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EWP Option Strategies – Part 7
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EWP Option Strategies – Part 7

by The MoleAugust 20, 2010

Alright, Evil Rat Academy is officially in session – and since Mrs Tightbuns is needed otherwise (ahem), I was able to find an adequate replacement for today’s installment:

Okay, and now it’s time for the seventh part in our ongoing EWI sponsored series on option strategies. The following post is excerpted from the Elliott Wave International (EWI) eBook, “How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies — Vertical Spreads.” EWI has agreed to make the full eBook available for free to all Evil Speculator readers until the conclusion of this series. So go ahead and download it here if you want to study ahead – however I would appreciate it if we kept all discussions limited to the current chapter.

Last time we were introduced to the Bear Call Ladder and the Bull Put Ladder. If you missed that chapter then I strongly recommend you go back and study it before continuing here. You can also pull up all prior installments of the the entire series via this link.

We now press on with an actual real life example of how to trade/manage a Bear Call Ladder.

Fig. 32

Let’s go through a trading scenario where we use one of these strategies in a situation of ambiguity. This is an Elliott wave-labeled weekly continua- tion bar chart of heating oil. Let’s count up from the 2007 low: we have Minor waves 1 and 2 (red), a big extended 3, and now maybe 4. Keep in mind, heating oil is a commodity. We know that in commodities the fifth wave is often extended. We already have an extended third, so chances are we won’t get a repeat performance in the fifth — but we could. That small possibility is enough to move us forward. The chief question to answer is whether wave four has ended. Maybe the small rise from Minor wave 4 is part of an expanded flat and we come back down. Or, maybe we’re going to skyrocket up in wave five. The first step into figuring that out is to look at the retracement made by Minor wave 4.

Fig. 33

Figure 33 overlays a Fibonacci retrace- ment table to the chart of heating oil.  As you can see, wave 4 has made a .236 retracement of wave three. That is acceptable, albeit shallow. Far more common to fourth waves is a .382 retracement of wave three. But again, .236 is still adequate.

Fig. 34

The next order of business is to assess where we could go in Minor wave 5. In Figure 34, I’ve calculated two common Fibonacci projection points by multiplying the net distance trav- eled of waves 1 through 3 by .382 and .618. We get 3.5247 and 3.9421, respectively.

Fig. 35

Those are possible targets for wave five. Another thing we can do is use the Fibonacci dividers that we dis- cussed early on in section one (bull call spread/ bear put spread) and illustrated in Figure 11. To reiterate: Wave four often divides the entire impulse wave into either the Golden Section or two equal parts. The chart above identifies those two areas in the case of heating oil. The Golden Section would bring wave 5 to 3.7116, and two equal parts would bring wave 5 to 4.2448. This handy guideline gives us two more targets for this particular strategy.

Fig. 36

What about time? Here again we can use Fibonacci analysis to estimate when wave 5 will end. As a guideline, wave five can equal the time it took to finish waves one through three multiplied by .382, .5, or .618. In Figure 36, you can see where these dates fall into the future on the weekly bar chart.  Our entry point is April 11, 2008, so in sequential order .382 comes out to the week ending September 12, 2008; .5 comes out to the week ending October 31, 2008; and .618 comes out to the week ending December 19, 2008.  So, now we have a reasonable time reference.

Fig. 37

With price and time targets in place, we can now set the wheels of this trade strategy in motion. We’re going to do a bear call ladder on April 11th. In Figure 37, the daily chart of heating oil is blown up to magnify the price point of interest — the up leg rising out of Minor wave 4. Make no mistake, this move is unclear. The initial drop could just be wave A of 4, making the rise wave B (leading to a drop in wave C).  Maybe we get lucky and we skyrocket in wave 5. Or, the way we lose the most, wave 5 barely bounces. This is the chance we take.

