Far to often as traders we sink into habits (a good read on the subject is The Power of Habit by Charles Duhigg). The beauty of new tools is that they shock us into new ways of trading.
Case in point: For years I've concentrated my trading on highly liquid stocks. That meant I was habitually tracking around 250 stocks at any one time.
My new toolkit, which I custom wrote in the programming language perl, allows me to do a more thorough and rational job of weeding out trades likely to have losing results.
As a consequence, a 250 stock universe is far to small to produce enough trades to support my operation.
That paucity of good trades is exaggerated by the fact that we're entering earnings season, which means under my rules that I can't open new positions in a company within 30 days of its earnings announcement.
So this morning, when I ran my report on highly liquid stocks, I found nine breakouts, only three of which scored high enough to interest me. Of those three, one was knocked out because of a pending earnings announcement. And the remaining two dropped back within the price channel today, and so their breakouts weren't confirmed.
The net result: Zero possible trades.
I reworked my universe by lowering the floor on average volume from 2 million shares a day down to 500,000 shares, producing a universe of 1,049 stocks.
Please note that these are in no way penny stocks. A volume of 500,000 shares is liquid, and the stocks are priced at $15 and up, have stock options associated with them, and are tracked by the stock analysis web site Zacks.
Among those, there were 31 breakouts beyond the 20-day price channel on Monday. Nine of those were both confirmed and were free of earnings announcements for the next 30 days.
By expanding my universe, I now have some trade possibilities, all of them issues that I've not looked at before.
For scoring, I combine the odds of successful trade with the average magnitude of profit when trades succeed.
My rule of thumb is that I want to see a score of five or better in the direction of the breakout -- up or down -- and also for all breakouts whatever the direction.
Four stocks met that criteria. In descending order of average volume, they are Ocwen Financial Corp. (OCN), Catamaran Corp. (CTRX), Cimarex (XEC) and Viropharma Inc. (VPHM).
Volume matters because high volume stocks allow for better options selection and narrower bid/ask spreads. Options matter because they provide leverage, which boosts profits.
I don't like to trade opens with open interest below three figures, and four figures is much better. Three of the issues -- OCN, XEC and VPHM have several strike prices with three-figure open interest.
VPHM has the highest success score and the lowest volume, and that's the first issue I'll look at.
Viropharma Inc. is an Exton, Pennsylvania biotech company that operates globally with a focus on specialty products that, in the company's words, "support patients with serious diseases for which there is an unmet need".
The price of VPHM stock on Monday broke above its high of the last 20 days -- $24.64 -- and continued to rise today. The breakout came on the fifth day of an upleg that began from $22.12 on Dec. 31.
The stock is still correcting from its February high, and it would take a push above $31.36 to produce a higher high on the weekly chart that would count as a strong uptrend.
Since January 2009, seven out of 10 price-channel breakouts by VPHM have resulted in profitable trades, with an average gain of 13%. Upside breakouts, like the one on Monday, have resulted in winds 77% of the time, with an average gain of 20%.
The overall score -- the breakout success rate times the average yield -- is 9.2, and the upside score is 15.7.
These are far higher numbers than I'm seeing with highly liquid stocks, with average volumes above 2 million shares, where the scores tend to peak at 5.0 or 6.0, tops.
Analysts tracking VPHM are positive about its prospects, with their collective enthusiasm rating coming in at 19%.
Viropharma's return on equity is respectable but not spectacular, at 9%. Long-term debt is on the low side, amounting to 20% of equity.
Quarterly earnings are all over the map, without out a trend. The company showed losses in the last two quarters but was profitable in the 10 prior quarters.
Earnings have surprised to the upside in five of the last 12 quarters, and to the downside in seven.
Institutions own 66% of shares, and traders have bid up the stock to a quite expensive level. It takes $3.50 in shares to control a dollar in sales.
VPHM on average trades 705,000 shares a day. The options strike price selection is adequate but not great. Open interest in the 100 and 200 contract range is tightly concentrated near the money in the front month.
Front-month at-the-money call options have a 12% bid/ask spread, which is quite high in the world of highly liquid stocks but not unusual in the mid-volume issues like VPHM.
(Spoiler: While writing this post, I opened a bull put option spread with a February expiration. It took 10 minutes to get a fill, and to get filled at all I had to back off my asking price a bit as I negotiated with the market maker. The open interest was 609 contracts for the short leg ($25 strike) and 233 contracts for the long leg ($22.50 strike). It worked, but I really feel as though I'm navigating through a strange new world populated by bizarre illiquid beasts.)
Options are trading well below their five-day average volume: Just 36% of the average for calls, and a mere 5% for puts. This is not a very active day.
Implied volatility stands at 36%, the lowest level of the past six months. It has been declining since Jan. 3.
Options are pricing in confidence that about two-thirds of trades will fall between $22.65 and $27.85 over the next month, for a potential gain or loss of 10%, and between $24 and $26.50 over the next week.
The fair price zone on today's 30-minute chart from from $25.17 to $25.44, encompassing 68.2% of transactions surrounding the most-traded price, $25.32. The stocks is trading near the floor of the range. an hour before the close. Nearly all of today's price rise came in the first half-hour of trading.
Viropharma next publishes earnings on Feb. 25.
Decision for my account: As noted above, I've opened a bull position on VPHM, structuring it as a February bull put spread, long the $25 put and short the $22.50. This makes the trade profitable at expiration down to $24.25, for a 4% cushion. The potential yield is 23%.
If the price continues to rise, I'll add to the position either as long May call options or as shares. The May options only have double-digit open interest, and that could be an issue for me.
My trading rules can be read here. (They don't talk about the trend score because I'm still developing the tool.) A discussion of recent modifications to my trading methods, which haven't yet been incorporated in the original write-up, can be found here.
And the classic Turtle Trading rules on which my rules are based can be read here.
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.