How to view the entire chart:
1. Try clicking on the name of the most recent article in the column on the right. This will remove the "Archives" list.
2. Try right click on the chart itself and open it on a separate window.
I am sorry that I cannot always make the chart small enough to fit neatly on the left column. I want you to be able to see the details I want to point out.
I Hope this helps,
Juan
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Before I continue with the details of the PCCRC, it may be a good time to show the basics of a risk graph. This is important because the risk graph is what tells you when and how to modify your PCCRC to take profits or reduce cost or at the very least, to exit with the lowest possible loss. First, when you buy shares in a stock you put the entire invested capital at risk, unless you place a stop-loss order as well. Although you may think that you are limiting your loss, nothing may protect you against a drop of 30% in the price of a stock following a preanouncement. This has already happened to me several times, and it was so devastating that I still remember the stocks that suffer such a loss while I had them in my portfolio: SCHL, INTC and AAPL. No stop loss can protect you against such a loss.
In the example below, I have entered an order to buy 100 shares of AAPL at $67.81 for a debit of $6781. My Max Risk equals the debit because there is the potential for the stock to go to "0". However, it is also theoretically possible that the stock may go to infinity, hence my Max Profit is "unlimited". Note that the Delta is equivalent to the number of shares: for every $1 the price of the stock moves UP, I will make $100. A positive Delta = 100 also means that I may lose $100 for every $1 that the stock price declines. If you short 100 shares of stock, your Deltas = -100.
To the left of the chart we have the stock price as it moves in time. To the right, we have the potential profit ($) as the stock price changes. Keep this in mind because the options risk graph illustrate the same potential gain(loss) with the movement of the stock price.
Options traders would tell you that it is a better deal to buy 1 long call of the underlying than it is to buy 100 shares because with options you limit your risk. In the chart below, I have bought 1 contract of the Oct06 $67.5 calls. This means that I may only lose $457, even if the stock declines 30% or more overnight. In a way, this would be equivalent to placing a stop loss in 100 shares of stock, if AAPL was to decline $4.75 from my current price. The only real protection that I have with the option call, compared to owning the stock, is in the case of a catastrophic loss overnight.
Although 1 long call is supposed to be equivalent to owning 100 shares of stock, I would not be making $100 for every $1 increase in the price of the stock. As you can see, the Delta is only 56.24, not 100. Other factors are at play here. For one thing, altough I bought the calls very close to the money there is a premium to be paid when the option is due to expire 57 days later. The chart shows me the status of my potential gains on the day of entry: this is the red curve along the profit field. As time progresses, this curve changes and it will look like the blue curve 38 days before expiration, like the green curve 19 days before expiration, and like the black angle at expiration. With this strategy, we will only make any money if the stock closes above the breakeven (grey line) at $72.25/share. Despite what Options' fans may tell you, this is not such a good deal because the price underlying stock would have to move strongly before you make any money. Add to that the time limit and your chances of making any money are very limited indeed.
What you sacrifice in time you gain in leverage. After all, if the stock price moves to $80/share you could be making close to $1000, eventhough you are only spending $475, less than 10% what it would cost you to buy 100 shares of stock. with the long call you could double your money, while only gaining less than 10% if you owned the stock. However, options traders hardly ever think about how much they are saving by 1 long call instead of 100 shares of stock. They want to be able to make as much as possible with the capital they have to work with. For example, you may have a $10K account to trade: When would you ever think of holdind 1 call on a $67.5 stock and a $32.5 stock? yet these 2 positions would be equivalent to holding 100 shares of each, respectively. So the comparison is not valid. If you are an options trader, you want to use the leverage the option trading affords you and enter reasonable positions that would make you money. So you must examine the risk and reward of each opportunity on its own merits, not in comparison a position with the same Delta with shares of the underlying stock.
