The Perfect System, Part I

It has been over a year since I started trading the PCCRC (or Calendar Straddle), and I have had excellent success with it, regardless of market conditions. So I think it is only fair that I teach what I know and let others judge for themselves. First, the suggested reading: I was first introduced to the Put Call Calendar Ratio Combination from the book "Options as a Strategic Investment" by Lawrence G. McMillan. My edition is the 4th edition, and the PCCRC is described under page 345. I suggest that you read that, as well as the "Calendar Straddle" on page 348. McMillan states that these strategies are designed to limit risk while allowing for a large potential profits if correct market conditions develop. I would modify this to say that you can certainly limit risk and allow for large potential profits, but it is up to you to identify the stocks that have develop the right market conditions. I intend to show you several of those appropriate market conditions. Further, I would like to show you from the basics to the implementation of this strategy, so please be patient, and DO try what I do, but ONLY on paper, until you feel comfortable with the many details involved in the PCCRC.

The first item in our agenda is "The Greeks". This is important because the PCCRC can take advantage of Delta, Theta and Vega. Hence, we have to do some work on understanding them. I thought of an analogy about the PCCRC shortly after I begun to trade it: The PCCRC is like a carriage pulled by three horses. When one tires, the others pick up the slack. However, it can also be said that when they all fail, you may lose money. We don't want to stay in trades that are not working. Fortunately, there are very distinct decision making points in which to get out if the trade is not working. You'd be surprised, however, of how often the opposite is true, and you get out with some good profit.

Delta

Delta indicates the risk or reward in an option with a 1-point move in the price of the underlying. Your position should be Delta positive if you expect the stock to go UP and Delta negative if you expect the stock to go DOWN. If you buy a call, your Delta is positive. When you buy a put, your Delta is negative. It follows then, that if you want to be "hedged" perfectly against any Delta move, you may want to enter a STRADDLE. With a straddle you take full advantage of Delta (any strong move in either direction), but you are severely affected by the other Greeks (see below). Only if you expect a strong move in either direction would it make any sense to enter a straddle.

Theta

Because all options have expirations, there is a time component to its value that is separate from its intrinsic value. An option that is AT-the-money (strike price equals the current market price) has no intrinsic value, yet you hardly ever see a worthless ATM option, unless it is at expiration. If you look at an ATM option 1 year before expiration, it has plenty of value. That is a time premium. Clearly, the time value decays as expiration approaches, and this is precisely what is measured by Theta: the time decay of your option or your position. The closer you are to expiration, the faster the time decay. Option traders take advantage of this time decay when they trade Calendar spreads. One could SELL an ATM option that are due to expire in less than 30 days, and buy the options at the same strike price that are due to expire 60 or more days later. Again, a Calendar spread you take full advantage of the Theta decay, but you are at the mercy of any severe change the stock might take (Delta change). I'd like to say that trading calendar spreads are like watching grass grow while worrying about your dog peeing on it. It is just not my style. However, I DO see clearly the logic of selling front month options while buying options that expire farther out in time.

Vega

Options are very highly affected by Implied Volatility, which I'd like to think about as the demand for options. You may say that uncertainty and speculation fuel Vega, as traders and fund managers alike seek to hedge their positions in advanced of news. Everything else being equal, one could enter a straddle about a month or more in advance of the news and see their options appreciate by virtue of their implied volatility as the news event approaches, only to see those prices collapse after the news are out. Theta then takes over to reduce the price of the options further and cause you a loss, unless the news does cause a strong move in either direction. Entering a straddle one month before earnings seems like a sound strategy but if the strong move (Delta) does not materialize, you may end up with a loss. If, on the other hand, Vega spikes and you get out before earnings, you may end with Vega profits but you may miss the opportunity that a strong move represents. For me, this way to trade is too stressful because there is no real way of knowing what would occur before earnings.

As a long-time Elliottician (since 1995), I have come to believe that any stock, given sufficient time, will jump strongly in either direction. I have found that such a jump occurs more frequently in stocks that we will name “momentum stocks”. However, it is nearly impossible to regularly predict that jump with pinpoint accuracy in a way that would allow us to trade options with consistent success. Unless you are willing to trade with stop loss and trailing stops (see the QST method) to limit your losses, there is no easy way to use options to hedge your positions sufficiently to avoid major losses if your predictions are wrong. In my experience, even after more than a decade of Technical Analysis and Elliott wave experience, even the strongest of candidates turns out to be a loser. There is simply no way to know the future (I am open to suggestions, hehehe).

In conclusion, the straddle is the best way to take advantage of Delta and Vega increases, but we are at the mercy of the options time decay. If we can find a way to deal with Theta decay to protect our straddle against the passage of time, we could extend the life of our trade to assure that a strong move will occur in time for our profits to appear.

With a straddle we could choose momentum stocks at a point when IV is low, understanding that it is likely to increase in the weeks ahead, we may benefit from a Vega spike along the way. However, we want to be able to increase the life of our trade sufficiently so that we give plenty of time for the Vega spike to occur.

In the next few articles I will show you the basics of the Calendar Straddle and the PCCRC. Meanwhile, please do ask questions and do some reading of your own.