Please feel free to ask him all questions you may have.
Juan
==========================
It was a good long bullish market and Earning type PCCRC was generating very good outcomes and there was a plenty of candidates. But recently market has turned bearish an it has become harder and harder to find PCCRC bullish type candidates. Even after finding a few they hardly ever rally in a falling market.
So the question arises: How do we design a PCCRC system which will work in bearish market?
Let’s review current post-earnings PCCRC system:
One of the general rules is that a position should be created at ATM strike in 1/1/2/2 ratio. By the way I think that choosing upper or lower ATM strike will change position outcome, but it is a completely different story to research and backtest.
So the 1/1/2/2 ratio creates a straddle-like risk graph with positive delta. In order to benefit from delta, the trader must find candidates which are likely to rally. The 10% jump after earnings was very good predictor of a Delta move in the in the bull market.
Now that the market turned to bearish/sideways, why not change the PCCRC to delta neutral? If you have an IB or a TOS account it is easy to enter a position with four legs with any short/long option ratio.
Why delta neutral? Because it is frustrating to see how a stock makes large moves down, 1 or 2 strikes, with very good IV increase but because of the bullishness of PCCRC position may end up with a loss.
NVLS trade was a good example.
Fig.1. Please click on Image to enlarge.
Fig.2. Please click on Image to enlarge.
Now compare with same trade but entered as delta neutral.
Fig.3. Please click on Image to enlarge.Fig.3. Please click on Image to enlarge.
Fig.4. Please click on Image to enlarge.
So isn’t it worse to buy 1 additional put at entry in this case and turn a loosing trade into a winner? Absolutely! I’ve backtested all my losers (I don’t have many of them) as delta neutral entries and they all became winners!
Well, I agree that in the bullish scenario delta neutral will yield less profits than the bullish PCCRC , but how much less? Don’t you agree that is better to make less in the bullish scenario than to have losing trade?
I want to ask everyone who has backtesting capabilities. Please go back to your losers end reenter them as delta neutral then take your winners and make the same and please post your results.
So how to create delta neutral PCCRC?
After playing with a couple of combinations I found that in order to create a delta neutral PCCRC the following ratios can be used:
1. 2/2/4/5
2. 2/2/3/4
3. 3/3/5/6
4. 3/3/6/7
Note: Ratios are given in Short Call/Short Put/Long Call/Long Put format and the total position size can be multiplied keeping above mentioned ratios.
Now which ratio to choose for current stock market conditions?
For each stock delta neutral ratio will be different, and you need to play with long Calls , long Puts and shorts as well to find the best ratio.
If you have to choose between let say 2/2/4/5 and 2/2/3/4 then you need to answer to the following question. From which Greek are you planning to benefit more in current case, Vega or Theta? 2/2/4/5 or 3/3/6/7 has more Vega less Theta because of long are more by 1 contract in each side. This is the case when you are planning to benefit from Volatility increase and the stock has large movement history. If it is relatively quiet stock and has low IV jump potential, and you are more of a calendar type trader then 2/2/3/4 or 3/3/5/6 might work for you, because Theta here is higher.
Now let’s go through PCCRC system for any given market.
1. Choosing PCCRC system to trade
• If market is bullish then 10% earning system has been proven to be the very good one and I think there is no need to change anything in that system.
• If market bearish or sideways then Delta neutral system might be a good choice.
2. Candidate screening. (for bearish/sideways)
Any post-earning IV crashed stock. And of course IV skew is preferable.
Platinum has two interesting places to look at. Go to
Site Map > Folders-Share Tools > More Tools > Earning Effects
and
Site Map > Folders-Share Tools > More Tools > Smart Stock Rankings > Big –Change in Implied Volatility.
Any stock at 2 year low IV and good pre-earnings IV rising history.
3. I would like to add one more evaluation point to filter out candidates. I call it Volatility Evaluation.
Each Stock has its own IV channel to fluctuate. Looking at IV chart for longs you need to find current and maximum IV for recent 1-3 earning periods. Then we need to subtract current IV from max IV and find what is our expectation for IV to move toward next earnings.
