Here’s something you may not have realized: the last 2 weeks has seen the S&P500 trade in its most narrow range on 2 consecutive weeks since May 2011. This means alot of shares have traded hands in this 1,250-1,285 range. Moreover, anytime you get a tight range like this, be it on an index or a stock, alot of technical traders take notice.
In addition to the tight range we noted on a weekly basis, we also have one on a daily basis. Wednesday-Friday of last week saw SPX trade in its tightest 3-day range since April of last year. Technical traders love set ups like these because it makes for a simple strategy. If SPX breaks the top end of the recent range (1,285), then many will likely position for a breakout and expect a test of 1,300. However, if SPX breaks the low end (1,265), those same traders would position for a breakdown a test of 1,250 support.
We don’t recommend guessing as to what will happen, a breakout or a breakdown, but we do recommend taking the best risk/reward scenario available. Currently, since SPX is closer to the top end of the range, we recommend getting short. Reason being is your stop loss (a breakout above the 1,285 high) is very close so you can get short and losses will be minimal if SPX breaks out. Meanwhile, should SPX breakdown and test 1,250 you will already have benefited from the 2% drop. So your stop loss is .06% away while your potential profit target is 2.1% making for a profit to loss ratio of 3.38 – a fantastic ratio in our opinion.
Due to the lack of volatility in the market so far in 2012 we suggest buying further in the money options. Why? Because there is much less premium on options trading further in the money and when there isn’t alot of volatility premium can come out of options rather quickly. This can leave you vulnerable to a losing position even if you get the directional move you need for your options because the move may not be big enough. We’ll be looking at purchasing the 132 puts on SPY expiring January 21st tomorrow for under $4.50, this would put us short SPY at $127.50 (want to better understand how we get that break even point and why we’re buying further in the money options? Watch these 2 video’s here and here.)
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