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EWP Option Strategies – Part 2

EWP Option Strategies – Part 2

by The MoleJune 25, 2010

Alright, Evil Rat Academy is now officially in session – everyone please return to their desks – BobbyLow, stop chewing gum and blowing paper bullets at Tronacate. Tradingmon – stop that fire in the trash can!

It’s Friday and thus time for the 2nd 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 chaper.

Last week we introduced the concept of debit spreads and appropriate stages in the wave count at which to trade them. If you missed the chapter then I strongly recommend you go back and study it before continuing here.

Now it’s time to see an example of how to use these strategies on an actual price chart.

Figure 4

This is a futures weekly continuation bar chart of the euro against the U.S. dollar from 2005 to 2008. I’ve labeled the chart starting from the November 18, 2005, weekly low at $1.1661. From there, I’ve counted completed Intermediate waves (1) and (2), and a partial Intermediate wave (3). Intermediate wave (3) sub-divides into Minor waves 1 and 2 (in red) and Minor wave 3 (not labeled on chart) subdivides into Minute waves 6 through 9 (circled in brown). That leaves us with an open ticket into Minute wave 0, so let’s blow up that leg of the advance.

Figure 5

We’re going to start trading on April 23, 2008, the last bar on the daily chart. This will be our entry point.

Figure 6

Now I’ve attached some wave labels, and you can see we have a decisive move up in Minuette waves (i), (ii), and (iii) (in blue). Within Minuette wave (iii), I’m counting Subminuette waves i through v (in red) as one probable scenario. This brings us to the exciting part: Subminuette wave v contains five overlapping waves (circled numbers) with a wedge shape, the classic trait of a fifth-wave ending diagonal. This is an exciting event, because fifth-wave diagonals qualify as one of the key patterns that signal a swift and sharp reversal ahead. And, according to Elliott wave guidelines, the reversal will end at least where the diagonal began. In this case, that area is marked by the start of Subminuette wave iv (in red).

Figure 7

So, what are we looking for? A sharp albeit limited decline for Minuette wave (iv) back to at least the start of the diagonal, and maybe even further beyond that. What if we’re wrong?  Are there other possibilities? Yes, the ending fifth-wave diagonal scenario may instead be waves A and B of some type of flat structure. Even so, in a flat, wave C should still come down to where wave B began — a similar target zone as the diagonal scenario.  In either case, the larger implication is the same – a move down. The one difference is time. If an ending diagonal is at hand, the decline will be swift; if it’s a flat structure, the drop may take longer to unfold.

Figure 8

Another way to determine how far wave (iv) may go is to look at the market from a Fibonacci retracement point of view. Keep in mind that fourth waves are normally shallow and make .382 retracements. You can see in Figure 8 that the .382 area lands at $1.5362, within winking distance of the level where the diagonal began — $1.5273. Pretty close. Of course, wave (iv) could go further, in which case I’ve also labeled the three common runner-ups for Fibonacci retracement levels: .500, .618, and .786. However, since fourth waves can never end in the price territory of first waves, we can eliminate the .786 scenario.

Figure 9

On this chart, drawing a trend channel doesn’t help in terms of price, but it does offer us a guide in terms of time. It calls attention to the fact that we’re looking for a move that could happen fairly soon. Therefore, we don’t have to go out too far with respect to option expiration dates.  We don’t have to go out six months, or even three months, to realize the same move. Keep in mind, we want to maximize yield or return on capital.  The less money we spend by being able to select a shorter time period for our expiration date, the greater our return on capital will be if we can still achieve the same move within that time period.

Figure 10

Ideally, we’ll hit the nail on the head here. However, Elliott wave analysis is about probabilities, which are never accurate 100% of the time. So, the last thing we need to do is prepare for a Plan B exit strategy, in case we’re wrong and the euro goes up. In Figure 10, I use the Fibonacci guideline of expansion for fifth waves to determine where one should get out to salvage this trade. According to this guideline, one possible scenario is wave five will be equal to .618 times the net distance traveled of waves one through three.  And that comes up to $1.6230. So, if prices do go the opposite way and we have a net debit, that’s the one level to keep in mind to unwind the trade and recover whatever we can in terms of premium.

Figure 11

Another useful guideline of Fibonacci analysis states that wave four often divides an entire impulse wave into either the Golden Section or two equal parts. On the chart, you can see that there’s a Golden Section if Sub-minuette wave v (red) ends at $1.5840.  (We’ve already gone past that level.)  The 50% divider comes out to $1.6191.  So, if we’re wrong, this offers another possible area for wave v to travel. In terms of unwinding these trades, we’ll look around that $1.6200 level to warrant getting out of these positions.