For example NVLS (Fig. 3 2/2/4/5 position at 07/18/2007 entry point) current was 32% and maximum was 35%, so our expectation is 3% IV move. Vega - $60 , Maximum Risk $130.
What we can look here at is what percent of expected IV move should happen for this trade to become risk free. In the NVLS case the numbers are telling that only 2% increase in Volatility will add $120 to the trade and it will become risk free. So 2% from expected 3% is 66% of expected IV move. The other 1% (37% of expected) should generate a Vega profit of 1x60=$60. So less portion of expected IV move will make trade risk free is better. For some stocks the full range of IV change hardly move them in to positive territory, so this kind of stocks are not good to generate volatility profit. In the NVLS case IV raised more than the expected, 39%. So in this case we have captured approx. 7% IV move. And this move generates more than 100% profit on risk. Also some Delta gain has been captured.
4. No change in Entry, Maintenance and Exit rules.
The Delta neutral PCCRC is more of a Volatility and/or Theta play. But it is still an open-ended trade which can benefit from large Delta moves in both direction. Specially in bearish moves with rising IV.
21 comments:
I enjoy reading your blog on advanced trading. You are very kind to share your knowledge.
Have you tried using your strategy on the indices. QQQQ, DIA, SPY. Try using Leaps with the indices 6 months to 1 year or more. The indices are more liquid and tend to make a big move some time in a 1 year cycle and you don't have to worry about implied volatility.
Dear Anonymous:
I don't use the PCCRC on indices. I Use PCCRC's primarily for DELTA gains on the upside, Vega gains (whenever they may occur), and protection against sideways with the front month shorts.
I fear that indices may be too low in IV. You may not find a skew because so many people trade these (they are extremely liquid).
Going too far into the future may cost too much, defying the cost control that you want to produce with the front month shorts.
I don't trade indices at all, and I shy away from LEAPS. That is not meant to stop you from experimenting and find your own recipe for success.
=============
I will continue to hold opinion on Davits article, until others state theirs.
One important observation.
Please take a look at NVLS trade Max Risk in both cases.
2/2/4/4 ratio has $305 Max Risk.
By adding additional Dec07 Put for $271, to make position Delta neutral 2/2/4/5, decreases Max Risk by $170 to $130.
Now according money management rule we can at least double position size which will double position Vega/Theta, and still have less risk than directional PCCRC.
As we can see from NVLS example, adding debit does not necessary mean adding Risk to the trade.
What if bullish PCCRC has been entered and later stock shows signs of weakness.
May be in that case it will be better to add some Long Puts and making sure that we reducing Max Risk, and resulting trade is Delta neutral?
Davit, thanks for sharing I'm sure your article took a lot of time to write
I'm going to also spend some time on this subject hopefully I will be able to add to your findings
I agree that it is a great idea to be looking at different variations of the PCCRC since market conditions have really changed the past couple of weeks
It seems that it should become easier to find candidates ounce the volatility of the overall market calms down
I look forward to others opinions on this subject
It will become clearer to most of you that the PCCRC is very flexible. You will find that every stock you trade will be different and with time you'd learn what works and what does not.
My caution would be in overinterpreting the market pressures. Note that Davit invoques the "bear market" as the motivation to change the strategy. The question is: What is our criteria to call the market bearish or bullish?
I have insisted in using the PCCRC as a reactive, rather than proactive approach. In essence claiming that it is better to adjust a trade by taking Delta or Vega profits, rather than proactive, making desicions in advance as to whether we are bullish or bearish. A delta Neutral trade would be more in keeping with that phylosophy.
I started trading all same strike price, two straddles because of contrains from OptionsXpress. There is no real reason why you should not trade legs of different size, except of course to keep it simple. With TOS or IB, your four legs may take any combination.
