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Over the years I have attempted to highlight a variety of trading ideas. While like most traders I have developed my own “core” methods over time, in this space I have attempted to point out that there is clearly more than one way to skin a cat. There are long-term, intermediate-term, short-term and intraday trading methods. There are methods based on trend-following, technical indicators, overbought/ oversold indicators, fundamental indicators and so on. There are option strategies to take the place of trading the underlying security. There are trend-following and counter-trend trading methods. And the most interesting part of all of this is that while an individual may argue that the method or combination of methods that he or she employs is “the best,” the truth remains that there is no such thing as the one best way to trade. Which, of course, is a good thing. Because if there were a “one best way” then everyone would use it and therefore everyone would be trying to buy or sell at exactly the same time. This would leave the financial markets just “a bit illiquid,” as there would be no one to take the other side of any trade. So the next time you find yourself debating trading techniques with someone, remember to be thankful that there is such a diversity of opinion out there. For that is what makes the financial market go ‘round.

This week we will discuss a simple combination of trend-following and overbought/ oversold analyses to highlight some potentially useful opportunities especially suited for option traders. This simple method looks for a simple confluence of two standard indicators:

1. The security in question is above its 200-day moving average
2. The 2-day Relative Strength Index [RSI] is below 5.0

This simple setup can suggest an opportunity for a short-term trade. Basically all we have done is:

• Designate that the overall trend is “up”, based on the fact that the security is above its 200-day moving average, and;
• Highlight a potentially oversold situation based on the extremely low reading from the short-term (just 2 day) RSI.

What does this look like in practice? Let’s look at three unique securities. In Chart 1 you see the Market Vectors Gold Mining Index (GDX) which tracks a basket of gold mining stocks.

Chart 1 – GDX

In Chart 1 you see four alert signals. The first one was followed only by a weak bounce and would have been tough to trade profitably. The three subsequent signals offered some upside profit potential.

As an example, following the 2/4/08 buy alert, an option trader could have bought the March 48 call at 3.30. By 3/14/08 this trade would have showed an open profit of $490, or +148% (see Charts 2 and 3).

Chart 2 - GDX March 48 Call Option

Chart 3 – GDX March 48 Call Option

In Chart 4 you see a chart of TLT, which emulates the 30-year Treasury bond. In the chart you see three alert signals. The first two identified outstanding buying opportunities, while drifting lower prices has followed the third signal.

Chart 4 – TLT

Following the first signal on the far left, an option trader could have bought the November 88 call for 1.00 (or $100). By expiration this option had risen to 4.20, for a gain of +320% (see Charts 5 and 6).

Chart 5 – TLT November 88 Call Options

Chart 6 – TLT November 88 Call Options

In Chart 7 you see a chart of USO, which emulates the price of crude oil. In the chart you see two alert signals. Both were followed by moves to higher ground. There was also a “near miss” on 5/1/08 when the 2-day RSI fell to 5.2. An aggressive trader might have considered a trade at that time given the strongly uptrending nature of the crude oil market as of late.

Chart 7 – USO

Following the 1/11/08 alert signal an option trader could have bought the April 73 call at 4.80. While USO initially moved lower, by 3/13/08 the buyer of the April 73 call option was sitting with a profit of $950, or +198% (see Charts 8 and 9).

Chart 8 – USO April 73 Call

Chart 9 – USO April 73 Call

Summary

No one should assume that every setup such as the one I have described this week is going to generate a profit. Some setups will show immediate profits, some will experience small to moderate losses before moving to profitable territory and of course, others will never see the light of day. As with any type of trading method there are other important factors to consider beyond just a buy and a sell signal. The amount of capital that will be allocated to any single trade, the total amount of capital that will be allocated on all trades at any given point in time, the point at which you will cut a loss or take a profit will all have considerable impact on long-term success or failure.

Still, all successful trading stems from a simple initial idea. Let’s add this one to the list for consideration.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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Recent Articles by Jay Kaeppel, Optionetics.com

• August 27, 2008
  Kaeppel’s Corner: When Sideways Is Swell
• August 27, 2008
  Outside the Box: The Strengths and Weaknesses of Automated Trading Systems
• August 20, 2008
  Kaeppel’s Corner: When Up Is a Downer
• August 13, 2008
  Kaeppel’s Corner: A New Tool—The OTM Butterfly Finder
• August 13, 2008
  Kaeppel’s Corner: When Down Is Up