Mastering Derivatives: Option trades when breakouts are not convincing

Previously in this column, we discussed when to use options to trade price breakouts. Specifically, we showed that you could use a bull call spread when you identify an overhead resistance after a price breakout. This week, we discuss yet another instance when options can be setup for price breakouts.

Managing fakeouts

Not all breakouts from a major resistance level lend themselves to uptrend in prices. Bears could also push an underlying’s price above the resistance level only to hammer the price down. Alternatively, bulls could show strength till the breakout level, but lose control thereafter. Such price behaviour can be called false breakouts or fakeouts. It would be optimal to avoid such trades. But it is not easy to differentiate a good breakout from a fakeout.

So, the optimal strategy is to find out if the bulls are exhausted. The argument is simple. If the bulls have control on the underlying, it is highly likely that the price will continue the momentum after the breakout. Your decision to buy a breakout should depend on two factors. One, whether the bulls appear exhausted at the breakout level. And two, whether the breakout indicates that the momentum will continue.

The first factor asks the question if the bulls have the resource to continue an uptrend. The second factor asks the question if the bulls are still in control, having taken the underlying from the support to the resistance level. It is possible that bulls have the resource but still fail to exert control at the breakout level. Or bulls may show control at the breakout level but may have exhausted most of their resource, pushing the price up to the breakout level.

It is one of these scenarios that lends itself to an option trade. Suppose you decide that the price breakout is strong but believe that the bulls may soon be exhausted. In such cases, you can set up a long call position or a bull call spread. It is a risky trade, but your risk is limited to the cost of the call or the net debit. Of course, you can still trade futures if you are an experienced trader. But remember that the near one-to-one movement makes futures riskier than trading options; the breakout could fail if bulls show exhaustion after the breakout.

Important note

Bulls or bears cannot continually win for a long period as they need resources to move the price in their preferred direction

Optional reading

It is important to observe how the bulls have behaved on the last leg of the rally up to the breakout level. If bulls have been on a winning streak (a series of, say, seven consecutive green candles) and the breakout is supported by heavy volumes, it may be a cause for concern. Why? Bulls or bears cannot continually win for a long period as they need resources to move the price in their preferred direction. And resources are not unlimited. This explains why you will find minor pause in prices even if the underlying exhibits strong uptrend.  

The author offers training programmes for individuals to manage their personal investments

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