The post-earnings jump MUST be kept bullish, even if in the end the pressures of the market and macroeconomy cause a stock like NVLS fall. You are looking for the next AAPL, or GOOG or CMI, and that can come by fundamental reasons and it should outperform the markets. A temporary set back due to market pressures should be a temporary thing. What you need to examine on NVLS is not so much what possible modification of the trade would have made the trade profitable, but rather what was wrong with our interpretation of the earnings results. In other words, what we could have detected that would have kept us out of the trade. I am suggesting that you should not substitute the options strategy for the fundamental (in this case) or technical (in others) interpretation of the analysis before entering the trade.
You may go crazy over analyzing the multiple permutations of options strategies, but if you do not have a grasp of the fundamental analysis or technical analysis, you will be missing out on the strongest moves. What matters here is that whatever combination you choose, it must have fundamental or technical reasons.
I don't see Vega as the strongest of the greeks when it comes to PCCRC, I am a Delta player, but hey, if Vega jumps, what the heck!!! it is easy money. Remember the 3 horse and carriage metaphor.
Whatever your approach ends up being, you must feel comfortable with it. Markets will change, so a little adaptation may pay off. Whatever you decide to do, be sure to test it sufficiently on your own.
NVLS caused ME a small loss, but given all the gains in IV as of late, it is a small price to pay for the overall profits. So don't feel bad about one bad trade here or there, it comes with the territory.
And of course, thanks to Davit for his contribution. I hope you all follow suit and offer your insights as well.
Juan,
As I said before, your 10% jump systems was proven to be very profitable. And I wasn’t looking substitute for that system.
But what to do when Earning season almost ended and half your account is in cash? Correct me if I wrong, in your paper trading account you have used only half of the money and that because of absence of bullish candidates. This IS the “bear market” criteria for me.
You have two choices , do nothing, keep cash, or try to find other type of plays until “good times” will return and you’ll have plenty bullish candidates to choose from.
The reason I liked option trading is that options have two very important thing which you can turn in your favor, first is a time decay which is hard-coded into option model and second one is soft-coded around-earning IV fluctuation. And PCCRC uses both in your favor. I believe that it is possible stay out from Delta-guessing game using only Delta-neutral approach and still profit on this volatile market. I know you like Delta, but that because of huge experience and Elliott Wave theory in your arsenal. For beginners Delta-guessing has coin-flipping probabilities. For me exception is your 10% strong system and EW theory which requires lot of time and effort to master.
I don’t think NVLS would pass my Volatility Evaluation filter. There was not too much Vega potential at entry point. That trade has been used to illustrate how one additional put can dramatically reduce loosing trades quantity, minimize max risk and at the exit point this put still might have value in it to bring back.
Idea behind this Delta neutral PCCRC was to have plenty candidates in any given market. You need to find IV crashed stock which has good Vega potential, at least 100% on risk. And of course any big Delta moves are welcome.
Is anybody tried to backtest Delta neutral approach to past and current losing and winning PCCRC trades? I did my home work, but it would be nice to hear from you.
I am not saying it is not a bear market, I am saying is: What is your criteria?
One may be the direction of the 200dMA in the SPX. In that case, we are not there yet. But close.
The number of trades in the paper money account may be a function of the high volatility that has forced me out of some trades, while profits mount. You don't need to be fully invested with the PCCRC, remember the portfolio and money management rules: 2% max risk per trade and 10% max capital per trade.
I wouldn't go pressuring myself to have all cash invested at any single time. I'd rather wait for the right time. Remember that there are alternatives to the post-earnings strategy. Your approach is sound too. As long as you have tested it sufficiently.
The issue here for me is: what is your trigger to enter the trade? in the case of NVLS it was the post-earnings jump, right? if so, the apparent bullish bias of my trade would have been appropriate from the perspective that in such scenario, I have obtained very large profits. So the fact that the NVLS did not work out is not sufficient reason to change the strategy don't you think?
I understand that you are trying to find alternatives to the bear market. I have one of my own. My issue is: what would trigger you into the trade? for me would be an Elliott bearish configuration. Do you think it is worth changing the game plan? I am not being critical, I am being inquisitive.
