Adjustments to the PCCRC

When I was a young man back in the 70’s, fresh out of high school my friend Felix was starting Medical School, but he also had a keen interest in Astronomy and had an intellectual curiosity about Extraterrestrials. He attended some seminars from a guy that claimed to have routine contacts with an advanced civilization of Extraterrestrials that were benignly observing human kind. Although I regarded this individual as a charlatan, he would make the interesting claim that “The extraterrestrials were from a civilization that was so advanced they had knowledge such as the cure for cancer, but were not willing to share it because mankind was not ready to receive such information.” Since then, medicine has made advanced such as monoclonal antibodies, DNA cloning, protein synthesis and cellular chemistry that have facilitated the discovery of “cures” for some cancers.

The point of the story is that passing along technology is not an easy thing. The recipient must be ready to receive it. In fact, the individual would actually be better off doing the research himself and figuring out things in his own way. My implementation of the PCCRC has been based on knowledge acquired over 15 years of trading, with a lot of trial and error and experimentation. I have attempted to pass this technology along to you, but it is necessary that you do a little reading of your own so that the knowledge falls in fertile ground. I have prepared countless hours of video and written hundreds of articles on the PCCRC, many of them being stand alone and others being reiterations of the same observations, only in different forms so that I might spark some interest on your part.

Today, I received an e-mail from a friend who says: “Your variable time straddles look like the safest trades to place […] I don't feel I understand the management of them over the duration of the trade and when to close them out". Well, my friend, it is really quite simple, but only if you understand the three basic forces controlling the value of an option: Vega, Theta and Delta. I have compared their functions in the PCCRC as 3 horses pulling a carriage. When one falters, the others pick up the slack. Your job is to simply take profits when one of them is too strong. That is the adjustment you need to do.

My friend appropriately calls the PCCRC the “time straddle”. You can also call it the Calendar Straddle because that is what McMillan calls it in his book (see below). I believe that given sufficient time, any stock will move strongly in either direction. So, the straddle is the perfect trade except for one detail: Time decay. The Straddle works with Delta and Vega because as the stock moves up or down, one of the calls or puts would appreciate to compensate for the loss in the value of the other. Alternatively, Volatility may increase the value of both options simultaneously. This is the effect of Vega, which tends to be brief, so one needs to be aware of what a high Implied Volatility is, so we don’t enter a straddle when volatility could decrease, thus causing us to lose money. The problem with the Straddle, is that passage of time will cause our options also to decrease in value, so the clock is ticking for Delta or Vega to produce profits, or we will have a loser. By selling a front month straddle, presumably at a higher volatility, we reduce the cost of the back month long straddle, but we also moderate the effect of Theta (passage of time). In fact, if the stock did not move at all, it is conceivable that we could get some Theta profits out of our PCCRC as the time of expiration approaches.

So here are some guidelines for “adjusting” a PCCRC:

