At times, the chart pattern is so exceptional, and price moves so much, that you have to expect a retracement. No matter how significant the news, surprises inevitably cause an over-reaction in price, followed by an adjustment.
Case in point: Amazon.com moved on Friday, October 27 by 128 points to the upside. An abundance of reversal signals accompanied the move. The earnings news was not significant, but one analyst raised Amazon’s target price above $1,300 per share. Amazon’s stock price reacted by going from about $970 up to $1100.95 in a single day.
The chart summarizes the overall impact of this move. The price ended up nearly 52 points above the upper Bollinger Band. It would be impractical to believe that the price will continue trading this high, so by itself, this extreme move mandates that a reversal is very likely.
Accompanying this was the biggest volume spike in the last six months, and a move of Relative Strength Index all the way from mid-range to over seven points above the overbought index level.
What happens next? Swing traders are, by nature, contrarians; and this condition points to an ideal situation in which a bearish trade makes perfect sense. There are many ways to accomplish this. Here are a few, with option prices based on Friday’s closing levels:
- Long put. Buy a put and wait for price to decline. The problem here is that the shorter the time until expiration, the more difficult it will be to recapture and surpass the cost. These puts are expensive. And the longer the time to expiration, the more expensive the long put. The put expiring only one week from the big day trades at the money (1,100) and costs $1,440 (ask) plus trading fee. So about 14.5 points of decline are needed in five days just to get to breakeven. Going an extra week out to expiration on November 10 puts the 1,100 put at an ask of 1970, or about 19.75 points of decline needed just to break even.
- Vertical spread. A bear call spread sets up a credit, but the maximum profit is limited to the credit itself. For example, with the 7-day expirations, a bear call spread is set up by buying the 1102.50 at an ask o 14.95, and selling the 1,097.50 at a bid of 15.70. This sets up a credit of $75, minus trading fees for each. A bear put spread sets up as a debit but has greater potential for profits. For example, buy the 7-day 1,102.50 put at an ask of 15.70 and sell the 1,100 for a big of 15.00. The net cost is $70, minus trading fees for each position.
- Synthetic short stock. Normally, this would be a high-risk trade because it involves opening an uncovered call. However, given the extreme price move, the risk itself is reduced. Just the large gap and proximity so far above upper Bollinger mitigates the short call risk. The synthetic position mirrors movement in the underlying and costs very little compared to other trades. For example, a one-week synthetic short stock would be set up as close as possible to the money: Buy an 1,100 put at the ask of 14.40 and sell an 1,100 call at the bid of 15.00. The net in this case is a credit of $60, which is reduced by the trading cost (about $5 per contract, or $10 total). So, for a credit of about $50, you leverage the position and benefit from any significant downside movement, as the long put will mirror decline in the stock price, gaining one point for each point the stock price loses.
As always options traders have plenty of choices. By the time this article appears, it could be too late to take maximum advantage of Amazon’s big move (which also made Bezos the world’s richest person, gaining $10 billion on one day for a total of $90 billion in value of his 80 million shares). But the takeaway here is that extraordinary price moves present great opportunities which may not last for long. This is why swing traders have to be ready and willing to act fast.