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OPTIONS TRADING


Southwestern Energy June Call Sales

05/19/10 09:18:50 AM
by Donald W. Pendergast, Jr.

Southwestern Energy shares have been weakening for about four months now, with the daily and weekly charts presenting aggressive traders with a modest-risk call option play.

Security:   SWN
Position:   Sell

Peaking near $53 in early January 2010, shares of Southwestern Energy Corp. (SWN) stock have slipped by about $15. With a fresh Rahul Mohindar oscillator (RMO) swing sell signal on its daily chart, might this energy-related stock be offering us a possible call option sale setup? An examination of SWN's weekly graph may help to answer that question (Figure 1).

FIGURE 1: SWN, WEEKLY. The first order of business for an aspiring option seller is to ascertain the existence of a strong weekly downtrend. SWN's weekly trend appears to be sufficiently bearish to provide a favorable backdrop for a daily based, June $41 naked call option sale.
Graphic provided by: MetaStock.
Graphic provided by: CS Scientific Expert Advisor from MetaStock.
 
When selling naked short-term (two to five weeks) call options, the first item to look for is strong downward momentum on the stock's weekly chart. With SWN, an easy case can be made for a bear market:

* Lower lows and lower highs
* Weak money flow (based on the Chaikin money flow [CMF][34] indicator)
* A short MetaStock CS Scientific expert advisor signal (red oval)
* Bearish RMO trend (red price bars)

In addition, note the location of the downsloping 50-week exponential moving average (EMA). Not only is SWN trading below it, but the EMA is also hovering slightly above the highs of the most recent two weekly bars, forming a modest resistance area, something we can use to protect a short call sale with a $41 strike price. More on that later — for now, let's check out the daily chart for SWN for more detail (Figure 2).

FIGURE 2: SWN, DAILY. Like father, like son. The weekly chart's technical apples didn't fall too far from those on this daily chart of SWN; in fact, they're nearly a fractal duplication (carbon copy) of those seen on the weekly graph, a major boon to June $41 naked call sellers.
Graphic provided by: MetaStock.
Graphic provided by: CS Scientific Expert Advisor from MetaStock.
 
On the daily chart, the picture gets even more interesting. The CS Scientific expert (a valuable momentum tool for option players) is also flashing the short advisory, even as the long-term money flow (based on the Chaikin Money flow [CMF][100] indicator) is weakening at a noticeable rate. And again, just as on the weekly chart, the 50-period EMA is also curling around two recent daily swing resistance points, also a little south of $41. And with the broad markets looking even more vulnerable after today's action, it only makes sense to put such a bearish chart setup to work by selling a short-term, out-of-the-money (OTM) call option. See Figure 3.

FIGURE 3: SWN, OTM, CALL. Getting $100 for selling a short-term, far-out-of-the-money call in a stock with heavy bearish technicals is about as good as it gets in the equity option game.
Graphic provided by: Thinkorswim.
 
Based on the twin desires for a reasonably short time until option expiration (to maximize time decay, or theta) and that of a strong resistance barrier to protect a short call position, it appears that selling the June 2010 SWN $41 call option for $1.00 or better may be about as good as it gets. With the call nearly $5 OTM already, this market would have to stage a sharp turnaround in order to neutralize the heavy downward momentum that is already bearing down on it, meaning that collecting $100 ($1.00) in margin account cash for this call sale looks almost too good to be true, but there it is just the same. See Figure 4.

The trade plan is dirt simple, too. If the option doubles in price, simply click the "buy to cover" button on your trading platform. But for as long as SWN stays beneath that $40.75 area, this short call will be shedding $3 (-$0.03 per share * 100 shares of underlying stock = $3 per day per option contract) per day in time value (again, theta) right from the get-go, gradually losing even more time value as the option gets closer to expiration. Even better, observe the vega column; this measures the risk of changes in implied volatility (IV) on the option price, and a ratio of nearly 1 to 1 (theta to vega) means that this call sale is reasonably balanced between time decay and IV risks. If implied volatility for this call increases by two full points tomorrow, the call will increase in value by about $8 ($0.04 * 100 shares of SWN * 2 IV points = $8). This increase in the call's price will be partially offset by the $3 in daily time decay losses, for a net loss on the day of about $5 for a call seller.

The big idea here is this. When selling puts and calls, try to make sure that the theta to vega ratio is close to 1, if not higher. That way, a sudden spike in IV won't hurt your short option position too much.

Finally, as far as taking profits on this play, if SWN drifts (or plunges, as the case may be) down toward that major low from some weeks ago (near $35), you might just want to buy the call back before expiration and walk away with a nice little profit in your jeans. As you can see, such a drop would give you a relatively painless open profit of about $81 in a little over a week.


FIGURE 4: SWN, JUNE CALL. With the next major support in SWN near $35.40, it might pay to buy back the short $41 call should the stock make a swift, sustained move toward that price zone. Doing so might net nimble traders more than $80 in profits per contract, should the move happen in a week or so.
Graphic provided by: Thinkorswim.
 



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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