by Ethan Roberts | October 28, 2011 9:29 am
When you’re deciding whether to go short or long on a particular stock or ETF, it is important to consider the relative strength of that stock in relation to the overall market.
When we get a strong day in the markets, as we did yesterday, I scout out potential short (or put option) candidates by looking for stocks that did not join in the festivities. In doing this, however, you want to eliminate stocks that were down because of a bad earnings report, dividend cut, or some other very bad news.
Conversely, when we get a day of substantial market weakness, for example, a Dow decrease of 200 or more points, I look for the stocks or ETFs that bucked the trend and were in fact profitable on the day.
Can’t Whitewash This
So after yesterday’s 339-point Dow rally, I noticed that — by contrast — Clorox (NYSE:CLX) put in a rather poor performance, closing 1.75% down for the day. In fact, a look at the chart below shows a bearish engulfing candlestick pattern on Thursday that frequently forebodes more selling to come in the near future.
You can also see that intra-day low of $67.01 actually breached the 200-day moving average, and the closing price was right on that average.
The stock was lackluster for most of the day, and only a-last minute gap higher at the end of the trading day saved CLX from having an even-worse performance. After opening at $69.41, it sank slowly throughout the day, with declining peaks, until near the closing bell.
CLX briefly touched $67.01 before finishing at $67.43. After the bell, the stock traded up to $68.57.
You will also note that the Stochastic oscillator has now fallen from overbought territory to 63 and change, a bearish sign. The 14-period Relative Strength Index (RSI), though neutral, seems to be languishing. And the Moving Average Convergence/Divergence (MACD), while still in buy mode, seems to be precariously close to generating a sell signal.
This Chart Should Come with a ‘Mr. Yuk’ Sticker
Another ominous sign is the “Death Cross,” whereby the 50-day moving average has recently crossed below the 200-day moving average. CLX hasn’t fared too badly since then, but remember that the major indexes have been moving up in recent weeks, and carrying most stocks with it.
However, a look at CLX, when compared to the S&P 500 shows that over the last month (23 trading days), the S&P has risen over 9%, while CLX is up less than 1%. Increasing that time frame, over the last three months, the S&P has outperformed CLX by about 6%.
So we see that it was not just a one-day fluke that CLX was bested by the general market, but instead a longstanding pattern. Therefore, as the general market nears the top of its trading range (see the next chart with the S&P 500 Bollinger Bands), it stands to reason that this is an excellent candidate to play for further downside.
The trade that looks good here is buying the CLX Dec 17 Puts.
Charts courtesy of stockcharts.com
One caveat to note: Clorox will announce earnings on Nov. 2. It’s always a bit of a risk to trade options right before an earnings report, so set your stops 3% or 4% below your buy point, in case there is a big upside earnings surprise. However, given the recent lackluster performance of CLX, I would be surprised to see that happen.
It is also possible that CLX could have a brief bounce higher from the 200-day moving average. In fact, I would prefer to see that, before entering the put position. The ideal entry point would probably be somewhere just below $72.34, which was the intra-day peak of Aug. 30.
However, I don’t anticipate CLX bouncing that high. So I would most likely enter the first half of my position around $68.75 to $69, which would be just below Thursday’s high.
My goal for the put is to sell it when the stock price drops to around the $63 to $64 price, which would be a re-test of the most recent lows.
Even if we only re-test the Bollinger band trough at $64.33, we can still “clean up” rather nicely with a CLX put!
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