Figure 12

So, now that we have all the pieces in place, let’s examine the big picture.  We’re going to do a bear put spread on April 23 (recall Figure 5). On that day, the price high was $1.5964, the low $1.5826, and the close $1.5854.  Please Note: All of the option prices that I’m showing are closes.  On our entry point of April 23, we’re buying an at-the-money June $1.5850 put at .0228. The June puts expire on June 6th, so we’re keeping this short, just about a month and a half.  Next, we’re going to sell an out-of- the-money June $1.5250 put at .0054.  And why did I pick $1.5250? That’s our previously determined target from Figure 8, which is close to where the diagonal began at $1.5273. So, we’re going to look for a move to that level over the next month and a half.  We end up with a net debit of 174 points, so our maximum risk is .0174; our maximum reward is .0426; and our breakeven comes out to $1.5676. I’m also showing the implied volatility at the time on the front contract — June. I’m not going to get into any analysis on implied volatility in this particular course. This is purely a directional price movement strategy.  To review: We’re going to look to unwind the trade when we get to $1.5273 and, hopefully, that’ll happen right at expiration. If things go the other way, we’re going to look to get out and salvage something at $1.6235, based on those Fibonacci calculations for wave five.

Figure 13

In Figure 13, we flash forward to see how the trade unfolded. The fifth-wave ending diagonal did indeed deliver a swift reversal (recall Figure 6). And, as you can see, we reached our target of $1.5273 on May 8th. From a risk point of view, there is no reason to stay in this position so we’re going to unwind the trade and close out on May 8th. We’ll sell the June $1.5850 puts at .0508; we’ll buy back the $1.5250 puts at .0123. We get a net credit of 385 points and a net profit of 211 points.  Implied volatility did not change much — it was 10.3% (versus 10.6% on April 23), so that worked in our favor. The “secret” to the trade’s success was its adherence to the ideal wave characteristics of a bear put spread strategy as identified in Figure 3. It was a countertrend move in a fourth wave of low degree (Minuette). We entered early. And, most importantly, the key to setting up everything was identifying that we had a fifth-wave ending diagonal in the prior wave at the next lower degree. As we know, this pattern implies a dramatic reversal ahead.

Figure 14

So, we got out on May 8th, but the contract didn’t expire until June 6th.  In Figure 14, you can see that our choice to exit early was the right one in order to satisfy the risk/reward ratio. We made a slight new high in Minuette wave (v) at $1.5988. (The previous high in Minuette wave (iii) was $1.5985.) This move unfolded as another fifth-wave ending diagonal, which, sure enough, was followed by a swift and sharp reversal to the downside.

Mole here again: Alright, this completes chapter 1 – congrats if you made it all the way to down here. If you have questions, ideas, contributions – then please post them below in the comment section. We will continue this series next week with the introduction of the Bull Call Ladder and Bear Put Ladder – fun stuff!

See you on Sunday.



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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  • gsavli

    AAPL finished right on the support.

    i guess either gap up or down on monday is quite possible.


  • OldChicago

    Mole – thanks for the lessons. Always helpful.

  • raised_by_wolves

    Brings back memories, painful memories . . . I was one the smartest students in class. More often than not, I aced tests without studying. Unfortunately, I had difficulty getting my work done. Doing papers was especially difficult. “Excruciating” is best descriptor. The only way I found to numb the pain was to stop doing papers. That lead to me dropping the fuck out and people saying I'm a fuck up. Note to self: Fade the noise and the naysayers.

  • amokta

    Nice photo!
    Will read post later.

  • raised_by_wolves

    Mole, I'll come back and read this after I steal some dark chocolate.

  • https://evilspeculator.com molecool

    Geeezzz and I was in such a good mood – now I don't know if life is worth living anymore… goodbye cruel world!!!


  • OldChicago

    A question for all – today's closing vol. is huge. The “net money flow” tracked on WSJ website is all time negative for a single day. It actually is twice as negative than Oct. 17, 2008. From an TA perspective, is this distribution? or end of quarter positioning?

  • http://www.mylifemytrade.com MyLifeMyTrade

    Dont look at volume today – it is wierd because of russell 1000 rebalance..

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

    just a couple of comments from the old hamster

    1. at least paste an image of scruffy (just the janitor) from futurama and write my name on it

    2.as i mentioned at open “bounce not yet”, If we have something it should be a small one and downtrend should resume soon (at least hamster bandwise)

    3. Vix 27.5 is a majorline to watch

    should get back by sunday

    best regards

  • Tooncez

    Nice zero color Mole! So pleasing to the eye. It makes you _feel_ frosty.

  • yudhisthira

    Assuming complete decline from Monday today's low, ES bounce hit the 23.6% fib.
    At the minimum an A wave. Bearish scenario is C wave to next fibs at
    1088, 1096, and 1104 ouch!


  • BigHouse(Aka Mr Vix)

    Seems the class room has changed from last year…Miss the old crew….

  • https://evilspeculator.com molecool

    People come and go – make new friends! 😉

  • https://evilspeculator.com molecool

    Right on!

  • BigHouse(Aka Mr Vix)

    Indeed. To bad they are going to miss the heart of P3

  • https://evilspeculator.com molecool

    Expected – bear markets kill both bulls and bears – the latter because patience is key. When it happens it happens fast.

