Trading Topic of the Week: 5 Tips for Trading Stock Trends

Every once in a while, you'll encounter that rare setup where you pinpoint the bottom of a stock's decline just so, and you jump into the trade just in time to catch the beginning of a major rally. Those types of winning trades are definitely sweet -- but you can still pad your portfolio, even when you're not the first visionary on the bandwagon. To learn our top tips for profiting from existing stock trends, keep reading.

Trust that the trend is your friend (but do your homework). Every trader dreams of calling the top (or bottom) of a stock's trend, and capitalizing on the big reversal that no one else saw coming. But momentum is a powerful force in the stock market, so why not go with the flow instead of fighting the tide?

Some simple research can help you determine whether a stock's current trend is likely to continue. Before going long on an uptrending security, it pays to ensure there's technical support in place to guide the shares higher. (This could include moving averages, trendlines, round numbers, or other significant levels -- perhaps the stock is finding support at a 10% year-to-date gain, or at the site of a previous high.) Conversely, if you're going short, locate levels of technical resistance to help you determine a prime entry point for a bearish play.

 

Confirm that there are still some skeptics on the sidelines. From our contrarian perspective, this is a key ingredient to any momentum play. A solid uptrend is certainly impressive to look at, but a pretty chart alone doesn't guarantee a profitable trade. You must also ensure that there are still plenty of potential buyers on the sidelines to push the stock higher (or, for a bearish bet, plenty of possible sellers left to send the shares lower). Generally speaking, we like to see negative sentiment surrounding a technical outperformer, or positive sentiment on a lagging stock.

 

Whenever the prevailing mood among analysts and investors is out of line with the equity's price action, it's a clear sign that not everyone has capitulated to the existing trend. As long as there are still some holdouts who have yet to face reality -- and whose eventual surrender will further feed the stock's momentum -- it's likely the shares will continue on their current trajectory.

 

Don't be afraid to buy plenty of time. When you're playing trends, go ahead and spring for that longer-term option. It might cost a bit more than its front-month counterpart, but you'll be buying valuable time for the expected stock move to play out in full. Plus, time is generally "on sale" in the world of options. Due to the statistical basis of the options pricing model, the cost to buy a six-month option is not double the cost to buy a three-month option. Since you can purchase the additional time at a relative discount, it makes sense to avail yourself of some wiggle room on the calendar.

 

Consider at-the-money option plays. At-the-money options -- that is, puts or calls with a strike price roughly equal to the underlying stock's price -- are an appealing alternative to buying shares directly. One option contract affords you control of 100 shares of the underlying stock, but the cost to buy the option (the "premium") is only a fraction of what it would take to purchase an equivalent number of shares on the open market.

Since your cost of entry is dramatically reduced at the outset, you stand to reap much greater percentage rewards on a move in your favor than if you had traded the stock directly (an options benefit known as "leverage"). When your technical forecast calls for the continuation of an existing trend, it makes sense to maximize your profit potential by playing at-the-money options instead of shares.

Don't sweat the small stuff. When you're playing trends, it's important to remember that stocks don't move in straight up-and-down lines. Within a broader uptrend, there will be modest dips and periods of sideways price action -- "backing and filling," essentially -- as the shares consolidate gains and prepare for their next move higher. The same is true of bearish stocks, which experience the occasional bounce on their way down the charts.

With this in mind, there's no need to panic over a minor adverse move, so long as the overall trend remains in place. (After all, if you've heeded our prior tips, your longer-term option offers you the luxury of patience.) To ensure your forecast is still credible, simply verify that the technical support and contrarian-friendly sentiment backdrop remains intact for your focus stock. If so, relax and let the trade develop. And, as always, stick to your predetermined profit and loss targets to help you remain disciplined in the event of any hiccups in the share price.

All About At-the-Money Options

"At the money" describes a call or put option with a strike price that's equal to -- or very close to -- the price of the underlying stock. At-the-money options offer an attractive risk/reward profile for traders interested in playing existing price trends, since they provide a number of advantages relative to both stocks and their option counterparts at different strikes.

As noted above, all options afford you the benefit of leverage -- that is, the ability to amplify your returns by minimizing your upfront investment. Since calls and puts carry a lower cost of entry than an identical amount of the underlying stock, option buyers stand to collect far greater percentage gains than shareholders based on the exact same move in the share price.

Taking this concept one step further, at-the-money options require an even smaller upfront capital investment than their in-the-money relatives -- and, as such, they'll yield a greater percentage gain following a favorable move by the underlying equity. In other words, since they're cheaper to buy than in-the-money options, at-the-money positions allow you to fully exploit the benefits of leverage.

Meanwhile, at-the-money options also carry a greater probability of expiring profitably compared to out-of-the-money contracts. This probability is measured by a metric known as "delta." At-the-money bets have a higher delta than out-of-the-money calls and puts, which means they're more likely to move into the money prior to expiration.

As compared to more conservative in-the-money contracts and more aggressive out-of-the-money bets, at-the-money calls and puts offer a "just right" alternative for those looking to capitalize on trends. 

    
    

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