I have discussed that the PCRCC benefits from strong Delta and/or Vega profits, and when worse comes to worse, Theta compensates for any inactivity. In the end, you have little if any loss at all. It makes a lot of sense then to pick the high fliers because of their potential directional moves, but to avoid volatility crush, it is essential that we pick stocks that have low volatility.
Recently, with the current market decline, the selection of high fliers has been difficult for someone like me, who would like to have 6-10 of these trades going on at the same time. This is why I have been exploring another possibility: Stocks with high statistical volatility that may have reached a bottom, are trading with low implied volatility, but that may rally or have begun to rally.
Today, we had a post from optiontrader who suggested that I look into WLP as a possible candidate for a PCRCC. He identified using the Type II sell (5th Elliott wave). I do NOT recommend anyone to use AdvancedGet for any sort of Elliott wave analysis (I have the software, I have been doing Elliott wave analysis since 1995). Let us agree that WLP has high flier status.
WLP is well above the 20 dMA (red curve), the 50dMA (yellow curve) and 200dMA's (blue curve) here, and the oscillator indicates a bullish position, well above the strength line.
I select stocks by their performance over the last 90 days. I pick those that have the largest percentages, as long as other conditions are met. Let's take a look:
There are 21 candidates in this list, but not many of them fit all the necessary conditions that I'd like to have before entering the PCRCC trade.
WLP, as a matter of fact, is number 60 in the list of recent performers. I would go through the list above WLP for a good candidate. Remember, we want stocks that have moved strongly, not slowly UP.
Following the identification of a high flier I have one Litmus test that rules out many candidates. That is the IV/SV ratio. Note the settings I prefer: The numerator is 7-149 day IV, and the denominator is 6 day SV. I do NOT place this trades in stocks whose IV is exceeds the SV of the last 6 days (ratio >1). We want stocks that will tend to increase IV.
It is also very helpful that the IV is at lower end of its range. If the volatility is on the rise, after a period of bottoming, the trade has the best opportunity to generate profit soon.
PCRCC in Bottoming Stocks
After a strong decline in late 2004, BRCM has formed a double bottom and has rallied over the previous short-term high. More importantly, the stock price is above the 200dMA (blue line) and the 50dMA (orange line). The 50dMA may well cross over the 200dMA, giving a strong buy signal. Assuming that one is bullish, it does not mean that we should consider ourselves free from a collapse in the stock in this very erratic market. PCRCC, thus, may be used as hedge positions, without fear of an unexpected piece of news that may direct the stock to the 52 week lows. If that was to occur, it might well happen with high volatility, which usually results in good profits with this trade.
Before I am willing to enter this trade, I must see that the percent IV is below the percent SV (last 6 days). The ratio, thus, must be below 1.
You may use the Put/call ratio as an indicator of the bullish sentiment in the stock. This would imply that a piece of bad news would take traders by surprise with the resulting increase in volatility. Such increase in volatility would result in profits if the stock declines in the news.
In my experience, the best results with this trades occurs when a stock goes UP in price and in volatility. This is so because Delta and Vega would work together to generate profits. Rarely, does Volatility increase when a stock price is even or higher. On a sideways market, Theta is the most likely to generate profits. To the downside, you rely mostly on Vega.
BRCM's IV is well below 40, which is acceptable to me. In the 2 year IV chart you see that the IV is the lowest it has been in over 2 years. However, it seems to have bottomed.
I will enter this trade tomorrow and wait until it is executed at the desired price.
Please note that this post is not intended as investment advice. I am not a professional and do not claim to be a market pundit. I am only one more trader trying to share my experiences in the hope to get input from others like me. I will post more information in the days to come, and follow the progress of this trade.
Let us start with the entry. Today, May 18th, I entered the long portion of my PCRCC as a straddle. Notice that at the opening of trading for the day, the bid/ask for my trade was 6.8/7.1. I entered my limit order at the bid price, assuming that volatility will decrease slightly by the middle of the day, triggering the fill of my order. If the order is not filled, I have always tomorrow, or any other opportunity that may come up then.
Next, I am showing you the status of my trade. I hope that one of these prices (or both) will reduce sufficiently towards the middle of the day to have my trade filled:
By the end of the day, or maybe even tomorrow, I will enter the short portion of my trade, which I hope will be filled at one of the high volatility periods of the day: the amateur hour or the professional hour.
May 19, 2005
My trade did not fill yesterday, there was not much decline in volatility toward the middle of the day. I will try again today.
