One of the most difficult chart-reading skills is determining whether a directional change is a reversal or a retracement. During a dynamic trend, the distinction is a key one to recognizing when to exit, or when to hold on.
As a general rule, retracement – a pause in the prevailing trend during which price moves in the opposite direction – is recognized by the lack of any reversal signals. A true reversal should be easily identified with specific reversal indicators and confirmation.
Even so, these general rules are not guaranteed to work in all situations.
For example, when the price is moving sideways in a consolidation period, a breakout is likely to occur based on an earnings surprise. The price movement will usually represent an exaggerated move, so a reversal has to be expected in the near future.
For example, on the chart of Chevron (CVX) as of the close on January 27, price gapped far below support after a negative earnings surprise. EPS was 0.22 versus expectations of 0.65. And revenues came in low as well, at $31.5 billion versus expectations of $3.38 billion.
The price had been consolidating between $115 and $119 per share since early December, so this well-established range was significant when the earnings-based drop occurred. Invariably, reaction to earnings surprises is an exaggeration. So some of the gap has to be expected to close over the next few sessions.
With this in mind, short puts are exceptionally attractive for several reasons. The price moved below the 50-day moving average. It broke through support on a gap. And the typical reaction to earnings is an exaggerated move, followed by a reversal in the short term.
The Feb. 10 put was very attractive as of the chart date, January 27. The 114 put closed at a bid of 1.25. Deducting trading fees, the net would be approximately $116. This is an attractive trade, given that uncovered puts have the same market risk profile as covered calls.
Maximum profit on this position is the net of the uncovered put, or $116. Breakeven is the net of the strike minus the net premium received (114-1.16=112.84). And a loss occurs if and when the price declines below the breakeven price. In that event, the uncovered put can be closed or rolled forward to avoid exercise.