What we need is an objective approach to finding those delta neutral candidates that can be reproducible. How do we locate post-earnings IV crashed stocks with history of high IV. The answer may be in Platinum.
By the way, your comments about the Elliott wave are well taken. However, if you want to be an options trader, this is a skill that will serve you well over the years, and that everyone should endeavor to master. It is not that hard really, but it requires:
1. Read the books.
2. Test yourself on pattern recognition.
Elliottician.com has an Elliott Speed test, a small program that is included with the RET software that sharpens your skills. Go for the books first, though. The theory is essential.
Juan: " in the case of NVLS it was the post-earnings jump, right? if so, the apparent bullish bias of my trade would have been appropriate from the perspective that in such scenario, I have obtained very large profits. So the fact that the NVLS did not work out is not sufficient reason to change the strategy don't you think?"
Davit: I'm absolutely agree with you. NVLS triggered 10% system with jump and positive outlook. And using bullish PCCRC was a right choice. Only thing I can suggest to look closer here is when trader has strong confirmation that stock will fail to rally in entered trade, maybe some action could be taken to reduce risk. Taking any action before trade became profitable is against your rule, but what if that action will reduce risk in trade which likely will go against you? And even more, will allow you to benefit from that move down.
Regarding delta neutral candidate selection, I want to start researching stocks with 5%-10% jump. Stocks which are out of 10% system but still have significant drop in IV.
Davit: There is a factor that the risk graphs will not allow you to see, and which would have been of significance regarding the NVLS trade, if you had entered the larger put leg, and that is the reduction in IV when a stock rallies.
Unfortunately, the Optionetics' risk graph does not easily illustrates what would happen if the stock rallies and volatility falls. In other words, if the stock falls, you are likely to have volatility on your side. If it rallies, volatility works against you. So the Delta neutral is NOT IV neutral. Your greater risk (not apparent in the Platinum risk graph) is to the up side with low IV.
Davit, I trade the same way you suggested, delta neutral. So far this year I have 7 closed PCCRC’s. All were profitable. I even did a NVLS trade that made about 10% of capital, but was opened a couple weeks before yours. I have one other trade open that is currently at a small loss. They are not the same structure as Juan’s. Sometimes I would strangle the stock price if the stock price was between strikes.
I trade with OptionsXpress. Therefore I am very limited in entering the position. I enter a 1/1/1/1 (OX condor order page) then the extra long straddle, then the extra puts. If anyone knows a easier way with OX, let me know. I have tried doing two ratio calendars, but have been burned when the stock moves before the second fill. Since I have to enter the extra puts as a separate order, I sometimes buy one strike lower since all I want is more negative delta. I use Platinum’s delta/quote.
I created a shared folder in Platinum of my closed 2007 PCCRCs. These are my actual real money, real time trades. Here is the share key d79c95bc52f3a5f6dfcc03e857d38724 I don’t expect anyone to analyze them, but if you do, you will find mistakes. I could have made a lot more money on the trades. I usually closed them too early or rolled at the wrong time. But I am learning while making money.
I found the trades using skewfinder II then option ranker. I only open if the IV is low for the stock and has the capability to rise. I didn’t know the earnings effects tools existed. I appears to be powerful. Thanks David.
I have back tested PCCRC several ways and time periods. Juan’s methods works better, of course, if the stock rises. However, I am not skilled in predicting market direction. I found delta neutral works better for me. I can make money whichever way the stock moves.
The very worst thing to happen to a PCCRC is a merger / takeover at your strike price. All options will go to about parity and you can lose a lot more than platinum’s estimated max loss.
Thanks, Davit, for your excellent post.
Rick
Rick, you simply HAVE to go to TOS!!! You will feel a relief of not having to worry about entry in portions. Additionally, you could get a much better deal on commissions. With PCCRC's, the ticket commission can really kill you, particularly if you intend to do adjusting.
I am looking forward to examine your trades.
