Archive for February, 2009

Velvet Underground – After Hours

February 27, 2009

Goodnight capitalism, my old friend

I thought these drawings illustrate our government’s sophistication. Simply beautiful, or what?

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FAS straddle trade fails

February 23, 2009

As it turns out, the credit I got last week for a short straddle in FAS at the 10 strike for $3.05 was not a bargain after all.

Readers will recall my logic in selling high volatility (250%), my misgivings with being naked (buying back month strangle against short straddle) and my plan to roll the straddle from FEB to match up with my long strikes in MAR.

Well, FEB expiry has come and gone and what looked like a promising trade has blown up. Well, kinda blown up, because I defined my risk to a maximum loss of $2.50 ($250 per contract). There was an opportunity early last week to roll my short 10 put into MAR for about $0.60. That trade would limit my risk to $1.90 and would lose if FAS settled below $9.40. Looking at the landscape at the time, I decided not to roll and hold on to this trade. Why? Because I don’t like it anymore, that’s why. I didn’t want to be short the 7.5/10 put spread in MAR. That spread normally has positive time decay, but with my long hedge in-the-money, it actually has negative theta.

When you don’t like a trade, I find it better to plan an exit instead of trying to make it look prettier in hopes it will become transformed and you will suddenly like it again. With that in mind, I considered three viable strategies this weekend.

First, let’s recap my position on Monday morning. I am assigned the FAS 10 put and now own the stock (100 shares) at a price of $10 a share. My short 10 call in FAS expired worthless. My long strangle in MAR includes a 7.5 put and a 10 call. My cost of putting on the trade is $0.00 (excluding commissions and the cost of typing on my fingers). After I got assigned on Monday, and I of course was hoping something got missed and I would be left alone, I owned the following position:

Long 100 shares FAS (cost basis $10 a share)
Long MAR 7.5 put in FAS
Long MAR 10 call in FAS

Now back to my possible exits.

1. Sell stock and sell straddle.

2. Keep stock and sell straddle.

3. Sell stock and keep straddle.

When I purchased the MAR options, I did so to limit my downside risk to $2.50 and my upside risk to zero. Based on the principle of not widening my risk on a trade I don’t like anymore, I excluded choice #3. The reason being that I would book the $5.00 loss or so on the stock (FAS trading around $5) and I would risk the $3.05 I initially paid for the straddle if FAS settled between 7.5 and 10 by MAR expiry.

That leaves me with taking the trade completely off the table (choice 1), and with selling my straddle and keeping the stock as long as it’s new cost basis does not exceed a $2.50 loss.

Part of me wants to just sell stock and sell the straddle and leave this bad trade behind, but another part of me wants to at least give it a chance of redeeming itself somewhat. I decided to give the trade one last chance, so I chose option number 2.

I sold my straddle on Monday for $3.40. That creates a cost basis for my 100 shares of $6.60. Remember with this fancy footwork, let’s not lose sight of our commitment to not extend the risk beyond the $2.50 we initially assumed. Okay, given that it’s easy math. $6.60 – $2.50 would mean stop loss FAS at $4.10.

On the upside limit portion of the trade, I’m happy (actually thrilled) to get out for no profit, no loss. That would mean selling at my cost basis of $6.60. It’s one of those sentiments often expressed by mice: “keep the cheese, just let me out of the trap.”

So that’s what I’ve done. I now own FAS stock ($6.60 basis) with a stop loss at $4.16 and a limit of $6.63. Good until cancelled. I threw the weird numbers in there instead of the exact $4.10 and $6.60 because that’s just the way I enter orders.

Now I can rest knowing my foray in FAS short straddles will cost me a max of $2.50. And who knows, maybe I get this lesson for free.

Frankly Mr. Shankly – Smiths

February 20, 2009

Oh please Mr. Shankly, I’m frankly not interested in your money

But if you insist, please pay my mortgage, health insurance and potato vodka martini tab. If you can’t do it all, you can leave out the health insurance.

GLD skip-strike butterfly in APR

February 18, 2009

Yesterday we were filled on a three lot of long skip-strike call butterflies in GLD, the gold ETF. Our strikes are 99/100/103.