So, let’s get to the numbers. I’ve sold the September 300 calls at 31.40. On April 11th, the high was 3.2376 and the low was 3.1557. If you’re confused by the “300” calls, don’t be. The puts and calls that I’m dealing on are quoted based on the price (on the right side of the chart) times 100. For example, 3.00 would be quoted as 300 (3.00 times 100). That’s how these options are quoted, so from this point forward I’ll refer to the prices in the same manner. The September options expire on August 26, 2008, close to the .382 time relationship. That gives us about five months, a suitable stretch of time since this is NOT a short-term strategy. Remember, we’re looking for a big move at a relatively high degree. The 300 calls were in-the-money. We were trading around 315-323. I’m going to buy the out-of-the-money September 330 calls at 18.11. If there is just a small up move, I will be giving up 30 points, but we knew we had to sacrifice a small move to implement this strategy. Then I’m buying further out-of-the-money September 350 calls at 12.68. Why 350?

If you recall, we said that if wave 5 were .382 times waves 1 through 3, then it would go up to 352.47 (see Figure 34). We’re looking for wave 5 to go at least to 352, with the potential to go much higher. The maximum risk is capped at 29.39. The maximum reward is technically uncapped, but 395 is a good target, and at 395 we would make 15.61 points. Again, 395 comes directly from the analysis in Figure 34; wave five commonly equals .618 times the net distance traveled of waves one through three. That target came out to 394.21.

Let’s sum it up. At minimum, we should get up to 352. The lower break/even is 300.61. The higher breakeven is 379.39. The implied volatility is 35.85 percent. And, we’re doing this all on April 11th. If prices collapse past this wave 4, we have the net credit. We really don’t have to do anything. We could just walk away. So, let’s see what happened.

Fig. 38

In Figure 38, you can see that we did, indeed, get a big move up. This is now May 15, and we made a high of 372.28 the previous day — this is actually around the area where wave 5 would form the Golden Section. (Recall Fig- ure 35 and the guideline of wave four as a Fibonacci divider.) We still haven’t gotten to 395, and it looks quite possible that wave five could extend. So, we can afford to hold onto this position for a little while longer. The next chart reveals whether the decision to stay in this trade and hold out for further gains was the right one.

Fig. 39

Yes, we skyrocketed up even further.  The last bar on this chart, May 22nd, has a high at 401.53 and a low of 390.80, so we got to that 395 level. It’s time to unwind and get out. So, let’s see how we did. We bought back the September 300 calls at 102.45, sold the 330 calls at 74.74 and sold the 350 calls at 58.14. We earned a net credit of 30.43 points. The implied volatility was 40.49%, however that’s a bit misleading. That was still on the June contract, which had about two weeks to run. The September contract was really down to around 34% — so no major change there. Finally, this trade produced a net profit of 31.04 points.

Fig. 40

Bear in mind, the key to this strategy was not just the wave count. It was using Fibonacci analysis to give us an approximation of what we would expect.  And, if we pan out a bit further, we can see how close our projection came to reality. Our exit day was May 22nd.  On the chart in Figure 40, that date correlates to the peak of Minuette wave (iii) (blue) of Minor wave 5. After that, there was Minuette wave (iv) and (v), the latter of which unfolded as a fifth- wave diagonal. As we have repeatedly learned from the first three sections of this course, fifth-wave diagonals precede dramatic reversals. And that’s exactly what occurred here.

Mole here again – boy, that was a long one – congrats if you made it all the way down to here. But I think it was definitely worth it as we will use this type of ladder in the future at motive stages of the wave cycle.

Enjoy your weekend, you deserve it!

Cheers,

Mole


About The Author
The Mole
Mole created Evil Speculator amidst the chaos of the financial crisis in early August of 2008. His vision for Evil Speculator is a refuge of reason, hands-on trading knowledge, and inspiration for traders of all ages and stripes. You can follow him and his nefarious schemes at the usual social media waterholes.
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  • http://sshamster.blogspot.com/ Stainless_Steel_Hamster

    Boss, you do find nice replacements….

  • http://sshamster.blogspot.com/ Stainless_Steel_Hamster

    A bit AWOL because i had a small divergence with my ISP (no, 20% discount for 20% of contracted bandwith is NOT ok for this hamster) and some heavy duty action for mrs. hamster's birthday.

