I’ve been taking my shots trading put options on Chevron Corp. (NYSE: CVX). It’s been a battle given how volatile oil has been and how sensitive its reactions have been to the news…
(I’ll share details of my recent options trade on CVX soon.)
Why am I bringing this up?
Because if you haven’t noticed, right now several markets are weak. And some of the best setups have been on the short side.
But if you’re like me, shorting stocks is just too risky … That’s why I like to trade options and buy puts — I’m able to define my risk.
There’s an old saying that says, “Stocks take the stairs up and the elevator down.”
I want to catch that elevator down, as you can generally make more money in a single day on the downside than you can over entire weeks on the upside.
Now, there are a few indicators and tools I like to use before I dive into a puts trade…
I’ll break down the five most important tips for nailing put trades. We’ll cover the first two today and the following three tomorrow…
Tip #1: Target Tops on Overextended Stocks
If I had to choose one key to my strategy, it would be finding tops on overextended momentum stocks.
How do I do this? Recently, it’s been as simple as targeting the single hottest momentum stock that week. In other words, I’ve been trading the news.
From crypto crashes to oil tanking (excuse the pun) — I’ve been catching the backside of charts that ramped following major news events and retail trader enthusiasm.
For weeks, these stocks were all anyone on social media was talking about. The share prices ascended rapidly, with each day bringing in a new barge of anxious retail investors, naively starting fresh positions at higher and higher cost bases.
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In these cycles, the weekly charts began to look incredibly overextended, one green bar after another. (The two oil stock charts I showcased on Tuesday were shining examples of this.)
At that point in the pattern, it’s not a question of if the chart will take a huge dip — only when. So how can you time it right? What are the specific topping signs to look for?
Tip #2: Be Ready to Strike on the First Red Day
When momentum stocks have several green days or even weeks in a row (preferably with ascending volume), it can be tempting to consider starting a short position.
Sound familiar? These were my exact thoughts around trading USO puts this week.
But as we know, when trading options … timing is everything.
So how can you decide when to buy puts?
For most stocks, a critical psychological pivot point is a new all-time high. When a stock surges into a ‘blue-sky breakout,’ as it’s sometimes called, the psychology is in the bears’ favor.
And when a ticker has spent several days (or weeks) in a row making new highs, it’s usually time to get bearish. Think about it…
- There will likely be a dropoff in potential buyers as prices get further and further above the previous all-time high.
- No stock in the history of risk assets has ever rallied continuously with no pullback or gap fill.
- Bulls who have been holding the stock through a swing trade could be eyeing any nearby price target to take profits (or liquidate their entire positions).
- Meanwhile, short sellers will be salivating at the prospect of borrowing shares at such a lofty price, ready to profit from the inevitable plummet.
At this point, any crack in the share price will likely result in a much larger dip.
And this is exactly why I wait for the first red day pattern.
After a long string of higher-priced closes, the first red day comes like a knife in the heart to the bulls. It’s always a crushing psychological blow — a prime strike zone for loading up on puts.
Sometimes this effect can take place intraday, where the first few deep red bars following a high-volume momentum surge act as a near-term topping signal…
Bringing these ideas full circle, CVX was a perfect example of this. A rejection just under the $175 level proved to be the death rattle of the energy sector’s eye-popping momentum surge.
I was prepared for this because I was watching the $175 area as potential resistance. As soon as I saw the selling coming in near $175, I felt I had the confirmation that CVX wouldn’t push to $200.
When all of these signals start to line up, it’s usually time to pull the trigger! (But more on that tomorrow…)