by Tyler Craig | October 23, 2013 9:29 am
With the market rally lengthening its stride, many stocks are entering overbought territory. The S&P 500 index is now up eight of the past nine days, delivering a quick 6.9% gain to investors. While hoping for higher prices ahead is certainly understandable given the bullish backdrop, traders mustn’t impose unrealistic expectations on an already extended market. A pause or pullback is more than likely in the coming week.
The transportation sector in general and FedEx (FDX) in particular have reached extreme levels. One way to measure just how stretched FDX has become is to view the stock with a Bollinger bands study. Bollinger bands is an adaptive volatility tool created by plotting an upper and lower band set at two standard deviations around a 20-day simple moving average. The “adaptive” part of the indicator comes from its tendency to contract when stock volatility diminishes and expand when stock volatility increases.
Along with measuring stock volatility, the bands also help identify extreme price moves which occur when a stock’s price ventures above or below the bands. Consider the recent action in FDX for example. The mid-October breakout resulted in no less than six consecutive candles closing above the upper Bollinger band. Given the extremity of the move it’s a good bet a reversal of the upswing is close at hand.
Further buttressing the case for at least a pause in FDX’s rally is Tuesday’s candlestick, which finished with quite the long upper shadow. Sometimes called a “topping tail,” this long shadow reveals a sizable bearish intraday reversal — an inability of the bulls to maintain the early-morning gains. A break below Tuesday’s low would confirm the potential reversal.
Traders looking for a way to exploit a pullback could sell an out-of-the-money November bear call spread in FDX. The short call spread provides a higher-probability, more conservative alternative to buying puts or shorting the stock outright. To enter the position, sell the November 135 call and buy the 140 call for a net credit of 77 cents.
The max reward is limited to the initial 77 cents and will be captured if FDX remains below $135 by November expiration. The max loss is $4.23 and will be incurred if FDX rises above $140 by expiration. To minimize the potential loss, consider exiting if FDX rises above the short strike at $135.
At the time of this writing Tyler Craig had no positions in any of the aforementioned securities.
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