    Furthermore, and until I see above 1115 or below 1025 i think I keep my shorts and just wait.

    Don't expect much as comments are concerned this week, and the next. Have 1) hollydays 2)see ISP issue above 3) some business projects to check

    best regards and good luck to all stainless criters

  • http://channelsandpatterns.blogspot.com/ springheel_jack

    There was a query this morning over whether the rising 10 week SMA condition on the possible Hindenburg Omen yesterday had been met.

    I've looked at this very carefully today and the 10 week SMA was rising on $NYA last week, at the close this week, and at the closes for Wednesday and Thursday this week as well.

    Regardless of which one of those matters therefore, we therefore do have a confirmed second Hindenburg Omen on Thursday this week & I've read some talk tonight that we may have had another today.

  • convictscott

    Maybe some of the wave theory gurus around here can answer this. Is the price action down over the last 2 days “in character” with a primary wave of a wave 3 of a primary wave 3?

    To be honest I would have expected thunder n lightning wrath of god stuff. I'm not ruling it out after a small bounce to get rid of weak hand bears, but is it possible that we have just seen a B wave of 2 with a C to come… then the drop?

  • Tooncez

    ooohh… the answer is the integral of x^n + sin x dx.

    You know? Integration? The area under… the curve…

  • ablebonus

    Yes, it is “in character”. Here is Daneric's chart tonight: http://1.bp.blogspot.com/_TwUS3GyHKsQ/TG7ohXuzs

  • OldChicago

    That wave 2 scenario did come to mind today. But, there could be a problem with this count also – time. I am not clear on that.

  • Thespookyone

    I believe we are in an A down. Other than that, I'm quite good with Moles count. In my case, the wave we just finished was 1 of 3 of A down. I feel that explains both the lack of size and thunder here, as well. I have never traded the overall count as motive, it looks corrective as hell-and trades MUCH better when looked at in terms of impulse waves inside of ABC's. inside With internal breakdowns in many sectors, including the XLE (huge caps there) I think the chance of a C up here is very remote, especially when combined with the Ending Diagonal overhead-and what it usually implies.

  • equity_momo

    Yup Fri was a 2nd CONFIRMATION , thats 3 HOs since Aug 12th plus a few near misses. This market is eating itself from the inside.

  • Brishort

    For what my lttle sole being opinion could be worth, dan's chart is exactly my count as well, except that I was one day before him questionning any abc x abc x abc scenario ;-p and favorng (iii) had started and updating here in real time!!

    Please allow me the little humor above on a Saturday morning… I have bitten my shorts so many times in my short term leveraged account, it felt good to be in sync with the market, EW wise.

    🙂

  • tempest218

    Beware of a market explosion next week. Bonds are way overbought and all that money could flow into stocks. We still have unfilled gaps on the VIX in the 15-17 range that might just fill before the real “crash” begins.

  • BobbyLow

    Brishort,

    Your P&F Charts have caught my interest. I've haven't used them in the past but I've begun to take a look at them.

    I notice that the last S&P P&F Chart you posted had a One Box Reversal as opposed to the Default of 3 on Stock Charts. Com.

    I understand that it was a Daily Chart and has a relatively slow read which can be good for longer term trading.

    I also notice it has a Bearish Target with the 3 Box Reversal of 1010 and no target with the 1 Box Reversal.

    I plugged in the P&F for the Weekly with the 3 Box Reversal and found that the Bearish Objective was 900 which was very interesting.

    Anyhow, I would appreciate it if you could tell me why you chose the one box reversal. (I assume that it is because of it being faster action in the shorter run, but I just want to make sure.)

    Thanks

  • convictscott

    For anyone trading AUD…. We had an election here last night which is critical for issues relating to currency (one party wants to impose a “super tax” on mining profits)

    Tthe result will be a hung parliament with no firm result known for weeks, and with no party having a majority in either house.

