Wednesday, 17 May 2017

Follow up on Coiled Spring Experiment and Final Blog Post (New Blog Coming)

It's been a long while since I last posted. My regular profession as a Chartered Professional Accountant resulted in my being inundated during tax season (in Canada this runs from basically, end of February through end of April) with very little time to opine on anything. But there's been lots of time to think since my last post.

I wanted to debrief my last couple of posts on options trading with a number of irrefutable observational truths in no particular order:
  • Option trading at the best of times is a frustrating endeavour, enough to drive a participant absolutely nuts. 
  • Options are not assets, they are decaying derivative instruments. If a participant does not realize this up front, he/she has no business participating. How best to understand the concept of price change and decay? Start with understanding theoretical greeks. Theta measures time decay. Delta measures sensitivity to changes in the price of the underlying instrument.
  • The more time there is to expiry, the more expensive the time value component of the option price is. As time lapses, time value decays, and the closer to expiry, the faster the decay.
  • Options are priced by professionals, using professional models (Black Scholes, etc.). On top of theoretical pricing is the bid/offer spread. A market maker will use a combination of theoretical model output + the bid/offer spread to make a market. The more liquid the underlying, the more liquid the option will be, and vice versa. So, not only are participants up against a decaying derivative instrument, they are up against professional market makers who set the option spread on any given day. They are also up against their own particular biases. 
  • Not only do participants have to be right in terms of strike price and time to expiry, they have to be right about direction, all while not getting juiced on the spread. All of this begs the question, why bother in the first place?
  • It is not uncommon (in my experience) for market makers to price the tails surrounding a price range at greater than the near term volatility range (on the offer anyway). For example, say a stock is trading at $50, and the near term at-the-money straddle (i.e., the $50 call + put) is pricing in between a 5 & 10% move. This would make the premium of both strikes between $1.45-$2.50 each, and depending on how liquid the underlying is, the market maker could vary the bid offer spread according to his/her discretion. For example, he/she could make a market with a $.05 spread (i.e., $2.45/$2.50) or a $.50 spread (i.e., $2/$2.50). The $.50 spread is an invitation to lose money. The market maker can then set the range of prices in the chain up/down accordingly. For example, at say +/-10% x $50, he/she could set the $45 put at $0/$.50, and the $55 call at $0/$.50. I ask again, why bother?
So why am I going into all of this detail?

Well, firstly, the Coiled Spring Experiment was a cute idea, but it was stupid. So I identified a bunch of charts with triangles. Who cares. Is this research? No. On top of that, I suggested buying strangles midway between the expected break-out range. What does this particular trade setup achieve? It really achieves one thing, an almost certain transfer of wealth in terms of premium paid for the strangle between the participant and the option writer.

Secondly, while the strangles were a novel idea back in January, and while one leg of the strangle did appreciate noticeably in the direction of whatever breakout occurred, the other leg depreciated noticeably once direction was established, and if my call on the mid-point of the breakout range was too distant or the premium paid for both legs ended up being more than the intrinsic value of the winning leg by expiry (i.e., for a call, IV = stock price - strike price, and for a put, IV = strike price - stock price), then the overall experiment was a losing proposition. As theta burn kicked in during mid-March, the winning leg started to decay feverishly. At least if I was long the underlying in the direction of the move, I'd be right on direction with no time limit, and no decay, and I'd earn dividends while I waited.

Thirdly, none of this is a good use of time or effort. Looking back at the above, I believe that the Coiled Spring Experiment was an exercise in first level thinking, something along the lines of, "hey, there's a triangle, it's going to resolve and I'm going to be able to take money from a derivatives desk who's only job is to professionally set the odds (by the second) by paying up for premium six months out".

Sounds dumb in hindsight doesn't it? Where is the research to substantiate risking capital above and beyond observing a chart pattern?

Fourthly, as I mentioned above in my irrefutable observational truths list, I've observed (experientially) that the tails around a volatility range are often over-priced. This negates the ability to buy tails cheap, and I believe that the best way to make money in options is to pay nothing, and therefore lose nothing. This really means paying nothing for the tails, so in the event of a abnormal standard deviation move, the tails get valuable. But market makers are not stupid, and they don't easily get picked off, which explains why the tails often appear overpriced relative to the near term volatility range.

