Things sure have come a long way since I started in this business. “Back in the day” the idea was to “invest” our money and make it “grow over the long-term.” Nowadays, the market is dominated by high frequency trading, where “long-term” is defined as “anything longer than a couple of milliseconds.” Ah, progress.
I myself have been affected. Way back when I would study a company’s fundamentals (for you tech savvy newcomers that is earnings and sales data, etc. – oh, never mind) and look at the bar chart for clues as to which stocks seemed to have the best “growth potential.”
Now like so many others, I tend to adhere to a simple 3-step program:
1) Find an opportunity and make a trade
2) Try to make some money
3) Get the heck out before something scary happens
So in this pursuit it is helpful to have some objective set of criteria to rely upon, rather than just “flying by the seat of one’s pants”. Which reminds me to invoke:
Jay’s Trading Maxim #82: Investors who “fly by the seat of their pants” so to speak, ultimately experience "backside heat discomfort", so to speak, and spend a lot of time being unable to “sit down”, so to speak.
Anatomy of a Setup
There are a lot of ways to “play the game”. One useful endeavor for a trader is to find a situation when a given security appears to be running out of momentum and then play the opposite trend. Here is one example setup:
1a) A stock makes a high which is higher than the previous high and the previous high was at least two weeks ago (for the record, two weeks is an arbitrary choice. Also for the record, I am using a slightly longer-term version of MACD with defaults 18/37/9 rather the more traditional 12/26/9).
1b) on that same day, the faster MACD line (referred to as “MACD Graph” in Figure 1) registers a daily reading that is below the reading on the day of the previous high.
2) The faster MACD line (referred to as “MACD Graph” in Figure 2) then (either that day or some subsequent day) ticks lower for one day.
3) The MACD Histogram (which is the difference between the two MACD lines) also ticks lower for a day (this can occur before, after or on the same day as #2).
This constitutes a bearish setup. See Figures 1 and 2.
Figure 1 – HAL makes higher high, MACD does not
Figure 2 – MACD and MACD Histogram tick lower
Considering Additional Factors for Confirmation
Other factors can help confirm or deny the potential usefulness of this setup. For example, in Figure 3 you can see that as of 9/20, HAL completed a 5-wave up pattern according to ProfitSoure by HUBB.
Figure 3 – HAL Daily Elliott Wave count complete a 5-wave bullish pattern
Lastly, in http://www.optionetics.com/market/articles/2012/09/19/kaeppels-corner-time-for-energy-to-run-out-of-well-energy, energy stocks have shown a seasonal tendency to decline between September Trading Day #10 and October Trading Day #6.
So as of 9/20 a lot of bearish pieces were in place for ticker HAL. Buying a put option seemed like a logical idea. From a close look at Figure 2 you can see that on 9/21 HAL opened higher - $0.75 higher to be exact. A trader could have purchased 16 HAL October 37 put options on the open of trading on 9/21 at a price of $1.30, for a total dollar risk of $2,080.
Why This Option?
As of 9/20, the October 37 put had only 29 days left until expiration. Ideally you would buy an option with more time left until expiration to minimize the dangers of time decay. However, the October 37 put was selected for the following reasons:
1) With this setup we are looking for a relatively quick profit if the stock declines in the short-term.
2) The next available option month at the time was January. While it is typically a good idea to buy a longer-term option, in this case the January puts would be far less sensitive to the price movement of HAL stock (the October 37 put had a Gamma of 13, the January 37 put had a Gamma of about 6.5 – long story short, if in fact HAL declines the October will increase in price much more quickly than the January 37 put).
3) The October 37 put had the highest Gamma among October put options so it stood to gain ground more quickly than other nearby options.
As of the close on 10/1, the position looked like the risk curve that appears in Figure 4. At that point the option is trading at $3.40 and the position shows an open profit of $3,360, or 161.5% on the original $2,080 investment.
Figure 4 – HAL October 37 put option risk curves as of 10/1
Trade Adjustment: Turning a Long Put into a Straddle
One of the benefits of trading options is the ability to turn one position into another position. Let’s say you held a profit of $3,360 on a position of long 16 October 37 HAL put options. With only 18 days left until expiration you might rightly be concerned about letting your profit slip away if HAL decides to reverse to the upside. You could simply sell all 16 puts and take your profit. But in the interest of "letting it ride", let’s consider one alternative.
-Sell 15 October 37 puts @$3.40 (leaving us with one put option contract)
-Buy 1 October 37 call @ $0.11 (at a cost of $11)
Consider in Figure 5 what holding on to one put option contract and spending $11 to buy one 37 call option accomplishes.
Figure 5 – Long 16 puts adjusted to long one call and long one put
-The worst case scenario is that HAL closes exactly at $37 a share at option expiration and the profit declines from $3,360 down to $3,009.
-If HAL continues to decline, the position can accrue additional profit.
-If HAL starts to rally the trader doesn’t have to worry about giving back more than about $350 of his or her open profit.
This started out as a relatively simple setup that turned into an option trade that turned into another option trade. So chances are some readers are scratching their head a bit and wondering, “What the heck jut happened?”
In a nutshell, what happened was:
-We saw the potential to use a simple setup that does not involve rocket science nor a computer cranking out orders every few milliseconds.
-We saw how to enter a position with limited risk and unlimited profit potential (and much less risk than would be involved in selling short shares of HAL).
-We saw how when things went as hoped how to lock in a profit and turn one position into another position with unlimited profit potential in both directions.
That’s a lot of stuff to see. Go ahead, take a break. You’ve earned it.
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site