Keys to Success
No matter which trade is more suitable to Kathleen’s risk tolerance, the
overall concept is the same: profit from little directional movement. Before
Kathleen found a stock on which to trade her spread, she will have sifted
through myriad stocks to find those that she expects to trade in a range. She
has a few tools in her trading toolbox to help her find good butterfly and
condor candidates.
First, Kathleen can use technical analysis as a guide. This is a rather
straightforward litmus test: does the stock chart show a trending, volatile
stock or a flat, nonvolatile stock? For the condor, a quick glance at the past
few months will reveal whether the stock traded between $65 and $75. If it
did, it might be a good iron condor candidate. Although this very simplistic
approach is often enough for many traders, those who like lots of graphs
and numbers can use their favorite analyses to confirm that the stock is
trading in a range. Drawing trendlines can help traders to visualize the
channel in which a stock has been trading. Knowing support and resistance
is also beneficial. The average directional movement index (ADX) or
moving average converging/diverging (MACD) indicator can help to show
if there is a trend present. If there is, the stock may not be a good candidate.
Second, Kathleen can use fundamentals. Kathleen wants stocks with
nothing on their agendas. She wants to avoid stocks that have pending
events that could cause their share price to move too much. Events to avoid
are earnings releases and other major announcements that could have an
impact on the stock price. For example, a drug stock that has been trading
in a range because it is awaiting Food and Drug Administration (FDA)
approval, which is expected to occur over the next month, is not a good
candidate for this sort of trade.
The last thing to consider is whether the numbers make sense. Kathleen’s
iron condor risks 4.35 to make 0.65. Whether this sounds like a good trade
depends on Kathleen’s risk tolerance and the general environment of UPS,
the industry, and the market as a whole. In some environments, the
0.65/4.35 payout-to-risk ratio makes a lot of sense. For other people, other
stocks, and other environments, it doesn’t.