In the context of the $50 stock above,  it wouldn't surprise me at all to see the $50 calls, $52.50 calls, and the $55 calls priced as follows (assuming 25% implied volatility and assuming a $.50 spread):

$50, $.95/$1.45
$52.50,  $.05/$.55
$55, $0/$.50

There's no way to buy cheap options in this case.

So in the order of final debriefing:

  • Options are a losing proposition from the outset, so why bother?
  • If a participant wants to trade options, the best way to participate is to buy tails for cheap with a lot of time left for the underlying to do whatever it's going to do. BUT, in my observational experience, tails don't often get cheap due to market makers setting wide bid/offer spreads. And the longer the time to expiry, the more expensive the tails get due to wide spreads. The best way to participate is to be the market maker yourself and just have silly bids in between the existing spread and hope they get hit, and the likelihood here is that the bid will just sit there and not get hit, which begs the original question, why bother?
  • If a participant is lucky enough to have a silly tail bid filled with enough time to expiry, he/she should look to immediately sell another strike against the premium paid in order to have a spread on for free. Case in point on the $50 stock, if the ATM straddle is pricing in 10% and the bid/offer spread on the $55 calls is $0/.$50, and and the bid/offer spread on the $45 puts is $0/$.60, have silly bids in for $.05 on both legs. If either of the bids happen to get filled, look to sell the $60 calls, same expiry, for $.05, or look to sell the $40 puts for $.05. This way, the participant has either the $5 call or the $5 put spread on for free. I believe this is the only way to successfully trade this stuff. Have enough premium on that if it erodes to zero, you don't care, and if you just happen to get lucky enough for the underlying to blow through your short strike before expiry, you paid nothing and you make something.
  • There's a hidden element of psychology embedded in this entire discussion, and that is, what does your own read of a chart tell you about your own psychology and biases, and what does it tell you about other participants' psychologies and biases'. If I see a triangle, you can bet other participants see a triangle, and participants will either try to front-run the resolution or wait for resolution either in the underlying or in the options. Going back to my original post, I identified a set up in Abbott Labs that hadn't resolved yet in January 2017. The May 2017 $44/$38 strangle was priced at $2.35 in January with the stock at $40, the May $44C was priced at $1.01, and the May $38 put was priced at $1.34. Abbott broke up, but moved nowhere near midway between the $13 breakout range I originally identified in January. My bias was to overlay my expectations on resolution vs. what price actually did, and my model paid too much for the privilege of trying to participate. In theory, a $13 range/move suggested a +/- 30% move in the underlying, and here's where the gut check comes in: what research was done to support a +/- 30% move beyond observing a nice looking chart pattern? NONE. How likely are +/- 30% moves without some fundamental change in the operating business?
I close off with the following final observation:

If there's no research tied to allocation of capital, don't bother. And if a participant wants to bother for the fun of it, don't EVER overpay for the privilege.

On the subject of a new blog

I'm going to start a new blog which does not have Stable, or Dividend, or Portfolio in the title. As I progress in terms of experience (what fools endearingly refer to as their mistakes over time), I want to write closer to home on a range of financial topics which may include or exclude any or all of the above aspects of my previous blog.

I'm thinking of either two titles:

1) Confessions of a retail muppet 

2) Diary of a retail muppet 

I will try and get this set up in the next few weeks.

Thanks all for reading.

Monday, 16 January 2017

The Real Time "Coiled Spring" Experiment: Nike, Discovery, Abbott, Lennar, and Viacom

All of this thinking over the weekend on pennants, triangles, and strangles got me thinking.

I have long been of the belief that consolidations inside pennants / triangles lead to resolution, either up or down once price reaches the apex of the pattern. The longer the pattern of consolidation, the more meaningful the resolution.

The issue I have always had in my own speculation is leaning to one side in terms of positioning myself in advance of any resolution, and this is a dangerous endeavour because I truly believe that flexibility is the epitome of a successful speculative trading operation, not stubbornness. Anticipatory trading is bad enough: anticipatory stubbornness is a sure path to losing money!

