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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Recently, our friend Hung made me go back to the basic question of using OTM longs, instead of ITM longs when trading a PCCRC. I would like to illustrate the basic reasons why I abandoned the idea entering OTM longs in my PCCRC's.
In essence, the longs would form a STRANGLE, not a straddle. The short portion of the trade would be a short straddle in both cases, so the credit would be the same. Because the debit of the strangle is lower than the debit of the straddle, your position would be entered at a lower debit. As Hung would say, because the position is entered at a lower debit, you'll have a potential for a higher return on investment (ROI).
Let us start with a fictituous trade on DDS which fits my profile for a PCCRC. Typically, I would enter all legs of the trade at the same strike price, in this case $35, with the number of long contracs being 2x the number of short contracts. Note that the trade has a bullish bias, eventhough the legs are all ATM. The IV is about the same in all legs. This bullish bias is fine with me because the stock is in rally mode, following the post-earnings jump, as I have described in countless articles.
You can use the Trade calculator in OptionsXPress to see what the commission costs and cash requirements would be in such a case. By the way, you cannot enter the position in one ticket with OptionsXPress, so your trade would have to be entered 3 possible ways:
1. As a Long straddle (2x2) followed by a short straddle (-1x-1).
2. As a long straddle (1x1) followed by a Condor (1x-1x-1x1).
3. Or as a CRC (call ratio Calendar -1x2) and a PRC (put ratio calendar -1x2).
In all of these trades, your risk equal your debit, as long as volatility remains the same. The commissions may vary, so be sure to test your trade using the Trade Calculator, to be sure you understand all the charges.
What Hung proposes is that we not buy the long calls ATM, but rather OTM, thus reducing our cost. The proposed trade would look like this:
The resulting PCCRC is more balanced and the bullish bias is minimal. The IV of the long are different, but the debit on the trade is actually $0!!! Is this for real? I am not even shaving much from the entry, except just a bit from the long put. In this case, the potential ROI is infinity!?!?!?!
Well, yes and not. What many Optionetic's students fail to realize is that behind every credit spread there is a cash requirement. In this particular case, we could split the trade into two DIAGONAL CALENDARS. The shorts are ITM while the longs are OTM. Let's take a look at the two portions of this trade and reveal the risk that the Platinum graph is not showing us:
The call portion of the trade could be entered as a DCRC (Diagonal call ratio calendar). As such this is a CREDIT spread because the ATM call, which we are selling, is more than 2x as expensive because it is an OTM call, which we are buying. As it is often the case, we tend to overlook the fact that credit spreads carry a risk that is different than the debit, but that does not mean that the position is cheap or risk free. In fact the Max Risk is actually $779.44. Note also that the IV of the short is higher than the IV of the long. this slight skew may contribute to the credit in this portion of the trade.
The put portion is not a credit spread, but it is a diagonal and as such carries a risk which is higher than what is immediately apparent in the debit your broker may ask you for this position. In fact, the higher IV in the long portion of the trade may be contributing to make this a debit, rather than a credit spread like the call portion above. But what is more remarkable is that the max risk is >2x that of the call porton, or $1879. This means that even if IV in each portion of the trade remains the same, we can lose $1879, not just the $250 debit.
This misrepresentation of the actual risk by the PCCRC is our responsibility, Platinum will not really tell us how much we can lose. Even if all legs are entered at the same strike price, the maximum risk is probably going to be misrepresented in the Platinum risk graph. This is why it is so important that we choose the right IV profile (IV below 40%, and at the lower end of the IV range for the stock we are trading.
You may say, if both trades have a hidden risk, isn't it better to enter the trade with the lesser debit? as I said before, for a debit of $0, my potential ROI is infinity. Well look again. Your broker understands that there is a point were your longs may be worthless while your shorts have appreciated. This is kept in your account as untouchable cash called "Options Requirement". Because your buying power is reduced by this requirement, it is effectively the same as a debit. When comparing both trades, do not compare just the debit, but the combination of the debit and the "options Requirement. Here is how OptionsXPress sees the PCCRC trade with OTM longs. Eventhough the debit is $0, the Total requirement is actually $3000 higher than that for the ATM PCCRC, which requires only $7000:
8 comments:
RE:DDS trade
Juan,
I'm glad Hung asked that question on strangling the PCCRC as that was the question I had in mind. I see what you mean about the increased risk if you have different strikes between the short and long Puts.
However, you can still do a strangle but using the same strikes for each side. I checked the risk on each side and it was fine. Here is the link to the trade: tinyurl.com/uxrjs
What do you think?
Mary
Mary, I think you have gone back to Coach Phil's contributions in a previous article. Feel free to ask him what his experiences are. I have not tested his approach.
If you are referring to strangling the long months instead of purchasing a straddle, you are right that it reduces the cost.
However it also makes the position need a larger move before it becomes profitable. I used straddles for RIMM and AAPL and both are already profitable. I used a strangle on ISRG and it is still negative. There is extra cost with the straddles but I think you have a better shot at a profit with a smaller move AND the vegas are higher.
