Schaeffer's Tool Box: Trading Expectations with Intuitive Surgical Inc.

              

Whether you are trading stocks or options, the reasoning behind any position in your portfolio boils down to one thing: expectations. When you buy a stock or call option, you expect the shares to rise. When you sell short a stock or buy a put option, you expect the shares to fall. Even more complex option trades such as butterflies and short straddles also revolve around expectations for the underlying security.

Along these lines, the Schaeffer's stock screener is a valuable tool designed to help you find stocks that meet your expectations. What's more, the screener is fine-tuned with a contrarian methodology in mind. This means that the filter is designed to help you locate stocks that are trending higher amid a wealth of investor skepticism, as well as those falling despite a heavy degree of investor optimism.

Let's say that you are looking for a bullish trade to take advantage of the market's recent upside bias. From a contrarian perspective, you would want a stock that has strong price action, but a heavy degree of negative sentiment from the investing public. The idea behind this methodology is that these bearish investors will eventually need to buy back their positions due to the security's continued advance, thus creating the potential for a sharp move higher in the stock.

One of the best ways to find potentially bullish trading ideas on SchaeffersResearch.com is via the stock screener's "Stocks showing heavy all-around skepticism" filter option. By selecting this option, the filter will return only those securities with strong price action, unusually high levels of short interest, elevated put open interest, and excessively negative analyst ratings.

For a more in-depth rundown of how to use the Schaeffer's stock screener, you might want to start by reading this primer. Listed below are the settings used for today's search for a potentially bullish trading idea:

• Heavy all-around investor skepticism
• 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 their 20-day moving average
• Total analyst rankings greater than 10

Stock Selection Via Sentiment

After sorting the results in descending order, according to their 60-day relative strength versus the S&P 500 Index (SPX), we arrive at several interesting prospects. Con-way Inc. (CNW: sentiment, chart, options) rises to the top of today's results due to the fact that the stock has bested the SPX by more than 51% on a relative-strength basis. However, I covered CNW earlier today, so let's take this opportunity to delve a bit deeper into the filter results.

Scanning the table above, Intuitive Surgical Inc. (ISRG: sentiment, chart, options) arrives at a close second pick to CNW, having outperformed the SPX by nearly 47% on a relative-strength basis. Furthermore, ISRG has been targeted by negativity across the board. Specifically, the stock's Schaeffer's put/call open interest ratio (SOIR) of 1.08 ranks above all but 10% of such readings taken during the past year. The SOIR compares put and call open interest for options with less than three months until expiration, and is a good measure of short-term expectations from speculative investors. Elsewhere, a hefty 19% of the stock's float is sold short, providing potential fuel for a short-covering rally, while nine of the 12 analysts following ISRG rate the shares a "hold," leaving room for potential upgrades.

Without getting too bogged down in the details, the key takeaway from this sentiment backdrop is that investors are not looking for ISRG to extend its strong price action, creating the potential for an upset. If the shares continue to rally, then put open interest could unwind, short sellers could begin buying back their positions, and/or brokerage firms could upgrade the shares. Since we entered into this filter expecting to find a bullish trading idea, these drivers make for compelling arguments in favor of ISRG's upside potential.

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. Zeroing in on ISRG's price action reveals that, while there is some potential for short-term weakness, the stock could be a good longer-term play. On a year-to-date basis, the equity has rallied more than 24%, putting the SPX's gain of about 1% to shame. What's more, since bottoming near 7.50 in mid-March, ISRG has surged more than 85%.

Helping the equity maintain its uptrend is its 10-week moving average, which ISRG has not closed a week below since early April. Furthermore, the shares have recently toppled former resistance in the 150 area, a region that market support for the security in October 2008.

There are a few detractors in this technical backdrop, however. First, ISRG was recently rejected by overhead resistance in the 165-170 area. This region has held the shares in check since early May, and could be a sticking point for the equity during the short term. Second, ISRG's 50-week moving average has descended into the 170 area. The stock's last rejection at this trendline prompted a considerable plunge in the shares. That said, if ISRG can move convincingly above the 170 level (and its 50-week trendline), a rally to the psychologically important 200 level could be in order, potentially netting the shares a gain of more than 25% from yesterday's close at $158.22.

Trading Expectations

So, we've run a filter looking for a bullish trading idea, discovered that ISRG has plenty of potential sideline money, and examined the stock's technical backdrop. What's next? If you aren't satisfied with ISRG's prospects, you can repeat the process again, starting with your filter results -- IntercontinentalExchange (ICE) and Freeport-McMoRan Copper & Gold (FCX) look especially nice right at the moment. But what if you want to move forward with a bullish ISRG 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 5%, a stop-loss on a trade below the 150 level could be a good starting point, as it means that ISRG will have dropped convincingly below support at its 10-week moving average. Setting the target depends on whether you expect the shares to be stopped at the 170 level, or continue on to the 200 level.

Option Selection

For options traders, the same reasoning applies regarding your expectations and risk tolerance. With June options expiring at the end of the week, traders might want to consider buying more time to allow this position to play out, especially with the potential for short-term resistance in the 165-170 area. Given the data above, a more reasonable approach would be the October series of options. Choosing an option in this month will incur additional costs due to the added time premium, but it will give you more time for the trade to play out according to your expectations.

Let's say that with ISRG hovering near $158 per share in today's trading, you choose to enter the in-the-money July 155 call. The option is currently trading with an ask price of $23.30, meaning that one contract would run you about $2,330 sans brokerage fees. In order for this trade to reach breakeven (i.e., in order for you to make your money back), ISRG would need to rally to the 178.83 level at expiration. It is important to remember that there is the potential for technical resistance at the 170 level, which could impact returns on the position. If you don't believe that the shares will overcome this hurdle, then you might want to reconsider entering this trade or select a different option.

However, if you expect ISRG to break out above the 170 level and rally up to the 200 level (the next potential layer of technical resistance), then this trade could prove quite lucrative. If the trade does play out as expected, and ISRG jumps to the 200 level, the July 155 call would be worth $45.00 at expiration, netting you a gain of about 93% on the trade at expiration, compared to the stock trader's gain of only 29%.

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.