1. If the stock moves strongly UP, Take Delta profits. This means that you begin to sell calls. Be sure to sell only a small proportion of them. This way you don’t want to have to figure out when has the top been reached. Even with my 15 years of experience, I still cannot tell with certainty when has a top been reached, no Elliott wave or traditional technical analysis can pinpoint the top with accuracy. So you want to sell some of your calls, but leave a positive proportion of long/short calls, in case the stock continues to move strongly up.
2. If you only have 1 long call in excess of the short calls, consider selling that long call and buying 2 long calls at a higher strike price. Recently, I entered a PCCRC on WYNN at a strike price of $115 and the stock rallied as high as $169. I sold calls along the way, which reduced my cost and locked in some profits. BUT near the top I simply ran out of calls to sell. Only 1 long call in excess of the shorts was left in the trade. It seemed as though the stock will continue to go up, so I simply sold that one excess long call ($115 strike price) and bought 2 long calls ($170 strike price). The result was that I kept the possibility of profiting for continued rally open, while at the same time I reduced my cost and opened the possibility for a decline in stock price. The stock has fallen to $149, but my profits continue to increase as the shorts have depreciated faster than the longs, and the puts have make gains.
3. If the stock moves strongly DOWN in high volatility, take Delta profits. Here we sell put options, progressively. But be aware that Vega (implied volatility) may increase and that increases your profits but Vega can easily snap back and reduce your profits very quickly (See taking Vega profits below).
4. If the stock moves strongly DOWN in low volatility, prepare for a rebound. Some of my trades have lost value progressively as the stock moved down with low volatility. This is the worse case scenario and loses can accumulate. If you only have a month or two to go, you may want to take the loss and move on, but if there is sufficient time, and the stock has a history of strong moves, the rebound may make the trade profitable again. If you sell puts along the way, the rebound may be quite profitable. This is a discretionary trade adjustment. Just be sure that the resulting trade does not exceed your max risk (2% of your account value). I should mention here that when the stock declines in low IV, you have an increased risk of being assigned stock shares (from your short puts). This is no big deal, but you must be prepared to sell the shares and substitute them with short puts again. This can get silly as the new short puts can be assigned again and again. One approach is to sell back month options (do not exercise them) to compensate for the assigned shares. You could even sell second month puts. One way to avoid this tiresome game is to enter your PCCRC at a strike price that is below the market price, although this is no guarantee that you won’t be assigned.
5. If the stock moves sideways in low IV, the loss of IV in the front month and the erosion of the short options due to theta may actually give you a small profit. Near expiration is a good decision point if the stock has been moving sideways, you may want to close the position with Theta profits. Alternatively you may want to rollover the trade by buying back the decayed options and sell second month options. Be selective when you do your rollovers. First, you may still believe that the stock will move strongly in either direction. As an example, let’s suppose that the next expiration is October and that your long options expire in December. You could safely rollover your shorts from October to November. In this instance, you are running out of time for the stock to make a strong move. However, if your long options expire in January or beyond, there is still plenty of time for the stock to make its move. In the second instance, a rollover is better indicated than in the first. Additionally, I would examine the volatility of October and November options. As a rule of thumb, we want to buy low IV and sell high IV. Sometimes, near expiration, options may be quoted as having high IV, but because of Theta decay, they are losing value quickly. Don’t leave the rollover for the last minute. Your rollover should be done one week before expiration, but you can do as close as 3 days before expiration. Don’t go any closer than that. Why? Because you are dealing with momentum stocks and they may move strongly in either direction in unpredictable ways. The closer you are to expiration, the more your trade is going to look like a calendar spread and the profits that you may have accumulated until then due to theta decay, may vanish quickly. Finally, if one week to expiration you are not showing any gains, exit the trade. The rollover would only make your losses widen. You may lose in some cases but from a portfolio management point of view, you’ll do fine in the long run (see managing your portfolio below).
6. IV spikes. There are few reasons why an IV may spike, but when it does your profits may rise quickly. Don’t be deceived into hoping that the windfall will continue indifferently. In his book, the Volatility Course, George Fontanills explains that IV tends to quickly return to its historical average. As a rule of thumb, I do not enter PCCRC’s when the IV of my long options is above 40%, or when the IV of the short options is less than the IV of the longs. I want to buy low IV and sell high IV. When IV is above 50%, I begin to consider closing the position and run with the profits. It is hard enough to know when the price of a stock is high enough to sell, it is even harder to know when the IV has ran up enough to justify exiting the trade. The IV goes up for good reasons, usually related to some unexpected change in the psychology of the stock.
a. IV increases regularly in advance of earnings and decline quickly after. If you see Vega profits in your trade coincide with the proximity of earnings, exit the trade before earnings. Be aware of the earnings schedule of all your trades, and also be sure that you know whether the company will report earnings before or after hours. The IV will decline after earnings and you did not exit the trade, you may have lost a great opportunity, but IV may begin to climb again. Still, try to avoid earnings. You can always reenter the trade, once IV has declined.
b. FDA approvals. In advance of the news IV will climb, as the stock may move in either direction. Sometimes only a few people know when the news are to be released. It is quite dice to play PCCRC with Biotechnology stocks. If you follow my rules, you are unlikely to enter a trade in this industry because these are generally high IV. Remember, we buy low IV and sell high IV.
c. Take over rumors. I have had 2 great trades this year and one loss with this strategy. My best trade of the year was AQNT, which was taken over by MSFT. However, I lost money with MNST whose sale did not materialize. Just days ago, I entered a PCCRC for DISH, in rumors of a takeover. Once the rumors are mentioned, the stock jumps >10% in high IV. At first, however, the IV climbs for the front month options, so if you act quickly, you may enter a PCCRC where the front month IV is high and the back month IV is still climbing. Before you know it your Vega profits accumulate, as the IV continues to climb. BUT, just as soon, the IV’s may decline as the rumors are denied. If the rumors materialize, the stock may jump. That was the case with AQNT. The stock went from $35 to $63 overnight. I then closed the calls side of my position for a $31,000 profit. The put side was worthless, but could you imagine if the sale had not been completed? The puts would have made me additional money. Why did I close immediately? Because IV goes down to zero after the sale is announced. Further profits would not justify risking the large profits I had accumulated. So don’t wait until IV declines, close your position when IV is high.

