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Kaeppel's Corner: 'First Thrust', Then 'Adjust'

By Jay Kaeppel, Optionetics.com | Wed January 30, 2013 2:30AM PT

 

Note to myself: Maybe think through these article titles a little better before you get yourself in trouble. 

Anyway, in last week’s article I introduced a simple trading idea that I refer to as “First Thrust”.  In a nutshell, we look for a situation for a given tradable security when the 10-day moving average moves above the 30-day moving average and the security closes above its 200–day moving average (10 below 30 and close below 200 for a bearish signal).  The idea is to enter a long position and to (hopefully) profit from a new trend.

Like a lot of trading methods, sometimes this one follows through in spectacular fashion, sometimes it follow through to some limited degree and/or for some limited period of time, and of course, other times it simply doesn’t work at all.  So from a trading standpoint the key is to maximize profitability on the winning trades and to limit the risk on the losing trades (Hey, this sounds like an idea that could catch on!).

 

The Beauty of Options

If you have read my stuff in the past then you know that Optionetics lets me write about a wide variety of topics – market timing, seasonal trends, sector funds, currencies, and so on.  And I appreciate the flexibility.  Still, as a dutiful believer in the power of options and the power of Optionetics to teach people how to trade them more effectively, I feel obligated every once in a while to get “down and dirty” on the topic of options trading.  So this is going to be one of those articles.

If you are interested in learning more about how to use options to take advantage of situations while limiting your risk, this article will at the least give you some ideas to seriously consider.  On the other hand, if you have absolutely no interest whatsoever in trading options then you are pretty much free to stop reading at this point and go on about your business.  Hey wait, where are you going?  I was just saying that - I didn’t really mean………oh well, maybe its better this way.

So what we are going to do is walk through some example trades using call options on Cisco (ticker CSCO) to see:

-One example of a timing method

-One set of trade entry criteria

-One set of trade exit criteria

-The net result

 

One Example of a Timing Method

In Figure 1 you see three “First Thrust” signals as described above for CSCO – two bullish and one bearish.

Figure 1 – First Thrust signals for CSCO

The goal is to buy a call or put option and attempt to adjust the trade if quickly as possible to lock in a profit, and with any luck to let the adjusted position ride and achieve even greater profits. 

 

One Set of Trade Entry Criteria

For bullish (bearish) trades we will look to buy a call (put) option with:

-At least 45 days left until expiration and

-The highest Gamma value among the near-the-money call (put) options for that expiration month

 

One Set of Exit Criteria

Here is where it gets a little “interesting.”  When you buy a stock or a futures contract you buy at one price and hope to sell at a higher price.  With options you can be a lot more “creative” in terms of managing the position.  So our goal is to attempt to adjust our original position in order to lock in a profit and to hopefully let the adjusted position ride in hopes that the trend turns out to be an extended one. 

So our exit criteria for a call option position are as follows:

a) Sell 1/3 of the original position if 2-day RSI rises from below to above 85 (a maximum of twice) and the option is 10% or more above the entry price

b) Adjust to a 2-3-2 upside butterfly if close > Upper Bollinger Band (20,2)

c) Sell if 10-day moving average drops below 30-day moving average

d) Can use discretion to exit trade in last 7 days left until expiration

For a put option:

a) Sell 1/3 of open position if 2-day RSI rises from above to below 15 and option is up a minimum of 10% from entry price (a maximum of twice)

b) Adjust to a 2-3-2 downside butterfly if close < Lower Bollinger Band (20,2)

c) Sell if 10-day moving average rises above 30-day moving average

d) Can use discretion to exit trade in last 7 days left until expiration

Criteria a) is designed to take a quick profit on part of the original position and to reduce downside risk just in case the move fails to follow through as hoped. 

Criteria b) is designed to get us into a position that we can “let ride” after possibly already locking in a profitable trade. 

Criteria c) forces us to acknowledge that the trend is no longer in our favor and that it is time to move on. 

And criteria d) allows us to shoot ourselves in the foot – er, I mean to utilize our own experience and analysis as the position nears expiration.

So let’s look at the trades shown in Figure 1:

Trade #1:

8/16/12: First Thrust bullish signal:

Action - Buy 30 CSCO Oct 19 calls @ 0.73 (cost of $2,190)

 

8/27/12: 2-day RSI >85, option up over 10%

Action (Exit Criteria a) - Sell 10 CSCO Oct 19 calls @ 0.85 (profit of $120)

 

9/6/12: 2-day RSI >85, option up over 10%

Action (Exit Criteria a) - Sell 10 CSCO Oct 19 calls @ 1.00 (profit $270)

 

9/26/12: 10-day moving average drops below 30-day moving average

Action (Exit Criteria c) - Sell 10 CSCO Oct 19 calls @ .20 (loss of $530)

Net result for 8/26 trade = loss of -$140

As you can see in Figure 1, CSCO did not follow through to the upside after the 8/16 First Thrust signal.  Still, the two instances of Criteria a) allowed us to minimize our risk on the trade, and the net result was a relatively small loss of -$140.

