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.

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