The long stock has a synthetic options equivalent. By this, I mean that a combination of a long call and a short put is the "synthetic" equivalent of owning the stock. Owning the stock has in itself the risk of a short put, and the potential reward of a long call. Hence, a risk graph of this combination is equivalent to that of the long stock. Please compare the chart below with that of the first chart above. Note how the Maximum risk approaches that of the long stock: you may lose close to $6800, if the stock was to fall to $0. Note here that the Deltas for this position are 100, the same as owning 100 shares of stock. This ilustrates a very important point: Professional traders evaluate their positions not only by how much money they could make if the stock price goes their way. More importantly, they establish what their risk is in the trade. Further, they take every step possible to reduce the risk whenever possible, even at the expense of reducing their potential profits. While the position below mimics the long stock, and the debit is only $90, we have ignored the devastating effect that an overnight drop of 30% in the price of the stock may have in our $10K acccount.
In an ideal world, we would choose stocks that have the potential to move strongly and buy calls at just the right time, just before the move. However, after >11 years of Elliott wave experience I can tell you that all the technical analysis in the world may increase your odds of success, but they hardly ever guarantee success. Swing trading is one of the best approaches to trading options because you may choose stocks that reach support and are ready to reverse and go higher. Theoretically, options in these stocks are not in the minds of most traders, so their volatility may be low. Thus, you can enter a long call when they are the cheapest, hoping to make large profits as those options may easily double or tripple in value. The same may be said of a stock that hits resistance such as a double top or reach a down trending line. One may buy a put exactly at the time in which the demand is low. Note in the chart below how the long put is exactly the reverse of the long call, only the debit and the risk is much lower. This may be because AAPL had been rallying until recently. Buying puts if you were convinced that the swing was about to occur would have been a low risk trade. When I speak of low risk, I don't imply high probability of success. Far from it. A low risk trade means simply that I could potentially make a high return with a small amount of capital.
If the professional is interested in reducing risk as much as he is in generating a good profit while investing a low amount of capital, it may appear that the Straddle is the "perfect system". Since puts and calls are relatively inexpensive compared to owning stock, the Straddle provides the most hedged position. But there isn't such a thing as a free lunch in Wall Street. There is the small issue of the time value or premium in the price of an option. The chart below shows a combination of the long put and long call above. This is named a "Delta Neutral" position to convey our lack of concern over the direction the stock may take before expiration. However, look carefully at the grey lines across the chart: These are the "breakeven" lines. These lines most be crossed over if we are hoping to make any money in this trade. In the example of AAPL this represents a gain or $9 or a decline of $9. Not an easy thing for a stock to do, unless there is a catalyst or news item to show up during the life of the trade, or the next 57 days to be precise.
You may choose to place this trade at a time when the implied volatility is low, but at the same time you are aware that a news item may appear in the near future. Earnings dates are readily available for most stocks so you can easily locate candidates for straddles among the stocks that are near an earnings report. BUT beware, the closer you get to the earnings release date, the higher the price of the options will be because many traders may be thinking the same way as you do. The Implied Volatility (I.V.) is high when the traders are expecting a large move in the option's price. Following earnings, however, the expectation of a large move is quickly dissipated and the price of the option may quickly decline. Trading straddles this way is not exactly my favorite approach because if there is no strong movement after earnings I may lose a large portion of my money. Yet if one exits just before the news release, assuming that the rise in I.V. has reached a peak, may be premature if the strong move does materialize on the next day.
The worst case scenario for a Straddle trader is to let the position untouched until expiration. This is because time has a deleterious effect upon any long option, hence time has double that effect on a straddle. Remember I said there is no free lunch in Wall Street. Yet if we choose a momemtum stock, I can almost guarantee that there will be a strong move in either direction, given sufficient time. The perfect trade, it may appear, would be a straddle that could be stretched in time, so that we could profit from a strong move in the price of the stock, regardless of the direction. In my next article, I will begin to introduce you to the Calendar Straddle and its cousin the PCCRC.
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