The Perfect System, Part III

In the first article in this series, I concluded that 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.

The best way to deal with Theta decay for our intermediate to long-term options is to sell a number of short-term options with less than a month to expiry. A Call Ratio Calendar or Put Ratio Calendars may be used as bullish and bearish trades when we expect a strong move in either direction, but we are not confident about the time it will take for the stock to make the strong move we are expecting. I usually sell 1/2 as many contracts of the short-term options as the number of contracts I buy for the long term to complete the CRC or PRC.

My experience with CRC's and PRC's has been mixed because even with a solid forecasting system like the Elliott wave analysis or a triggering system like the volume and price spike alerts I have used in the past, there is no telling when the stock will reverse and go in precisely the opposite direction to what I expected. You may be in a trade like this for months, accumulate good profit, and then have your profits vanish overnight, in unpredictable ways. This is particularly true if one goes over the earnings day. Surprises are the norm in the stock market. So making a directional commitment over a period exceeding weeks or months, also called position trading, may be dangerous. We simply do not have the tools to help us see with clarity how would a stock behave in that period of time. I often say that it is easier to tell where would a stock be over the long term or the very short term, than it is to forecast where would a stock be in 3 months.

Fortunately, with the PCCRC, you need not make such a forecast. All you need to do is to learn to recognize one of the following 3 conditions:

1. High Fliers: the best performing stocks over the last 90 days.
2. Momentum stocks: Stocks that jump with >10% gain in a single day (or up to 5 day period).
3. Stocks with Volatility skews.

One important exception to the candidates above are those with HIGH long-term IV. We want to SELL high IV whenever possible, but we do NOT want to buy high IV. Otherwise, we are paying too much for the options. Hence, our job is to select good candidates, and let them do their job on their own.

High fliers and IV skews can be easily found with Optionetic's Platinum susbcription, but I have found a new approach that makes elaborate searches and software unneccesary. I still recommend Platinum to follow up your PCCRC trades, but the entry candidates can be done quite simply from among stocks jumping >10%, preferably as a result of good earnings and hopefully increases in earnings guidance. Let me elaborate on this point:

A stock that jumps as a result of exceeding earnings expectations or raising earnings guidance will have a reduction in volatility shortly thereafter. The price may go sideways or up shortly thereafter. Within days of the event, earnings, the implied volatility SHOULD drop below 40% (not all stocks do). Volatility will begin to increase eventually, and possibly exceed 40% as it approaches the next earnings report. However, if the expected rally in stock price as well as in the IV do not materialize, we could still make good money from Theta decay. If along the way some unexpected bad news occurs and the stock declines strongly, it is very likely that such a decline would be accompanied by a spike in volatility, or be only temporary. In either case, with the PCCRC we have the opportunity to profit from Delta as well as Vega gains.

In the first article in this series, I said that the PCCRC is a carriage driven by three horses Delta, Vega and Theta. The only way the carriage will fail is if the stock declines in price without an appropriate increase in Vega. In my experience, when this happens, the stock eventually climbs back to our break even point, allowing us a small profit or a break even result to our trade. However, most trades may generate 30% returns in a very short period, either from Vega increases, or from significant gains in the price of the stock.

In the following parts of this series I will introduce some examples from my own real trades.