HK has alerted me to the possible use of a strangle, rather than a straddle in the long portion of the trade. The cash requirements for his proposed trade would have a $4,000 less. Here is the trade in Platinum:
OptionsXPress allows you to calculate the cash requirements for any trade using a tool called the "Trade Calculator". Here are the positions, if I was to take the ask for my buys and the bid for my sells. First my original trade:
Here is the trade that HK suggests:
This is a viable alternative. My objections are 1) A spike in volatility is most likely to occur in ATM options, thus, I could make my money faster using the straddle. Remember, I am interested on the monster move. I only use the shorts as a protection against Theta. HK's suggestion may be more profitable in sideways markets. I will test this approach in a couple of trades in which I profited from volatility spikes. 2) I DO dislike credit trades. This is a cost that is not immediately evident in my risk graph, and I tend to forget about that. BUT, if you are willing to live with that, then this is a viable alternative.
Last friday, I entered the BRCM trade with the suggested adjustments (buying OTM, long term puts and calls). Here is the resulting trade as of today.:
I intend to keep track of this trade with my readers. I did indeed enter the position and will report any modification I make, so there is no speculation about its validity. Here is the confirmation from OptionsXPress.
17 comments:
I got an e-mail for David Lim:
Hi Juan,
You stated in your article that you do not recommend anyone to use
AdvancedGet for Elliot wave analysis. Why is that? Is AdvancedGet not a
good tool for this type of analysis?
AdvancedGet counts are innadequate. For example, Double ZigZags are common series that are totally ignored by A-Get. But there are many others that are not part of the Repertoir of AGet.
For those of you really interested in the Elliott wave, begin by subscribing to this free newsletter.
http://www.elliottician.com/showpage.asp?p=21
Juan: If you could be filled on the 4 legs , would you ? Or do you prefer to leg in and sell calls on a runup and puts on a run down. The risk is that one side won't fill well if legging in. Is it more important in your experience to have the trade on or try to get better fills ?
Thanks
Excelent question.
Assume that the long straddle has been filled first. This is the expensive part of the trade, and you want to get a good price. If you get filled is because your price was met. The short portion is less important, and whatever price you get, is the icing on the cake. Now, remember that a strong move in either direction, even with an overnight piece of unexpected news, can only favor your trade, if the volatility increases too.
I have had good fills in the past by just sitting here in front of my computer with real time (60 min) charts and enter the put sale at an oversold condition (i.e. Stochastics oscillator). Then waiting for the oversold condition to sell the calls. Several trades have turnout great like that. Do the opposite if the 60 min chart shows an overbought condition.
You are probably thinking what a hassle! yes it is, and in the end you may save only a couple of hundred dollars. This is why I have been following a new approach, which OptionsXPress allows me to do: enter the trade as a short straddle, with equal number of contracts in the put and call side. This can be done as a single trade, it is cheaper, and I can put a limit price in my order.
Originally, I have been entering the trades with an unbalanced number of puts and calls in the short side in order to make the trade more Delta neutral. My experience lately has shown me that this is not so critical. To benefit from a sharp drop in price, we count on Vega, not Delta. IF the stock was to fall without much volatility, we would lose money whether we have equal number of short puts (compared to the number of calls). The important effect is that of Vega, not Delta, to the downside. This is why is so important to enter trades on stocks with low IV.
Hi Juan: Great answer. The long and short is we have time to leg in. As far as watching for $2-300 I day trade stocks so for me it is how I make money. I usually trade around my option positons to add $'s to the risk graph when I'm right. I put all stock trades in with the option trades on a position so I can see the total postion. I also call in complete 4 legged trades but once the straddle is on it is pretty easy with direct access to sell the strangle part. As further claification if the trade moves down without the short side call sold then you have not help pay for the call leg. You have time for the stock to rebound to short the call but I'm curious how you would handle that situation if the stock dropped but not enough to pay for the whole straddle and did not rebound ? I had no fill today at $6.8 maybe thur.
Thanks again.
I'd like to think of this trade as a long-term straddle. In theory, this would be a no losing trade, if only options would not decay. In the present trade, BRCM would have to move >$7 in either direction for us to make money, and it would have to do it before november. The shorts are there to let us stay in the trade until the volatility spike occurs of the stock moves in either direction.
So we enter our straddle at the high cost. Almost $24000 for the BRCM. The shorts should bring the total cost down to just above $19000. If the stock drops 5 points overnight, and I have not sold any shorts, It is not unlikely that my trade would be profitable then, if only by virtue of the jump in IV. At that point I would make one of 2 possible moves:
1. Close the Nov. $35 calls and sell 16 Jun $35 puts short term to take Vega profits. This trade would be equivalent to the PRC i have described in the Sarmiento System.
2. Sell 34 Jun $35 calls and 16 June $35 puts.
I probably would do the call selling right at the opening, assuming the stock will continue to trave down. I would sell the puts towards the end of the day, if the drop subsides.
Something like this only happens with bad news, and they are usually associated with increased volatility. If there is no big drop, or increase in implied volatility, then use the 60 min chart strategy.
My guess is that you'll settled for the short straddle approach with a good limit. There is no big rush to do the short portion, it is only there to limit the Theta decay, IMHO.