(On the flipside, stubbornness is most likely the epitome of a successful investing operation, as evidenced by great investors who have succeeded because they have had better and deeper anchors than their participant counterparts in evaluating and sticking with great businesses over time)

Well, it's time to put my theory to test, partly by way of a real money experiment, and partly by way of a hypothetical paper trade experiment.

I spent this past weekend scouring the S&P 500 and the DJIA for monthly or weekly consolidation triangle / pennant patterns and have found the following 6 charts out (of 500+, believe it or not).

First up, Nike (already mentioned last week):

Next, Discovery Class K:

Next, Abbott Labs:

Next, Lennar:

Next, Viacom:

And finally, Sealed Air:

There is a noticeable commonality amongst all six setups, and this appears to be characterized by a long term consolidation inside a pennant / triangle over the last two years in each case. I have indicated total distance inside the consolidation, and the option strikes to be considered on eventual breakout/resolution.

I have added a link to a new model to the blog which assumes that I invest equally in six strangles positioned slightly above and slightly below the apex of each consolidation pattern, and this is where I ran into my first problem, in that the spreads on the Sealed Air options are too wide, so I dropped Sealed Air from consideration due to illiquidity in the spreads.

I used the closing prices of the strangles as quoted at optionsexpress for each of the five remaining setups being considered as of Friday January 13th, 2017, assuming I purchased the strangles at the market.

In my new model spreadsheet, I have added objective targets based on breakout / resolution resulting in a move up or down equal to the triangle / pennant width, and my assumption in updating the model once a week is that I will have GTC orders in the market at all times equal to a theoretical profit of 1/2 x the resolution distance to be conservative.  Once a pattern resolves, the 1/2 x resolution P/L GTC order will theoretically close out one half of the strangle, while the other half is left to expire at a loss.

By conducting this experiment, I hope to see how resolution unfolds in real time on a forward looking basis.

As disclosed on Friday, I am currently long two June Nike spreads ($57.50/$62.50 and $47.50/$42.50) and I have decided that being the long the spreads is incorrect as it locks me in and there is diminished flexibility inherent in being short the out of the money spread strikes. Therefore, I have an order in the market GTC to buy back the short legs of the spreads which I will execute at some time tomorrow, leaving me long one Nike $57.50C  / $47.50P strangle.

I also have a GTC order to buy an ABT May $44 C / $38P strangle outright for a debit of $1.80 based on my evaluation of potential resolution of ABT's current consolidation.

Once I have executed my closing NKE short legs and ABT long strangle, I will immediately place GTC orders in the market for each leg of the strangle I own based on my evaluation of potential resolution in the market.

Finally, I have compared the overall P/L of the "Coiled Spring" Experiment to equal dollar exposure to SPY as of the close on Friday January 13th, 2017.

This should be an interesting experiment overall.

Saturday, 14 January 2017

Follow up post on TA and the psychology behind setups; Cisco, Brown Forman, And Abbot Labs

Passive Income Pursuit asked a great question on learning about TA. My response is detailed in my previous post, reproduced below:

"Ok, on TA, it may be worth doing an entirely separate post on this subject. My layman's opinion is that it works, and at the same time, it doesn't work. It works by virtue of participants believing it works. I now look at TA entirely from a psychological perspective, but I never used to. There are loads of participants at any one time looking to latch onto breakouts in either direction. This type of trading fits into trend following. A successful breakout is usually followed by a trend. The problem here is that because so many participants are looking to trade breakouts, the event of the eventual breakout often occurs after a bunch of false breakouts, whipshawing traders. So I've come to believe that while trading breakouts can be a viable system, a participant must be mentally prepared to lose on the first n independent trials before the breakout actually occurs, and even then, the breakout may go in a direction which was completely unexpected by the majority of participants.

Case in point, SPY on the night of the election, financial MSM worked all participants into a frenzy expecting a crash if Trump ended up winning, and the majority must have been positioned for a crash. The night of the election, ES was down close to 10% at one point and anyone short the hole in the futures market that night got creamed on the open. 

