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WEDGE FORMATIONS


Trading The Zone

12/04/01 10:09:54 AM
by Eric Utley

The Retail Sector Index (RLX) is currently consolidating its most recent advance. So is Autozone (NYSE:AZO). Which way will the wedges break?

Security:   RLX, AZO
Position:   N/A

Autozone is one of the best performing components of the Retail Sector Index this year. The stock is higher by 130 percent year-to-date. In the same period, the Retail Sector Index (RLX) is higher by a meager three percent.

The RLX is about 200 points higher, or 31 percent, from its September 21 lows. The index traded sideways in the last month, between the 870 and 895 levels. It hasn't made any progress in either direction. However, the lows have been set at relatively higher levels, which gives the recent consolidation a slight bullish bias. Although, the bias of the RLX's consolidation is open for debate. In any case, the RLX is poised to make a big move in one direction.

Figure 1: RLX - Hourly
Graphic provided by: Quote.com.
Graphic provided by: QCharts.
 
There are two approaches to trading the RLX pattern. The first is by implementing either a straddle or strangle in the options market. The straddle and strangle are neutral options strategies where you buy both a call and put on an equal ratio basis with the same expiration. The straddle uses the same strike price, while the strangle uses out-of-the-money contracts. Both strategies are predicated on a big forthcoming move in the underlying.

Implementing a straddle or strangle on the RLX underlying may not be the best of choices. The options on the RLX are illiquid. The at-the-money contract has only 106 contracts open; the spread is $300 wide. The better choice for straddling or strangling the RLX is through one of its components. Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) are two components that are relatively highly correlated to the index.

The other approach to trading the RLX pattern is in waiting for a breakout in either direction: simply buy a breakout above 895 or short a breakdown below the ascending support line, which currently sits around 870.

Like the straddle and strangle trade, it may be better to implement a directional trade with one of the components of the RLX instead of options on the index. Fortunately, an RLX component in Autozone (NYSE:AZO) is currently conducive to placing a directional bet. The stock traced an ascending wedge in the last month. The wedge in Autozone is more concrete that the RLX's pattern. The ascending trend line has supported a pattern of relatively higher lows while the upper-end of the pattern is clearly marked at the $68 level.


Figure 2: AZO - Hourly

The similar set-ups in the RLX and Autozone allow for confirmation when placing a directional bet. Ideally, the RLX will make its move in one direction and Autozone will follow. It remains to be seen which way the RLX breaks. But there are several ways to profit from a forthcoming move in the index. Moreover, the congruent pattern in Autozone comes at an opportune time. A break in the "zone" can be confirmed by a move in the RLX, which would add conviction to a trade.

At the time of publication, Eric was net long calls on HD and net long puts on WMT, although holdings can change at any time. Under no circumstances is Eric recommending the purchase of any of the securities mentioned.



Eric Utley

Eric Utley is a professional trader and contributing editor to www.OptionInvestor.com, a web-based newsletter that serves stock and options traders. While he cannot give investment advice, Eric welcomes your questions at eutley@optioninvestor.com.

Title: Contributing Editor
Company: OptionInvestor.com
Website: www.OptionInvestor.com
E-mail address: eutley@optioninvestor.com

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