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Once inside the site, traders can perform a host of options related studies including creating hypothetical trades, plotting volatility charts, back-testing strategiesCOMPUTER SOFTWARE When I started trading, the charts we had available to us were newspapers or other print publications. Today, however, charting software makes the process extremely fast and easy. While there are a large number of great packages out there, we will just mention the three that our students seem to use most often: The Optionetics Platinum site, ProfitSource and Advanced GET from eSignal. Optionetics Platinum site is a web-based computer software program designed for options traders. Access is available for an annual fee. Once inside the site, traders can perform a host of options related studies including creating hypothetical trades, plotting volatility charts, back-testing strategies, viewing historical prices and implied volatility levels, monitoring put/call ratios, initiating trade searches based on specific parameters, and plotting risk graphs. Many of the case study examples in this book were created using Optionetics.com Platinum. ProfitSource is a market analysis program that combines a fully featured technical analysis suite with a comprehensive set of special market direction tools such as Elliott wave, trend filters, and gap filters. These tools enable the user to adopt a rule-oriented approach to trading. In addition, it has the ability to scan for potentially profitable opportunities such as Wave 4 and Wave 5 trades, a state-of-the-art Walk Through Mode for learning how to apply concepts such as Elliott wave, alerts functionality for price, indicator and Elliott wave parameters, and a complete portfolio management package. ProfitSource can be used in multiple markets including stocks, indexes, futures, and foreign exchange and gives the user access to international markets. Advanced GET from eSignal has also gained popularity among options traders. It is a graphical charting package that gives traders access to a full set of technical analysis tools, specialty tools and indicators based on Elliott waves and Gann theory, and also one of the most complete sets of standard studies available in the market today. Many options traders use these three software packages to enhance their ability to confidently use options strategies. PUTTING IT ALL TOGETHER In order to get a better understanding of how traders combine trading tools to create a promising trade, lets work through a simple example. The first thing we need to employ is a method of finding stocks that are expected to make a strong directional move to the upside or the downside. In this case, we are looking for an explosive move higher. There are several tools on Platinum that help us find stocks, but for this example we will use the Candlestick I tool. This tool searches for stocks based on candlestick formations. (There is a wide array of different candlestick formations that go well beyond the scope of this book. Traders interested in the topic are encouraged to visit Optionetics.com and look through the article archives for a complete discussion of the various patterns.) In this case, we chose the Bullish Patterns search using stocks that were trading above $12.50 and that had volume above 300,000. Once a list of stocks appears, we need to look at various price charts and implied volatilities. To keep things simple, suppose we find a bullish stock and decide to buy a long call. When buying a call, we want the implied volatility to be below the average IV for at least six months. Remember, when IV is low, the options are cheaper. After eyeballing the charts, we found that Lehman Brothers (LEH) looked like a strong candidate. Figure 18.4 is a chart of LEH on May 20, 2003 showing the candlestick pattern known as Red Candle + Doji that flagged the stock. Not only did the stock form a bullish pattern known as a Harami, but it also bounced off support at its ascending trend line. Once we find a stock that looks promising, we want to check IV to make sure it isnt too high. Figure 18.5 is an IV chart of the stock on May 20, 2003, the day it came up on the Candlestick I search. We can see by looking at this chart that IV was definitely low on a historic basis. This is important because the higher the IV, the more the option will cost. IV also acts like elastic, stretching to extremes, but ultimately coming back to its mean. If we buy a call and IV increases, it raises the price of the option. Now that we have a stock picked out that fits our criteria, we can enter the data into Platinum to view the risk graph. Before we actually enter the data into the Create Trade screen, we need to first decide which option strike and expiration month we want to test. Of course, after this is entered into the graph, we can view it to see if the trade makes sense given our outlook and resources. Since we are buying an option, we want to give the trade enough time FIGURE 18.4 Daily Chart of LEH (Source: Optionetics Platinum 2004) 7 - 30 day = unk 30 - 60 day = 27.19% 60 - 90 day = unk 90 day = 30.73% 02/13 IV Chart for LEH (Source: Optionetics Platinum 2004) Currently: 2003-05-20 03/14 04/11 to work in our favor. Mainly, we dont want to hold long options that expire in less than 30 days because time erosion picks up the last month of an options life. The stock closed the session at $66.04 and since we dont normally want to use too far out-of-the-money options, lets look at the October 70 call. We choose the October expiry month because June and July are too close and there arent any August or September options on May 20 to choose from. After entering the data into Platinum, we get the information shown in Figure 18.6 from the program. This screen is just part of what Platinum tells us about the trade, but there is plenty to see from just this information. First, we see that the model price is between our bid-ask spread, so we know that option isnt overpriced. Second, we can see our breakeven point at expiration. It is important to remember that the breakeven point here is figured as of expiration. Usually, we will see a profit well before this point. This screen also gives us the Greeks and the specific option information. The next thing we want to look at is the risk graph (Figure 18.7). This graph gives us a visual of what the profit or loss would be given a move in the stock and using different time frames. Obviously, if the stock moves up in the short term, we will see higher profits than if it takes three months to occur. Our initial debit was $340 in this trade for buying one long October 70 call. By looking at the chart, we can see that Another tool we can use to assess the trade is the implied volatility chart. The IV chart shown in Figure 18.8 details the profits we would achieve on a move in IV alone. This graph assumes the stock stays at the same price. We can see that a rise in IV can affect the trade drastically, and that is why we want IV in our favor. Before we enter the trade, we should have already decided on our exit points. The price we decide to sell at should be based on our outlook and money management. Remember that its always important to have a set exit point before entering a trade to take the emotion out of it. An oft-used exit strategy for a long call is to sell if the option loses half its value to the downside or when the option doubles in price to the upside. Of course, we can always set stops once our price target is achieved to let our profits run, but the last thing we want to do is see a profitable trade turn into a loser. This trade did indeed work out well, with LEH shares moving up following this bullish sign. As originally expected, the stock went higher and our option was at a double on June 2 with the stock trading near $72.50. At this point, either the option could be closed or the trader could set a stop to make sure that if the stock were to move lower, the option would be sold before the profits were lost. Keep in mind that buying long calls is a great way to use leverage, but it is also a high-risk one. When the strategist identifies an explosive situation like in the Lehman Brothers example, he or she might want to consider other trades like bull call spreads, call ratio backspreads, or some of the other bullish strategies discussed in the earlier chapters of this book. CONCLUSION Not all traders use charts or computers. In fact, 20 years ago much of this information was either not available or extremely expensive. So, traders do not need to spend a lot of money on research and analytical tools. A high-speed Internet connection, a brokerage firm that specializes in options trading, and access to research can produce enough information to trade successfully. Hopefully, this chapter has helped to expand your knowledge regarding the tools that are available and how a trader uses information to create a trade. The example toward the end of the chapter explained how to find an explosive opportunity and how to analyze the situation to find the best options contract for the given strategy. Not all successful traders use the same approach. Through time, you will undoubtedly develop your own tools and methods for picking winning trades. Hopefully, the chapters in this book are helping you along the way. |
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