This butterfly gave us a CREDIT of $0.40 per contract, which is counter-intuitive given that we are long the butterfly. Butterflies are normally purchased for a small amount and act like little lottery tickets. If the underlying settles near the middle where the short strikes reside, the profit potential is pretty cool, given a small investment.

Here’s how a butterfly is constructed. First, it’s all like options, meaning all calls or all puts. Once you start mixing them up you end up with an iron butterfly or a gut butterfly. We’ll leave that for another day. For now, we focus on the simple butterfly.

Alright. Like options. Let’s choose calls for now. Next, we choose equidistant strikes between three strikes in the same month. In GLD let’s choose the 99, 100, 101 strikes. They’re all one dollar apart. We can write this as a long GLD call butterfly 99/100(2)/101.

The body of the butterfly is the middle strike and it will have double the amount of contracts as the outside strikes. We collect premium from the body so we are short the inside strikes. In our example we would be short the 100 call (two times).

The wings of the butterfly are the outside strikes and they are long options. In our example, we would be long the 99 call and long the 101 call.

The body of the butterfly almost pays for the wings, but not quite. There is usually a debit of around $0.10 per contract. In an ideal scenario, GLD settles at exactly 100 at expiration. You can see that your long 99 option is worth $1.00, your two short 100 options are worthless, and your long 101 call is worthless. Your profit is $1.00 for a $0.10 investment. Not bad.

But remember, we are talking lottery tickets here, so the odds are not in your favor. But for 10 cents … why not? You only risk what you paid for it since your short strikes are beautifully hedged by your long wings. It may be worth a shot.

What would be better, though, is if you can hold a butterfly not for a debit, but for a credit. This involves some fancy footwork, but not too fancy. Basically, if you want a credit you need to take on some risk. A typical butterfly has little risk (remember, what you paid for it only). But if you adjust the strikes, you can receive a credit for your risk.

Adjusting the strikes means tweaking the equidistant concept of your typical buttefly. Let’s stick with our two short calls at 100 in GLD and start tweaking the wings. If we move the lower call lower to say 98 and leave the others we end up with a 98/100(2)/101 call butterfly. There is no credit here though, because your profit window increased.

Not sure why? Split up the butterfly into two spreads and you’ll see. You have a long 98/100 call vertical and a short 100/101 call vertical. The long spread can make $2.00 and the short spread can lose only $1.00. Nobody is gonna give you this trade for a credit.

So how do we get a credit? We take on some risk and spread out the upside call. For the actual trade we made, we spread it out by two strikes to create the 99/100(2)/103 call butterfly. Splitting it into two verticals we can see we are long the 99/100 call spread and short the 100/103 call spread. The most we can make on the long vertical is now $1.00 and the most we can lose on the short spread is now $3.00. The good news is that before we start losing money on the short vertical, we’ve maximized our credit on the long vertical. Essentially, we are now risking $2.00 for this butterfly.

Well, if we’re gonna risk $2.00, we better get a credit for our exposure to risk. And sure enough, we do. We received $0.40 for the 99/100/103 butterfly, which brings our risk down to $1.60 per butterfly.

Here’s the secret to transforming our risk into no risk. If you’ve waited this long to find out you’ve earned it. Now mind you, GLD has to initially move away from our short strike (100) for this to work but that is our general opinion of what’s happening in gold. A little pullback is likely. Should that happen, we have a chance to take our risk off the table. Remember, our risk is the 100/103 call vertical.

The 100/103 short call vertical is short the 100 strike and long the 103 strike. What we want to do is buy back the embedded 101/103 call vertical hiding in there for less than the credit we initially got ($0.40). If we are buying the 101/103 call spread, we are long 101 and short 103. By buying this spread, we cancel out our position at the 103 strike and initiate a long position at the 101 strike. The result being our 100/103 short call spread becomes a 100/101 short call spread.

Remember we did not futz around with the 99/100 vertical. We simply changed the 100/103 into a 100/101 spread. Adding them together we get the 99/100(2)/101 butterfly.

Ah, finally.

For this trade to work, GLD needs to sell off a bit so we can buy that transformational 101/103 call spread for less than the $0.40 we got credited, thereby creating a risk-free butterfly for credit.

