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OPTIONS TRADING


WFR A Possible Short Put Play

07/06/10 10:28:24 AM
by Donald W. Pendergast, Jr.

It can be difficult to consider a short-term bullish play on a stock that has dropped by more than 43% in 10 weeks, but sometimes the trades that are hardest to take can be the ones that can provide a pleasant surprise.

Security:   WFR
Position:   N/A

A little background first, before going over some of the appealing aspects of this potential trade setup in shares of Memc Electronic Materials (WFR). Near-term measures of broad market internal strength suggests that we may see a short-term bullish bounce within the next week or so, and this short-term put sale setup is intended to capitalize on such a move should it materialize. Be aware that the intermediate-term fundamentals for the broad market are downright pitiful, and extreme caution is advised for those considering holding on for anything more than a $1 or $2 pop in this particular stock.

We should see a meaningful bottom reversal and subsequent rally at the next weekly cycle low in the broad markets, and that isn't going to happen for at least two to three months, all else being equal. That said, here's a brief look at a simple, relatively low-risk short put setup, one designed to snatch quick profits on a short-term broad market reversal.

FIGURE 1: WFR, DAILY. Falling volatility, rising money flow, and bullish Detrend divergence paints a potentially bullish reversal picture for shares of WFR. A daily close above $10 might trigger a playable rally.
Graphic provided by: MetaStock.
Graphic provided by: WB Detrend RT EOD from ProfitTrader for MetaStock.
 
WFR shares have been sideswiped to the tune of 43% since they topped out with the rest of the broad market in mid-April 2010, but there are several hopeful technical clues suggesting that selling enthusiasm is beginning to wane in this stock (Figure 1). First off, the WB detrend oscillator is showing a very bullish divergence with price; this is almost always an early indication for a potential reversal in a stock or commodity, as is the bullish money flow divergence seen at the bottom of the chart. In addition, note how the daily range has shrunk substantially on the drop to the fresh swing low; this tells us that selling pressures are fading fast even as money is slowly starting to find its way back into this stock.

Here's an automotive analogy that might prove helpful here. In every internal combustion engine there is a certain point where the piston is still rising in the cylinder during the exhaust stroke and where both the intake and exhaust valves are open to some degree. The phase where both valves are open is referred to as "overlap" and actually causes some of the fresh air/fuel intake charge to sweep right across the top of the piston and then right out the exhaust valve with the remnant of the burned air/fuel mixture from the power stroke. If you can visualize that imagery, then you may be able to understand how the same kind of dynamic applies to this particular divergence setup:

1. The recent selloff was the power stroke of the market cycle, crushing the price of this stock. A massive amount of selling pressure was ignited by sparks of bad news, oil spills, European debt problems, and so forth.

2. The current divergence on the chart confirms the presence of an exhaust stroke (as selling pressure continues to exhaust itself) and the positive short-term money flow could be analogous to a new round of fresh air/fuel mixture coming into the market prior to the onset of a brief intake stroke. At this point in the market cycle for WFR (overlap), both the exhaust and intake valves are open at the same time. Such periods of overlap (falling price patterns but bullish indicator and money flow patterns) always occur prior to every market turnaround, and this appears to be no exception. The only real question is this: How far will WFR actually rise on a short-term rally?

If nothing else, the chart is at least warning us that going short shares of WFR is a major-league bear trap at this time. Now let's analyze a simple way to play WFR on a short-term sympathy rally in the Standard & Poor's 500.

FIGURE 2: WFR, PUT. Per the price trigger points described in the article, if you can get about $0.50 for selling a WFR August 2010 $9.00 put, you may want to set $0.20 as a potential profit target for this short put position.
Graphic provided by: Thinkorswim.
 
Figure 2 shows that the trigger for the WFR short put sale is very basic. If you see the S&P 500 reverse and make a daily close above 1033.58 and WFR makes a daily close above $10, consider selling a WFR August 2010 $9.00 put for $0.50 or better. The option has a decent bid-ask spread, good volume and reasonable open interest. Without getting too technical, if you can get a fill at $0.50 and the stock continues to rise to $11, you can expect to see the option's value drop by about $0.30 or so. That equates to a 60% return on the initial credit received, making this a very attractive put option sale for short-term profit hounds. Again, only consider selling this out-of-the-money (OTM) put if you get the twin reversals in both the S&P 500 and in shares of WFR.

If you see this happen, consider taking advantage of this setup, using modest amounts of risk capital to keep the potential for damaging losses low. For example, if you set a stop-loss value of $0.90 and you sell five of these puts, your maximum loss should only be about $200 before commissions (assumes a fill of $0.50 or $50 per put sold). If you have a $20,000 trading account, a $200 loss is only 1% of your total account equity, meaning that you'd still have $19,800 left to play the next attractive trade setup that comes along. Conversely, if you do get that nice runup to $11 in WFR, consider taking most if not all of your positions off (covering them, buying them back at say $0.20 or so) to ensure that any resumption of the big bad summer bear market won't turn your winning option trade into an unexpected loser. There's no need for your summer to turn into a bummer because of a dumb trading mistake, eh?



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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