Schaeffer's Tool Box: Are Massey Energy Co. Calls the Place to Be?

              

This column is designed to introduce you to some of the valuable trading tools available on the SchaeffersResearch.com Web site. Today, we're going to use the Schaeffer's stock screener to look for bullish trading ideas by sifting through stocks with high Schaeffer's put/call open interest ratios (SOIR). For more on why monitoring near-term options activity can help guide your trading, please click here.

One of the easiest ways to find a potential bullish trade using the Schaeffer's stock screener is via the "Stocks with a high put/call ratio" filter option. By selecting this option, the filter will return only those securities with strong price action and an unusually high degree of put open interest. With the basics out of the way, there are a few more settings to tweak. Below are my personal favorites:

• Stocks with a high put/call ratio
• A minimum stock price of $10 per share
• Minimum put & call open interest of 10,000 contracts
• Minimum average daily stock volume of 100,000
• Trading above its 20-day moving average
• Stocks near an annual high
• Total analyst rankings greater than 10

For a more in-depth rundown of the Schaeffer's stock screener, you might want to start by reading this primer.

Stock Selection Via Sentiment

After sorting the results in descending order according to their Schaeffer's put/call open interest ratios (SOIR), we arrive at several interesting prospects. Patriot Coal Corp. (PCX: sentiment, chart, options) rises to the top of today's results due to the fact that the stock has outperformed the S&P 500 Index by more than 34% on a relative-strength basis during the past 60 trading days. However, since I covered PCX in a recent edition of the Casual Contrarian, we will focus on our No. 2 filter result, Massey Energy Co. (MEE: sentiment, chart, options).

Having bested the SPX by 26% on a relative-strength basis during the prior 60 trading days, MEE is no slouch from a technical perspective. The shares have also drawn a wealth of pessimism, with the stock's SOIR of 1.61 indicating that puts easily outnumber calls among near-term options. What's more, options traders have only been more negative toward MEE 11% of the time during the past year, as the security's SOIR ranks in the 89th percentile of its annual range. An unwinding of this negativity as MEE treks higher could provide a tailwind for the shares.

Additional support could come from the short-selling community. Specifically, some 9.7% of MEE's float has been sold short. If these bears become spooked by a continued run higher in the equity, we could see a short-covering rally provide extra lift for the security.

There is a potential risk in MEE's sentiment backdrop, and it comes from the brokerage bunch. Currently, 10 of the 15 analysts following MEE rate the shares a "buy" or better, compared to five "holds." As such, downgrades could be a concern for the energy company, especially if Wall Street analysts grow more nervous in regard to the economic recovery. However, with the shares apparently in a solid uptrend, the risk of downgrades should be limited.

Getting Technical

While all of today's filter results are pre-screened to be outperformers, not all uptrends are created equal. As such, it is important to look at your potential trading ideas a bit more closely from a technical perspective. If you have followed the energy sector at all this year, you have probably considered adding Massey Energy Co. (MEE: sentiment, chart, options) to your portfolio due to its technical merits alone. Since the start of 2009, shares of the coal miner have spiked more than 186%, bringing the stock's gains for the past 52 weeks to more than 234%. By comparison, the S&P 500 Index (SPX) has added a mere 37% since November 2008.

Drilling down on MEE, the stock has enjoyed the support of its 10-week and 20-week moving averages since April 2009. The shares are also poised to close above both their 10-month and 20-month moving averages for the first time since August 2008. The latter of these long-term trendlines was located in the 34 region, an area that had provided stiff technical resistance for MEE since October 2008. This area should now provide key technical support in the event of any weakness in the shares.

There are two potential caveats to entering a long position on MEE. First, the shares have outrun support at their 10-week and 20-week moving averages. Today's pullback is correcting part of the problem, but the stock could be vulnerable to additional consolidation and weakness over the short term. The second caveat is that the 42 level is home to a 38.2% Fibonacci retracement of the stock's July 2008 high and its March 2009 low, which could create a significant speed bump to the security's uptrend. Above 42, the next potential area of resistance appears to be the 46 level, which capped MEE in September 2008 and provided a floor for the shares in April 2008.

Stock Selection

So, we've run a filter looking for a bullish trading idea, discovered that MEE has plenty of potential sideline money in the form of negative investor sentiment, especially from options traders. We have also seen that the stock has room to run from a technical perspective.

What's next? If you aren't satisfied with MEE's prospects, you can repeat the process again, starting with your filer results. But what if you want to move forward with a bullish MEE trade? Well, if you are a stock trader, you would simply set your stop-loss and target at comfortable levels, and purchase the shares. Assuming you are comfortable with a potential loss of about 10%, a stop-loss on a trade below the 34 level could be a good starting point, as it means that MEE will have dropped back below former resistance at its 20-month moving average. Setting the target depends on whether you expect the shares to be stopped at the 42 level, or continue on to the 46 level (as mentioned above).

Option Selection

For options traders, the same reasoning applies to your expectations and risk tolerance. The front-month November options would require the least amount of capital, but they also expire at the end of the week. You would want to avoid this month unless you had reason to believe that MEE will rally sharply within roughly the next 48 hours. Given the data above, a less aggressive approach would be to trade December or January 2010 options. Choosing an option in January will incur additional costs due to the added time premium, but it will give you more time for the trade to play out.

Let's say that with MEE trading between $37 and $38 per share today, you choose to enter the in-the-money January 37 call. The option is currently trading with an ask price of $3.50, meaning that one contract would run you about $350, sans brokerage fees. In order for this trade to reach breakeven (i.e., in order for you to make your money back), MEE would need to rally to $40.50 per share at expiration.

Assuming that MEE breaks out above potential resistance at the 42 level and rallies to $46 per share (the next potential layer of technical resistance), then this trade could prove quite lucrative. In the event that MEE jumps to the 46 level by January expiration, the January 37 call would be worth $9, netting you a gain of about 157% on the trade, compared to the stock trader's gain of only 22%.

Hedging Your Bets

Let's say that the potential for technical resistance in the 42 level has you worried. You are still bullish on MEE, but you don't see the shares rallying past the 42 level by the time your January option expires. In this case, you can hedge your bet (so to speak) by converting your long call position into a vertical call spread. Keying off expectations that the shares will not break out above $42 per share, you can sell the January 42 call, currently bid at $1.50, to lower the overall breakeven and cost of the position.

Doing so lowers the total cost of the trade to just $2.00 -- $3.50 - $1.50 = $2.00 -- or $200 per contract. Furthermore, you only need MEE to rally to $39 per share in order to reach breakeven. In the event that MEE rallies to $42 per share by January expiration, the sold 42 call would expire worthless, while the 37 call would be worth $5, netting you a gain of about 150% on the trade.

Remember, your risk tolerance may be different from my own, and I encourage you to expand on the research I've done here to arrive at your own conclusions. And always remember to set your stop-losses and targets before entering a trade.