The technical chart patterns are nothing more than just that…a pattern.  I reasoned that the better I can get at recognizing patterns, the better trader I will become.

So i’m going back to basics, chapter 1, the beginning.  What direction is the market moving? In simplest terms one can look at the daily indexing average or a moving average over x number of days.  Does the line go up or down? Probably the simplest pattern to recognize.

Taking it one step further…look at the volume trading for the day.  How does it compare to the day before? How does it compare to the volume average?   AGain…a very easy pattern to recognize.

Now we combine these two simplest patterns…market direction or variance from yesterday and market volume to give us a matrix of options. Is the market accumulating or distributing? Accumulation with rising prices is a good sign of a either strong bull market or of a market follow through indicating market bottom.  Distribution with falling prices is a sign of market top or a bear market.

I’m going to be following these most basic market indicators by studying day by day charts of the three major indexes, the NASDAQ, the S&P and the NYSE.  I’m going to become a master at pattern recognition.

Company Profile: Walter Energy Inc (WLT)

Company Description: PRODUCES HARD COKING COAL AND STEAM COAL FROM UNDERGROUND MINES FOR USE BY THE STEEL AND UTILITY INDUSTRIES.

Investools basically gives this company and it’s industry group the thumbs up.  If I had a little more time to research, this might even be a good buy & hold stock.  The financials are sound and the industry group (COAL) is solidly held by the big investors rating  a 99% this week.

Investors Business Daily gives it a smart select rating of 99, EPS rating of 98, and RS rating 95.  The group rating gets an A+.  Other leaders in its industry group include  AHGP, ARLP, ICO and BTU…all companies worthy of further research for purchasing of equity or options.

this looks like a solid BUY to me, so let’s check the options available:

Underlying Price: $130.27
Support: $120
Risk:  $10 on underlying

March 135 Call
Price $7.45
Delta: .46
Option Risk (Risk * Delta) = $4.60
% Account Value 14%

March 140 Call
Price $5.60
Delta: .38
Option Risk (Risk * Delta) = $3.80
% Account Value 11%

Both of these are high risk trades due to the small size of my account.  If we go out one further, let’s see how the risk improves:

March 145 Call
Price $4.15
Delta: .30
Option Risk (Risk * Delta) = $3.00
% Account Value 9%

That at least brings the risk down below 10%. Keep in mind that I would likely sell before hitting that price, but I want to keep my maximum risk in mind.

I ended up putting in a bid for 100 shares of the March 145 call option at $4.10. I’m willing to pay an extra $5.00 (.05 x 100 shares) to have a better chance of getting the option when the market opens. Ideally I’d wait till after market open and see what direction we’re going, but I’ have to work at 6am, so I’ll miss out. I’ll check back in after 9AM and see how its going.

As of close, my option was up 60% in just 1 week, and my total account value up 6%.

Checking the Fundamentals

I always cross check my companies first by using resources such as the IBD and Investools.  Here is what each had to say about VPRT. While the financials remain strong, the industry group (Printing Services) has been pulling back…this is one red flag. Despite that, the industry as a whole has also been in an uptrend for the past few months.

Investors Business Daily doesn’t have promising vital signs either…the composite rating is only a 68 and the industry group receives a D+ for it’s relative strength rating.

Overall, it’s a risky trade when the fundamentals are taken into account on top of the technicals.

Managing Risk - Emotions Sometimes Rule

Breaking all rules, I decided to purchase VPRT…I’m anxious to trade and the technical pattern looks wonderful!

Here is the purchase I made:

April 47.5 Call
Trade Price $3.30
Delta .42
Open Interest 198
Underlying Stock: $45.76
Support: $42.26
Risk: Underlying $3 Option $1.26 (%age of account = ~4%)
Target: $3-5 in 2 weeks time

Update- Beating Earnings Estimates

As of today’s close, 1/28, I’ve held the trade for 5 days.
Underlying closed @ $49.45 after exceeding earnings estimates.
Option Price is $4.90, a gain of $1.60, or 48% gain in the 5 days I’ve held it.
This is a 5% gain in my total account value.

Decision Points - Setting a stop loss

I’m very happy with this amount of gain, and shouldn’t get greedy.  I’m going to set a stop loss at recent support, which is about  $48.27, drawn as a line connecting recent highs.  This allows for a pullback of just over a dollar, and with the current delta at .5, the option pullback is about 50 cents.

