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Trading Primer: AN EARNINGS TRADE FOR BIDU

BIDU appears to be sliding down the slippery slope of hope.  This once loved momo stock has fallen out of favor since itsnearly 200% gain.  BIDU reports earnings on Thursday and is expected to earn $.83 a share.  BIDU exceeded expectations he last four earnings releases, however, this has been on a very small margin.

Take a look at this chart:  http://tiny.cc/l2ekc

This chart shows the movement of price within the downtrend channel.  Each time it tags the upper boundary, price is rejected and eventually makes itsway back to the bottom of this channel.  This is a pattern; patterns repeat and thus are actionable events.  The trend change indicator came in the form of an evening star pattern which is a bearish reversal pattern that continues an uptrend with a long white body day followed by a gapped up small body day, then a down close with the close below the midpoint of the first day.

On the next chart I applied the SMA study so you can see the character change of the stock.  Prior to this point, the price consistently bounced off the 200sma and made for a good buy point.  With the rejection of price at the 150sma and price violating the 200sma,  BIDU became a confirmed short.  The rejection is shown in the form of the hanging man candle pattern.  http://tiny.cc/vxb88 

The final chart http://tiny.cc/x5kbj shows warning signs, confirmed reversal patterns and 2 of 3 possible outcomes for price.

I find that it is easier to make a decision by first eliminating the least likely possibilities.  In this case the choices are:  Price goes higher from here and makes a bullish W creating a higher low, price consolidates here and enters into a volatility squeeze or price breaks down and forms a bearish M creating another lower high.  As BIDU has catalyst I would eliminate consolidation.

Next, I view the options chain to see where the highest open interest lies.  For October week4 (the day before expiry) new call purchases clearly outweighed open interest for the strikes $110-$130.  Thats why you see a higher number in volume vs. open interest.  On the put side of things, the $110 and $120 levels saw new positions opening on Friday.  From this we know there is an expected range for BIDU between $110 & $130.  Now combine that with the historical price percentage move after earnings which is 10% and youve got yourself a compression trade candidate.

 For BIDU,  I like the 105/95 bull put spread for $.96 credit.  In taking this trade I am saying that I believe BIDU will be above $105 on Friday.  Please note that I will exit the trade early if BIDU announces and price responds favorably.  If price falls, I will buy the short option back and let the long option do itswork.  No matter what happens, volatility should suck out the very next morning and enable me to take a profit.  The process of volatility sucking out after a catalyst is known as a compression trade.  I will add here that I'm aware the risk/reward ratio is out of whack - risking $9 to make $1 - but for this particular type of trade that risk is outweighed by statistical probability.  I don't have to guess which way price will move, I've only got to beat the spread.

Suz



Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BIDU over the next 72 hours.

Additional disclosure: I am entering bull put spreads for BIDU as an earnings trade.