  • amokta

    The indicator in question is freight car loadings, which reflect the amount of goods transported over the railway system

  • http://thefxspeculator.blogspot.com Onorio

    Mental masturbation…

    Since yesterday last low had been placed on a corrective wave here`s the deal


    After all if we`re in a 3rd wave retracements are shallow, and we`ve retraced exactly to 23.6%

  • OldChicago

    Yes, we had that. Hugh vol came in after hours. Thanks.

  • http://thefxspeculator.blogspot.com Onorio

    Man..ES is dead…

    Mole, bring the defibrillator.

  • BobbyLow

    Hey Mole,

    I had to laugh when I saw the picture of the class room with “me” in the front row. It's also what my grammar school class rooms actually looked like. My grammar school had a total of 3 rooms for Grades 1 + 2, 3 + 4, and 5 + 6. There was no Principle, but I think I remember that there was a secretary who had a little office, 1 phone, 1 typewriter and a big ole mimeograph machine. Somehow we all made it through and most of us turned out OK. LOL

    Thanks for the Heads Up on the Option Strategy Download. The thought of combining Option Spreads with potential Elliot Waves is exciting to me. Why? Because instead of hit or miss with a Spread, a Spread gets put in either a Bullish or Bearish Fashion with additional reasons or evidence to establish the Spread in the first place – Has a Time Certain in order for it to work- and above all, uses Leverage and in most cases risk can be limited.

    I just got online now and will be doing more reading and studying over the remainder of the weekend.

  • http://pitch3.zstock7.com/ zstock7 Pro Select!

    Not trusting WMT long, until the 48's, or yearly low retest.
    WMT long chart , Great exits for when the market returns to fundamentals.

  • https://evilspeculator.com molecool

    It's Saturday afternoon, mate – most of us take the day off.

  • BobbyLow

    OK, after reading the EW Download about tying Option Spreads into potential E – Waves, I still like it. I've been trading Spreads for a while but I've never put the idea of a putting a Spread together with an E Wave on purpose. Over the course of time, I've had a number of Spreads that were profitable in early stages and then then turned into a loss. This perhaps could have been avoided if I had recognized that something in the wave structure was violated or the maximum wave had been achieved. If this were the case, I could have taken some of these spreads off for at least a smaller profit, at BE, or at the very worst a smaller loss.

    Now I have no idea if there has been any change in the current numbers so I'll use Mole's latest numbers from June 24 for a potential Bull Spread Counter Trend Move. Namely Orange 1100 {ii] and Green 1150 (a).

    Mole had suggested to get set up for this prior to the latest 10% increase in Vega but that is a separate but important issue as well.

    That aside, if we don't get a large Gap tomorrow morning, I might consider either Buying July 17 – ATM 108 Calls and Selling July 17 – OTM Calls for a Net Debit of $1.44. This net Debit would be my Maximum Loss and my Maximum Gain would be $3 – $1.44 = $1.56. If I was inclined to believe that we had a good chance to get to 1100 by July 17th this might be a good way to go.

    OTOH, if I am worried about running out of time then I might consider Buying the August 21 ATM 108 Calls and Selling the August 21 OTM 111 Calls for a Net Debit of $1.65. This Net Debit would be my Maximum Loss and my Maximum Gain would be $3.00 – $1.65 = $1.35.

    The August scenario adds an increase Vega exposure but that's part of the game.

    One area that I want to mention is that if I were to play for the 1150 Green (a), I would not sell options currently that far out of the money (as in 115's) in a Spread because on a SPY Spread I have a Minimum of $1.00 that I want to be paid on the Short Side but that's just me.

    Again if we get a large gap, I'll probably sit on my hands until the dust settles. Or as “Forrest Gump” might say, “The Market is like a Box of Chocolates you never know what you're going to get.” 🙂

    Anyhow, I thought I would throw this out and if anybody would like to add anything to improve upon this please feel free to do so.

  • http://www.portfoliotilt.com PortfolioTilt

    Thanks for the education, looking forward to today's update!

  • https://evilspeculator.com molecool

    Grabbing a late lunch right now and will post it in about 90 minutes. A bit late for the East Coast, I know, but trust me, you don't want to miss this one 😉

  • http://thefxspeculator.blogspot.com Onorio

    FX seems set for a calm open, EURUSD and EURJPY will open where they closed friday, only AUDUSD is gap down about 20pips or so.

  • gsavli

    I must say, I'm a bit surprised, I expected a gap of some kind. Well, that is still an option before US markets open.

  • https://evilspeculator.com molecool

    ¨°º¤ø„¸ N E W „ø¤º°¨
    ¸„ø¤º°¨ P O S T “°º¤ø„¸

    This is not one to be missed, guys…

  • raised_by_wolves

    So, we want to use a bear put spread at the top of (iii) because we think the downside will be limited with (iv) and we expect there still to be upside with wave (v) to complete the uptrend. But after wave (v), using straight puts would be appropriate, right? 🙂

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  • HighRev

    Mole, sorry for such a late post here, but I've been a bit out of touch.

    My question here is, wouldn't it be better to put on a Bear Call Spread in these setups?

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