Wednesday's Hot Stocks: Finding A Rose Among Many Thorns

With the major indices ticking slightly higher Wednesday, there were many stocks which broke out to the upside on BIG volume. If this is your first time reading one of my breakout reports you'll want to read the section below, however if you are familiar with my daily breakout report you should skip ahead to the list of stocks and option strategy below it.

To reiterate previous blog posts like this, the first thing I do is scan the list for familiar names, such as stocks I am quite familiar with or ones which have appeared on similar scans multiple times in the past week or two (most of these names are unfamiliar so it saves a lot of time). This indicates there may be some real momentum behind the stock, and that it could trade higher in following sessions as well. Then (if and when any of the stocks I find are familiar to me), I make sure the stock has options available to trade, and then take a look at the chart(s) to see if I can structure a potential option trade. The list in this post is quite large and includes 27 stocks, all of which traded higher on heavy volume Wednesday January 13, 2010. However I will only be writing about one stock in detail which I'll be adding to my watch list, and outline an option trade I may look at opening in the near future.

This method is just one of the ways I use to find stocks for potential option trades. The first part of this post will show the list of stocks which traded higher on above average volume. The second part of this post requires the knowledge of stock options. To learn more about the option strategies outlined in this post, risks, pricing, calculations, other strategies, and options in general, click heres..

The table below shows the company, ticker, per share % increase, and volume increase (% increased compared to 50 day average). For your convenience I have ranked the stocks in order from greatest to least volume % change.

One stock from the list above which really caught my attention during trade Wednesday is Rosetta Resources Inc. (ROSE). All of the listed February call contracts seemed to be getting some heavy action Wednesday with the February 22.50 strike (highest contract available) trading almost 1000% of the open interest (179 contracts traded on open interest of 18). However before we get into the chart details, I will give a company profile from Google (GOOG) Finance below.

Rosetta Resources Inc. together with its subsidiaries (Rosetta) is an independent oil and gas company engaged in the acquisition, exploration, development and production of oil and gas properties in North America. The Company’s operations are concentrated in the areas of the Sacramento Basin of California, the Rockies, and South Texas. In addition, Rosetta has non-core positions in the State Waters of Texas and the Gulf of Mexico. During the year ended December 31, 2008, the Company drilled 184 gross and 152 net wells, with a success rate of 89%. In 2008, the Company had 398.2 billion of cubic feet equivalents (Bcfe) of proved oil and natural gas reserves, including 376.5 billion cubic feet (Bcf) of natural gas and 3,603 million barrels (MBbls) of oil and condensate.

By glancing at the chart I believe this stock is a bit overextended to the upside so I would like to get into this on weakness. Shares of ROSE made a new 52 week high Wednesday and closed just 11 cents below it, a rather bullish sign. I am considering opening the following option trade on ROSE below, but I'd like to see it test minor support levels near 20 on lighter volume first.

Click chart to enlarge
ROSE Option Trade: As stated earlier I will be monitoring the chart to see if the stock can pull back on lighter volume and hold the 20 level. If it can, I would look to open Diagonal Call Spreads. Two major reasons I chose to structure this trade with this stock are: 1) I expect oil and gas to tick significantly higher by spring 2010, and 2) with volatility near 20 month lows I believe it is a great time to be buying some longer dated call contracts.

To begin this trade I would first purchase April 20 strike call options. This would give me the rights to this stock at 20 per share for just over three months, and being a small cap stock I believe it will outperform larger cap oil and gas stocks, if commodities really start to heat up by early spring. Using current data these calls are roughly $270 per option contract. I would then look to write out shorter dated higher strike calls against them to lower my cost basis. Looking ahead to February options, I could fetch $100 per contract for the 22.50 strike. This would lower my cost basis by 37%, however it would limit my return to 47% if assigned at February expiration. This would be great, but if ROSE moves lower or sideways until February options expiration and closes below 22.50 per share on expiration, I would have the underlying contracts to write again for the March expiration lowering my cost basis even more. I will continue to write shorter dated and higher strike call options against the April 20 calls until April options expiration, I get assigned, or I cannot receive premiums (in the case that the stock sells off significantly). The data used is for example purpose and will not be accurate if shares of ROSE reach my ideal entry point. If shares fall to my entry point near 20 per share, premiums for all call contracts will reflect it and become cheaper.

Profit & Loss: The maximum loss per spread using current data is $170, even if the stock trades to zero. If the stock continues higher and come February options expiration shares of ROSE are at or above 22.50 per share, this strategy will return $80 per option spread (47%). It is also important to note that the break even point for this strategy would be shares of ROSE at 21.70 on February options expiration, anything less would result in an unrealized loss for the April contracts and anything more would result in an unrealized gain for the April contracts.

This is a bullish strategy and should not be considered if you think the stock will sell off in the near future. However if you feel the stock could move higher in the near future, this strategy could yield a nice gain. To get a better understanding of stock options and different option strategies please check out my Simplified Stock Option Trading E-Books.

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

The reason option volumes have surged in the last five years is because they are a great way to hedge your portfolio as well as create income off of your shares (see chart here). Keep in mind when using this strategy it is essential that broker commissions are low enough to profit from the position.

Disclosure: No Positions