Portfolio Management is critical! If you enter one PCCRC you may be lucky and enter the next AQNT. But you may also be frustrated when the very first trade you enter, turns out to be a loser. It is hard thereafter to ever try the PCCRC again. Understand that we are playing a probability’s game. So start small, risking 1% or less of your account. You have a better chance of success at any particular time if you have 10 of these trades than if you have only one. It is a lot easier for me to accept the losers when I have several winners. But if you only have one trade, and it turns out to be a loser, you’d dismiss the PCCRC strategy as a hard one and never trade it again.
Understand that the advantage of the PCCRC is that Theta, Delta and Vega all work for you, and it is only when the three of them fail you that you lose money. Your probability of success is high, but sometimes all that could go wrong will go wrong. It is easiest to cut your losses when you have several winners.

Having more long than short options make your potential gains unlimited. If I had used any other strategy in the AQNT trade, I would never had made as much money as I made. If I had only bought calls or a call ratio calendar, my lack of a hedge would have prevented me from putting so much capital on the line. The PCCRC is capital intensive, but it is risk limited. If I had sought to limit my risk by entering a Bull Call Spread, I would have never gotten any where near the profits I got, as my short would have crippled my gains.

The PCCRC is particularly useful when you have a large trading account. Let’s say that you have a $50,000 account. You’d have 10 trades with a maximum capital per trade of $5,000. However, your theoretical risk would not exceed $1000. Further, if you follow the profit taking/adjustment rules above, you’d very quickly reduce the actual risk on each trade, locking in your profits.

In a recent interview in a “Trader Interview” podcast, long time trader Dan Fitzpatrick stated: “I have been trading full time about 12 years but I have been interested in the markets about 20 years, the first 8 mostly losing. I traded actively about 5 years before I could trade with confidence. This was a time when you got your charts through the mail, you did not have any internet capability. The key for me, and probably should be for everybody although most people never seem to get this, is I started profiting when I stopped losing.

The PCCRC is the perfect trade for me in that is it reactive. I let the markets tell me when it is time to get in, and progressively get out by taking profits. I don’t try to guess tops or bottoms, or what would happen after earnings. I simply limit my risk every time I get a chance by ringing the register when I can. The PCCRC is not risk free right off the bat, but the proper moves at the proper time make it almost always profitable. I select carefully my candidates and I never brake my entry rules, no matter how tempting the trade might seem, if IV is too high, I pass.

Finally, remember the smiley face. Your trade, whenever possible, should look like a straddle. If you do that, it will become unimportant for you whether a stock you are trading goes up, down or sideways. Then you’d have the control over your psychology and thus stop losing, as Firzpatrick said.

References:

Options as a Strategic Investment. Lawrence G. McMillan
The Volatility Course. G. Fontanills and T. Gentile.
The Trader Interview Podcast. Downloadable from iTunes.

Are you interested in learning how to select candidates for the PCCRC strategy? You can read the archives of this blog. I have published over 300 articles in this blog, most of them having to do with the PCCRC.

You can also obtain my DVD collection of 3 disks as follows:

In DVD #1, I open a paper trading account and build a portfolio of long puts and long calls. I demonstrate how to use a basic technical analysis software to locate potential movers based on Elliott wave theory. I teach how to recognize Elliott patterns visually, and using the Refined Elliott Trader software by Elliottician.com. The prospective account is shown real time, without me knowing in advanced how it was going to turn out.

In DVD #2, I have compiled all videos previously posted in my blog. These are meant to accompany the articles published over the years. I just wanted to removed the old videos from my ISP server to reduce costs. This is a bonus, really.

In DVD #3, I open another paper trading account and fill it with candidates from my various PCCRC strategies. I explain in much detail exactly what I know and do. All of it.

For the price of $100 payable by Paypal to my e-mail account (paperprofit1@gmail.com), you will receive the three DVD’s in the mail.

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