This is just my limited observation but I would only use the strangles on really big movers and expensive positions. A great example is GOOG. I chose the strangle instead of the straddle, just one strike or two OTM and it is already up a small amount. GOOG can move quite large so the strangle makes sense. For lower priced stocks, the straddle is worth the cost in my opinion.
Hi Guys,
Good article Juan about the Cash Reguirement but that's not the kind of Strangle PCCRC I mean. The example Mary gave us looks more like it! And yes, I agree with Phil that for Strangling the PCCRC you need a stock that moves a bit more than for a Straddle PCCRC.
I'm testing this approach with your ERTS trade entered the 11-6-2006 (Straddle PCCRC) and 11-7-2006 (Strangle PCCRC). They're both profitable wrightnow with the stock moving sideways and the Strangle PCCRC is a little bit more profitable by almost 1%. There's a bit of a skew in this cause I was surpose to put them both on on the same day. But anyway, I do think that if you change the criteria/rules for Juan's Straddle PCCRC (ie. higher movers/IV stocks, lower priced stocks, better IV skews so the gamma of the PCCRC is less or even slightly possitive when entering the trade) you have a better edge. I do have to test this in practise though to make my theory solid! I would love if you guys can contribute in this too.
Thanks for your contribution and keep up the good work!
Cheers,
Hung
P.S.: Juan, I think you do a great Job of helping people to become a better trader. I thank you for that!
Thanks for your efforts Hung.
Let's be clear that the trade presented by Phil using the strangle, rather than the straddle for the long portion of the trade IS a different animal.
I have accumulated some months of experience with what I do, so I know what to expect. So it is a big job to modify the position to that extend, become familiar and comfortable with it. My first impression is that the PCCRC as I play it is protected for the sideways movement. On occassion, I have left a trade that is moving sideways, one week before expiration. You will need to keep that in mind when using Phil's approach.
In other words, I am willing to use my capital to pay for a trade that will not lose me money if the stock loses momentum. Some of you may be thinking of a strong movement in either direction. Be on the look out for a volaility crush, though, and report here!
Hung: How would you like to share the load of your testing so that I can contribute without reproducing the effort?
Hi Juan,
You're welcome but thank you too.
I've not much testing to share as surpose the Strangle version of the PCCRC. I do want to remind you that I don't have platinum so I'm limited with my testing capabilities. especially if it comes to backtesting. I'm currently testing/paper trading AAPL, ERTS and GOOG. I've closed RIMM with a nice profit with a Straddle PCCRC. On the ERTS trade I both have a Strangle and Straddle PCCRC approach. at the beginning of last week the Strangle version was up a little compared to the Straddle version. I have to check tonight how the position is currently. I think that the Strangle PCCRC is losing a bit cause ERTS is not moving the last couple of days. But I do have to ad that I think that ERTS isn't big enough of a mover to use the Strangle version. A much better candidate for a Strangle PCCRC I think is SNDK (SANDISK CORP). Also I think you shouldn't widen the strikes to much for it to work. As the Greeks are concerned, I think the ideal setup of the greeks to start with is: Delta (neutral or close to), Gamma (little positive or close to), Theta (positive or close to), Vega (Positive, the more the better). And after the first rollover the ideal Greeks (for me) will hopefully look like: Delta (Highly positive/negative), Gamma (more positive), Theta (negative), Vega (decreased but still very positive).
Last I want to ad is that Juan likes to look at candidates who jumps higher after strong earningsreport. For a Strangle PCCRC I would like to try out/check a strong decline after bad earnings making the front month options more expensive (higher IV) than the back month (lower IV) which makes a better IV skew for this strategy. But you have to wait until the stock bottomed and the IV are at low end of the ranges but still in a skewed situation!
Can anyone with Platinum or backtesting capabilities backtest this approach for me on for instance SNDK (SANDISK CORP) or if you like with other candidates. You have to choose (very) big flyers/movers with good liquidity and options (enough trikes, months etc.) for this to work. Can you than share your results with us as I will do if I have some!
Thank you for your time and efforts.
CHeers,
Hung
Juan/others,
I'd like to discuss which months to select for the long options. I find that you get the most vega in the furthest months but those IV's don't move very much. I did a chart of indexed IV moves on a stock just prior to earnings (assuming a beginning value of 100 for each option's IV, the following the % change.) The I weighted the indexed IV's by the vega to see where you were getting the most bang for your buck. In other words, where do you get the largest dollar change in option value - what month? Anybody thinking like this that would like to chat here?
I Eric....
Sorry for the delay in responding. Happy New Year to all...
This is an important issue. You want to be able to collect on Vega changes, if there is a jump in its value. You are right that the changes may be less pronounce if you go further out.
In theory, you buying futher out options would have the advantage of given you more time for the change. In practice, the change in stock price you may get may be insufficient to translate into good Delta profits.
My suggestion is a compromise. Always look for stocks with low IV in the back month (<40%) and higher IV in the short term (>40%).
I have been trading PCCRC's right after earnings, or days after, as long as the IV has declined sufficiently. I pick month >3 months out. My thinking is that as the next earnings approach, IV will increase, making the whole position more valueable.
So I don't go much more than 4 months out, but of course it varies. Right now I would be picking May, if not available, I would play June options.
IF you have a formula, please share! this is an important issue, and so far I have been using just common sense.
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