Learning points to current time
This is a risky trade to start with due to the underlying weakness of the industry group and relative lack of relative strength. However the company still has strong financials and has been an uptrend for several months. I purchased the option just 4 days prior to quarterly earnings estimates which was probably not a smart idea, but I got lucky and the stock went up several points today.

By setting a stop loss at the previous high, I should still lock in some potential profit while limiting loss, and still allowing for earning’s momentum to carry the option even higher. I have 72 days until expiration, so here’s keeping my fingers crossed!

The risk assumes I place a smart stop loss order and that the open interest is high enough that it will sell quickly at market value.

Chipotle Mexican Grill is not only good eats, but is setting up for a nice trade.  Despite a recent decline since June 16th, the 30 day trendline is still moving upwards.   Last week the stock tested a low of $133.60 and $133.40 just six days apart, and has been holding it’s  value since.  In the past two days trading has been positive and todays closing of $139.50 is above the 7 day moving average.

But are the Fundamentals Still Strong?

CMG has been on my watchlist for quite sometime, and companies and markets change.  It’s always a good idea to cross reference the industry group.  I am a member of Investools and have been for several years. Checking the company’s information on Investools, I see that the industry group is strong with a 94% rating with industry money moving into the restraurant sector.

CMG as a company has also maintained strong financials which adds strength to the equity.

Cross checking with one other source, Investors Business Daily, we see a smart select rating of  99 and that CMG leads it’s industry group in its composite rating. (others that lead the group in order include MCG (McDonald’s), PEET (Peet’s Coffee), THI (Tim Horton, Inc) and NATH (Nathan’s Famous))  Each of these would deserve further research for short or long term trading, but none were previously on my watch list.  In addition, in order to stay diversified I would not invest in more than one restaraunt group at this point in time.

So my fundamental and financial analysis is complete with the cross checking of both IBD and Investools.  Either one of these subscription services can save you a ton of time in research, letting you make the decisions about technical analysis, timing and type of trade.

Managing Risk: Analyzing the Option trade

The Basics:
Current Equity Price: $139.57 (close on 7/8/10)
Recent Support: $133.50
Difference between Current and Support: $6
Target: ~ $10 gain in a 5-7 day period

Potential Options (> 30 days until expiration)
August 140 Call: $8.70  Delta .52  Risk $6*.52= $3.12  %age of account: 9.5%
August 145 Call:  $6.30  Delta .43 Risk $6*.43= $2.58 %age of account: 8%

Analysis of Risk
The general rule of thumb is not to risk more than 1-2% of your account value on a single trade. This allows for many “losing” trades with limited loss of account value.  Having a single “double” which isn’t uncommon in well chosen short term options trades will more than offset a number of small losing trades.   However as a rule of thumb in trading account with less than $10,000, you’ll need to accept a higher amount of risk in order to trade even single options contracts. (an option contract is 100 options…the minimum you can purchase in a single transaction).

So while 8-10% is higher than I usually risk, I will keep this on my short list for purchase in the morning depending on how the first hour of trading is going.

Comments or questions? I’ll keep you posted how this one may workout.

Two days later it set up again and I just couldn’t resist. Today I’m up 20% so far…$90 on a $380 purchase. I’m going to set a stop loss on this and wait and see if it goes higher.  Whenever I’ve lost money on a companies option, I always like to see if I can make it up later.   Nearly break even today, we’ll see what happens tomorrow and over the weekend.

ICE is also showing a rising 30 day moving average with a recent pullback. The price is strong at $100+  / share, which could encourage a good ROI on an options trade.  Not quite into oversold territory, so the set up is not quite there yet.

Finally PCP is showing a strong chart with hints of a pullback. I’ll keep an eye on that one as well.

Interestingly, a lot of my old watch list companies are showing really strong charts with consistently rising trendlines…some evidence that the company fundamentals are strong, which is a pre-requisite for showing up on my watch list in the first pplace.  (I Use Investors Business Daily ratings for my initial screen)

Here’s what I see:

CERN
Underlying: $60.80
Support: $56.50
Risk: $4.30

Sept 65 Call Option
Ask: $2.50
Delta: .57
Option Risk $4.30x.57 = $2.45

Acct Value:$2825.00
Risk = 10%

Since my account value is so small right now for a trading account, this is an acceptible risk for me. Ideally the risk is kept at 1-2%. For smaller accounts $10,000 or less, 5% is acceptable. For $3k, I’m OK with risking 10%…after all, this is my original money from nearly 2 years ago that I am still trading (infrequently).

So I just placed the order, and it was filled at $2.35

Now I’m going fishing!