Thanks for the follow up.
Hi Juan,
A similar looking risk graph can be obtained by substituting the long straddle with a Nov 32.5P/37.5C strangle. This will result in a lower debit even after taking into consideration the margin requirements.
Is this be a viable alternative ?
HK, thanks very much for your contribution. This is exactly why I do this, the kinds of contributions I am getting are very useful for me. As I have said I am learning thanks to you all.
I have entered the a more elaborate response with charts at the end of the Blog above.
I will try my trade again today.
Juan, Many thanks for your response. I am just a novice in these type of trades. All your posts are really beneficial to me and I have learned a lot from it already.
Your examples are precise and straight to the point with clear illustrations. Keep up the good work.
Looking forward to receiving your pdf write-up soon.
Juan,
Can you comment on the IV/SV ratio some more? I understand that you must have low implied volatility on PCRCC trades, but I'm unclear as to the value of the 6 day SV ratio.
Thanks,
Ambience
In a seminar in January, Alex Jacobson told this to the audience:
The important volatility in a stock is today's volatility. Not 6 months volatility, not 6 days volatility, TODAY's volatility or actual volatility. This makes a lot of sense, since today's jump in price is a departure for the trading of the last few days. Whatever the price movement was days ago, means nothing to the volatility of today.
Platinum does not calculate today's volatility, but that is an easy one to calculate: It is the percentage change in the stock price (today) * 16% (this formula is an estimate, Jacobson suggested). Let's take the case of AAPL, that jumped $1.71 yesterday, after a week of minor movement. The IV/SV ratio (using 6 day SV) is about 0.86. If we calculate the 1 day SV, we have:
1.71/37.55*100=4.55*16=72.8% actual SV
Meanwhile, the IV in ATM options is about 40%.
Our IV/actual V ratio is really 40%/72.8%=0.55. This is lower than the IV/6day SV which is 0.86.
Nevertheless, using the 6 day SV ratio is good enough for me, since it does show that it is below 1 and it shows a chart that indicates the direction of the ratio. In the case of AAPL, the ratio chart is pointing down.
If you enter this trade with a high ratio, you are almost assured to loss money, as the volatility will have to decrease before it can increase.
I also look at the volatility of my longs vs. that of my shorts. I like to see the shorts to have the same or larger IV than the longs.
Juan,
Would you pls explain the reasoning behind the use of the 7-149 IV instead of the >90 IV in the IV/SV ratio.
As we are looking for low IV to buy the longer term options, would the >90 IV better reflect the implied volatility of the back month option (long legs) ?
Thanks.
HK
I use the 7-149 IV to get a cross section of the IV. But you can do that extra bit of homework. If you are selling front month the 7-30 d IV that IV could be high, couldn't it? The options you are buying should be relatively cheap, otherwise you'd have Vega playing against you, right?. I suggest that we look at some successful trades like the SNDK example and see how they compare. If you do, please report back.
http://stockoftheday.blogspot.com/2005/05/straddle-or-strangle-what-is-better.html
Using the SNDK example backdated to 3/18/05, I got the following ratios (IV/ 6days SV):
7-149IV, ratio is 3.04
>90IV, ratio is 3.21
Therefore, not much to conclude but to note it failed your litmus test (< 1) eventhough the IV is at 2 years low.
I guess it was luck for me in that case, as I obviously ignored the ratios. The IV ratio was high because the stock movement was miniscule then, while traders were probably already expecting news from the courts. The IV continued to increase strongly, making me good money. Perhaps cases like that would be the exception, rather than the rule, and we should really stay away from stocks with >1 IV/SV ratios. If I had stayed in the trade, my profits would have vanished, as the ratio began to decrease, judging by the current charts.
Perhaps the high IV/SV ratio was a function of the low SV, rather than the high IV (which was low, as you well point out, in the 2 year chart). In a triangular formation, the amplitud of the price change gets smaller and smaller, but eventually snaps in either direction, that is the principle behind the straddle. Something to think about.
An obvious question.
Can the straddle strategy be used successfully to trade PCRCC ?
As you know, I have tested this strategy in high fliers, so I should only comment with credibility on that. However, I see the PCRCC as a long-term straddle. I give myself time for the big move (or volatility spike) to occur between now and one month before expiration of the long portion of my trade.
As I explained in my blog about AAPL, that long-term trigger of volatility could be an earnings report. It follows that you would BUY options for the month of earnings, and short other months in between. That is similar to the Straddle strategy, only buy the straddle, no shorts here, about a month before earnings.
Similarly, if you see a stock forming a triangle, you could do a straddle (as long as the volatility is low). I suspect that you could do the PCRCC in stocks that have a long-term triangle formation (you can use Advanced Get's ADX search to look for stocks that may be forming triangles in the weekly charts. BUT make sure that the apex of the triangle will be hit BEFORE the expiration of your long options. This is worth testing!
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