I don’t know about you, but I always find that taking time at the end of the year to reflect on what you can do better in the New Year yields positive results.
For me, in addition to being the best father I can be to my children, my focus for 2022 is to make sure I am providing the BEST market research and trading ideas I can provide!
One area that has strong momentum heading into the New Year is in its quantitative analysis and trade ideas. But rest assured, I have plans to make these even better in 2022.
One key theme that our quantitative studies have been focusing on of late has to do with the volatility-based opportunities that are now developing as a result of inflation’s historically-bearish effects on tech stocks.
Specifically, these studies suggest that semi’s could potentially lead the pack in volatility as 2022 unfolds.
That’s why I am starting the year with SIXTEEN Long-Term and SHORT-TERM SWING TRADE STRANGLES spread out across a few key semiconductor stocks.
Today I am going to share with you how I am trading my standout name in the semiconductor industry, Broadcom Inc.(AVGO).
Did you know that typically when inflation rises fast, tech stocks correct and/or underperform? That’s what some have been saying as of late.
As the ‘Quant Calculator’ (shown below) has been showing us, when it comes to being vulnerable to mean reversion, AVGO is a standout.
That’s because it’s been trading above its 200-day moving average for an incredible 401 days and currently stands at 34% away from this average, which compares to the average Percentage Away of 17.2%.
What you see above is a snapshot of the new quantitative tool that I developed with the help of a Ph.D. statistician, and it’s been incredibly effective at helping me identify stocks whose long-term trends have traveled too far, making them vulnerable to corrections.
But there is also a technical tool that traders can use to visualize when stocks have moved too far away from a long-term moving average.
This tool is called a Moving Average Envelope, and an example is shown on the chart below.
The default setting for this tool may differ depending on which charting platform you are using. Usually, you’ll find the default moving average to be a 21-day moving average, with 2.5% bands.
On the chart directly above, I’ve customized the settings to use a 200-day moving average and a 34% bands away from that average, as this reflects what is currently being registered by the Quant Calculator.
As you can see, the last 3 times AVGO stretched to roughly 34% above its 200-day moving average this proved to be an indication that the “rubber band” had become too stretched to allow the rally to continue without volatility picking up as the stock corrected lower.
Now, if you’re not careful when trading stocks that are this extended, you could be setting yourself up for a visit with Vince from Slap Chop.
But there is a trade that we can use when increased volatility in either direction is anticipated after prolonged rallies above the 200-day moving average, and that trade is a “strangle” options trade.
Why would a trader use a “long strangle” options trade?
It is important to highlight the strangle trade I am using in this particular case is a long strangle. I’ll explain the difference between a long strangle and a short strangle in a moment.
A trader uses this strategy to capitalize on large price moves in the underlying asset, in either direction.
In other words, the favored forecast is for a large price move in the stock to occur, in either direction.
With a long strangle, a trader buys one call with a higher strike price and also buys one put with a lower strike, both of which have the same expiration date.
This trade is established for a net debit and profits if the underlying stock rises above the upper break-even point or falls below the lower break-even point.
This compares to a short strangle, which is constructed by selling one call and selling one put of the same expiration date, thereby creating a net credit and profits if the underlying stock stays between the upper and lower break-even points.
Here are the details of my long-term AVGO trade idea:
Buy 1 14 Apr 22 AVGO 820 call at (5.40)
Buy 1 14 Apr 22 AVGO 500 put at (4.50)
Net cost = (9.90)
I decided to go with the April contract to give myself plenty of time, in the event the anticipated increase in volatility takes longer than expected.
What is the loss potential of a long strangle?
The maximum a trader can lose on this trade is limited to the total cost of the strangle plus commissions.
Maximum loss occurs when, at expiration, the underlying stock price closes between the breakeven points of the trade, causing both options to expire worthless.
How are the 2 breakeven points calculated?
Top breakeven point = higher strike price plus total premium paid:
In this example: 820 (strike) + 5.40 (premium) = 825.40
Bottom breakeven point = lower strike price minus the total premium paid:
In this example: 500 (strike) – 4.50 (premium) = 495.50
How does time affect a long strangle?
Since this is a net-long options strategy, the trade will have to fight the effects of time decay.
And since the strangle consists of two long positions, these trades tend to lose money more rapidly if volatility does not pick up as was originally anticipated.
With this in mind, it’s important to make sure you give yourself enough time for this trade to work out.
How does volatility affect a long strangle?
As mentioned earlier, this trade is meant for situations when volatility is expected to rise substantially. So, it goes without sayin’ the trader wants things to get crazy (big price swings beyond the breakeven points are desired) in terms of price movement when this trade is implemented.
What about the risk of early assignment, you ask?
Well, since the trader owns the options in this strategy (the trader bought both calls and puts to open the trade), they decide when they want to exercise the options. Therefore, there is no risk of early assignment.
Ultimately, I’m looking to exit this trade, which I paid 9.90 to enter, at 22.00.
Of course, as is the case with any long options trade, these contracts could expire worthless, and that would be throwing away the $9.90 I paid to enter the trade.
However, given the track record of this stock’s price action to grow increasingly volatile after a rally to roughly 34% above the 200-day moving average, I believe this trade could potentially be one of the many strangle trades I place in the semiconductor industry for the spring of 2022.