What's in Your Portfolio? A Short Capital One Strangle, Of Course

05/25/10 09:18:22 AM

by Donald W. Pendergast, Jr.

The Raff MarketSpace Stock System has issued a bevy of new short signals in numerous S&P 500 stocks. Here's a glance at an interesting short setup in Capital One Financial shares, one that can be played a couple of different ways.

Security: COF
Position: Sell

Like just about every other Standard & Poor's 500 stock, shares of Capital One Financial (COF) have taken a pretty good hit over the last five weeks or so. The stock's current price of $40.92 places it squarely between two solid technical support/resistance (S/R) areas, allowing enterprising traders a couple of ways to play this financial services giant. Here's a look at COF's daily chart, along with some tips on how to play a short stock trade and a short-term short strangle options spread (Figure 1).

FIGURE 1: COF, DAILY. While the term "strangle" seems to evoke images of mayhem and violence, in actuality, traders selling this particular June COF $48/$33 strangle are being afforded a very easygoing, almost leisurely way to allow time decay and powerful S/R barriers to guide them toward potential short-term profits.

Graphic provided by: MetaStock.

Support and resistance is, in the minds of many pro traders, the single most important technical dynamic to consider before initiating any given trade. In the case of our COF daily chart, these dynamics are so overwhelming that we're almost compelled to investigate some of the ways to extract profits from those stock and/or options available for it. First off, note the large dirty gap (pink shaded area) between $45.00 and $43.70, a tear in the fabric of an otherwise orderly decline from the April 2010 highs. The gap is a visual representation of the obviously strong desire of big-money players to part company with their COF shares. Note also that there has been no serious attempt yet to close the gap; instead, the stock has fallen further and is now firmly ensconced beneath its downsloping 50-day exponential moving average (EMA). Further, one of the more profitable MetaStock expert advisor systems (the Raff MarketSpace Stock System) has added more bearish fuel to the fire with a fresh short sell signal. In addition, the short-term money flow (Chaikin money flow [CMF][34]) has just gone negative, with the long-term CMF (144) money flow indicator remaining flat to listless, offering a reasonably good foundation for bearish to sideways price action over the next few weeks, if not longer.

Beneath the current price lies the powerful support area formed by the Fibonacci 62% retracement of the huge February to April 2010 bull run and the venerable 200-day EMA; this area spans the range from $38.42 to $39.30 and should act as at least a temporary place to expect a bounce of some degree, should COF hit it fairly soon.

So with all of the essential chart topography covered, what we need to do now is decide how to either short COF or strangle it using June expiry, far-out-of-the-money put and call options. Let's lay out the stock plan first before going over the finer points of selling a June strangle in COF. See Figure 2.

FIGURE 2: TRADING PLATFORMS. Some stock/option trading platforms are loaded with easy to use, highly customizable order entry, and trade analysis tools. Thinkorswim happens to be one of the best of the bunch.

Graphic provided by: Thinkorswim.

The 50-day EMA is offering a wonderful initial stop protective barrier right now, so if you're going short now, simply place your buy-stop (to cover your short trade) a few ticks above the EMA near $42.67. When filled on your short position (preferably on a minor intraday bounce higher to get a better fill than $40.92) that initial stop will be tough for the market to get at unless there is a significant reversal right away, and from the looks of the overall market landscape, that ain't gonna happen for at least a week or two.

If the stock declines as planned, run a three-bar trailing stop of the daily highs until that previously mentioned support zone is reached; wise traders will probably want to cover their entire position near the 200-day EMA. Doing so will net you a bit more than $2 per share in profits. Those convinced of further weakness for COF at that point might want to take half or even two-thirds of their position off near the 200-day EMA and then run a tighter two-bar trailing stop of the daily highs until final stop out.

For option players, trade management is actually much easier and stress-free, especially with the short strangle I have in mind:

Sell 1 June COF $48 call option (ticker: COF100619C48)
Sell 1 June COF $33 put option (ticker: COF100619P33)
---------------------------------------------------------
Net credit received of $0.85 ($85) or better, before commissions

This trade has only 24 calendar days until June equity options expiry, meaning that as long as COF stays in a range between $33 and $48 during that time, the trader who sells this strangle will walk away with all of the credits he or she received at the time of the sale. Using a low-cost broker will make a big difference on the profitability; for example, at Thinkorswim (TOS) I would only have to pay about $5.90 in commissions to sell a one-lot of this COF strangle. At Interactive Brokers (IB), the charge is closer to $2 per spread. But if your broker is nicking you for $15, $20, or even $30 to put on this trade, I have only five words of timely advice for you: Wise up! Find another broker.

Back to the trade. With those two powerful support & resistance barriers likely to turn back prices on an initial approach, there is only a small likelihood that either option will go in the money next month, and since our short strikes are way beyond those S/R barriers in the first place, this is one of the best-looking equity option short strangles to come along in a while. If your margin account permits these kinds of trades (talk to your broker first if you're not sure; the margins are actually very low, especially at IB and TOS), there appears to be little or no reason to hesitate on selling this strangle, as it is a fairly low-risk proposition. If you have a large account, you may be surprised at just how many of these COF strangles you can actually sell while still limiting the overall risk to your account. As in all things trading, the more money you have, the more flexibility you have to pursue a variety of trading opportunities.

Since even the best-looking trade setup can go haywire from time to time, risk control is still important. Therefore, if COF gets uncomfortably close to either strike before June expiry, why not just close out that side of the spread and then roll out with a farther-out-of-the-money call or put (but only if you're convinced the new short strike won't also become market roadkill, wiped out by a strengthening up- or downtrend). You can let the other option simply expire, negating the need to spend commissions on a closing order. Or you can even close out the original short strangle, replacing it with one more in tune with the then-existing market conditions.

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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What's in Your Portfolio? A Short Capital One Strangle, Of Course

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