Something Wicked This Way Comes

The market has been retreating, and some analysts and websites are predicting a more substantial down-move.

An election that may accelerate or change the direction of the country is days away.

A “storm of the century” is heading towards the east coast.

There is a full moon today, adding perhaps the final ingredient to the mix.

Something Wicked This Way Comes – the 1962 novel referred to a traveling carnival, but we have our own nightmarish circus to deal with. How does one trade in an environment like this?

One way is to buy insurance. Not something a duck is selling – I’m talking about adding a put option to a long position in the stock you are considering
entering, to an existing position to protect against a large loss, or to an existing position to protect a profit. Let’s look at an example.

On September 21st, McDonalds had just broken above a trading range. The volume on the breakout was 37% higher than the average volume of the past 50 days:

MCD10.29.png

At the time, I mentioned the strong seasonal pattern MCD had for the next 9 weeks. However, that was the start of the triple-top and subsequent pullback by the S&P 500 that occurred over the past month. Playing an upside breakout of a well-defined trading range is a higher probability trade, but nothing works 100% of the time. Higher probability trades usually allow use of tight stop-losses, so any breakout trade should have been closed as soon as MCD showed the breakout was failing.

MCD fell back to the bottom of its trading range, helped by an earnings release on 10/19 that was below expectations. MCD has since fallen back to the 86
level, which as I remarked in on 9/24, “A nice double-bottom pattern on the weekly chart shows selling dried up at the 86 level both times.”

MCD10.29.2.png

We’ll now see if buyers are again interested in MCD selling at 86. Their earnings miss was only 4 cents. Total sales slipped just 0.2 percent. The thing
is McDonalds is still one of the top companies.

MCD still has a good seasonal record right now, an upward bias that goes into early next year.

If you believe this may be a good time to pick up some McDonalds stock, there is a way to do it with very low risk. The market may be pulling back a bit or may be consolidating for another move higher. Even if we’re due for several weeks of weakness, I would expect strength and maybe a rally as we head into the end of the year.

So the time period we really want to insure is the next 6 weeks. If we consider buying a put option as insurance, we want one that will not expire until at
least 30 days after the time period we want to insure. In this case, we’ll want an option that expires at least 10 weeks away. Therefore, January puts make sense.

Let’s evaluate a trade where we go long MCD stock at Friday’s close (86.71), and simultaneously buying a January 85 put, which had a closing Ask of 1.93. To help visualize how it works, I’ll use a few graphs that show what happens to such a position if MCD stock moves to various prices.

Monday will be 81 days until January option expiration. The chart below shows two lines. The red one is a graph of a position of just MCD stock. If MCD falls one point, we will lose one dollar for every share of MCD we hold. If MCD rises one point, we will make a dollar for every share, no matter if it happens today or 10 weeks from now. The red line in the chart below shows that relationship.

Now, let’s consider buying 100 shares of MCD on Monday with simultaneously buying one January 85 Put. The blue line below shows the net effect of the
combined position, right after entry in the trade, if nothing else changes. If the stock immediately falls to 84, we see the combined position will be worth
about $85. That means the Jan 85 put will probably drop from $1.93 to $1.00, but it will be protecting the position from any further losses. As the put will be in-the-money at that point, it will increase by one dollar for every dollar MCD stock decreases. As there will still be a small amount of time value in the option, the combined position will likely remain worth at least $83, no matter what MCD drops to. You would give up a little of the possible profit, due to the cost of the put. But this trade strategy is insurance against a large loss.

MCD10.29.3.png

Since there is some time value in the Jan 85 put when we buy it on Monday, what would the protection look like say 5 weeks from now, on November 30th? Not very different, as this chart shows:

MCD10.29.4.png

Again, if something changes, like volatility levels, the combined position chart will change slightly. As an example, the implied volatility on MCD options is currently near a 12-month low (14.5%). The high for the past 12 months was around 21%. Plugging that volatility level into the chart shows a
change only around the strike price of 85. The put will be worth more, but the downside protection stays where it was.

MCD10.29.5.png

What if MCD bounces from here and returns back to the top of the trading range by the end of November?

If MCD rises to that target price of 93, 33 days from now, with no change in volatility and other factors, the long stock/Jan 85 Put combined position
should have a value of around $91.20.

If MCD fell substantially below the trade entry price, the greatest loss such a position could suffer would be around $3.70. Of course, a reasonable stop-loss may be just below the trading range, say at 85.25. Exiting at that stop-loss level may mean selling the stock and the put for a combined $85, meaning a $3.40 loss.

So for the near term, this ‘Married Put’ trade would offer a gain of around $2.50 if MCD rose back near the top of the trading range, and a possible loss
of around $3.40 if a stop-loss is implemented. This is not the reward-to-risk ratio an active trade usually likes to achieve. But it is a way to pick up a
world-class stock at very low risk, and hold it through an uncertain environment.

You would also be holding a stock that is currently paying a 3.5% dividend. The next dividend payment will likely be $.77 a share paid in mid-December, so that would raise your gains, or lower your losses, even more.

Of course, there’s much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, click here: www.markettamer.com/seasonal-forecaster

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2013 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com with extensive experience in the financial sector.

Gregg started out as an Engineer and brings a rigorous thinking to his financial research. Gregg’s passion for finance resulted in the creation of a real-time quote system and his work has been featured nationally in publications, such as the Investment Guide magazine.

As an avid researcher, Gregg concentrates on leveraging what institutional and big money players are doing to move the market and create seasonal trend patterns. Using custom research tools, Gregg identifies stocks that are optimal for stock and options traders to exploit these trends and find the tailwinds that can propel stocks to levels that are hidden to the average trader.

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