The futility of bottom and top picking is a favorite verse to those preaching technical analysis. The ranks of those professing to have accurately picked a bottom are filled primarily with three groups of traders: those who conveniently forget to mention their previous ten failed attempts, out-and-out liars, and those struck by a rare occurrence of dumb luck.
When it comes to strategy selection, I contend that options are far superior to stock when attempting to trade against the prevailing trend. The difficulty with stock lies in the fact that you have little margin for error. Fortunately, options open the door to a much wider profit zone thereby granting additional breathing room. As opposed to shorting an uptrending stock expected to reverse, traders may opt instead to sell an out-of-the-money call spread or call ratio spread. In the event the stock continues to rise further over the next few days, the option spreads are generally more forgiving and easier to manage.
This explains in part why call ratio spreads are a strategy of choice when attempting contrarian plays in the SPDR Gold ETF (NYSE:GLD). Suppose on Nov 9th with the potent reversal experienced by (NYSE:GLD) and other commodities (see Commodity Reversal of Fortune), we decided to bet against the entrenched uptrend by selling a Dec 41-44 1×3 ratio spread for $2.10 credit. Consider the following two graphics comparing a simple short position to the call ratio spread. Take special note of the difference in the profit zones.
The “extra buffer” section of the ratio spread graph illustrates the additional profit zone that traders acquire when taking the option route over stock. Admittedly, there are other trade-offs between both approaches worth exploring, but we’ll leave those for another day.
Those engaging in contrarian trades may consider adding options to the mix to exploit some of the benefits outlined.
ABOUT: Tyler Craig, author of Tyler’s Trading and owner of TC Trading, Inc. Over the years I’ve educated hundreds of traders through my work with one of the nation’s leading educational firms. I enjoy writing and am a current monthly contributor to the Wealth Intelligence Magazine. My writings have also been featured in Expiring Monthly and frequently show up in the Abnormal Returns Options Newsletter. In 2009 I started Tyler’s Trading to share daily market commentary on stocks and options.