Even the hottest stocks have to take a breather from time to time.

As a trader, it’s your job to be able to identify when those rest periods have come to an end, setting the stage for the prevailing bull trend to resume.

More than just buying and selling stocks, options and futures, trading is a craft.

Like any craftsman, you have to become knowledgeable in the tools of your profession in order to be successful.

When I brought Moderna, Inc., (MRNA) to the attention of my members earlier this past week, it’s because I saw several market indicators come together to suggest that this stock may have been ready to start outperforming an otherwise volatile broader market.

Sure, price action was an important part of this, but there’s so much more that you can do to determine when the best odds of success are at hand, and today I am going to walk you through some of the procedures.

The best traders are always focused on setups that offer a strong potential for gains vs. the amount of money they are risking. 

In the industry, this is called the risk/reward ratio.

Now, if you’re new to trading, it may seem a bit difficult to fully understand what is required to be able to say that a stock has a favorable risk/reward setup.

Trust me when I tell you that knowing how to identify these setups doesn’t have to be overly complicated.

In fact, if you were to ask any number of professional traders what they feel is among the most important advice when building a trading system, I’m confident the majority would say, “simplicity is best.”

When it comes to simplicity, one of the best ways to find a favorable risk setup is to spot stocks that have either fallen to major areas of price support (for bullish ideas) or have risen to major areas of price resistance (for bearish trades) prior to placing a trade.

The reward portion of the equation then boils down to a combination of having a strong fundamental narrative (i.e., the fundamental reason) and technical price potential.

Let’s bring this all together with my MRNA trade.

Let’s start with the straight forward technicals that helped me identify that MRNA had found major price support earlier this past week.

On Figure 1 below, you will see that I’ve highlighted the $240, which was the July breakout area and the area where MRNA found support following the earnings-induced November price collapse.

Figure 1

Then, as recently as December 10th, MRNA shares formed what is known as a “bullish belthold” candle pattern (green arrow), which occurs after a stock’s price opens at a sharply lower low, then immediately reverses sharply higher to close near the highs of the day.

That was an indication that the market recognized the importance of this support, setting the stage for a sentiment shift from bearish to bullish. 

Then, the push back above 200-DMA confirmed that the sentiment shift is indeed occurring.

Now that I identified my downside risk (i.e., the area of support that I would use to stop out of a bullish trade), I had to identify my target zone.

As Figure 2 shows, that target zone ranges from $307 all the way up to the $370 area.

Figure 2

With the risk/reward picture determined to be favorable, I then used the following narrative as a reason to believe MRNA could outperform in what has been a weak broad market environment of late.

Specifically, in this new Covid world, when markets get a little nervous as they have been recently, biotech companies, especially those with products that have been used on a mass scale to treat Covid cases, like MRNA, tend to attract buying interest from investors seeking safety.

In addition, the fact that MRNA does not trade like the S&P 500, which has been very volatile in recent weeks, was also a deciding factor in my wanting to play MRNA from the long side.

How did I know that the relationship between MRNA and the S&P 500 has been inverse of late?

It’s simple. Correlation.

What is Correlation?

In the investing world, correlation, a statistical term, measures the degree to which two or more instruments (i.e., stocks, ETFs, futures contracts, etc.) move in relation to one another.

Correlation is presented on a scale of 1.0 to -1.0, where a correlation of 1.0 means that the instruments being compared move in perfect relation to one another, a correlation of -1.0 means that the instruments move in a perfect inverse relationship, and a correlation of 0.0 means that there is no relationship at all.

Correlation is a tool many traders and money managers use to diversify their portfolios, especially when there may be an anticipation of increased volatility in certain areas of the market.

As Figure 3 uncovers, at a correlation of -0.65 over the past 3 months (1 quarter), these stocks have traded with a fairly strong negative relationship to each other.

Figure 3

One thing to remember about correlations is that they are cyclical, meaning that they always change over time.

In other words, at some point, this negative relationship will change and both MRNA and the S&P 500’s chart will look very similar.

For now, though, I’m using this lack of correlation to my advantage as I take advantage of the trade thesis I laid out earlier.

How am I managing this trade?

Now, I originally alerted members to this bullish setup earlier in the week by buying the Dec 31 270 Calls for 20.00. 

Here is a shot of the original trade window shortly after entry:

By Friday’s close, those calls had appreciated to a value of around 31.00, so they are becoming increasingly profitable.

At that point, I could have sold some or all of this position to lock in a profit, or I could have held these calls and sell out of the money (OTM) calls against the position to protect the position against a potential increase in volatility. 

So, on Friday I decided on the latter choice and sold the 300 calls to create a “bull call spread” to collect $12 dollars of premium and lower my breakeven cost on the trade.

To YOUR Success!