The Greeks and my 4 Strategies for Fearless Trading

The way I look at the PCCRC is as a carriage pulled by 3 horses (theta, vega and delta). When I enter a trade, I want to presume that either of the three may help me make my money, I don’t pre-judge which one would be, I just want to make sure that all of them are on my side to begin with.

Thus, I look for momentum stocks. Stock that have performed exceptionally well over the last 3 months that I call high fliers. If your software allows you to locate stocks that are at a 52 week high, or that are the best performers (% wise) over the last 3 months, then you have a high flier. Delta is likely favor your trade, either because the stock continues to rise or because a strong reversal is likely to happen. Delta negative or delta positive, you win if the stock moves strongly over the live of your trade. In other words, you are putting Delta on your side. All that I need to check to enter this trade is, what are the chances that IV will increase in the coming months. When a stock falls with high volatility, or even if it just moves sideways, I make money, even if IV increases as little as 5%. All I need to do is to confirm that IV is low. What is low? The IV is at the low end of the chart and/or IV/SV ratio is below one and perhaps hooking up. Now you have Vega on your side. So how do you put Theta on your side? Simply by selling a front month straddle. It is true that Theta won’t make you much, but I’d rather make little than lose money. So if the stock does not change much in price and IV stays the same for the first few week of the trade, you are still OK, because Theta is on your side. This is my “High Flier Strategy” in a nutshell.

My second strategy, needs a strong catalyst that would cause the stock price to rise 10% or more with declining volatility. This catalyst, I have found, may come in the form of raised guidance in earnings going forward. Yes, I don’t care whether the stock beat expectations, that sort of news is usually expected (more or less), but the raised guidance is truly new news and have the potential to make the markets move. Nevertheless, it is still quite possible that the stock may go down thereafter, but that may occur after some negative (or perceived negative) piece of news, even after good earnings and guidance. Take MSFT as an example, how a stock that had performed very well in the last few months, suddenly tanks as they bid to acquire Yahoo! Delta helps you to the downside. Vega helps you too, though, if you enter the trade at a low point. This deflation in volatility is quite remarkable right after earnings in stocks that jump 10%. So you are entering at a low IV. Entering the long portion of the IV at a month that goes beyond the next earnings season assures you that they will increase in volatility as the next earnings report approaches. This is my “Post-Earnings Spike Strategy” in a nutshell.

Occasionally, you’ll find stocks with a volatility skew. These are easy to find if you have Optionetics platinum. Here I expect the front month IV to go down or the back month IV to rise. My assumption here is that IV’s will tend to even out. These is a rare trade, and you must be ready to exit if and when the IV changes and you accumulate profits. This may actually occur very quickly. Here, I’d take my profit as soon as the skew disappears. If the skew is due to rumors of a take over, for example, the take over may cause the IV to collapse in both front and back month. However, it is quite possible that Delta shoots strongly enough to give you an instant profit. If there is a definitive agreement of takeover, and your stock jumps 20%, let’s say, after the announcement, IV will dry out. Then I need to exit the position immediately, because no further profits will be expected after the move. This is my “I.V. Skew Strategy” in a nutshell.

Some of you may have heard of the strategy of entering a straddle one month before earnings, in the hope that IV will increase, or earnings will move your stock strongly. The straddle is a terrible way of trading because you are paying too much for the luxury of not carrying which way the stock will move, but you disregard the Theta decay risk. If IV increases toward earnings, it may appear that you are doing well, as profits may accumulate by virtue of Vega. However, as soon as the earnings are out, and unless the stock price moves strongly in either direction, you will lose your profits as Vega declines. You can certainly exit the trade BEFORE earnings, whether you make 25% or 1% or 100%. My guess is that the straddle will leave you frustrated with much effort and not much to show for it. However, if you incorporate the PCCRC to this strategy, you may do very well. Why? Because you’ll have Theta on your side. By shorting the front month straddle (which you’d be buying in the traditional strategy), you are making sure that time decay (which is more acute in the front month options) works for you. Now here you have a Vega play. If Vega increases towards earnings, it would do so both in your front month and back month options. BUT because you are long more options than you are short (by 2:1 in my strategy), IV increases work in your favor while at the same time Theta is with you, not against you. Delta, just like in the original straddle strategy, is still with you. You may decide to go over the earnings period, if you still expect Delta to govern your profits more than Theta or Vega. This is my “Pre-earnings Strategy” in a nutshell.