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Did you here the one about the woman who became addicted to line dancing?  She had to join a two-step program.

Okay, that’s a joke. But this is not:

Success in option trading involves two steps.  Those steps are:

• Developing the ability to spot opportunity
• Developing the ability to craft a position to take maximum advantage of that opportunity within the context of your own risk profile

Some individuals are good at spotting opportunity. Others excel at formulating trading strategies. The really great ones are good at both. Now this is a two-step program worth joining. So today let’s walk through a scenario that involves finding an opportunity and analyzing a few ways to try to take advantage of it.  

PLAYING THE YEAR–END RALLY

If you have read my previous articles you know that I have been looking for a rally into year-end based on the act that both the 40-week cycle (What a Difference 140 Days Makes, 6/21/05) and the Santa Claus rally (Is Santa on His Way?, 11/30/05) are bullish through the 5^th trading day of January 2006.

I have a list of about 50 stocks that I follow pretty closely, so I have perused this list to see if a unique opportunity for playing a potential year end rally might jump out.  Would it surprise anyone to learn that something did jump out?

Now I have never been much of an Elliot Wave guy.  In fact I have ridiculed it at times in the past in private conversations.  Nevertheless, one thing I have learned over the years is the benefit of occasionally revisiting previously dismissed ideas.  Occasionally looking at some old idea from a fresh perspective can yield a different point of view.  From my conversations with several Optionetics instructors I felt compelled to take another look at the Elliot Wave.  One thing I realized is that my previous disdain for EW stemmed primarily from my own lack of confidence in my ability to correctly count the waves.  So when I came across a way to have someone else actually count the waves for me (ProfitSource), I immediately liked the idea a lot better.  Another thing I have found is that assuming that every EW price projection will pan out is a mistake.  Instead it seems to be most useful in helping to decide to select one trading vehicle over another.  

The opportunity that jumped out at me involves Sandisk (SNDK).  As you can see in Chart 1, SNDK qualifies as a “big mover.”  

Chart 1 – Sandisk (SNDK) Weekly

This is a stock prone to experiences big moves, both on the upside and the downside.  Most recently, the stock exploded off of a July low of 23.64 and rallied 177% in just four months, to a high of 65.49.  Since then, the stock has pulled back about 30% and as this is written is trading around 49.  Volatility anyone?  So what is next for SNDK?

Well the Elliot Wave projection which appears in Chart 2 is suggesting the possibility of a Wave 5 move to 71.80 by the end of January 2006.  Were this projection to come true the moneymaking possibilities are myriad.  Still there are important questions to be asked and answered before any trade is entered:  

• What is the likelihood that this projection will actually be reached?
• What are my investment choices? 
• Which makes the most sense to me?

Chart 2 – Sandisk (SNDK) with Elliot Wave Projection  

The easiest choice is to buy 100 shares of SNDK.  This involves investment $4,923 of capital.  If the stock does indeed rally to 71.80, this trade will yield a profit of $2,257, or 62%, as shown in Chart 3.

Chart 3 – Risk Curve: Long 100 shares of SNDK

Obviously, some sort of stop-loss provision would be in order as losses would pile up very quickly if SNDK were to break recent support and start plunging lower.  

Now let’s look at some alternatives involving options.  For the sake of these examples, let’s assume that we are willing to put $2,500 into an option trade.

One approach is essentially to “go for the gusto,” i.e., to look for the trade that will make the most money if SNDK does indeed manage to reach 71.80 by the end of January 2006.  This would involve buying 33 April 80 calls at $0.75 each.  Chart 4 depicts the risk curve for this trade. 

Chart 4 – Risk Curves: Long 33 April 80 SNDK Calls

The good news is that if SNDK immediately shoots higher this trade will make ridiculous sums of money.  More conservatively, if SNDK happens to be trading at 71.80 on 1/31/06 this trade will show a profit of approximately $12,000.  Now before anyone gets stars in their eyes it is important to consider the fact that this trade amounts to nothing but sheer speculation.  Yes, if the stock shoots higher – and yes, in this scenario we are looking for (at least hoping for) it to shoot higher – this trade will generate a tremendous profit.  Still, the fact remains that the potential to lose money on this trade also is great.  

If one if still holding this trade on 1/31/06, the stock must be above approximately 57 or the option trade will show a loss.  In other words, the stock must rally at least 16% in order for this trade to show a profit.  Under any other circumstance – i.e., anything less than a 16% advance in a little more than a month and a half – this trade will show a loss.  In fact, if the stock is unchanged by 1/31/06 this trade will show a loss of approximately $1,850, or about –75%.  So do not make the mistake of looking at this trade as an investment.  It is more along the lines of a lottery ticket.  It may pay off handsomely if all goes well.  If not, a loss of a significant percentage of the entry price is guaranteed.

Another, less aggressive approach, would be to buy the April at-the-money call options.  We can buy four April 50 calls at 6.60 each, for a total investment of $2,640.  The risk curves for this trade appear in Chart 5. 

