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Wednesday, October 18, 2006

The Perfect System, Part V

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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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If you make a trade that you intend to hold until before the close, you are a day trader.
If you make a trade that you intend to hold for weeks, you are a swing trader.
If you make a trade that you intend to hold for months, you are a position trader.
If you make a trade that you intend to hold for more than a year, you are an investor.

If you have a small account, not to exceed $15K, you may want to make that small account grow quickly and be willing to take some chances. Perhaps this is why you entered a seminar to trade options. You are at a beginner level, and you want to keep it simple. If that is the case, my recommendation is that you explore the use of the Quantum Swing Trading system with calls and puts. This approach may be erratic, but when the markets are in a definite bullish or bearish trend, QST with long options will probably give you the best results in the least amount of time.

If your account is over $15K, you probably would like to "position" trade. With a good amount of cash to trade since the late 90's, I have been testing a huge variety of methods of trading that would provide a safe way of making me a respectable living (I though that 25%/year would be excellent because the best mutual funds in their best years make that much money), and that would give me complete financial freedom to come an go, vacation at least 2x/year to exotic places and spend my money exploring ways to contribute to good causes in thirld world countries. to do that, I thought I needed a low risk approach with good hedging against unexpected moves. The PCCRC does not require baby sitting, although it is fun to watch your trades and modify them at critical points, it is only essential that you be there ONE WEEK before expiration.

Why one week? Why not two days or even one day before expiration? I have found that the largest difference between front and second month options occur about 1 week before expiration. Further, we are NOT trading calendar spreads here, we are trading straddles, expecting the unexpected, which is a strong move in the price of an option. The only possible exception to this rule is when trading stocks that are about to announce earnings on the week before expiration. Three of my trades are in that situation right now: AAPL, GOOG, and CDWC. In that case, IV continues to increase UP TO the day of earnings, so it is best (but not absolutely necessary) to do the rollover on the day of earnings report.

So what is this "rollover"? Think of the PCCRC as a Straddle Calendar. Yes, you sort the front month, but if the conditions are valid, you can buy back your front month shorts and sell second month options to continue the straddle. You can do this rollover in a single ticket in the form of a "Condor" to get the best possible price trading all legs at once. You only need to do the rollover, once a month. If the rollover is not worth it, you have the choice of exiting the trade or go all the way to expiration, as if it were a calendar spread. If, on the other hand, you believe the stock will move strongly in either direction and the resulting trade looks still promising, by all means, Do make the rollover.

Here is an example of a PCCRC I entered some weeks ago on ANF, following a jump after earnings. Point to the original article if you will, to see my reasoning for entering this trade:

http://stockoftheday.blogspot.com/2006/08/entered-anf-pccrc.html

Here is the trade again:

One week before expiration, we note that the stock has made no strong moves one way or the other. At this point I could have chosen to exit the trade at a small loss (about 4%). Instead, I chose to continue the trade, as long as the resulting trade looked very much like the original. However, the rollover has removed $1800 from the table, partially financing my trade. This make sense to me more than any modification you can make to any complex trade because you are not throwing good money after bad as the inexperienced tends to do, instead, you are truly giving yourself time for the trade to work, while removing cash that may be used in other trades. Here is the resulting rollover trade:



Or shorts go now all the way to October, while the longs can stay in place until January.

Once again, one week to Oct. expiration we reach another decision point. This time the stock HAS moved strongly UP, making our trade profitable. Now we are close to 32% or $4056 on our $12384 investment. Exiting the strade should be considered for two good reasons: We already exceeded the 25% target for this trade, the stock has moved almost 17 points away from the strike price of my options and thus it may be difficult to adjust the trade to make it look like a straddle, again.



One possibility is to close the position and open a similar one at a higher strike price, $75 would be a good choice. However, you still have the choice of simply rolling over the call side (the put side would not generate much premium) and increase the number of short calls as a way to take profits. Again, this is a reactive move, not a proactive one. You don't have to make any assumptions or T.A. evaluations as to where could the stock be in several weeks. Here is the move. Now my debit is only $4000, but my profit is $3300.

You may say that I lost $700. Perhaps, but if the stock declines or climbs strongly from here you still have a good chance to add to your profits. Again, there is nothing wrong with taking the trade off one week to expiration, there are always big winners during earnings season. So be in the look out for them.



2 comments:

Anonymous said...

Hi Juan

You have said the PCCRC has a possible risk that the stock moves down without a rise in IV.
Have you considered selling fewer puts than calls? If you buy 10 puts & 10 calls then sell 3 puts & 5 calls, the risk graph looks more symmetrical. ie the downside risk is removed.

Also, from my experience Optionsxpress does not allow ratio trades like these to be placed. I may have to consider moving my account to IB.

cheers
Kevin

Juan Sarmiento said...

Thanks for you comments, Kevin.

You are right, selling more calls than puts (or buying less calls than puts), would produce a symmetrical trade here.

Remember that my system calls for stocks that are:
1. high fliers.
2. one day jump of >10% (i.e. earnings related).
3. IV skew.

The IV skew may be best suited for the symmetrical trade you are suggesting, since your bias in not bullish, necessarily.

You are right that OptionsXPress would not allow the PCCRC in one single ticket. This is why I enter the position as two straddles: one long and one short. The long being 2x the number of contracts as the short.

You can also enter the trade as a condor and a long straddle.

In all these cases, you cannot generate the symmetrical trade you describe. As you mention, only IB (interactive Broker) and CyberTrader allow the entry of multiple, uneven legs in one ticket.

I remind you that my trade is part of a system and as such I have only tested the very specific situations described here. I have not extensively tested the symmetric trade. However, it is important to understand that reducing the downside risk in the way you suggest, would probably increase the upside risk.

My observation is that stocks that decline with low IV are likely to bounce back, while the ones that decline with high IV are not likely to rebound. Hence, my bias fits well with my expectations.

Since I have selected stocks that are high fliers or that bounce following earnigns, my bias is bullish. My protection to the downside is against a catastrophic decline at first. As the stock rallies, selling some of my long puts creates a trade that would also benefit from downside move.

I hope this is clear, Kevin. Please feel free to question further, if you wish.

EWI