A Quick 20% Profit on Perfume?

While the major indexes took another hit on Friday, the charts of many quality stocks show possible reversals. Reversal candlestick patterns appeared, and the Stochastic indicators are at oversold levels and likely to give ‘buy' signals soon. If this current market pullback does end here, it will be nothing more than another short-term cycle low, and another good opportunity for short-term traders to enter bullish trades.

One type of trade setup I like to look for in these situations is trading-range rebounds. An example is Estee Lauder (EL). EL has been moving sideways for 3 months now, forming a well-defined trading range. On Friday, it set a lower-low, touching the May lows, but ended the day closing higher. If there is even a minor follow-through here, the Stochastics will form a ‘buy' signal.

A lot will depend on the tone of the overall markets. As of writing, it is 6 hours to go before NYSE open. Asian markets are on the upside, and the European markets are opening up. If the U.S. markets open on the upside, EL could quickly add a point or two. It has pretty good fundamentals (a 35% ROE!), and although it pays only a 1.1% dividend, the dividend 5-yr growth average has been 30%. It has increased dividends for 4 years in a row. While revenue growth has been in the single digits, last quarter it produced an 11% increase in revenues (42% in earnings).

Certainly, the stock could be bought here, and with a tight stop-loss just below the bottom of the trading range, a good Reward-to-Risk trade could be set up.

For option traders, a bull call spread could be used to play the rebound. To increase the odds of success, it would make sense to target a specific profit, such as 20%, and implement a slightly higher stop-loss on the spread (25% would be good).

Another strategy would be to enter a Long Diagonal trade. This is sort of a combination of a covered call using all options and no stock, and a Bull Call spread. You short a near term slightly out-of-the-money call, and buy a longer term in-the-money call. Similarly, it would make sense to target 20% profit or 25% stop-loss exit points. One important factor to keep in mind is Estee Lauder will report earnings on August 15th, before the open. You should be out of all, or at least most, of any directional option trade before then. But perhaps a quick profit can be worked out before earnings.

Right now on EL, the primary difference between a Bull Call Spread and a Long Diagonal is the Long Diagonal is a ‘long Vega' trade, and the Bull Call spread is a ‘short Vega' trade. This means that if the Implied Volatilities on the underlying options in the Long Diagonal go up, the long-Vega Long Diagonal trade will increase in value (hopefully along with the increase in value from the underlying stock moving up). The short-Vega Bull Call trade will counteract the increase in value from price rise.

Right now, EL's Implied Volatilities (IV) are in the middle of the range. And analysis of the Implied Volatilities before each earnings release shows EL's IV's rise into the earnings announcement and then fall off sharply after the announcement, and this usually happens whether the stock was moving up or down prior to the announcements.

So the Long Diagonal may be a better fit here, if EL's IV's continue to rise into the August 15th earnings release. Let's think about the theoretical price of a Short August 75 Calls/Long October 70 Calls diagonal trade 5 days from now. Would a quick 20% profit be possible, in just 5 trading days, if EL moves up just slightly, and even if the IV's stay the same?

Here is a chart of the theoretical price of the Long Diagonal spread 5 days from now, if entered at current mid-prices. It shows that a 20% gain in the spread prices could be achieved if the stock rose to just 74.50 (from 73.87 currently). A less than 1% rise in the stock could produce a 20% return in the spread in just 5 days.

There are other factors at play here, and nothing is guaranteed. These are only estimates. But a long diagonal could produce a quick profit if EL rebounds slightly, and Implied Volatilities follow through with their typical rise into earnings.

This is a trade that should be exited as soon as the 20% profit is hit, and certainly no later than next Thursday afternoon, just prior to Friday's pre-market earnings announcement. But it is a good example of matching the trade strategy to the current conditions.

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, please click on the following link: www.markettamer.com/seasonal

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2014 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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