  
Chart 5 – Risk Curves: Long 4 April 50 SNDK Calls

If SNDK happens to be trading at 71.80 on 1/31/06, this trade will show a profit of approximately $6,470, or +245%.  If one if still holding this trade on 1/31/06, the stock must be above approximately 52.50, or the option trade will show a loss.  In other words, the stock must advance 6.6% by 1/31/06 in order for this trade to show a gain.  Under any other circumstance – i.e., anything less than a 6.6% advance in a little more than a month and a half – this trade will show a loss.  If the stock is unchanged by 1/31/06 this trade will show a loss of approximately $700, or about –26%.

Now let’s look at another – and even more conservative possibility. Chart 6 depicts the risk curves for buying two April 40 calls at 12.30 each.  


Chart 6 - Risk Curves: Long 2 April 40 SNDK Calls

If SNDK happens to be trading at 71.80 on 1/31/06 this trade will show a profit of approximately $3,990, or +162%.  If one if still holding this trade on 1/31/06, the stock must be above approximately 50.88 or the option trade will show a loss.  In other words, the stock must advance 3.3% by 1/31/06 in order for this trade to show a gain.  Under any other circumstance – i.e., anything less than a 3.3% advance in a little more than a month and a half – this trade will show a loss.  If the stock is unchanged by 1/31/06 this trade will show a loss of approximately $290, or about –12%.

Of the three trades detailed above I personally would prefer to buy two April 40 calls.  However, that is not the same as saying that it is the “proper” choice, or that everyone should agree with my opinion.  For the purpose of enlightenment, let me explain how I come to this choice.  

THE POWER OF NEGATIVE THINKING

The most critical assessments a trader makes in buying call options is determining:

• Their level of confidence that a particular price target will be reached
• Their willingness to tolerate the consequences if their anticipated scenario does not play out.

Because I have been trading for a long time – and because I am cynical by nature – I operate under a simple, unspoken rule – “Expect Nothing.”  In other words, I never go into a trade thinking “oh boy, this is gonna be great!”  For each new trade I simply assume that my worst case scenario will probably occur so I’d better figure out the downside and determine if I can stomach that.  There are pros and cons to this mental approach.

On the one hand I am sure there is some psychological price that one pays for going through life as a cynic (but enough about me).  Likewise, focusing more on minimizing downside risk, it can be argued that you never give yourself the chance for the “moonshot” (see Chart 4 above), and will from time to time miss out on a massively profitable trade.  Still, the benefits are several:

• First off, while the deep-in-the-money call position (April 40 calls) does not offer anywhere near the profit potential nor leverage of the other trades, upside profit potential remains significant, particularly when compared to simply buying the stock.  
• Secondly, the stock needs only to make a small move up for the April 40 call to begin enjoying almost point-for-point profit with the stock itself.
• Thirdly, time decay will begin to adversely affect the April 80 and April 50 calls significantly by the end of January.  Remember, if the stock is unchanged by 1/31/06, the 80 call will be down 75% and the April 50 call will be down 26%.  Under the same scenario, the April 40 call will be down only 12%.  

THE WORST OF THE WORST

One other assessment I like to do in comparing long call or put trades is what I refer to as the “worst of the worst” test.  Okay, I admit it doesn’t sound terribly inspiring (hence the reason you always see the more upbeat and popular “Best of the Best” mantra in marketing slogans), still I find it useful.  It works like this: rather than assuming that some particular price target will be hit, I determine what will happen to the trade if the stock rises one standard deviation or falls one standard deviation during the particular time frame that I am looking at.  I also include the “what if the stock goes nowhere” assessment in the mix.  According to my calculation, one standard deviation for SNDK between now and 1/31/06 is approximately 9.76 points.  So now we have a few points of reference:

• The Elliot Wave target of 71.90
• One standard deviation up = 59.00
• Unchanged = 49.23
• One standard deviation down = 39.47

So let’s compare the outlook for each of the trades under these different scenarios:

Table 1 – Trade Comparisons

CONCLUSIONS

Different traders will look at the risk curves I’ve shown and the results depicted in Table 1 and reach different conclusions. Again, if one is highly confident that a price movement of a particular magnitude is likely to occur, it makes a great deal of sense to position a trade which will maximize your benefit from that scenario.  Still, you pay a price for everything – in life as well as in trading.  If you buy the SNDK April 80 calls and SNDK does in fact rally sharply between now and 1/31/06, you will make a lot of money.  But ala Clint Eastwood as Detective Harry Callahan, you have to ask yourself one question, “do I feel lucky?”  When it comes to trading, I never “feel lucky.”  I prefer to enter positions that can profit from more than one scenario.  

By purchasing the April 40 calls I can enter a stock equivalent position which can profit under circumstances which do not necessarily involve having to have SNDK rally more than 24%.  Why 24%?  As of 1/31/06, the April 40-call position will show a greater profit (or smaller loss) if the stock is at any price below 61.00 (i.e., about 24% above its present price level).  Does this mean it really is the best trade?  I’ll leave you to answer that question yourself.  

The key is to ask the question each time you spot an opportunity and make the decision that makes you most comfortable.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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