Both Davit and Rick, there are two things I want you to examine:
1. Clear rules of entry. If you can write them down and share would be great.
2. Your bias when doing a Delta Neutral PCCRC is to the downside where both Vega and Delta will help.
3. Your risk is to the upside where Vega may work against you, even if Platinum tells you otherwise.
I suspect that even in bear markets there will be the big winners, and those are the ones to pursue anyway.
There is not a great deal of difficulty in picking post-earnings winners, since the fundamentals should be strong, or you simply pass. We will see in the months ahead, if the bear market develops.
A PCCRC is not IV neutral. We don't want it to be. Your greatest risk is almost always IV. High vega works for and against you. That is why it is so important to open only when IV is low for the stock.
Risk graph II lets you change the IV at expiry to see the effect of lower IV. When you lower IV you will see your max risk rise.
My CTMI shared trade is a good example of a delta neutral trade that made good money when the stock rose.
Rick
Rick said: Your greatest risk is almost always IV. High vega works for and against you. That is why it is so important to open only when IV is low for the stock.
Agreed. This is why we must balance the Vega risk in all situations. The risk is hidden from the risk graph (unless you adjust the IV in Graph II, as you suggest).
In order to balance the Vega risk to the upside, we have to rely on Delta picking up the slack.
Did your CTMI trade occurred as Delta increased on the rally? this is a rare occurrence, unless there are specific news that cause IV increase.
Rick said: Your greatest risk is almost always IV. High vega works for and against you. That is why it is so important to open only when IV is low for the stock.
Agreed. This is why we must balance the Vega risk in all situations. The risk is hidden from the risk graph (unless you adjust the IV in Graph II, as you suggest).
In order to balance the Vega risk to the upside, we have to rely on Delta picking up the slack.
Did your CTMI trade occurred as Delta increased on the rally? this is a rare occurrence, unless there are specific news that cause IV increase.
I assume you mean, did IV increase? Yes, it did 3-4%. I was able to sell the puts at just a small loss.
If I had of left some puts open, I would have made a lot of money when the stock dropped 10 days later. However, I would have increased my risk if the stock kept rising.
I will try to post my rules later today, as I will be away from the internet for several days.
Rick
In all fairness, I added another NVDA May15th trade to the shared trades. I opened it as a strangle, not a PCCRC. I later added the short options at a lower price. Not very smart. I also made other mistakes.
It still has some long Sept puts that are not doing good. The trade will end close to breakeven. A PCCRC would have made good money.
Davit, you absolutely right. Being more delta neutral reduces risk. I choose the number of extra puts to buy by adjusting the number up and down for the lowest risk. I will also leave the puts alone and buy less calls if the capital required is too high. However, I have found that modification can reduce adjustment choices later on.
Rick
Rick,
Thanks a lot for sharing your experience. It was very helpful for me. By analyzing your trades I made one important discovery for me, how to structure PCCRC position for volatility play.
I took your trades and I tried to mimic same delta and position size but with four leg instead of 5 leg as you did in CYMI example. What I notice that 5leg PCCRC had more Vega than 4leg. After small investigation I found that OTM Puts you were using to balance PCCRC were bringing more Vega into position than additional ATM Puts in 4leg. Then I calculated Vega/Cost for each strike in Option Chain and it showed me that OTM Options have cheaper Vega.
Then I went further , I made 6leg PCCRC and guess what, I boosted position’s Vega for same amount of money.
Here is comparison of 4 5 and 6 leg PCCRC. Numbers are based on CYMI 07/20/07 entry.
4leg 11/11/22/28 A7-J8 40 Debit $ 14772 Max. Risk -$341 Vega $452 Cont. Quant. 72
5leg 12/12/24/24 A7-J8 40 +12 J8 35P Debit $15888 Max. Risk -$532 Vega$521 Cont. Quant. 72
6leg 16/16/16/16 A7-J8 40 +16 J8 45C +32 J8 35P Debit $14784 Max. Risk -$662 Vega$655 Cont. Quant. 112
As we can see 6leg’s Vega is much higher than 4leg’s. If Volatility rises 6leg will generate $200 more profit on each increased %IV.
