Can We Follow a 30% Profit With a 25% One?

In the November 10th, 2014 Seasonal Forecaster newsletter I wrote another article on the topic of matching the right trade strategy to the current market environment. Here is the actual trade analysis from that newsletter. I'll follow it with an update.

(From the November 10th, 2014 Seasonal Forecaster newsletter)

But there are higher probability ways to trade possible further upside while accommodating a pullback if it occurs. While I try to focus on just stocks and alternative long calls/puts in this newsletter, I have covered a few other strategies when the environment was right. And today I want to suggest a new trade opportunity using a long ‘straddles'. This trade strategy is only for readers who have experience and are comfortable with option strategies of this nature. But let me lay out the case for a straddle trade on Monsanto (I'm not going to define the strategy. You shouldn't consider this trade if you aren't already familiar with them. Just do a web search for ‘straddle trades' if my analysis is interesting and you want to learn more about them). And this trade should only be done in very small quantities. I think of straddle trades is terms of earning ‘pocket money', not for seriously increasing portfolio values.

I'll be brief on this trade setup. The ideal conditions for a higher probability long straddle trade are:

• The overall stock market may be at a consolidation point, or ready to make a major move, possibly a reversal to the downside.
• Ideally, the stock should be in the middle of a trading range where even a partial move to either end of the range should make the straddle position profitable.
• Very important: the Implied Volatilities of the stock's options should be right near the bottom of the past year's range.
• The stock, and its options, should be actively traded with recent moves of several percent.
• The stock price should be near a strike price
• An upcoming earnings announcement usually helps the situation.

On Monsanto (MON) right now, all of the above except the last condition are present. Here's the quick picture:

Monsanto is in a long-term trending channel that started in 2010. This chart of the last 2 years shows MON has come off the bottom of that channel. If it has buying strength behind it, it has plenty of upside before hitting the top of the channel.

If market nervousness or profit taking comes in, the lower trendline would be a likely target. That is still several percent away, enough for a straddle trade to become profitable.

iViolatility.com shows the Implied Volatilities of MON options are just slightly above the past year's lows (the gold line below).

Historically low IV means the options are not richly priced. And this is an ideal situation in cases where a market pullback is likely. Rising IV helps long options to increase in value, and IV typically rises when a stock declines. So usually smaller moves to the downside are needed to make a straddle trade hit a certain profit target.

Seasonally, in terms of a 4 to 5 week straddle trade, MON usually puts in moves of 5% or higher:

I didn't show volume on the above daily price chart, but MON has had some very high volume down-close days. I feel the likely near-term direction for MON is down.

Plugging Friday's closing mid-prices into an options valuation program tells me that a December 115 straddle (one long Dec 115 call at 2.17 plus one long Dec 115 put at 2.66) would cost $483.00 to enter (without commissions). The breakevens at December's expiration (42 days away) work out to 110.23 and 119.83. Looking at MON's daily chart and its recent moves, either target seems likely.

But I'd make this trade even higher probability by exiting the straddle trade as soon as a 30% profit is hit. And with a straddle trade, I don't like to stay in them more than 2-3 weeks.

So using the options modeling program, I see that if nothing else changes (like IV), MON would have to reach either 109.30 or 120.47 within 3 weeks for this straddle trade to be up 30%. And if IV increases, which is likely to happen if MON pulls back a little, the trade may hit 30% profit well before 109.30 is hit.

The MON straddle trade:

If MON opens close to Friday's close of 114.44, I will consider a December 114 straddle at 5.0 debit (limit). I will close the position as soon as a 30% profit is reached. If the trade has not been closed within 2-3 weeks, I may close it before 30% profit is reached (a ‘time stop').

(End of November 10th, 2014 article)

Update:

MON began a 5%-plus climb that Monday morning. By Thursday it had hit our 30% profit target and the trade was closed.

Now what is interesting is the current setup is nearly identical to the morning of the 10th.

The seasonal track record for the next few weeks is even stronger than before:

The Implied Volatilities on MON options are even lower!

Checking current December option prices, a December 120 straddle is even cheaper than the December 115 straddle back on the 10th. The only downside is there now are only 29 days left until December option expiration. But since I recommend readers implement trades like this in only small quantities, I'll counteract the shorter time period by going for a lower profit target.

The new MON straddle trade:

If MON opens close to Thursday's close of 119.52, I will consider a December 120 straddle at 4.0 debit (limit). I will close the position as soon as a 25% profit is reached. If the trade has not been closed within 2-3 weeks, I may close it before 25% profit is reached (a ‘time stop').

Would I buy the stock here? No. I think the overall market is overbought, nervous, and ripe for a pullback. It may rally through the end of the year. But I think the odds favor at least a minor pullback. Intuition is telling me to take profits, pare back positions, and adopt a more conservative stance.

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.

The content on any of Market Tamer websites, products, or communication is for educational purposes only. Nothing in its products, services, or communications shall be construed as a solicitation and/or recommendation to buy or sell a security. Trading stocks, options, and other securities involve risk. The risk of loss in trading securities can be substantial. The risk involved with trading stocks, options and other securities are not suitable for all investors. Prior to buying or selling an option, an investor must evaluate his/her own personal financial situation and consider all relevant risk factors. See: Characteristics and Risks of Standardized Options (http://www.optionsclearing.com/publications/risks/riskstoc.pdf). The www.MarketTamer.com educational training program and software services are provided to improve financial understanding.

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