My favorite in using options to leverage on short term stock movements is bearish reversal. A Bearish Reversal is a change against the prevailing upward trend. Early detection of a bearish reversal patterns can be very profitable for a Put Option purchase often resulting in triple digits gains. Mastering the ability to identify major Chart Patterns and Japanese Candlesticks formation are highly beneficial in order to catch them early.

This is base on the concept of contrary thinking. When the crowd thinks the stock is bullish usually not many will pay attention to the Put Options and therefore it is usually cheap, at least before everyone starts to buy Puts to hedge against their stock. It only requires one analyst to downgrade the stock or just a negative news can drive the stock down. Identifying the bearish reversal signal early is crucial as stocks always go down faster.

“The Bull climbs the stairs but the Bear usually jumps off the window”

 

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I spotted a bearish reversal candlestick (Dark Cloud Cover) on ACOR on 15 Jan 08; it was trending for the past two months. The stock price has been going up but the MACD Histogram shows a negative divergence which makes it more likely to reverse.

My entry signal was if the stock price drop below the low of the bearish reversal candlestick which is $23.70. You see I don’t make to entry decision, the stock decides for me. This removed the chance of emotion trading.

The next day I bought Apr 22.50 Put @ $3.30 when the stock had dropped to $23.50, $0.20 below my entry signal. Stop loss set immediately at $1.70 roughly 50% of my option value. I always set at 50% stop loss in order to have sufficient room for the daily trading noises. Setting tighter stop will get it triggered out often before it can be profitable.

The stock when down for two days, then rallied on the third day, my position suffers some losses but has not trigger my stop yet, by the forth day it reversed back down and by today it closed at $22.31.

The put option was just merely in-the-money and it has increased to $5.40, a 63% profit in just seven trading days. Not bad eh! The stock hasn’t fallen much but the put options has increase dramatically because the fear has raised and so is the Implied Volatility.

Fear increase = Implied Volatility increase = Options Premium increase

I did not exit yet because by looking at the chart, the Williams %R and MACD Histogram indicators, there are still some room for it to drop further. I want to be a bit more greedy to reap more and yet protecting some of the profit so I moved my stop from $1.70 to $4.80 giving another $0.60 for it to breath.

If I am stopped out at $ 4.70, I would still make $1.40 which is 42%, but if it drops further there will be a triple digits gain.

Be smart. Sometimes it pays to be contrary.

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