A Pivotal Test Looms for Market Leaders

by Tyler Craig | May 28, 2013 9:09 am

Despite the elevated angst of market participants, the pullback in the S&P 500 Index has remained quite benign. Sure, it began with an ominous-looking 2% intraday reversal and has boasted higher-than-average volume, but when you survey it from afar, the damage has been pretty contained. All told, we’re down a mere 3% during the past three trading sessions — not exactly the type of correction worth panicking about.

Provided the selling pressure remains somewhat contained, the opportunistic trader ought to be welcoming the current retracement with open arms. After all, shallow corrections amid an uptrending market provide low-risk entry points for initiating bullish positions. Many extended stocks — particularly those who have led the market higher in recent months, such as Google (GOOG[1]) and Netflix (NFLX[2]) — have finally retraced to potential support levels.

Now comes the true test. Will buyers once again step up and accumulate these popular momentum leaders, thereby maintaining their uptrends and driving them to new heights? Or will potential support fail, leading to deeper downturns?

Let’s take a look at both stocks in greater detail and see if there’s a play to be had.

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We begin with the recently resurrected media company Netflix. Since breaking above its post-earnings gap resistance at $220 and running to new multiyear highs, NFLX has developed a textbook multiday retracement to its rising 20-day moving average. If Thursday’s doji and Friday’s bullish engulfing candle are any indication, it appears the bulls have successfully defended this short-term support level.

Adding further appeal to the pullback is the fact that it occurred on light volume, indicating an absence in any aggressive institutional selling. Finally, NFLX’s relative strength line (green line in bottom panel of chart) is still in an uptrend, showing continued outperformance of the S&P 500.

If you’re in the camp that believes the uptrend in NFLX remains intact, consider buying the July 230-245 bull call spread by purchasing the 230 call and selling the 245 call for a net debit of $5.80. The max risk is limited to the initial $5.80, and the max reward is limited to the distance between strikes minus the net debit, or $9.20.

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Like Netflix, Google also has experienced an average-volume, multiday pullback to its rising 20-day moving average. Its relative strength line remains in an overall uptrend, though it has experienced a deeper drop than NFLX.

In addition, while NFLX formed twin reversal candles on Thursday and Friday, GOOG has yet to develop any definitive signs of rebounding. The best-case scenario going forward would be for buyers to take control early this week and save GOOG from breaking decisively below its 20-day moving average.

If you’re looking for exposure to additional upside in GOOG, you could purchase the July 870-890 bull call spread by purchasing the 870 call and selling the 890 call for $9.50. The risk is limited to the initial $9.50 paid and the max reward is limited to the distance between strike minus the net debit, or $11.50.

For added confirmation, you could wait to enter the trade until after GOOG has formed some type of bullish reversal candle.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

  1. GOOG: http://markets.financialcontent.com/investplace/quote?Symbol=GOOg
  2. NFLX: http://markets.financialcontent.com/investplace/quote?Symbol=NFLx

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