So my overall perspective is that TA is a function of my analyzing long term time-frames (monthly charts mostly), and making an educated guess as to how the majority of participants are positioned, and then doing the opposite in the options market. I seem to have stumbled onto this almost by mistake. I literally study all of the Dow components, the QQQ components and the S&P500 at least once a week on a monthly basis to see whether any setups look enticing. And for the most part, I can't find many enticing looking setups right now. The only Dow component that looked interesting was Nike b/c it appears to have consolidated for almost a year inside a triangle and this type of consolidation is usually followed by resolution out of the triangle (I just don't know which way, nor do I care).

There are more elements to this, including studying setups and evaluating which setups appear more probable in terms of volatility resolution, looking at the liquidity in the options market to see whether it makes sense to play, and looking at cost of the options themselves.

For example, I looked at the monthly setup this week on Brown Forman (BF B). It looks like a nice bearish setup on the monthly, about to break down. The problem here is two-fold, 1) if I'm noticing a bearish setup, you can bet other participants have as well, so the smart play is to either play both sides (like I have done with Nike) in case the break down doesn't resolve, and/or wait for resolution and trade in that direction, and 2) there is no liquidity in the options as the spreads are too wide, therefore the answer to the BF B problem is, don't bother playing.

If you really want to study TA, I suggest approaching it from the perspective of learning basic patterns and then trying to figure out the psychology behind the pattern itself. If you notice that a stock is currently in a one year triangle, you can bet that everyone else out there notices the same pattern and is waiting for resolution, and you can probably bank on a good %ge of those waiting for resolution being wrong when the resolving event actually occurs. This is why trading is so difficult, because you are fighting against yourself first, and if you get married to your perspective and are inflexible, it's about as good as flushing money down the toilet."

So what patterns seem to have a high probability of working (in my opinion)? I think this is probably easiest illustrated by virtue of some current chart setups I have on watch. I've had the most success in trading pennants or triangles, and the least success trading patterns like H&S tops (more on this later).

Caveat, none of the following are recommendations, and in most if not all cases, I'm going to argue both for and against the pattern working, so I may end up leaving readers more confused than when we first started the discussion.

First up, Cisco monthly:

I'd characterize this as 15 years of nothing. So the obvious question becomes understanding the rationale behind the nothing over the last 15 years, and trying to understand what the catalyst might be for Cisco to get over multi-decade resistance at $35. This is where fundamental research comes into play, in order to tie everything together.

One way to play this setup is long $35 leaps. January 2018 $35 calls can be had for around $.70. The risk is the premium. The obvious pattern appears to be a rising channel of some sort. The problem I have with this set up is that it's too obvious, and I can see that the January 2018 $35 calls have the largest OI out of all of the strikes (42K in OI). This could be symptomatic of participants selling calls against the underlying in order to generate additional income, or it could be symptomatic of participants positioning for a breakout. The pattern is therefore ambiguous. It's a chop until it actually breaks out above $35 and holds above it. A better way to play this is to probably just buy Cisco and collect the dividend and let it do what it's going to do.

A less obvious point to put on the January 2018, or even better, the January 2019 $35 calls, is on a sharp move down to $25 on an overall market or Cisco specific correction. If Cisco moved down 15-20% on an earnings disappointment or on an overall market correction, the contrarian play would be to have orders in the market to buy the January 2018 $35 calls for between $.15 & $.20 and/or the January 2019 $35 calls for between $.35 & $.45 as there seems to be significant t/l support going back to 2012. To me, the most opportune time to add risk in terms of premium is when risk comes out of the market. For the same $.71 of risk today, I can have a GTC order in the market to buy 3 Jan 2018 $35's at $.20 or 2 Jan 2019 $35's at $.35.

Somewhat riskier would be putting on a risk reversal on a sharp move down to t/l support, i.e., sell the Jan 2018 $25 strike puts to finance the purchase of the Jan 2018 $35 calls for a credit. The risk here is that you are obligated to take delivery of shares at $25 should Cisco keep going right through $25 if t/l support doesn't hold. If you are only long premium, you simply lose premium.

