-239-9564
E-mail address: lineartradingsys@gmail.com

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