As part of my multi-timeframe approach to managing money I specifically look for strategies that offer a high probability of profits and allow to be traded with a risk-averse setup.  Sometimes this means just trading the stock, sometimes this means using options instead, and sometimes it means using both.

One of my favorite strategies fitting this description focuses on stocks that dropped anywhere from 10% to 30%+ in a single day.  As with all strategies, what’s important here is to ensure to completely understand all the criteria that have to be met in order for a valid trade entry to occur.

Often when a stock drops least 10% in a single day, a significant and at least medium-term bottom-line-affecting event is the cause.  This is not to state the obvious, but rather to distinguish between events that can affect a stock’s price for a few days and those events that have potential to significantly alter the bottom line of the company’s income statement for an extended period of time.

Among those more ‘significant’ events that I look for are the following three:

  • Major Law-Suits
  • Accounting Issues and/or Fraud
  • Government Legislation

When a major publicly traded company (at least mid-cap) faces any of the above mentioned issues, the stock has serious potential to fall in price at least 10% and stay at lower prices for an extended period of time.  Once I have found a company with any of the above headwinds and the stock has fallen at least 10% in one day as a result of the news hitting the tape the first time around, the stock has fulfilled the first qualification.

Apollo Group, Inc (APOL) The stock fell hard on October 14, 2010 on the back of earnings, fear of crippling new government legislation, and lawsuits.

The second filter then becomes looking for ways to structure the trade in a risk-averse manner.  The following are some of what I look for:

  • Daily Average Stock Volume has to be above a certain threshold
  • Stock to be above $10
  • Options Volume and Bid-Ask have to be liquid and tight enough.
  • Specifically, options at least 3 months in the future and at least 20% out of the money have to be liquid enough

Once a stock fulfills both criteria it is time to start structuring a trade with the most advantageous terms, i.e. the best reward/risk.

What I try to accomplish is to sell call options at least 20% but preferably 30% out of the money, and at least three months out in the future.  The trade can either be structured as short call spread (sell an option and buy a cheaper one for protection) or as a naked sale of a call.  By doing so I do have a bearish bet on but all I am saying is that the stock will not go above the strike price before expiration of the option.  Most of the time in order for the options to rally in the money it would require a rise in the stock of 30%.  Given the stocks’ issues that I just discussed above, a 30% rise is unlikely to happen.

The additional major benefit of this strategy hast to do with volatility.  After a significant drop in price, the options usually have increased volatility (implied volatility), making them more expensive.  After a few days, once the news has been digested somewhat by investors, the implied volatility will begin to decrease, which will make the options I sold lose value, which is what I want  (as a seller of an option I want the price to decrease so that I get to keep as much as possible of the option premium).

For more details on this strategy or other strategies I use, please visit WWW.THESTEADYTRADER.COM

Have a great trading day

Serge Berger


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