One of the most reliable chart patterns for an upcoming directional trend is the consolidation range. Below is the daily chart of MU. Price experienced a strong 45% rally from the beginning of November thru December 4th. Since then price has moved sideways in a $5 range between ~69.50 and ~74.50. Since a range like that is typically a continuation move and the move preceding this consolidation was a rally then I’d expect the next major directional move to be up. Also, a consolidation range like this often appears near the middle of a large directional move. Since price rallied around $20 before entering this range then I would set an upside target price of around $90-$95 if price breaks out to the upside.
Another positive sign that this consolidation will likely lead to another leg higher in the stock price is where this consolidation is occurring. Below is the weekly chart of MU. There is one very large green candle that stands out above all others over the past 6 months. That candle represents a significant imbalance between the supply and demand for the stock. The buyer’s took price 17% higher in just that week alone. Whenever I see a particularly large candle I will often use the range of that candle to measure the strength or weakness of the ensuing price action. For instance, if the following week’s candle gave back a large percentage of the gains then I might discount the importance of the large bullish candle. Clearly that isn’t the case as the ensuing 3 weeks has consolidated in the top half of the large candle’s range.
Below is the daily chart again with the drawing of the large candle’s range showing as well as the 20-day SMA. We know that price often finds support at a rising moving average. The 20 SMA is a particularly well-followed moving average meaning there will be plenty of buyers lurking there. The fact that the 50% retracement of the large candle’s range, otherwise known as Half-Back (HB), is also located near the 20 SMA gives the $69-$71 price area potential support.
So the price parameters of the potential trade I’m considering are quite clear here. I would like to be adding a long position in the current price area and I would Delta Hedge the position if price approached the top of the range around 74. If price instead broke down and accepted value below 68.98 I would stop out of the position. I’m never worried about stopping out because if it turned out to be a failed breakdown and price moved back above the support level I’d enter the position again. I hold no grudges if a stock fakes me out!
Now, all of the price action that I’ve just described applies to any time-frame on any instrument. Consolidations are typically continuation patterns (but don’t ignore the possibility of the opposite move occurring) and once a range is identified, buying the bottom of the range and Delta Hedging the top of the range is a good way to trade the consolidation. Notice I didn’t say buying the bottom of the range and shorting the top. If the preceding move prior to the range was a rally I don’t want to get short that instrument. I’d much rather Delta Hedge a long position anticipating an eventual breakout higher. I typically use longer duration options because consolidations can extend over long periods of time.
If you keep reading this post you have to understand that the trade I’ll be describing (below) is complicated by the fact that MU has an earnings announcement on Jan7. Many traders do not like to hold positions over earnings and that is understandable as large price swings often occur after an earnings announcement. In this instance I’ll be attempting to take advantage of the increase in the implied volatility (IV) of the options within the earnings expiry to make the trade potenially more profitable.
The position I’m considering will have two components. The first will target a move higher in price based on the range of the current consolidation. I’d expect that move to happen before the earnings announcement. The best way to trade that expectation is a simple Call Vertical Debit spread with the Jan8 expiry. Yes, that expiry is the day after the earning’s announcement but I will have either exited the position or Delta Hedged it before the announcement. Below is that risk profile. I want to be clear that I won’t hold this position if MU sees price acceptance below the ~69.50 support level.
The second component is the earning’s play part of the trade. This is a strategy that I’ll use occasionally as a standalone earning’s trade. I used to do many more of these types of trades but, over the years I’ve decided I prefer to deal less with the higher risk that comes from these types of trades. You’ll notice this requires $300 margin per lot if this is done as a standalone trade. However, when I combine the two trades into one position there is no margin requirement because the Vertical spread covers the Diagonal spread.
Below is the combined position in a 1:1 ratio. It has a favorable reward/risk and no margin requirement.
I can improve the reward/risk ratio by buying two of the Diagonal spreads for every one of the Vertical spreads. There is still no margin requirement for this position but here is the caveat to that: I intend on either rolling up the long Jan8 MU 70 Calls to a higher strike or exiting the Vertical spread prior to Jan8. If I roll the 70 Calls up to the 72 strike or higher or exit this trade in order to Delta Hedge the position I will start incurring a margin requirement for the remaining position.
This trade may seem a little more complicated than most of the trades I tweet or post about. It is! I purposely chose this setup just prior to earnings for that very reason! This is an educational service and I don’t want any of you to be limited in your ability to understand even reasonably complicated strategies. I want you to be able to utilize all of the tools that option trading offers. You can also learn from observing without actually trading this position. The alternative is trading a 1 or 2 lot size to experience the trade while limiting the risk to a relatively small amount.
As always, if you have questions or comments tweet them at me!