Introduction

After an 8-week long rally leading into the year-end, the New Year has failed the so-called First Five Days indicator test. We have the highly significant inflation report scheduled for Thursday morning and earnings from major financial institutions on Friday, both of which will set the tone for January. If you subscribe to the idea of seasonality, January typically sees robust market performance, while February often brings about a correction. However, given the extraordinary surge in 2023, I anticipate an early correction this year. The consumer discretionary and growth/tech sectors are typically the first ones to take a beating when markets start pulling back. With this view in mind, I am looking to put on a bearish options trade on Domino’s Pizza (DPZ), which belongs to the sector.

Technical Analysis of DPZ

I have shown a 3-year weekly chart of DPZ above. Note that DPZ has been range-bound since 2022 and faces significant resistance around the $415 area. After testing this multi-year resistance again in December, DPZ seems to be getting rejected again and is clearly showing downward price momentum.

Trade Setup: DPZ $410-$415 Bear Call Spread

With a bearish directional bias in place, the trade structure I have chosen is called a bear call spread, also known as a call credit spread. To construct my trade, I will want to sell a $410 call option and buy a $415 call option as a single unit. With DPZ already under pressure and trading around 402, my thesis is that DPZ will not be able to go above $410 by my expiration date.

When selling credit spreads, you bring in a premium when you open the trade. If the trade goes in your direction, you get to keep that premium. This trade brings in a $145 premium with a 66% chance of success (as calculated by options probabilities).

Here is my exact trade setup:

• Sell $410 call, Jan. 19 expiry
• Buy $415 call, Jan. 19 expiry
• Credit: $145

Risk Management

Credit spreads are high probability trades. This means that you can expect every 7 out of 10 trades to become winners. However, there is a catch. The winners will bring in small profits which will add up over time. But the losers will bring in larger losses. In theory, the 3 losers will cancel out 7 winners. One will need to have a risk management plan in place, so that the losers are cut at predefined levels before they become too big. By having an effective risk management plan, these trades can be very rewarding over time.

About the Author

Nishant Pant is the founder of Trading Extremes. He specializes in mean reversion trading and shares his insights on YouTube and Twitter (@TheMeanTrader).

DISCLOSURES

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