The Role of the Greeks on the PCCRC

Today, I received this e-mail from a beginning trader:

Hi Juan!
I watched your video and it is obvious that you have worked out a system, been trading for awhile, and really understand how options work!!!!  You have a deep understanding of the Greeks. Is what you are doing something like a butterfly?  Hmmm, maybe I will call your style of trading, dragonflies! :)

I am not comfortable -- meaning I don't really understand -- all the Greeks yet.  I do understand Delta and some about implied volatility.  In the past I have traded long with options being in the money, higher deltas, and haven't paid too much about the other Greeks, not even really knowing that they had much importance.  As some traders, who are successful don't watch all those, and seemingly don't care about them ...

I am going to watch your video a few times more to try and understand more deeply.  I would like to learn what you are talking about, BUT I believe I have too little money in my account for doing this for real, and it requires some expensive stocks for great rewards!!! :)  I have to find ways to grow a small amount of money at first.

But I would paper trade it first to get the hang of what you are doing!!!  I am going to wait to join you until late January or early February.  I want to watch your video a few more times too.  I admire you for how thorough you have been in working out your system.

Laura

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As it is usually the case, I get motivated by people’s impressions of my techniques to write up articles. I will try to clear some misconceptions expressed by Laura, that could probably be reflective of those of many beginners.

...”some traders, who are successful don't watch [the Greeks], and seemingly don't care about them ...”

I can back that statement somewhat because I begun trading options after I became skilled in the Elliott Wave theory, candlestick, and other Technical Analysis tools. I soon realized that I was not taking full advantage of my abilities by simply trading stocks. I begun trading options very gingerly, but soon discovered the power of leverage in options. In essence, I relied on Delta which measures the appreciation of an option relative to the price of the underlying. The stock goes up, you make money using calls, the stock goes down you make money with puts. I thought I had all I needed, compared to people that shorted stocks. Shorting stocks was way too risky for my liking, so I either avoided downtrending stocks or bought, very occasionally a put or two.

Buying calls and puts is the natural approach for the beginner options trader. After all, they come mostly from the stock market, and have trained themselves to master either fundamental and technical analysis. But there is a lot more versatility to options than just that. The downside of course, is that options expire, and time has a very deleterious effect on options, particularly in the last month to expiration. This is why it is critical to understand the effect of time decay on the price of an options. This decay is measured by Theta. It does not take a rocket scientist to look at the Theta of an option and see how much you could be losing with every passing day. If Theta is -1.0, for example, you’d be losing $1.0 a share (100 shares in a contract) with every passing day. Obviously, you don’t want to be holding options with, say 10 days to expiration. But there is nothing wrong with selling some short-term options that are “expensive” (see implied volatility below), IF at the same time you have a similar option with a different strike price (see credit spreads) or a longer time expiration (see calendar spreads).

Back in the 1990’s, all I knew about options was that a strong move in either direction could make me a lot of money (leverage), but I also understood that I did not want to stick with that option for too long. How ever, understanding the Elliott wave theory, I was willing to risk Theta decay because I could “predict” how fast and how far could a stock go, mostly up. But those days of the Impulse waves (strong rallying or declining waves), it was easy to select a few technology stocks and take them for a ride. Eventually, the “.com” bubble burst, but close to the end I discovered another feature of options that saved my financial life: Limited risk.

I remember a friend that no longer trades, that routinely called me and ask: “What do you think of Cisco (CSCO) or Sun Microsystems (SUN), or Qualcom (QCOM)”. I would say invariably “it is too high, I would not buy the stock, but it could go higher” and of course, I would buy calls on them, and make very quick money. One day, I was taken out of all my long calls, but my losses where quite limited, thanks to the risk management features of options. I did not like what happened to me, but I was happy that I did not lose a great deal of money, as I saw many traders losing their fortunes and eventually leaving the markets to greener pastures. It was clear to me, however, that I should never own stock. Understanding the leverage and risk control built into options, I wondered if one could create an options position that could be a good substitute for stock, yet with sufficient risk control built in so that I could place large amounts of cash as a substitute for stock. If you have $10,000, you’d probably buy 10 stocks at a portion of $1,000 in shares on each stock. You’d probably do about the same thing if you had $100,000, maintaining about the same percentile allocations, wouldn’t you? However, if you were to buy puts or calls, you’d not dare to spend 10% of your capital because your risk would be exactly 10% of your account. Most aggressive options traders would probably keep their risk at 5% of their trading capital, understanding that you can lose all of that capital. Presumably, if you have a $10,000, you are willing to lose $500 in one single trade. My strategy is to place 10 trades with 10% of my capital per trade, and only 2% at risk in any trade. Overall, my maximum risk in the whole account at any given time is 20%. In the years I have traded the PCCRC, my loss has not exceeded 1% in any individual trade.

...I have too little money in my account for doing this for real, and it requires some expensive stocks for great rewards!!! :) “

Actually, a large account can be very deleterious to your financial health. You should not be using options as a substitute for stock in capital traded, but rather in amount at risk. Let’s say that your “small account” is $10,000, and you decide to invest $1,000 in each of 10 stocks. Would you place a stop loss 10% below the current strike price? that would limit your loss to $100, if your stock goes south, would you? Most people I know do not do this. They may stay in the stock until they lose 20% and some don’t use stop loss routinely. In reality, however, any stock can go down 30% overnight, without giving you the chance to sell at the 10% loss point. If you had bought a call, with equal number of shares, your loss would be limited to the cost of the option, even in catastrophic declines in stock price. However, if you had spent $1000 in one call on the same stock, you could lose it all, if the stock declines 30% overnight. The trick is to understand your own risk tolerance. If you were willing to lose $300 in a stock that declines strongly, you should not be spending any more than $300 in any single options trade.