 

Trade #2:

10/10/12: First Thrust Bearish Signal

Action – Buy 18 CSCO Dec 19 puts @ 1.31 (cost $2,358)

 

10/24/12: CSCO closes below Lower Bollinger Band

Action (Exit Criteria b) – Adjust into an 2-3-2 Downide Butterfly

-Sell 12 CSCO Dec 19 puts @ 1.87

-Sell 9 CSCO Dec 17 puts @ .67

-Buy 6 CSCO Dec 15 puts @ 0.19

 

At this point we are:

-Long 6 CSCO Dec 19 puts

-Short 9 CSCO Dec 17 puts

-Long 6 CSCO Dec 15 puts

 

The risk curves for the new position are reflected in Figure 2.

 

Figure 2 – Adjusted CSCO 6-9-6 Put Butterfly

 

At this point we have:

-An open profit of +$984

-A worst case profit of +$375

-Unlimited profit potential if the downtrend continues

-The potential for profits to increase if the stock stays relatively unchanged

 

11/26/12: 10-day moving average moves above 30-day moving average

Action (Exit Criteria c) – Close position

-Sell 6 CSCO Dec 19 puts @ 0.40

-Buy 9 CSCO Dec 17 puts @ 0.05

-Sell 6 CSCO Dec 15 puts @ 0.01

The net effect of all of this is a profit of +$576.  Combined with Trade #1 we now have a combined profit of $436 ($576-$140)

 

Trade #3:

11/26/12: First Thrust Bullish Signal

Action - Buy 42 CSCO Jan 19 calls @ 0.54 (cost of $2,268)

 

12/4/12: 2-day RSI >85, option up over 10%

Action (Exit Criteria a) – Sell 14 CSCO Jan 19 calls @ 0.67 (profit of $182)

 

12/10/12: 2-day RSI >85, option up over 10%

Action (Exit criteria a) – Sell 14 CSCO Jan 19 calls @ 1.04 (profit of $700)

 

12/18/12: CSCO closes above Upper Bollinger Band

Action (Exit Criteria b) – Adjust into a 2-3-2 Upside Butterfly

-Sell 6 CSCO Jan 19 calls @ 1.48

-Sell 12 CSCO Jan 21 calls @ 0.20

-Buy 8 CSCO Jan 22 calls @ 0.05

 

At this point we are:

-Long 8 CSCO Jan 19 calls

-Short 12 CSCO Jan 21 calls

-Long 8 CSCO Jan 22 calls

This adjusted position is reflected in Figure 3.

Figure 3 – Adjusted CSCO 8-12-8 Call Butterfly

 

At this point we have:

-An open profit of +$2,178

-A worst case profit of +$1,214

-Unlimited profit potential if the uptrend continues

-The potential for profits to increase if the stock rises slightly toward $21

1/18/13: Option Expiration Day

Action - Exit the enitre position just prior to the close.  

If this position was exited near the close of January 2013 options expiration day (1/18/13) the profit would have been roughly $2,790.

So in sum:

Trade #1: (-$140)

Trade #2: +$530

Trade #3: +$2,790

Total = +$3,190

 

Summary

There are a lot of possible lessons to be learned hear.  Among them (and in no particular order):

-Options trading generally requires a little more “effort” and time devoted than stock trading.

-Having a well thought out plan of action and following that plan is key.

-Taking advantage of opportunities to adjust trades and lock in profits is one of the most important advantages of option trading.

-Not every trade works out (duh) but if you have a good plan that works to maximize the profits for the winning trades and to minimize the losses for the losing trades, you afford yourself great upside potential over time.

-And so on and so forth……..

Hey, thanks for sticking around to the end.

Jay Kaeppel

Staff Writer and Trading Strategist

Optionetics.com ~ Your Options Education Site

 


Recent articles by Jay Kaeppel, Optionetics.com


July 24, 2013  -  Kaeppel's Corner: Just When You Think You Know It All....
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July 09, 2013  -  Kaeppel's Corner: Words to Trade By
July 02, 2013  -  Kaeppel's Corner: Of Gold Stocks, Falling Safes, and Moths to Flames
June 24, 2013  -  Kaeppel's Corner: How To Enjoy Market Summer Boredom


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