Use Puts Within a Bullish Portfolio

by Ken Trester | October 12, 2012 2:32 pm

Major stock indices weakened during the past week, and that near-term weakness may still be running its course.

Our indicators are giving bullish to neutral readings, a downgrade from last week’s bullish readings[1]. The primary culprit for the downgrade is the Nasdaq, which has slipped below its 50-day moving average. The Dow Jones Transportation Average is also struggling, giving Dow Theorists a reason for caution. But seven of nine industry sectors and five of eight global indices are still in bullish trends, so the overall picture remains bullish.

Nevertheless, with a key market index showing signs of weakness, it’s important to take note of important support levels in case the weakness should spread. For the Dow, key support lies at 13,310, its 50-day moving average. Similar support for the S&P 500 is at 1425. As mentioned above, the Nasdaq has already slipped below its 50-day moving average, and has actually fallen to the next support level at 3050. As the Nasdaq is the index currently undergoing a possible trend change, it’s the one I’m watching closest.

Our internal indicators are mirroring the indices, which are drifting lower. While the 200-day Moving Average Index, Advance/Decline Index and Cumulative Volume Index all continue to give bullish readings, the 200-day Moving Average Index slipped into neutral territory earlier this week before barely recovering on Thursday. This indicator has generally been the earliest to issue an advanced warning of impending market weakness. Make sure to keep a close eye on this indicator as well.

For their part, U.S. Treasuries, via the iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT[2]), and the U.S. dollar, via PowerShares DB US Dollar Index Bullish ETF (NYSE:UUP[3]), are also saying that bullish sentiment is still in force. TLT has rallied off of its 200-day moving average but it still looks to be in the process of forming a “lower highs, lower lows” pattern. UUP remains deep in a bearish trend relative to its key moving averages and is a long way from reversing that. Bearishness in TLT and UUP generally means that money is being deployed toward more risky assets.

So, while we are seeing some signs of potential weakness, most signs point to the rally continuing, and options buyers should continue to favor calls over puts. For now, the pullback can be considered a pause that refreshes an oversold condition. But it doesn’t hurt to sprinkle in some puts to your portfolio just in case the weakness grows more pronounced.

One short-side candidate that has emerged from our analysis is in diversified manufacturer Eaton (NYSE:ETN[4]), which reports earnings on Oct. 25.

The ETN Jan 40 put options are a good buy for $1.05 or lower. After entry, take profits if the stock price hits $41.50, or if the option hits its $2.00 target.

On any given week, only a few stocks give signals strong enough to make them a candidate for profitable options trading. My analytics evaluate the universe of options trades and give me the top finds, and then I hand-pick the best. This trade is based on ETN’s stock price movement, as well as the theoretical option value. Because this put is selling for less than its theoretical fair value, it appears to be an excellent buy.

It’s important to keep a tight rein on losses, so exit if ETN’s price closes above $46.30 or if the option trades through 80 cents.

Ken Trester[5] is editor of the popular Maximum Options[6] program. Trester has been trading options since the first exchanges opened in 1973 with a winning streak that goes back to 1984 with money-doubling average annual profits since 1990.

  1. last week’s bullish readings:
  2. TLT:
  3. UUP:
  4. ETN:
  5. Ken Trester:
  6. Maximum Options:

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