The secret behind the PCCRC techniques I use is to take advantage of strong moves in either direction, as you would using a call or a put (or both), while limiting my risk to 2% of my available trading capital, which is actually quite conservative. I finally met my goal of finding that hedged position with built in leverage and risk control that could substitute a stock position in terms of capital exposure, but with much more limited risk and much more leverage. But there is a lot more to this strategy, assuming that you are able to find stocks that can make monster moves in either direction within a 3-4 month period. Amazingly, I have found that the risk control serves me well by reducing the number of losers and reducing the amount lost per loser. I believe that this is what all traders traders are looking for, whether they have $10,000 or $100,000 of trading capital.

I have to find ways to grow a small amount of money at first.

While it is true that there are advantages in trading PCCRC’s with high price underlying stocks, it is not true that small accounts could not trade my strategies. There are some limitations, to be sure, but I believe that trading puts and calls exclusively, may end up being much more frustrating and limiting that a few simple PCCRC’s in relatively small accounts. In fact, I have the evidence to prove it. I have a relatively small retirement account which I started with about $15,000 at about the same time I begun to trade the PCCRC strategies. I decided early on that I would use this account for miscellaneous strategies, rather than running a scaled down reproduction of my PCCRC’s in the larger accounts. I have grown the account to as high as $27,000 and then reduced it to $17,000. The ups and down are frustrating and unproductive, and I can guarantee you that I would repeat the same trades given the same circumstances. Buying puts and calls, are simply too volatile. I call this form of trading “...yes, no, maybe so”, even with all the background and years of trading I have, trading is just too difficult to produce success in routine and consistent ways.

I watched your video and it is obvious that you have worked out a system, been trading for awhile, and really understand how options work!!!!  You have a deep understanding of the Greeks.

It is true that I was fortunate to have run across Larry McMillan’s book “Options as a Strategic Investment”, and amaze myself when I begun to test the “Put Call Calendar Ratio Combination”. It dawn on me that this form of trading was actually taking advantage of Delta, Theta and Vega. Eventually I begun to understand the value of Gamma in it too. But it is not true that it was my understanding of Greeks that lead me to the PCCRC. I just intuitively knew that it would work. Here is why: The PCCRC has two basic components: a. A front month short straddle, and b. A back month long straddle with 2x as many contracts. See if this phrase makes sense to you: “Given sufficient time, any stock will move strongly up or strongly down”. Regardless of the Technical Analysis or Fundamental Analysis principles that you use, all you need is time to make long options profitable. A long-term straddle may certainly accomplish this if it weren’t for the decay in time value.

Have you heard the phrase “options are meant to be sold?” this is born out of the misconception that most options expire worthless. However, there is some truth to the fact that selling OTM options would turn a profit more often than not. This is why former floor traders and professionals prefer to sell options, or sell credit spreads or use strategies such as the iron condor and butterflies. After all, Theta works with you in these positions, instead of against you when you buy calls or puts. I sought to take advantage of the well known fact that options decay faster one month before expiration. Selling the front month straddle would turn my trade profitable, month after month, even if the underlying does not move much at all. This is the same principle behind the calendar spread.

As I begun to make consistent and sometimes unexpectedly large profits with the PCCRC, I simultaneously continued reading about options trading and the secret weapon behind options: Implied Volatility (I.V.). It truly amazes me how most traders choose to ignore this the most powerful of factors behind the value of an option. Vega measures the effect of the change in I.V. over the price of an option. In fact, most traders limited themselves to avoiding I.V. when they should be taking advantage of it. When you buy a call or a put, a large portion of your premium comes from the demand for those options. That demand creates an artificially large price that “implies” that the underlying is likely to move strongly in either direction, or both, before the expiration of that option. Knowing this, an option’s trader may choose to create a vertical spread, rather than being exposed to the Vega in an expensive long call or put. In effect, they sell as much volatility as they buy, virtually neutralizing Vega, this most powerful of Greeks.

Others actually DO use I.V. or “Vega exposure” but in a somewhat schizophrenic way with the Calendar Spread, and here is why: A calendar spread consists of a short front month option and a long back month option with the same strike price. The Vega exposure comes from the fact that the back month option is more susceptible to changes in I.V. than the back month option. It makes sense that if options “imply” a strong move in the future, the farther away that future is, the stronger the move would be. You don’t expect a blue chip stock to move $10 in one week, but that may be a bet you are willing to make if it involves 3-4 month into the future. A Calendar is usually Vega positive, which means that an increase in I.V. would favor the position, but I.V. could only increase if there is a perceived potential strong move in either direction before the long option expire. Ironically, or paradoxically, the Calendar trader is expecting the stock to remain within a trading range for the life of the trade.

In many ways the PCCRC is similar to the Calendar spread because they both profit from Theta decay in the front month option, and from increased volatility in the back month option. However, when it comes to Delta, the similarities end. A strong move in either direction in a Calendar spread will turn a loser, regardless of the increase (if any) in I.V. However, a strong move in either direction and the PCCRC can make strong gains due to Delta Exposure. Very often, a decline in stock prices results in a spike in I.V., returning a profit.

So you see, the understanding of the Greeks is paramount to Options trading, whether you trade long options or fanciful spreads. The Greeks are, however, nothing to be scared of. In reality, if you have been trading options for a while, you intuitively know the role the Greeks play, even without knowing it. You know that options decay very rapidly toward expiration, so you know Theta. You probably know that stocks that move strongly in either direction routinely, demand high premiums and thus may seem to cost a lot more than a quiet stock of a similar price. This is the I.V. of an option is measured by Vega. Knowing that the PCCRC, when properly applied, can take advantages of all the Greeks alone or in combination, the better question would be, why would you not take advantage of all this potentiality? why rely on good old Delta alone?