Next up, Brown Forman monthly, here's the current setup:

I hate to admit it, but this looks like a giant H&S top. The problem with this setup is that if I see it, so too do most other participants, and my experience with H&S tops is that they seem almost as likely to fail to complete as they are to complete, so if the options were cheap enough, I'd look to buy strangles or spreads in both directions in the event that the H&S top fails and catches everyone short positioned incorrectly. The problem with the options market here is that the options are expensive, the spreads are too wide, and there is no bid on the June $40 puts to hit, so the answer here is, move on and don't play in this playground.

Finally, Abbot Labs:

Once again, an ambiguous setup which looks like a long consolidation inside a triangle/pennant. No one knows which way it's going to break, so certainly this could be a candidate for a long strangle or spreads both ways in case in breaks up or down. The May 2017 $43/$38 strangle can be purchased for around $2.10. The distance inside the triangle/pennant is around $13, so I expect some sort of resolution either up or down of between +/- $6.50 & $13. This would result in a retest of $50 at the highs, or $28 at the lows. On a $13 move, this works out to a reward:risk ratio of $13:$2.1 of greater than 6:1.

Alternately, a trader could reduce the cost of the strangle by selling the May 2017 $47/$34 strangle against the $43/$38 strangle for a credit of $.54, so the overall cost becomes $1.56, but the downside is a cap on total profit of +$4 each way (at expiry), or more likely 1/2 of $4, so +$2 in the interim time between now and May expiry. The risk here is that there is no resolution between now and May expiry, and you lose the net premium.

Friday, 13 January 2017

Revisiting Disney, and now Nike

Back in August, I put on a trade based on a chart setup in Disney, the link to the original post is here:

And here was the monthly setup I identified at the time:

The way I played this was long two spreads. I bought one Jan 2017 $105/$110 call spread and I bought one Jan 2017 $87.50/$82.50 put spread for a net debit of $1.57.

I closed out the call spread today for $2.95 (after commissions), while the $87.50/$82.50 put spread expired worthless. Not bad for taking a flyer. Here's what I liked about this trade:

  • I was able to profit despite being direction neutral (I was both long and short, I just didn't know which way was correct at the time, nor did I need to)
  • I was able to allow myself lots of time between trade identification and time to expiry
  • I let the market do whatever it wanted to do
Here's what I did not like about this trade:
  • I did not have an open order in the market to close out the put spread. But, this is not a big deal, as Disney never actually got down below $87.50 where the p/s would have been profitable. I think that going forward, it would make sense to at least put a GTC order in the market on both legs in case there's a spike up or down in the market.

Here's how Disney turned out:

In my play account, I'm always looking for interesting setups and ideas, and I stumbled across Nike, see below, the setup looks eerily similar to Disney pre break out:

So, once again, I am simultaneously long the June 2017 $57.50/$62.50 call spread and the June 2017 $47.50/$42.50 put spread for a net debit of $1.54 in my IB account.

The difference now is that I have a GTC order in the market to sell the p/s for $2.95 and I may do the same with the call spread so whatever direction this breaks, I may end up making something on either a move down or a move up (or both).  I may end up adjusting the GTC orders to $2.50 to at least be halfway between the two strikes on either side.

The distance inside the pattern (call it what you will), is around $20, so conservatively, I expect a move either up or down of at least 1/2 of this distance, depending on how exuberant the Fast Money traders are on the day/week of the break out. The one thing I can count on is that the idiots on CNBC will work everyone else watching them into a frenzy chasing the breakout on their say.

My ideal scenario is a sharp move down to test $44, my GTC p/s gets bought by someone in a panic, and then a sharp retracement back up to $64, and my c/s gets bought by someone else in a panic, whipshawing everyone who was positioned incorrectly by listening to Fast Money in the first place along the way.

I know this all sounds a bit evil, but it really is a zero sum game of chess.  I really don't care which way it breaks, I just care that it breaks and hits my GTC orders on one side or the other, and the more volatile, the better.

The risk to me is that it doesn't move below the short strike in either case and I lose my premium.