One of my readers from Indonesia sent me an email, asking me about this potential bearish reversal trade. First of all I want to thank you, Robert, for being interested in my work and I am glad that you have learned fast. I think you will be a good student. In the mean time just hold on to your horses first. Let us take this as a case study and analyze the risk involved.

By looking at the chart, there is a bearish reversal candlestick (Dark Cloud Cover) and it is above the 3 DMA lines – these are the first two conditions. The William %R is also in the oversold region and there is plenty of room for it to fall – fulfilled the third condition.

However there is a positive divergence instead of a negative one – this will increase the risk of turning around in the upwards direction.

By looking at the 12 months comparison, the Implied Volatility is at a relatively high level; hence the options premium can be expensive.

Let’s analyze the March 08 Puts with 50 days left to expatriation.

Nearest OTM March 08 $85.00 Puts is asking for $5.60 which is all time value, zero intrinsic value.

Nearest ITM March 08 $90.00 Puts is asking for $7.80.
Intrinsic value is $90.00 - $88.26 = $1.74
Time value is $7.80 - $1.74 = $6.06

These are the two options premium which are the most likely ones to buy, buying any further out of the money options is going to increase your risk even though it may look cheaper.

You tell me, whether it is cheap or expensive? Look at the time value, this is hell of an expensive price to pay for a 50 days option! Remember this equation, High IV = High Risk = Higher Premium. It is just like insurance.

Even though the first three conditions qualify for a bearish reversal trade, the odds are still high. I would not bet my money when the odds are up against me, I would rather wait for a better opportunity with a higher probability of making a profit. I hope that you can learn something so as to lead you to become a better trader.

“The financial markets generally are unpredictable. So that one has to have different scenarios.. The idea that you can actually predict what’s going to happen contradicts my way of looking at the market” – George Soros

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