Stock Market Showed Continuation of Bullish Signs Last Week

After I reported volatile market actions on August 9th post: Trading stocks in Turbulent Market Days, the stock market had 2 sell-off's within a week. Since the drops were accompanied by higher volumes and the decline of new highs - new lows indicators of NYSE & NASDAQ, I went to bearish outlook for the intermediate term. I tried to initiate bearish trades at the time. However, I was not able to find a candidate that could meet my bearish trade criteria until August 18 which coincided with the bottom of the SPX pull-back in last 4 weeks.

On August 18, I was glad to find HOG forming a picture-perfect descending triangle break-down with high volume as I posted on StockTwits. I bought Nov 17, 2017 $50 Put for $4.80 for this consumer sector stock as consumer sector performed poorly in those days. The stop loss point was set at a recent high around $48.27.

However, the stock pulled up along with general market in the next couple of days. Hence, I had to leg into a diagonal put spread by selling Sept 15 $46 put as shown in the chart below. Since then, the stock price has not been able to rise more than 2 days in a roll and formed another lower high at $48.12. The pricing pattern is not a descending triangle any more, but looks like it may be forming a low base pattern. I have to face it: any outcome is possible with all the trades I put on as my trading is a probabilistic game. This is one piece of fundamental truth of trend trading.

On August 22, the market rose strongly along with higher volume. I felt it could be the 2nd confirmation day to signal the continuation of the bull market. I noticed EDU (a Chinese company) was breaking out with high volume along with outperforming emerging & Chinese markets. So I entered an aggressive bullish position on EDU as shown in the chart posted on StockTwits in the middle of the day. The mental stop loss was set about a few cents below prior low of $74.98. I planned to stop out if the price drops below it or the Chinese ETF FXI breaks down somehow.

A few days later on August 28, EDU got sold off heavily. I had to sell a Sept 15 $85 call which had a Delta of 0.20 which was in the lower end of my typical short Delta. This was because that EDU had limited option strikes and I felt the volatile stock could bounce up to recent highs around $85. The next day, it briefly broke down below my stop loss point soon after the open but it was going up when I started to monitor my positions at my routine trading hour. The FXI was still looking bullish at the time. So I decided to keep the position for that day and waited to see if it would break down again. The market happened to be very resilient on that day and kept rising for a few days now.

One more day later, I started to feel more bullish about a bullish flag pattern of SPX and posted the following chart on StockTwits.

On August 30, I entered a long Dec 15 $165 call position on NFLX as it was bouncing up from a recent test of 50 day moving average line and seemed to form a bullish flag pattern. I also bought March 16 $220 call on BIDU as it broke out of a high base chart pattern. I'll post more about this trade later.

Hedging Call Option Risk by Selling Short Calls on MU

When upward momentum loses steam for stock price movement, the long call options face the dilemma of losing time value if the stock moves sideways or losing intrinsic value if the stock falls in the near term. If we believe the stock’s longer term uptrend is still valid, we can hedge the call option risk by selling short calls. The sold call option also helps to overcome the time decay of the option.
The downside of the hedge is the possibility of a surprise big surge of the stock price soon. It will cause the trade to gain less value than the original naked call position, since the short call option will cost more to be bought back. This is the cost of the hedge in this option strategy.

Today, the price of MU on which I have a naked long call position (Oct 20, $27 Call) expressed the first signs of its weakness. A few days ago, I bought the MU call option as MU broke out of a bullish flag chart pattern as posted in An Analysis of 3 Bullish Stock Chart Patterns. About 5 trading days later, MU had two days of price drops in a roll and looked going down today as well. Its MACD histogram also declined 2 days consecutively as shown in the chart below. These are the specified signals for me to hedge with short call option for such a position. As a semiconductor company, it also showed weaker relative performance against the SMH semiconductor ETF.

Therefore, I sold June 9 $30.5 call for a credit of $0.34 to leg into a diagonal call spread position on MU. As usual, I chose the option Delta to be greater or equal to 0.25. The OTM call Delta is the roughly the same as the probability of this option strike to expire ITM. So there is approximately 25% probability that MU will expire above $30.5 at this point. The new cost of the trade is reduced to $4.21 - $0.34 = $3.87.

As always, we need an action plan for the future in case the stock prices reverse its current course. If MU ends its short term pull-back and starts to rise strongly for at least one day, it means the stock is back to its up-trending pattern. Then, I’ll buy back the short call option.  This is what I had done for EEM as posted in EEM Diagonal call spread adjustment as emerging market outperforms. Otherwise, if the prices grind upward and the Delta reaches over 0.60, I'll roll out the short call.

There are many helpful free introductions to the basic concepts of diagonal call spreads. The one that I found with relatively complete descriptions on the characteristics of this strategy is at TheOptionsGuide.com:  Diagonal Bull Call Spread. It explains the following aspecs of the diagonal call spread:

• Spread construction 
• Profit potential 
• Downside Risk 
• Commissions 
• Theoretical Example 
• Similar Strategies 

2 live examples of Legging into Diagonal Spreads

5 days after stock market’s big surge due to French election result, the S & P 500 ETF SPY started to show a small sign of fatigue by moving down today from a prior 2 day sideways movement. A couple of my bullish positions (EEM 2017 LEAPS & PVH Sept 15 $95 Call) that were entered on the market surge day (4-24-2017) cooled down for about 2 days in a roll. So I sold calls against the long calls and legged the option positions into diagonal spreads as the MACD histograms and the prices of these stocks started to drop about 2 days.

My diagonal spread rolling rule will let me close the short calls when the stocks rise for two consecutive days, or roll to new short calls if the short call premiums result a good amount of profits. I also have stop losses in place to cut loss short in case the stocks go against me.

Among them, EEM has good liquidity of option trades. I sold June 02 $41 call with a Delta around 0.25 for $0.24 credit when EEM traded slightly below yesterday’s close price and it got filled quickly. The option entry was posted before and the price was $3.39. Thus, the debit of the diagonal spread is $3.39 - $0.24 = $3.15.  I’ll continue to track the performance of this trade position as we go.

PVH has less liquidity and has monthly options only (It’s not a good stock for option trades in my opinion as the bid/ask prices were wide).  I sold May 19 $105 call with a Delta around 0.25 for $1.00 credit when PVH was sold off and it got filled eventually as it bounced up intraday. The option Sept15$95c entry price was $12.22 on 4-24-2017. Thus, the debit of the diagonal spread is $12.22 - $1.00 = $11.22. PVH, an apparent shop holding company, seemed to follow the retail ETF XRT closely. This sub-sector did not perform well when compared with the general consumer section IYC.