by Ray Frazier
For expected bearish moves in a stock, and therefore a possible bearish put option position, I look for breaks in the stock price’s support and then confirmation of the break from at least one other indicator. Below is a chart of AOL which shows the stock breaking its support line.
As you can see, the support line used to be resistance about one month prior to the break in support. This is very normal. In almost all cases of a stock breaking through its resistance line, that resistance line becomes support. Now that the stock has broken support, we need confirmation of the move in the stock price. Looking at the stock’s chart, you would see that confirmation is written all over the place. First, the stock broke support and crossed its 21 bar exponential moving average at the same time. Second, the stock tried to bounce back the next day, but was unable to close above the “new resistance” line (old support) by the end of the day. And third, On Balance Volume tried to bounce back through its moving average but was unable to do so. These are very good confirmations of the sentiment coming from the investors of the stock.
So now that we have confirmation of the break in the support line, we are ready to buy a put option on the stock. In this case, since the stock broke support around the end of the July options expiration date, we would want to buy the August expiration. The stock broke support around 115, so we would want to buy the 115 or 110 strike price. Now we have our order that we will enter with our broker. We will buy the August 115 or 110 put. Below is what the stock actually did, which shows what a fine trade you would have made!
As you can see, you would have made ridiculous money on that put option. The stock lost about $30 per share in about two weeks after the break in support. That would be a gain of about $15 per option or 1500 per contract at the very least. The actual gain would vary depending on when you sell your options and the amount of momentum to the downside in the stock on the day that you sell. Your gain could have been as much as $21 per option or 2100 per contract. That would be on top of getting your money back that you originally invested. A very nice profit if you had bought 10 put contracts, $21,000!
Looking at the above chart, you can see that we are once again using the 21 bar regression line as our indicator in determining the exit point for our put position. The same rule which applies to bullish option plays also applies to bearish option plays! In other words, you can also ride the stock down with your put until you decide to sell or until the stock price violates the “2% regression line” rule.