How often do we see a price jump based on news, only to then see a reversal? When bad news (or good news for that matter) hits, the tendency is for markets to overreact – and to then take back some or all of the decline in future sessions. One example of this in trading occurred on Feb. 2 in Polo Ralph Lauren (RL) with the surprise resignation of CEO Stefan Larsson. Although that resignation won’t occur for three months, stock price had fallen more than $9, an hour and a half into the Feb. 2 session.
The spike lower created several technical flags, as highlighted in “What happens next?” First, price gapped well below the consolidation range between $86 and $92, to an exaggerated extent. At the point of the chart, the price was also $5 below the Bollinger lower band, which is never expected to remain for long.
Confirming the likely reversal to follow was the huge spike in volume and a momentum move, as measured by the Relative Strength Index, well into oversold territory.
These signals strongly indicate a coming reversal, at least into Bollinger range, or five points above the price on the chart.
With this exceptional condition in effect, timing was perfect for a swing trade using options. The most basic strategy of all would be to buy a long call. The 78 strike eight-day options expiring on Feb. 10 were at an ask of 2.05. Adding trading fees, the total cost would be $214. As a result, the breakeven is $80.14 (78 strike plus cost of call 2.14).
A problem with this is that between the Friday a week before last trading day, and the next session, Monday, options lose, on average, 34% of remaining time value. This puts a long trade at a disadvantage.
You could also open an eight-day synthetic long. A synthetic long stock consists of a long call and a short put at the same at-the-money strike. Combine your long call at a net cost of $214 with a short 78 put at a bid of 1.15. Subtracting trading fees, the net is $106. This produces a net debit of $108.
This trade is attractive with a breakeven of $79.08. However, remembering the warning about time decay from Friday to Monday prior to last trading day, this position could be entered in legs. Sell the 78 put before the weekend and open the long call on Monday. Both options will lose an average of 34% time value. This is advantageous for the short put opened before the weekend and reduces the cost of the long call opened on Monday.
Finally, you could open a 15-day synthetic long.
At the time of the chart, the 78 call expiring in 15 days was available at an ask of 2.40. Adding fees, this translates to a cost of $249. The 78 put was at a bid of 1.60. Subtracting trading fees, this sets up a net credit of 1.51. Overall, the debit would be 0.98, or $98. So, breakeven would be $78.98. That is $6.98 below the top of the gap opened up on Feb. 2. Considering RL is so many points below the lower Bollinger band, it is likely that gap will be filled.
Even though this highlighted a specific trade, the overall concept can be applied to any underlying when the price spikes abruptly higher or lower after any form of unexpected news. This includes resignation of a CEO, merger rumors an economic report far off expectations, earnings surprises or a provocative presidential tweet. Often markets overreact to initial reports creating opportunities.
The take-away is that options present low-cost leverage for unusual situations, so a contrarian approach allows you to recognize opportunities. But these demand fast action.