Southwestern Energy Low-Risk Short Setup?

04/20/10 12:05:51 PM

by Donald W. Pendergast, Jr.

Southwestern Energy shares are falling, and the stock has even issued a new RMO swing sell signal to boot. Here's a look at a simple option strategy designed to take advantage of this stock's current downdraft.

Security: SWN
Position: Sell

Southwestern Energy (SWN) shares have been locked into a steady downward trend since making a major high at $52.82 in early January 2010. The stock is weaker than the S&P 500 as a whole and, even better, the Rahul Mohindar oscillator (RMO) trading system in MetaStock has just given a very interesting short swing trade signal. Since we're not sure just how much more downside this stock has before major support finally holds, we'll attempt to construct a fairly low-risk option credit spread trade that hopes to profit if SWN continues to fall, drift sideways, or even rises by a few dollars over the course of the next month.

FIGURE 1: SWN, DAILY. Under the right conditions, selling a bear call spread may make more sense than actually shorting the underlying stock. With the current sell signal coming right in the middle of two chart support & resistance points, selling the credit spread makes more sense than going short shares of SWN.

Graphic provided by: MetaStock.

Graphic provided by: Rahul Mohindar (RMO) tools from MetaStock v.11.

Figure 1 is the daily chart for SWN. While the RMO swing sell signal (dark oval on chart) looks decent enough (with poor to mixed money flow and a bearish RMO indicator momentum), I don't care for the nominal reward-to-risk (RR) ratio that the trade signal's location offers -- it's basically right in the middle of two potentially strong support/resistance areas that could contain the price movement. Ideally, a daily swing trade setup should offer around a 2-to-1 RR, but in the real world of trading, sometimes you need to settle for something less than ideal. However, in this case, we'll simply sidestep the equities market and just construct a derivatives trade, one based on the call options that track the underlying moves that SWN makes. As long as SWN doesn't close in the money (greater than $42 per share at May options expiration on May 21, 2010, only 31 days from now), the short vertical option spread I'm recommending here will net the seller at least $55 per spread sold (not including commissions, of course) and will also be a very simple trade to manage once opened. Here are the particulars (Figure 2):

FIGURE 2: CREDIT SPREAD. As long as SWN closes at $42 or below on May 21, 2010, this credit spread will expire worthless, allowing the seller to keep all the premiums.

Graphic provided by: Thinkorswim.

Sell 1 May 2010 $42 SWN call option (.TKQ100522C42)
Buy 1 May 2010 $45 SWN call option (.TKQ100522C45)
----------------------------------------------------
Net credit of $.55 or better

This is known as a bear call spread and the big idea here is to sell option premium in the form of a credit spread that will slowly but surely wither away by options expiration, allowing the seller to keep all of the premiums collected upfront. It's important in these kinds of trades to make sure that there is a strong S/R barrier between the current price of the stock and the short option strike price, and in this case, we do see that there is a very nice downsloping trendline that ought to provide at least some protection for our $42 short call option during the four-week lifespan of this trade.

Managing this trade is very basic -- as long as SWN doesn't make a daily close above the downtrend line, continue to hold the credit spread until expiration or until you get that daily close above the trendline. If the trendline break happens very late in the life of the trade, chances are you'll still be able to close the trade out for a modest gain, due to the effects of ever-accelerating time decay, which is one of the major features of selling a credit spread. If the trade goes as planned, falling in price after you put the spread on, consider buying it back (covering your position) if you can buy it back for $0.10 or $0.15 after only a few days.

By the way, these kinds of multileg option positions are much more attractive if you use a low-commission broker like Interactive Brokers or TradeStation; you'll only spend about $2-3 per spread at either of these firms, but if your broker charges a $15 minimum, even if you're only selling one spread, you're at a tremendous disadvantage compared to traders who enjoy $1/contract equity options commissions.

When the market, in the words of a talented daytrader, "passes around the cookies," it pays to take some of them, since you never know when a stock may suddenly reverse against you, not only wiping out your paper gains but actually smacking you with a loss to add insult to injury. So if you see SWN take a fast dropdown toward that support line near $37.21, by all means, grab some cookies (that is, take some profits) before the market munches them for you, leaving you with an empty cookie jar and tears in your eyes.

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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