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OPTIONS TRADING


Chesapeake Energy - Buy Puts

05/18/10 12:02:57 PM
by Donald W. Pendergast, Jr.

Once in a while, it makes sense to buy put options for speculative trade purposes. Here's one such opportunity.

Security:   CHK
Position:   N/A

Chesapeake Energy (CHK) shares are in a fairly strong weekly downtrend, and with the Rahul Mohindar oscillator (RMO) trading system in MetaStock having just fired a new short swing sell signal, it appears that the support/resistance/option expiration dynamics of this stock may be offering a nice long put play, one using in-the-money (ITM) July expiry options. A closer look follows (see Figure 1).

FIGURE 1: CHK, WEEKLY. Strong downward momentum, weak relative strength, and well-defined SR areas help make this July $24 CHK long put purchase an attractive proposition.
Graphic provided by: CS Scientific Expert Advisor from MetaStock.
 
First off, what are the critical ingredients needed to cook up the perfect long put play, anyway? If you're going to buy puts, hoping to profit as a stock or index drops in price, then one of the first tasks is to make sure that the underlying stock is weaker than the broad market (nothing like getting a good head start) and that the stock is sufficiently bearish on both its daily and weekly time frames.

In addition, you also want to see clearly defined support/resistance levels (SR) surrounding the trade entry zone, ensuring that you have some rational way to determine "exit with a loss" or "exit with a gain" price zones. You also want to make sure that you're not paying too much for the option, especially since options are a wasting asset, inexorably losing a little more time value with each passing day. And finally, you also need to ensure that you buy an option with more than enough time till expiration in order to confirm that the option will still be alive and well in time for your stock to make its desired price move.

There's nothing worse than buying a cheapie put with only a couple of weeks time value left and then having the option expire worthless just before the underlying stock takes off on a run toward your original price target. If you think it might take three weeks for your stock to reach its price target, then why not buy an option with at least two months' time value remaining? Better to spend the extra cash on an option with some staying power than to take a risk with a low-cost, out-of-the-money option that is likely to vanish before your eyes, unable to produce anything more than another drawdown in your account's equity curve. With that said, here are the technicals that matter concerning the CHK put sale that I have in mind:

* The stock is in a confirmed (lower highs and lower lows) downtrend, one that is now below the 50-week exponential moving average (EMA).

* The stock is weaker than the Standard & Poor's 500 over the past 13 weeks.

* The CS Scientific Expert Advisor in MetaStock 11 has recently moved into the short zone (see the yellow ribbons at the base of Figure 1). This particular MetaStock expert is an exceptional tool for all varieties of option traders, simply because once this expert goes into either confirmed short or long mode, the stock or index in question normally has some amount of meaningful follow-through. Let's take a closer look at the SR boundaries now, along with an attractive long put purchase, one designed to utilize multiple exits.

FIGURE 2: JULY PUT. The July $24 put features very low time decay (at present), while the relatively high delta (0.64) ensures some wiggle room should CHK temporarily reverse higher.
Graphic provided by: Thinkorswim.
 
It's pretty easy to see the strong area of resistance near $25 on Chesapeake's weekly graph (blue shaded area in Figure1); that can function as an initial stop-loss area until the trade (hopefully) moves into the profit zone. You'll also note the swing low of $21 from two weeks ago (blue arrow) is the first profit target, where we will take off at least half of our profitable position.

Next, witness the substantial support area that exists near $16.92 (pink shaded area). That's the ideal profit target, but we have no way of knowing if or when CHK will actually hit that price zone again. So now that we have some nice chart SR points to work with, our next task is to go option shopping. Here's the best trade, from all outward appearances:

Buy 1 July 2010 CHK $24 put option (CHK100717P24)
-----------------------------------------------------------
Net debit of $2.65 ($265 per contract) or less, not including commissions.

This put is only losing about $1 per day in time value (but that will gradually increase as expiration approaches) so it has plenty of staying power for this trade setup, where we're looking for a swift and sharp drop in CHK over the next few weeks. The option's delta is 0.64, meaning that a move of $1.00 in CHK will equate into approximately a $0.64 change in the price of our July $24 put. The delta will increase if the stock continues to drop, which is exactly what we want to occur.

If you can only afford one option, no big deal, just take your profits if $21 is seen in CHK and walk away slightly richer and happier. If you can afford two or more options, take half off at $21 and then run a two-bar trailing stop of the daily highs on the remaining options, hoping to hold on for a run toward that heavy-duty support area near $17. See Figure 3.

Of course, this trade might not work out, so if you see a quick reversal toward $25 or if the option loses half of its value (say down to $1.25 or so), just sell it and wait for another trade setup.

FIGURE 3: CHK. Fantasy Island? Maybe, maybe not. Given the strong bearish down force being exerted on CHK shares now, it seems that a move to $21 within the next week could be readily achievable. A gain of $91.12 per contract would be the outcome if CHK does move to $21 by then.
Graphic provided by: Thinkorswim.
 
Overall, this trade has a lot going for it, and experienced long puts people should have little problem in pulling the trigger on this setup. Only risk 2% or less of your trading account's value, regardless of how good this chart looks, since anything can happen in the financial markets.



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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