For the purposes of this post I be focusing on the longer-term charts, primarily the weekly chart. The weekly chart is particularly useful for finding entries into option positions with 3+ months of duration. Of course they can be used for shorter-term trades but a balanced option portfolio will be comprised of bullish and bearish positions of varying durations and using charts from the various time-frames can also help diversify portfolio risk.
Below is the HD (Home Depot) weekly chart. Following a 100 point rally from the March low price has been consolidating in a 30 point range over the past 4 months. This kind of consolidation is typically a continuation move and if price breaks above the top of the range it would then target a rally roughly equal to the size of the rally preceding the consolidation. That could see HD’s price into the mid-300’s. However, right now there is an opportunity to add a long position at a better entry price than waiting for that potential breakout. The current price of 264.55 is right at the bottom of the consolidation range and offers a potential 30 point rally prior to the breakout point. First, let’s break down the price action and look for an entry and stop level.
3 charts below; monthly, weekly and daily. The monthly chart shows how price has had several good bearish setups since the August high and price has simply drifted lower with each setup instead of trending lower. When good bearish setups fail, that is generally bullish! This past week’s candle was a 2d which is bearish however the candle left a long lower wick and the body was green. While that wasn’t a buy signal last week, it could easily turn into one this week if price is able to rally past last week’s 266.07 high. That would turn this coming week’s candle into a 2u and is a buy signal. The stop level on that buy signal becomes the week’s 258.73 low. So, a good long setup and a defined stop level. So far, so good. One problem; that range is almost 8 points which means if I add a long on a break above 266.07 and price reverses I could lose a substantial amount of the trade capital before being stopped out. I need to find a trade that won’t lose a large amount but still offers good upside potential.
Below is the risk profile of a Jan2022 Call Vertical Debit spread. Plenty of upside potential should HD move higher into the mid-300’s over the coming year but, just as important, also minimizes the amount the position will lose if I’m stopped out of the trade. At $12.48 ($1,248) it’s a very expensive spread but because it’s well OTM (out of the money) and it has over a year of duration it’s a reasonably low Delta position. That means that the directional risk is minimal in the early weeks of the trade. In fact, if I had entered the trade at Friday’s closing price I would be risking approximately 13% of the initial capital by setting the stop level at around 258. So my likely loss on this trade is around $160 although I’m always prepared to accept a larger loss should HD experience a much larger than expected move lower in the overnight when I’m unable to close the position. Now, hopefully you’re already wondering how and where I would look to reduce the risk of the position by Delta Hedging (DH) it. Read on…
I’ve identified the consolidation price range as being between around 260 and 290. Since I’m looking to add this position on a break above 266.07 that leaves about a 24 point move before price reaches potential resistance at the top of the range. I’d hate to not DH the position around 290 and then see price reverse and move back to the bottom of the range again (or worse). Below is the risk profile of the DH that I would likely be able to fill if price rallied to around 290. What the adjustment trade is made up of is: 1) rolling up the 290 Call of the Vertical Debit spread to the 310 strike and 2) selling the 360/400 Call Vertical Credit spread. Both of those trades generate a credit and I would place the trade as a single order as shown on the risk profile below.
So, if price reaches the upper resistance of the range I should be able to get the position to zero cost. I would expect price would find enough resistance around 290 to at least experience another pullback. Not necessarily back to the bottom of the range again but some type of pullback. At some point in the future however I am expecting a breakout above the top of the range followed by a strong move higher. This DH’d position is still a bullish position and would benefit greatly from that kind of rally but I may look for even more potential profit on a breakout. Since, with this scenario, I will have eliminated all of my cost in the trade I’ll then have all of the $12.48 of initial risk capital to work with in a new position. Upon that breakout I could deploy that capital in perhaps a new Call Vertical Debit spread perhaps in a different expiry to increase my potential profit from the position. In that case I’ll have leveraged my potential profits without adding to my initial risk. That is a key component of the Delta hedging strategy!
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