The stock market is still rallying strongly and my hopes for a drop last week to benefit my Darden trade went unfulfilled.  Nevertheless, the beauty of buying an option, like I did with the Darden trade and the Nasdaq trade (which will be posted later this week), is that you are paying a “time premium” for the option, which gives you the luxury of not having to time the bottom perfectly or be exposed to a potential margin call from a market move which does not go your way.  I feel confident holding the trade even though the market has rallied since I do not think this latest rally is indicative of a true bottom.

The market has shaken off bad news about two historic events:  the bankruptcy of Chrysler and the Swine Flu.

Incredibly, the market seems to be chugging right along and unfazed by these developments.  Being a fan of technical analysis (charting), I went back to the charts to look at the powerful recovery of March 2003.  Right after the US invaded Iraq, the market began to soar.  I went back to look at the chart to see if I could learn anything about that powerful, sustained rally.

Below is a chart of the rally:

djia-march-2003

As you can see, the rally in March of 2003 had two prior bottoms that were put in, both of which were nearly lower. 

As a result, this level on the Dow provided a solid level of support (buyers), that stood at the ready to buoy (via buying) the market.

The same cannot be said of the March 2009 low.  The bottom has not yet been re-tested and no solid base of support has been established.  As a result, I think the March 2009 lows need to be re-tested until we can declare that the bear is dead and this rally is for real.

The March 2003 rally was preceded by trampoline-like bounces of +11%, -15%, +18%, -13% before the sustained rally of 30% that closed out 2003.  I do not believe that the market can have a durable rally with a V-shaped bottom without putting in a rounded bottom or multiple touches of a bottom.  I suspect we might see similar 2003-like bounces up and down before any sustained rally will take place.

Takeaways:

  1. The market hates uncertainty.  The post 9/11 malaise and sabre-rattling around Iraq proved to be distracting and the market from post 9/11 to March 2003 was a wreck.  Once the invasion and “quick victory” were established, there was more confidence in the market.
  2. A base or bottom needs to be established with considerable support, which has been tested more than once.
  3. In a “false bottom” such as this one, I feel comforted holding Puts against a consumer non-essential.

Note:  I apologize for the lack of clarity in the charts, better charts are on the way.

Options trading is a way to generate incremental returns for one’s portfolio (via selling covered calls) and speculate on large moves (buying calls and puts).  Options trading, when coupled with sensible charting and risk-taking, allow investors to profit in both up, down and sideways markets (if executed properly!).  My goal is to develop this skill over the next ten years and see whether or not I can consistently make money over the course of my trades.  Do not take my advice as anything other than one man’s attempt to educate himself by putting his own money on the line and documenting his lessons.

As I have written earlier, deliberate practice makes perfect.  I do not want to place “gunslinger” trades based on tips and buy on impulse.  When I propose a new trade, I will explain my logic and check against the eventual outcome to validate if my assumptions were correct.  I am posting my open options contracts to maintain a form of discipline over myself and make sure I do not trade out of emotion.  Please read my disclaimer below.  For the time being, I am only going to purchase (go long) options.  As a result, my potential losses will be limited to my initial investment.

First trade:

35 July PUT – Darden Restaurants Inc.

Rationale:  I have a bearish outlook on the equity markets in general and I believe our current rally (March – April) is the result of speculative buying and/or short covering.  I am not convinced that the rally in the price of Darden Restaurant from $15 to $40 has been driven by any tangible changes (higher sales, increased productivity, higher cash flow).  As such, I find this rally to be a short-term, speculative rally.  Does that mean that stocks cannot rise more?  No.  It simply means I believe the price is rallying for no intrinsic reason.  Therefore, I do not believe this rally can carry on forever, especially when I see the chart (more on that later).  With the price nearly tripling from its December lows (an almost 300% return!), I do not think the stock price can keep advancing for very long without a significant pullback.

The two strong reasons why I pulled the trigger:

1)  Going long this put means I do not have to time a downturn perfectly.  The stock can continue to rally, but as long as it finishes below $32.75, I will be profitable.  35 is the strike price, 2.25 is the price paid for the option.

When buying a Put Option, the following applies:  Strike Price – Initial Investment = Breakeven Point  35 – 2.25 = 32.75

Once the stock drops below $32.75, I will make (in theory) $100 for each $1 decline in price.

darden-10-year

2)  There is a large gap from $28 to $36.  Gaps are often retraced and filled and in a parabolic rally, like the one DRI is in, it is not unlikely the stock will fill these gaps.

darden-1-year1

There is also one weak reason I have for buying this option.

1)  Consumer weakness will eventually manifest.  This is a very weak reason since there is no telling when the consumer will truly slow down consumption.  The save over-leveraged spending habits have been in place for years… assuming they will assert their presence in my limited time frame makes this the weakest of the three reasons.

Exit

I believe Darden will retrace to fill in the gaps around low 30’s.  If I feel the market can plunge further, I will hold my position.  If the market appears steady, I will book the profit.  Since this option trade is small, I am comfortable holding this option until expiration (expiring worthless).

Comfort Level

Although I feel confident that Darden will pull back, I am not satisfied with the way I entered into it:  with a hunch and with a “Oh well, it can’t go any higher” attitude.  Calling tops and bottoms is not a strategy with a high-win ratio or a theory that can be executed with regularity.

Takeaway

I will post this trade in my Trading Log where I can track it daily.  Please provide feedback for this trade and let me know if you find my analysis to be lacking in any way.

For more about deliberate practice, read here.

DISCLAIMER:  All opinions expressed on this website are solely my own and do not reflect the opinions of anyone else. You should not treat any opinion expressed on this website as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinion. My opinions are based upon information I consider reliable, but I do not verify its completeness or accuracy, and it should not be relied upon as such. I am not under any obligation to update or correct any information provided on this website. My statements and opinions are subject to change without notice.  Past performance is not indicative of future results.  Risk of loss exists in futures, options, equities trading.

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