An examination of whether the reward is worth the risk.
In previous articles we have discussed the characteristics of different positions, and have looked at some charts that show when those different types of positions would be appropriate to take advantage of what the charts were showing. Today I want to go a step further, and talk about the risks and rewards of a position, and examine a situation that does ask the question of whether the “juice” is worth the squeeze.
To begin this discussion, I want to use a stock that I came across today when I was looking for a Stock To Watch. I looked at the charts on PAAS, and found them to be quite interesting. Here is the charts and the comments for the different time frames. The monthly chart is on the top left, weekly chart top right, daily chart bottom left, and a short term intraday chart on the bottom right.
The very long term chart was extremely overbought as this year began, and the price did have a swift pullback to the lower teens. The price has since bounced back up, and while it is showing some strength with the green candle and trend, we are seeing overbought conditions developing, showing a possibility that a very long term top could form.
The long term weekly chart did break above the July highs. It very quickly became overbought, and is now showing some extremely overbought pressure. This is a stronger warning that this upwards is getting extended and could come to an end.
The medium term daily chart did move up from 16 with overbought pressure, and became extremely overbought. The price pulled back to test that broken resistance and has bounced up to set a new high. What really sticks out about this bounce, is that the candles did not turn green to show strength, and this move is showing overbought pressure already.
The short term intraday chart was extremely overbought yesterday, and stalled just above 17. This morning the price did continue moving up, but did not turn green, and continued to show overbought conditions. The candles are turning yellow, and the trend is turning neutral, which is a very strong indication that the upwards move is stalling.
All of the time frames are overbought, and the shorter term time frames are giving us some pretty strong indications that the upwards move is likely to come to an end, and this 17.50 area is starting to act as a short term resistance level. The longer term charts are still showing some strength, so there is a risk of an overbought rally moving the price higher, back to the highs from earlier this year near 20.
I wanted to stop the analysis at that point and take a few minutes to review what we are seeing on this stock, and compare it to the different position characteristics in the regard of looking for an entry for a new position.
We will look at a “long” position first. Whether you are buying stock, or buying calls, both types of positions have the following characteristic: “Directional. Price must move up to make a profit.” And the best opportunity is: “Trend and momentum”
On the charts above, we do have the trend on all but the intraday time frame. We also have the strength/momentum on the longer term time frames. But we do have the warning of the overbought pressure, and the resistance of the previous highs on the monthly chart. This puts into question just how much more the price will be able to move, and shows that there would be a very high risk of “buying a top”. If anything, these charts would be showing someone that is holding a “long” position that they should tighten a trailing stop and start to consider either taking or locking in profits, not looking for a new “long” position. The reason for this that while it is possible for an overbought rally to take the price upwards, it is something that can not be counted on, and the lack of the shorter term strength is a warning that the upwards move could be ending sooner rather than later.
Ok, so a new “long” position would be very high risk, and probably not a good position to enter. So we can take a look at a “short” position, whether it is selling stock short, or buying puts. The characteristics for a short position are: “Directional. Price must move down to make a profit.” And the best opportunity is when you have “Trend and momentum”.
This is very simple, the price has been moving up! It is not in a downtrend, and does not have downwards momentum. So a short position would not show prospects for a profit at this time. If we do get the monthly chart lower high, and if we see the weekly chart stall and start to turn down, and we see the daily and intraday charts starting a downtrend, THEN a “short” position would be one to consider as it would show potential for the price to move down to generate a profit.
This brings us to the third type of a position, selling premium. There are 2 choices on selling premium, either selling a call spread, or a put spread:
- Selling a call spread. Characteristic “Price can move sideways or move down to make a profit.” Best Opportunity “When a longer term top is forming or when the price is moving sideways in a small defined trading range”
- Selling a put spread. Characteristic “Price can move sideways or move up to make a profit.” Best Opportunity “When a longer term bottom is forming or when the price is moving sideways in a small defined trading range”
In the “Best Opportunity” we can see that a call spread is a good choice when a longer term top is forming, which is what we have the prospects of occurring on the weekly and monthly charts of PAAS.
ok, now that we see that selling a call spread is the best opportunity, let’s take a look at some specifics.
There is no premium to be able to sell the Oct. 20 calls, and the Oct. 17.50/20 call spread is showing just 40¢ of juice, leaving $2.10 of risk. This is not very much reward, but there is not much time left until the Oct. expiration, just a week and a half. The Nov. 17.50/20 call spread only brings in around 70¢ of juice, leaving $1.80 of risk, and 6½ weeks of time. Neither of these positions offer much reward. With the strength that is still showing on the longer term charts, there is the risk that the price could continue moving up with an overbought rally, which does increase the risk potential that the price could move past the strike sold and retest the highs from earlier this year, and possibly even the 20 area.
The reason I went thru this is to illustrate that while these charts are showing a strong probability that a top could form on this stock, the only calls that could be sold are at a strike that is below the previous highs, and with the current strength, there is a real risk that the price might not stay below the 17.50 area. So while the charts are showing that on this stock for a new position you would want to consider selling a call spread, the actual options are not presenting an optimal situation, making for a very high risk trade if you were to enter it. This leaves us with a situation where at this time the best thing to do is to not take a new position on PAAS. Perhaps in the future as this top develops more a situation will arise that will present better prospects for a profitable trade. It is just as important to know when NOT to enter a trade, as it is to know when to enter one.