We put this trade on yesterday and today the transformational 101/103 call spread is marked at $0.43. So, we’ll wait it out. We have 58 days to APR expiration.

Beethoven Opus 130, 4th movement

February 13, 2009

This is what a fibonacci retracement sounds like.

Milan Kundera introduced me to Beethoven’s Last Quartets in his book titled “Unbearable Lightness of Being”. Beethoven was deaf when he composed this masterpiece. Maybe some day I’ll be able to make good trades blindfolded?

Short straddle in FAS

February 13, 2009

On Feb 10, 2009 I sold a straddle in FAS over the FEB 10 strike and received a credit of $3.05

FAS is the 3-times leveraged Financial ETF. It’s sister is FAZ, which is basically the short version of FAS. Well, before Geithner’s debut, the volatility on FAS was running around 250%. I’ll be honest, it looked like something that needed to be sold. So I put in an offer at the mid price and got filled immediately. That’s never a good sign. I immediately began second-guessing myself. Hmmm.

A short straddle is a short put and a short call over the same strike. Most retail traders prefer to BUY a straddle and they learn that their risk is limited to what they paid and their profit potential is unlimited to the upside, and limited to zero on the downside. It’s a common retail mistake to buy straddles ahead of earnings thinking they are getting a deal. What they fail to recognize is that the market has priced in the uncertainty, and most long straddles lose money. Those taking the other side of the trade, the straddle sellers, have the odds on their side, just like Vegas.

On my FAS short straddle over the 10 strike, I sold a call and a put at the 10 strike. My break-even is easy to calculate. On the call side it’s 10 plus the credit, or $13.05. On the down side it’s 10 minus the credit or $6.95. I took a trade that wins if FAS settles between $6.95 and $10.05 by FEB expiration, which is next week.

If FAS settles below around $7 by FEB expiry, I am the owner of FAS stock (100 shares per contract) after the holder of the 10 put exercises his rights against me.

If FAS settles above around $13 by FEB expiry, I am short FAS stock after the 10 call holder exercises and get hurt if it keeps going up, theoretically up to infinity.

So the plan is to let this hyperstock calm down, and buy back the straddle for less than the $3.05 I got in credit, thereby milking a profit. After the first day, the trade was up $0.40. But I have a hard time sleeping at night with a naked straddle so I woke the next day with a plan to define my risk.

I am going to buy protection in MAR that will hedge my high volatility sale in FEB. I’m really more concerned about a crazy rally to the upside (remember that’s where the risk is infinity). So I need to buy the MAR 10 call, and essentially create a calendar. On the put side, the most I could lose is about $7. And if FAS goes to zero, I’ll have bigger problems to worry about, such as stockpiling for Armageddon. So, I’ll settle for purchasing the 7.5 put in MAR. And guess what? The cost of that long straddle (strangle with wider strikes) was exactly $3.05, equal to my initial credit.

I have no risk to the upside, and $2.50 risk on the downside. This assumes I roll my FEB short strikes into MAR, which is what the plan is. After I do, I will have a credit for some amount (depends on when I roll next week). The calls will cancel each other out, and the puts will create a short put spread with strikes of 7.5 and 10. My trade is a winner if FAS closes above 10 by Mar expiry, which is March 20, 2009.

This trade has maximum profit potential if the price of FAS moves to my short strikes next week. Remember that when trading option spreads, you want the underlying to go to your short strike.

Trade System Alpha

February 11, 2009

The Trade System Alpha is my first formalized trading system. And yes, it’s not for sale.

I hold the belief that a trade system should be unique to the trader. Ideally, nobody should know about how it works in a meaningful way except for the trader.

My Trade System Alpha is designed for day trading setups. It uses the 5-minute to enter and exit trades. Here are the list of technical indicators used:

1. Heikin Ashi candlesticks. Used in conjunction with a moving average to trigger entries and exits.

2. Moving Average. Type and length confidential, but as stated above, it triggers entries and exits.

3. Donchian Price Channel. Length and displacement confidential. It’s main purpose is situational awareness.

4. RSI. Length confidential. Situational awareness as to the oversold/overbought condition.

5. Trendicator. Proprietary and confidential indicator. Confirms entries by indicating the current trend, and its strength. It may be difficult to gather from the picture above, but the Trendicator has four states: Green and above, Red and below, Yellow and above, and Yellow and below.

