Chip stocks are rallying, and one trader sees a bigger breakout

Chip stocks have gone from hot, to not, to hot again. TradingAnalysis.com founder Todd Gordon says the group is on the verge of a major breakout.

"From a technical point of view, the [chips are] just in consolidation, waiting for the next leg up," he said Thursday on CNBC's "Trading Nation."

On a chart of the SMH, the ETF that tracks chip stocks, Gordon notes the formation of an Elliott Wave triangle. This pattern of repetitive trading normally signals that a stock is about to move in the direction of trading prior to an Elliott Wave consolidation, Gordon said.

As a result, Gordon thinks that SMH will break out and rally higher, as chip stocks had seen a big rally that lasted from April 2017 until early February.

Gordon also points out that some of the biggest holdings in SMH, including Taiwan Semiconductor, Intel and Nvidia, look strong, and that's a bullish signal.

To play for a breakout, Gordon likes a call butterfly spread. In this strategy, Gordon is going to buy the October monthly 105-strike call, sell two of the October monthly 110-strike calls and then buy the October monthly 115-strike call. Altogether, the trade costs Gordon $1.33 total, or $133 for the spread.

In this particular trade, Gordon is targeting that middle strike of $110 for the SMH, which closed above $105 on Thursday.

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Trading Nation is a multimedia financial news program that shows investors and traders how to use the news of the day to their advantage. This is where experts from across the financial world – including macro strategists, technical analysts, stock-pickers, and traders who specialize in options, currencies, and fixed income – come together to find the best ways to capitalize on recent developments in the market. Trading Nation: Where headlines become opportunities.

Michael Santoli

Michael Santoli joined CNBC in October 2015 as a Senior Markets Commentator, based at the network's Global Headquarters in Englewood Cliffs, N.J.  Santoli brings his extensive markets expertise to CNBC's Business Day programming, with a regular appearance on CNBC's “Closing Bell (M-F, 3PM-5PM ET).   In addition, he contributes to CNBCand CNBC PRO, writing regular articles and creating original digital videos.

Previously, Santoli was a Senior Columnist at Yahoo Finance, where he wrote analysis and commentary on the stock market, corporate news and the economy. He also appeared on Yahoo Finance video programs, where he offered insights on the most important business stories of the day, and was a regular contributor to CNBC and other networks.

Follow Michael Santoli on Twitter @michaelsantoli

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