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OPTIONS ANALYSIS


With Abercrombie & Fitch, Keeping It Between The Lines

01/04/11 09:25:15 AM
by Donald W. Pendergast, Jr.

Here's a look at an attractive short option strangle setup now taking shape on Abercrombie & Fitch's weekly chart.

Security:   ANF
Position:   Sell

Short option strangles aren't necessarily for every trader, but for those who can clearly understand the relationships between probability, time decay, implied volatility, and support/resistance dynamics, these trade setups take on an almost irresistible appeal. Using the weekly chart for Abercrombie & Fitch Co. (ANF) (Figure 1), we'll examine this simple but potentially profitable option trading opportunity.

FIGURE 1: ANF, WEEKLY. Even a very simple price chart can be of great use to short option stranglers, particularly if the key S/R barriers are amenable to successful short-term strangling opportunities.
Graphic provided by: MetaStock.
 
What, no technical indicators? Isn't a chart supposed to have three dozen squiggly lines, five different wave counts, six cycle length projections, and a complete 10-day forecast overlaid on the price bars? Well, not really. In fact, if you can develop a sharp eye to interpret the complex interrelationships between major chart support/resistance (S/R) areas, option expiry, option volatility and probability of price movement, then you stand an above-average chance of becoming a very skilled options strangler -- either on the long side or the short side.

Here's a look at a beautifully formed short options strangle in one of the popular retailing stocks -- ANF.

No big secret here; ANF is still in a very long and strong uptrend, one that began way back in November 2008, just when it looked like the US stock market might be ready to plummet much of the way through 2009 -- and even beyond. Well, so much for gut instinct; the bears missed out on one heck of a good rally in ANF since then, with the stock up more than 250% so far since the crater low.

However, with the year-end bullish seasonal period nearly behind us, this high relative strength (versus the Standard & Poor's 500) stock may need a bit of a correction before attempting to take out a longstanding resistance barrier at the $65 price level. If we stretch a trendline along the major swing lows since late 2008, we also find a lovely support area at the June 2010 swing low (just above $30), one that could be a wonderful defensive tool to protect the lower end of a near-term short option strangle. Think of it: with strong S/R barriers in place on either side of a $40 wide price range and the stock perhaps nearing the terminal phase of a very mature uptrend, why not consider the possibility of constructing an option trade composed of two near-term short options that have an above-average chance of expiring worthless by February 18, 2011, in which both the short call and short put options will each be positioned at and/or just beyond either of those previously mentioned S/R "fences"? See Figure 2.

FIGURE 2: STRANGLE. A February 2011 70/25 short strangle will yield less in premiums but may be more suitable for more conservative traders. Those convinced of strong support near $40 may wish to investigate a 75/35 short strangle instead.
Graphic provided by: Thinkorswim.
 
Here's the basics for this trade:

Sell 1 Feb 2011 ANF $65 call option (ticker: ANF110219C65)
Sell 1 Feb 2011 ANF $25 put option (ticker: ANF110219P2)
-----------------------------------------------------------
Net credit received: $1.30 or better ($130 before commissions)

The only real way to get hurt on this trade is if you fail to set an exit point if one of the options starts to go in-the-money. Generally speaking, with only seven and a half weeks till options expiry, the $65 strike price should be the one more likely to be approached by the stock, but if a major correction decides to kick in in early January, it's also possible that ANF could retrace a third of the hard-won gains of the past two years in just a few months. The big idea is this: as long as ANF meanders between the $65 and $25 strikes until February expiration, you will get to keep all of the premiums collected at the time of the strangle sale.

Here are some sample P/L projections for the strangle, assuming that option volatility remains constant:

January 15, 2011 ANF at $64.60 P/L (-$191)
January 31, 2011 ANF at $66.78 P/L (-$223)
February 8, 2011 ANF at $62.41 P/L $45
February 18, 2011 ANF at $64.65 P/L $130

January 9, 2011 ANF at $54.60 P/L $81
January 22, 2011 ANF at $56.78 P/L $93
February 18, 2011 ANF at $37.65 P/L $130

These are approximations and assume an original sales price of $1.30 and do not include commissions. It's important to use a low-cost, high-quality broker when trading option strategies with multiple options, as the cost savings can be substantial. At Interactive Brokers, for example, you may be able to sell this strangle for about $2, a price which is substantially less than some of its competitors.

Trading short strangles works best when you can take advantage of a setup in which a stock or futures contract has already made a very substantial up (down) trend, one that is giving some signs of internal deterioration (money flow and/or price-momentum divergence, and so on) and where the projected trend reversal is below (above) a significant S/R barrier likely to offer major interference to further price movement.

Once you identify this (in Figure 1, the trend move up toward the $60 area easily meets this criteria), your next step is to locate major S/R on the other side of the start of the most recent trend move -- in this case, the major swing low near $30. Once you've found the two S/R points, all you need to do is start running various short strangle simulations in Thinkorswim, interactive Brokers, TradeStation, and so forth, and see if you can identify one that has attractive risk-reward characteristics. Based on my own personal understanding of the forces driving ANF, I viewed this $65/$25 short strangle as the best balance between risk control and profit potential. You may have felt more comfortable with a $70/$25 or even a $70/$30 version, and that's okay because that's what makes a market in the first place -- differing beliefs about the true value and/or risk nature of any given financial instrument.

If you do decide to put this short strangle on and prices do climb past $65, what then? Should you just bail and close the entire trade out for a modest loss, or should you perhaps consider rolling out to a $70 or even a $75 call instead -- after you buy back the short $65 call?

Pardon the pun, but it's really your call (well, not really, since you're short!) in a situation like this; if your own technical studies strongly suggest that ANF won't make it to $70 (or $75) by February 18, you may very well decide to roll out and opt for the higher strike(s) instead of closing out the whole trade.

On the lower end of the setup, that $25 strike is an awfully long way from the stock's current price of $57.15, but who really knows what might happen to this stock in less than two months, anyway? If your short strangle doubles in price (most likely if the stock goes into panic free-fall for some reason) all of a sudden, just buy the thing back and wait patiently for another setup to come along. In the option selling game, your best offense is always a good defense, so remember to cut your losses short before they can do real damage to your trading account and/or trading psyche.



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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