    I dont usually trade fundamentals but given that the AUD is technically very vulnerable to exogenous shock on a number of fronts at the moment it could be a good time to take into account that markets hate uncertainty.

    The AUD trades at the moment roughly as a proxy for global risk (because of the AUDJPY and AUDUSD carry trade), with an incredible correlation to SPX.

    If the equities waterfall decline eventuates this week I believe that AUD could offer a better profit opportunity and easier trading than the equivalent move in SPX. This is because carry trades, when they unwind, do so with MASSIVE leverage and so much weight of money that countertrend bounces are relatively insignificant.

    Also, currencies are demonstrably trendier than equities (leverage again, GS would have no chance of manipulating the euro in the long term) and the big moves tend to come as a 5th wave capitulation rather than a 3rd. See recent move in euro as evidence of this.

    One other thing I'll point out, from the chart of the 08 fall in AUD from .98 to .60…. once it started the weight of money repatriating after years of carry trade meant that the market was essentially moving all in the same direction.

    What this makes for is *easy trading* the fractal equivalent of a full day trend day on the equity markets, but occurring over several months. In other words, ideal for pyramiding up, taking extra trades in the same direction… all things that would be impossible in the equities p3 because of the severity of typical bear market rallies.

    Without going into the rationale for the trades, I have marked each bar with a valid sell signal on the krastins candlestick patterns. In each case its sell on the break of the low with a stop at the high.

    http://www.masterkillers.com/wp-content/uploads

    8 winning trades in a row capturing all of the massive 30% devaluation in the AUD is typical of what happens when a carry trade unwinds. I could give you other examples, but they are all the same.

    Carry trade is based on borrow in USA or JPY at zero, invest in AUD at 6%, earn interest rate differential + currency appreciation on massive leverage.

    Its a game of musical chairs, when the last chair stops it all falls apart.

  • Brishort

    Dear BobbyLow,

    My 1 box approach is exclusively based on the work of Jeremy Du Plessis for which I have read the book. I am nowhere close as good as he is, but my technical expertise and CMT degree are my basis to give a lot of weight to what he has done and to very much respect his work. I think he is the god of P&F and people dismiss way too much P&F for short term trading.

    I must also say that before Jeremy, I had dismissed P&F myself as too slow, lagging and just a circumstancial tool. But when you understand how brightly Jeremy has analyzed the modern use of P&F (which is one of the oldest technique before computer time!) you cannot do anything else but to fall in love with his technique.

    I find it has kept me out of trouble more times than not….. however, provided you use judgment and allow some mistakes on 1 box reversal. For example, on Friday, I allowed a 1 box “head fake” at the bottom because indeed 1 box reversal can get very sensitive.

    Believe it or not, using 1 box reversal, also brings more precision in doing EW squiggles. That is more my part and venture on P&F, Jeremy didn't go that far. I find it can assist me on about 50% of them to avoid the headfake and indecive times is you don't know if the famous “missing five” is to come or has passed. You may say that 50% is nothing more than flipping a coin, but in reality, if one tools refine your squiggle count by 50% more accuracy, it is the squiggle count itself ratio (let's say 1 chance out of 2 to be right) with 50% more accuracy on the choosen one = 75% probability you are on the right track….

    Here is two links on my god book on P&F:
    http://books.google.com/books?id=tEPxn1K2jSgC&d
    http://www.amazon.com/Definitive-Guide-Point-Fi
    If you use the “look into the book feature”, under content, chapter 2 starts the 1 box reversal technique.
    This is for the introduction and not exactly answering your question about the targets. But here is a little more premises, so I can be sure I get you on the right track:
    1) I can scan a little portion of Jeremy’s book on 1 box and send it to you for review. Let’s say page 57 to 76. I think this would be fair use of his material respecting his copyright as 1 box reversal implications is addressed in many other sections of his book. I am not a copyright specialist, but I think this is fair and respectful.
    2) Otherwise please tell me how I can contact you outside this blog and I will see what I can send you.
    On the targets, you must know 1 thing or 2:
    P&F targets on 3 box reversals are extremely unreliable in time and too long shot to be followed in my experience
    However the supports are extremely reliable (understand that a support has a 1 box leeway, allowing and encompassing, actually helping to weed-out the headfakes of trendlines and will usually lead you to pick stops at different numbers than the other majority of trendline only people)

    The key also is on what you do P&F on. As you would not rely on EW counts for one stock and would conclude it works betted on indicies, it si the same for P&F.