This system should be considered mostly discretionary since it isn’t in the market all the time, only when I choose to put a trade on. And though the entries are pretty clear cut, I take discretion in taking a trade.

The stop loss is set at a market-defined location where the chances of my trade working out start decreasing. I will also exit a trade before it hits my stop loss if it’s not setting up as expected. Again, kinda discretionary.

Trade System Alpha is my attempt to reduce random trading. It’s not a rules-based system in the true sense, but it is a framework that has a positive expectancy.

Once you set up your own trading system, you’ll find that losses are simply the cost of doing business and have nothing to do with you being right or wrong. In a twisted way, you can look forward to losses because you know your odds increase on the next trade being a winner. We can get into the statistical validity of that being the case if you’re not always trading, but let’s leave that for another time.

Good luck setting up your own trade system. And don’t get caught up in the phrase ‘trade system’ like I often do with certain phrases. You get the idea. Call it a system or criteria or whatever. As long as it’s not random dart throwing.

Candy Man, cover by John Fahey

February 10, 2009

Sweet. And yeah, pun intended.

Not quite like the candy we’re about to get shoved down our collective throats, though.

DIA Mar/Jun 70 put calendar

February 9, 2009

We are long the MAR/JUN 70 put calendar in DIA (Diamonds ETF) for a debit of $1.99.

More specifically, we are short the MAR 70 put and long the JUN 70 put. The risk of the trade is only the debit paid, which is $199 per contract. The way this trade works is that a though a debit is initially paid, premium is collected as the short front month option comes to expiration and is rolled into the next month. If the trade works out, each roll will generate a credit, the idea being that total rolls exceed the initial investment of $199.

Ideally, we want the Dow to trade around 7,000 at expiration in March, April and May. With the increase in volatility, that could generate individual roll credits in excess of $2.00 each. The plan, though is to pay for 50% to 75% of our initial debit with the first roll, completely pay for the debit with the second roll, and have the third roll on for free.

Short deltas. With our best case scenario being the Dow trading near 7,000, this trade is obviously bearish, which translates into short deltas in the options world.

Positive theta. Theta is time decay. We have it on our side with this trade because the value of our short front month option decays at a faster rate than the value of our back month long option.

Long vega. We like volatility increases with this trade. Long vol is like being long stock. You want it to go up to profit. If volatility increases, which it will likely do should the Dow retest November lows, we will get more credit for the rolls, because the option we are selling in a roll will be more expensive. Why will it be more expensive? Because grandma will start buying put insurance that’s why. And who cares what it costs, just get me some insurance! We will be glad to provide the service, for a small fee of course.

Calendars are ideally purchased during a suspect rally when volatility is decreasing. This makes them cheaper to purchase, and gives it more room to profit. For the trade to work, we do hold the belief that the current rally is suspect, a selloff is coming and volatility will increase.

MNX double diagonal becomes risk-free Iron Condor

February 5, 2009

Our FEB/MAR double diagonal with short FEB put at 121 and short FEB call at 127.5 has been rolled into MAR for a credit of $5.01.

You may recall we had long hedge against the FEB shorts in MAR with a 116 put and 132.5 call. And remember that we put this trade on initially for a credit of $0.00.

With the FEB/MAR roll, we have all our strikes in MAR. On the put side we’re long the 116 strike, short the 121 strike. On the call side we’re short the 127.5 strike and long the 132.5 strike. That creates a risk of $5.00 on the call side and a $5.00 risk on the put side. And since the MNX cannot settle at expiration at two different strike prices, we have a total risk of $5.00 for this iron condor. The credit received for the roll is $5.01 minus the risk of $5.00 creates a risk-free iron condor.

We’ll have to wait until MAR expiration to see how this trade settles. The worst that can happen is for MNX to settle below 116 or above 132.5. If that happens, we give back our $500. If it settles between 121 and 127.5, we keep the whole $501. Remember also that MNX is a cash-settled underlying. At expiration, everything settles to cash with no stock involved.

Sweet!