Kaeppel's Corner: Playing a Seasonal Trend with Options
April 15, 2009
Last week I wrote a bit about my inclination to utilize seasonal trends in selecting trades. While some people regard seasonal trends in financial markets as a lot of wishful thinking, and something with "no guarantee that it will work this time around," I have found them to be quite useful. The trick, however, is not to follow them blindly. In essence, seasonal trends work best as "catalysts," and not necessarily as "trading systems." A little bit of trend filtering and some thoughtful trade selection and trade management are other necessary pieces of the puzzle.
One process that I advocate for using seasonal trends involves four basic steps as follows:
- Identify a reliable seasonal trend.
- Make sure the market in question is doing what it is "supposed to be doing" when it is supposed to be doing it.
- Enter a low risk option trade.
- Manage the trade.
Please note that the seasonal trend in question represents only one of four steps.
Step #1: Identifying a Reliable Seasonal Trend
Last week ("Seasonal Trends I Have Known and Loved") I noted the fact that crude oil has demonstrated an historical tendency to advance in price between the seventh trading day of February and the fifteenth trading day of April. If you look at an equity curve that displays the results of buying and selling crude oil futures on those dates, the results are pretty good. Which is all well and good; unfortunately the problem is that in order to emulate these results a trader would not only have to be willing to buy and hold crude oil futures, but to hold them without using any sort of stop-loss. Not only would most traders not be willing to do this, the reality is that no one really should do this. The risks are simply too great. So does this mean that our seasonal crude oil information is "interesting in theory, but useless in the real world"? Not necessarily. Consider the four steps listed earlier. Step one is to find a "reliable" seasonal trend. Check.
Step #2: Make Sure the Market in Question Is Doing What It Is "Supposed to be Doing" When It Is Supposed to be Doing It
The second step is to make sure that now that crude oil is within a seasonally favorable period, is it doing "what it is supposed to be doing"? In other words, is crude oil rising in price? There are many methods that one might use to attempt to quantify this. For our purposes let's go with one of the simplest. We will use Optionetics' Founder George Fontanills simple 10-30 moving average crossover. In other words, we will only be bullish on crude oil if the 10-day moving average is above the 30-day moving average. Also for our purposes here we will use the exchange-traded fund US Oil Fund (USO) as our trading vehicle.
As of the close on 2/10/09 (the seventh trading day of February), the 10-day moving average for USO was well below the 30-day moving average. Thus no action would be taken despite the fact that the bullish seasonal trend was now in force. As you can see in Chart 1, it was not until 3/10/09 that the 10-day average for USO finally crossed above the 30-day average.
Chart 1 - USO with 10-day and 30-day moving averages
At this point both the seasonal and price trend parts of the equation were in place, so the time had come to find a bullish trade.
Step #3: Enter a Low-Risk Option Trade
The most straightforward approach to play an expected bullish move in crude oil would be to buy 100 shares of USO at 27.83. This trade would cost $2,783. An alternative with less cost and greater leverage would involve buying four July 28 calls at the open the next day at $3.50 each, or $1,400. The risk curves for this trade appear in Chart 2. The dates considered extend only through April 22 (the 15 trading day of April), since we would expect to exit this trade at that time.
Chart 2 - Risk curves for July 28 calls
Step #4: Manage the Trade
By 3/23/09, USO had rallied to 31.78 and the July call was trading at 5.95 and the long call trade had an open profit of $980. Now there is any number of actions that a trader might take in this situation in order to attempt to lock in a profit. The possibilities are myriad, but for the sake of example, we will look at turning this long call trade into a strangle in order to lock in a profit. A trader could have sold two of the July 28 long calls at 5.95 and used the proceeds to buy two July 34 puts at 5.10 each. The new risk curves for this trade - again assuming that we will exit after the fifteenth trading day of April - appear in Chart 3. As you can see in Chart 3, this new adjusted trade essentially has no risk of losing money and enjoys unlimited profit potential in either direction.
Chart 3 - Risk curves for adjusted trade
The tradeoff here is as follows: we now have no risk of losing money (assuming implied volatility does not plummet to around 10% and that we do in fact exit the trade by late April) and unlimited profit potential, however, we do not have as much immediate upside potential as we did before (remember we entered this trade to play a bullish bias). So if crude oil rallies sharply to the upside, we will make significantly less than if we had left the trade alone.
Summary
Obviously I am a fan of seasonal trends. And while I regularly sing their praises I also recognize that there is no such as the holy grail of trading. To me, seasonal analysis is a valid - albeit more narrow - area of analysis just like technical and fundamental analysis. I also understand that seasonal trend analysis is only one step in a comprehensive approach to trading. The trade detailed in this article is just one example of a way to use seasonal trend information to profit.
LEARNING MORE ABOUT TRADING
A couple of educational notes I would like to mention:
I will be teaching more ideas like the one presented in this article at this year's Optionetics OASIS gathering June 18-20. I look forward to seeing many of you there.
The next issue of Optionetics ETF Investor newsletter is due out this weekend. If you are interested in receiving a free 1-month trial to Optionetics ETF Investor - edited by Jay Kaeppel and Clare White - you can do so by clicking here.
Another tool I would like to mention is The Velocity Strategy, a collaborative effort between Optionetics and Agora Trading (http://www.velocitystrategy.com). This is an in-depth real world stock index trading course featuring Tom Gentile of Optionetics and Rick Pendergast, a professional trader and a market analyst for Investor's Daily Edge newsletter. Also yours truly had a behind the scenes hand in developing the course content.
Lastly, have I mentioned lately that I have a new book out? (You mean the mention that you make just about every week now, Jay?) Yes that would be the one. "Seasonal Stock Market Trends: The Definitive Guide To Calendar Based Stock Market Trading" was released by Wiley in January 2009.
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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