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Wednesday, August 29, 2012 - 15:00
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Wednesday, August 29, 2012 - 15:35
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Wednesday, August 29, 2012 - 15:00

This Trade Could Gain 614% by December

Wednesday, August 29, 2012 - 3:00pm

It's rare to see an extremely clear chart pattern develop. Usually, there are multiple interpretations of price action, so traders often pick the one that fits their bias. That is a recipe for trading disasters in many cases, as the bias wins out over the weight of the evidence. Clear patterns make it difficult to introduce a bias into the analysis and that increases a trader's chances of success.

We have clear patterns forming in major stock market indexes, and the patterns are uniformly bullish. My favorite chart right now is the chart of PowerShares QQQ Trust (NASDAQ: QQQ), which shows a cup-and-handle pattern forming.

The cup-and-handle pattern was popularized by William O'Neil and Investor's Business Daily in the 1990s. It was the favorite pattern of momentum traders who used O'Neil's CAN SLIM trading method. It's a simple pattern that generally serves as a consolidation during a longer up trend. Despite a lot of doubters, QQQ has been in an uptrend for more than three years -- up about 175% from its 2008 bottom.

To qualify as a cup-and-handle pattern, the base should form through at least seven weeks, with most bases taking three to six months to fully form. QQQ has formed its base within 19 weeks, or about five months. The 12% decline from the top may not be deep enough for pattern purists who look for a drop of at least 15%. O'Neil recommended calling shallow consolidations a flat base. No matter what you choose to call them, both patterns have the same measuring implications.

The depth of the pattern, $8 in this case, can be added to the top of the pattern to identify the price target. From the recent price, QQQ offers a target of $76 and a potential gain of about 12%.

More important than the potential gain is the fact that this is a leading market index that offers valuable market insight. If QQQ is rising, then it's a bullish sign and traders should be more aggressive.

Aggressive strategies, in my mind, usually include options. In deciding at which expiration month to look, I consider the presidential election in November, which could have a big effect on stocks. Options with an expiration date in November are likely to participate in any election related moves. A number of calls are available with November expirations, but the $74 call option offers the biggest potential gain if QQQ reached the $76 target price. November $74 calls are trading at about 28 cents. If QQQ reached $76, then the call will have an intrinsic value of $2 and deliver a gain of 614%. Options with different strike prices offer lower percentage gains, assuming that the trade is closed at the target price.

Some traders might be wondering how such a big gain is possible. One of the most important factors in options pricing is volatility, which has been lower than average this past month. Because volatility is down, options are priced at bargain levels.

Another reason call options are selling at low prices is because more traders are looking for a stock market decline. About 27% of advisers are bearish and an additional 30% are looking for a correction, or a drop of at least 10% in price, according to an Investors Intelligence weekly survey of investment advisors. Almost 60% of advisors expect a market drop, even as stocks are going up week after week.

Action to Take -- > Bearishness is probably due to a slowing global economy, the crisis in Europe, the uncertainty of the election and many other potential negative news stories. I think these stories are providing the proverbial "wall of worry" for stocks to climb, so trading options on QQQ is a high-reward way to profit from that climb. It doesn't pay to be a bear in a bull market. Low-cost options make it possible to profit with a small investment. As such, I recommend the following trade setup: Buy November $74 QQQ call options at 50 cents or less, don't use a stop and set the price target at $2.

This article originally appeared on TradingAuthority.com:
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Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.