It is open question, will Vega boosting justify increasing number of legs and number of contacts?
Theoretically numbers are telling us ”YES” but will see in real life.
Davit
Here are my current entry rules:
1. Skewfinder 2, Stock at least $25, IV > 21%. IV Skew between near term (1-45 days) options and the long term (30 to >90days) options of at least 10%. Save list. IV should have a history of increasing periodically.
2. Run Option ranker on above list, IV period > 90 day, length 1.5 yr, IV percentiles Cheap.
3. Save stocks with percentile bin of latest IV of a 1 or the most 2 to new list.
4. Analyze list. IV of long term options to be purchased has to be at the bottom range for the stock. (should be if the option ranker did it's job right) See Atm IV graph, Sell the red line and buy a lower line (black is best).
5. Check IV/SV charts with 7-149 day IV numerator and 6 days SV denominator. If the black line is below 1 you have a better probability of success. IV should rise to at least match SV. It is not require to be below 1, however the lower the better.
4. Sell equal numbers current month (1-45 days to expire) calls and puts. You may strangle the stock price if it is midway between strikes, otherwise sell ATM. Sell at least $.50 extrinsic (time) value in each option. If you can’t sell at least $.50, look at selling next month or doing a strangle/straddle.
5. Buy at least twice as many calls and puts long term, at least 90 days longer to expiration. I check the IV and actual cost of the options. If I can buy an extra month or more for very little cost, I will do it. However, do not go too long or you will have too much risk. You may strangle the sold options (higher call, lower put), however normally buy the same strike you sell. If you buy different strikes than you sell you will increase the amount of funds on hold in your account. However you will reduce cost of the trade.
6. For a Delta Neutral trade you will need to purchase more puts than calls. You can modify the ratio of all options to get the bias you want: bullish, bearish, and neutral. Adjust the ratios until you have a real low risk trade and the ability to be profitable no matter what the stock does. I start with a ratio of 1 short c/p, 2 long calls, and 3 long puts.
7. Check the news of the stock. Make sure it is not involved in merger. If the options are about the same price for the different long term options, you can be sure the stock is involved in a merger or something similar. If it is, do not trade it.
These rules are subject to change as I get more experience. I should add Juan's rule of 1,000,000 ave shares traded.
Thanks Davit for your comments. I will respond to your ideas later.
BTW, I have used the term "delta neutral" several times. However, I don't like to think of this method of trading as "delta neutral". You can be "delta neutral" with a real stupid trade and a lot at risk. I like to think of it as risk reduction. Creating the lowest risk trade possible with high reward protential. Rick
Davit, I built a CYMI trade as per your 6 leg trade above based on my actual entry/exit prices. I adjusted the Jan 45 call buy/sell prices based on the time of day I opened/closed the trade, not the platinum closing prices.
Entry: debit $312 less, risk $438 less ($591 vs $1029) , delta 28 less (59 vs 89), vega 157 more (658 vs 501), $9 less (38 vs 47).
Exit: profit $581 more.
I think you are on to something. Definitely worth more research. Getting more profit with less risk is what it's all about.
Thanks, Rick
I placed a trade on ADBE after Davit shared his thoughts about the stock over the weekend. At first I didn't like it. I thought Jan IV was still too high. However the IV of the short options rose and the long options stayed the same or maybe dropped a little which made the trade more attractive. I don't think long term IV will drop much more and most likely will increase going into earnings on Sep17.
Here is the trade: -1 sep 40p @ .88, -1 Sep 40c @ .98, +2 Jan 40p @2.225, +2 Jan 42.5c @ 2.87 and +1 Jan 37.50 p @ 1.40
As you can see I strangled the stock price, 41.24 at the time of the trade. I am also almost delta neutral or rather lower risk with the extra puts. PCCRC is such a flexible trade that it can be adjusted to whatever the market gives you.
My actual trade size was based on Juan's risk management. I expect IV to increase, stock movement, and time to pass going into earnings.
Have a great day everyone. Rick
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