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.