    I have long stopped using them on individual stocks, I do them exclusively on index SPX, NDX &RUT.
    Why? The value of the index being nominally high, you don’t have issues on chosing the box size and can concentrate on the 1 box, 2 box, 3 box, etc. Reversal techniques without worry.

    Long answer, but I wanted to make sure I could give you actionable items to answer your questions. Since a lot was enclosed, do not hesitate to ask complementary questions if you are still unsatisfied by the above or this did not encompass the focus of your questions.

    Sincerely,

    Brishort

  • Brishort

    Extremely interesting Convictscott, thank you for this.

  • amokta
  • BobbyLow

    Brishort,

    Thank's for taking the time to write such a detailed answer to my question. I will look into the two links that you have provided.

    It took me quite a few years to feel comfortable working with many areas of technical analysis. However, I honestly believe that I'm part of the 15% to 20% of people who will never be able to work with EW without help from people like Mole and others.

    OTOH, it appears that P&F might remove a lot of the subjectivity of interpretation and might be something I could work with on my own after a reasonable amount of study.

    Also the main thing that I'm trading now is Longer Term SPY Options so this could also be a fit.

    Thank you for your offer to send part of a chapter for my review. If you are willing to send it and anything else that you think might help, please send it to:

    rwlowman77@yahoo.com

    You've already been a big help so thanks again.

    Bobby Low

  • Brishort

    Thank you BobbyLow, I have your email address.
    I recommend you edit you post asap if you don't want to have computer bots finding your email and spamming it!

    Have a nice week end

  • Long_John_Silver

    So, puts on FXA?

  • chronographics

    Aussie, Kiwi here 🙂 Certainly thats on the cards at the moment – its the same in the Eur/USD this could be a B wave with C to spook the shorts. As for Character in the EUR on Friday night before I went to sleep it strted to look a little scarey on the down side and not much of a bounce up. If this is “3” then we need to take out the lows Monday and make this a “five” down. If not then we see”C”.
    Good Rugby on the weekend, hope you guys beat the Boks as well 🙂
    Moved House hence the late comment…

  • chronographics

    Bobby, Try David Fuller as well, I have watched his stuff over many many years and he is very very good. P&F as Brishort sys is under used as Computers gave the ability to do so many new things but it is a great way to filter noise and give you targets and stops. 🙂

  • equity_momo

    Is there an etf or equivalent listed on the NYSE that is a proxy on the AUD? if so , ticker please?

  • BobbyLow

    Thanks Chronographics.

    I will check him out as well.

  • fisheggs

    FXA

  • http://twitter.com/law6 law

    Hi All

    count me in….on the pnf…

    I use pnf regularily and cant say enough great stuff…Thank you for the links!
    .and yes you can see the Elliot waves moves much cleaner with it.

    how do we share our emails…??

  • convictscott

    Update on this, AUD trading opened for the week several hours ago (For those who don't know the first market to open in the world for a new week is New Zealand, and AUD trading dominates this market even though its tiny) and AUD gapped down 100 pips to 8839, went as low as 8837 (a rare double bottom with the previous low) and is now attempting to close the gap)

    As Australian markets are open in 3 hours from now for Monday trading well before US markets, its often a decent idea to have a look at this market for clues/correlations, both in equity markets and currency.

  • gsavli

    and crash in, say, november/december, when everyone would already be: ah, it surely won't crash now.

    that would be wicked.

  • equity_momo

    thanks for the link , 2 hours well spent and better than any 2 hours i will find on tv this weekend. (makes me wonder why i have a tv to be honest)

  • amokta

    2 hours nonetheless is a long time, hence sunday viewing was recomended 🙂