Damn Options!!

The markets have been kind enough today to leave us in a position where little has changed.  We got a nice morning rally, that quickly reversed into a decent sell-off, followed by our standard end of day rally. The  rally pushed right to the reversal area we expected, and the decline failed to push to a point where we could eliminate one scenario or the other, therefore, they both remain.  I am sure by now, we know my view is still that a flat was completed, and we are  (or will be very soon) heading lower in wave 5.  If this were the case, today’s action likely completed wave [v] of [I] of [3]… of [5] (meaning we rally, then fall, then rally, then fall, then rally on a larger scale (for you non-Elliotticians)).   As stated though, the triangle remains on the table which would also be heading lower after a slight push up.  On the 60d/60min chart, the Bollinger bands are squeezed in nicely.  So we will likely get an explosive (tradeable) move in one direction or another very soon.  There is a nice horizontal resistance in $NDX at 1275 (not shown).

$NDX options

The three reasons I maintain my view for a sharp drop very close to here is:

1. Occam’s razor*.  A flat was traced out with perfection, and the market turned directly from there.  Why would I make this more difficult, it wave 2 was long and choppy?
2. It would screw the most people it we fell directly from here.  All the bears I know are looking for a rally before we drop (or have turned bullish), and all the bulls are, well, bulls.
3. There was only a single divergence on the hourly chart, and no divergence on the daily chart at the previous bottom.  No divergence would suggest it was a wave [3], and the markets were not quite done falling.

That said, I will do a little talk on options.  Since there is nothing I hate more than a boring market, this will do many of us some good.  I can tell you right now, this will not have the glory many of you who knew Jeff Kohler have come to expect when we are talking about the wonders of options.  I am going to talk about MY option trading style.  This is likely going to be different than most people who trade options.  If it makes you money, I don’t care how hokey it is…stick with it.

I am going to assume that we all have a basic understanding of options and option pricing.  And that I don’t need to go into Delta, Theta, Gamma, or any of that good stuff.  In fact, I NEVER look at greeks anymore, but don’t be like me. B-)

There are a few things that I check for when scanning for options.  First, the underlying.  As we know, I am looking for stocks that will move far, fast, and now.  We should all still remember how I come up with those, but I will be using BIDU and FSLR for most of my examples in here.  After I have gauged the underlying and WHERE I would expect a near and mid-term move to take me (i.e. PRICE TARGETS), I can begin to select the proper option.  I know you are thinking… “Pick the right option, from someone who doesn’t use greeks….SURE.”  Nonetheless, in the short time I have been trading options, I have payed VERY close attention to how options are priced… IN REAL TIME.  The black-scholes and all the other theoretical pricing models are great, but that is really too much work, IMHO, when it won’t give you the ACTUAL value should this happen.  If it works for you, GREAT, stick with it, but you don’t need it.  Again, don’t be like me.

From here, I operate on a few assumptions to select my options:

1. The underlying will make the desired move BEFORE expiration.
2. My analysis of the underlying is correct (enough) (i.e. see number 1).
3. Desired move will be explosive, ’cause I want to get that extra Vega kick!

That said, let me walk you through my FSLR purchase this morning.  Knowing my mid-term target is around 95, and my short term target is about 1 ATR ($18), with FSLR trading around 147 (my entry), I am looking for 130 today to take profits.  I try to spend the same amount on every position (except that I have 2 distinct groups stocks I trade and stocks I don’t.  Stocks I trade I am willing to put in about 50% more than stocks I don’t due to familiarity), I selected the Oct 135P.  Almost 3 strikes OTM at the time, I knew should it hit my target, I will be sitting $5 ITM.  IF that move happens before expiration, I will be sitting on $7.5 (price of O135P) + $5 (distance ITM) for a total of $12.5 should we hit 130 today (or in the next day or so).  Since this represents a 60%+ gain, if I hit that today, I will sell, as 60% in one day is good enough for me.  I sold out today with FSLR trading up to 137 after bouncing from 135.  I closed out for $10.30, a 50% gain.

FSLR Entry/Exit

$VIX in respect to FSLR/BIDU entries/exits

Let’s review…  Move was large; 10 points from entry to exit.  Move was explosive; dropping with a major sell off in the markets, letting me cash out with $VIX at 61.  Good enough for me; Making a 50% ROI in 5 hours at the market is good enough for me. (THIS trade is not a recommendation, and is solely for demonstration)

BIDU entry and exit

The other example will be BIDU, of which I entered far too late to get a spectacular return.  Since I “thought” I missed the initial move in BIDU this morning, I waited until it broke a consolidation phase, and looked to be heading lower.  I was looking for 200 (entry at 222.5 – ATR(10) of 22 = 200.5), but sold on a 50% gain with BIDU at 205.  In this trade I grabbed 17.5 points, so the move was large enough.  It fell pretty quickly from my entry, dropping about $8 in the 1/2 hour after my entry.  And I managed to escape with the $VIX pushing highs of the day at that time.  The option I chose for this was the 200, expecting to get right into the 200 range.  I did not make it ITM (target) but when BIDU stalled out around $203, I decided to take my gains and go.  ‘Nuff said!

Since my timeframe is very small (notice the 3 minute charts), I decided to trade front month options (notice that Theta was not an issue on either of these trade (and yes, I know we all can’t day-trade, though if you had bought Friday’s close (at least on BIDU) you would have had an entry very close to mine)).   Since the stocks are very volatile, expecting a 10% swing per day, IMHO, is not unreasonable.  Therefore, depending on stock price, I can choose an option 2-3 strikes out, and still be looking at a VERY good chance of seeing ATM, and likely ITM, at some point that day (again, assuming the trade goes in my favor).  Personally, I would rather trade the OTM/ATM than ITM due to intrinsic risk.  I just don’t like to have that much on the line.  Mr. $VIX is your friend.  He is one of my best friends while trading puts, and I will use every point he gives me to my advantage. Finally, in this market, know when enough is enough.  Returning 50% on a single day’s move is good enough.  Frankly, I would have taken 25% and been quite happy.  If a stock finds resistance right above your “target,” don’t be afraid to take a little off the table (if you just have one contract, forfeit the rest of the move to lock in your profit, or roll into a CHEAPER option).   Notice I sold at or very near the lows of the day on both of the examples, despite “missing” my target.  My target is an area (you will always here me say “target range”) and close counts in option trading.

With that…  Happy trading. I hope you can pick up a thing or two that you can use from that…

Skål!

* Entia non sunt multiplicanda praeter necessitatem. (Latin for ‘Entities should not be multiplied more than necessary’).