Candlestick Signals and Option Trades (Part 3, advanced) Hour One

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Candlestick Signals and Option Trades (Part 3, advanced) Hour One 1. Hedges, long and short A hedge is any strategy designed to reduce or eliminate market risk.

1 Candlestick Signals and Option Trades (Part 3, advanced) Hour One 1. Hedges, long and short A hedge is any strategy designed to reduce or eliminate market risk. This applies to equity positions and the use of options strategies. A hedge may involve either long or short positions, or long/short combinations that perform best when based on assumptions of either a bullish or bearish trend to follow. Among popular hedges are protective puts and synthetic stock positions. 2. Hedging strategies The protective put is a straightforward strategy. An owner of 100 shares buys a put to protect the paper profits. This is appropriate when the value of the stock has grown above the original basis; the trader wants to keep stock but also wants to protect profits. However, the cost of the protective put should not exceed the paper profit itself. For example, a trader bought 100 shares and paid $70 per share. Today the stock price has grown to $77, an increase of $700. A protective put with a strike of 75 will cost $200. In this case, the first two points of decline represent the breakeven on the protective put (the strike of 77 minus the two-point cost for the put, or $73 per share). Once the price declines below that price, the protective put can be sold to offset losses; or it can be exercised and the stock sold at the fixed strike of 75.

Lowes saw a rise in price like this. At the peak of the bull trend, a bearish inverted hammer appeared. This predicted a decline in price; so this would be a good spot to open a protective put.

2 Lowes saw a rise in price like this. At the peak of the bull trend, a bearish inverted hammer appeared. This predicted a decline in price; so this would be a good spot to open a protective put. This hedges against price decline after adjusting for the cost of the put. After this reversal signal appeared, the stock price did fall. The three inside down was a very convincing bearish signal confirming a bearish tendency and taking the price down to $63 per share. At this point, a trader could exercise the put and sell shares for the strike of the put; in this example, that was $75. This produces a profit of 12 points, or $1,200 ($75 - $63). Or the put could be sold with intrinsic value of 12 points, offsetting the loss in the stock. Synthetic stock is another set of strategies aimed at hedging an equity position. It is called a synthetic position because the net increase or decrease in option values mirrors the same change in the underlying stock price. A long synthetic stock position is so called because it assumes the price of stock will rise. It consists of a long can and a short put at the same strike, as close as possible to the current price per share of the underlying. The cost of this two-part option position should be at or close to zero, or may be possible with a small credit. As the stock price rises, intrinsic value of the long call mirrors the change in the underlying, and the short put value declines. The short put may expire worthless, or be closed to take profits. The purpose of the long synthetic is to set up a net zero (or close to zero) basis in the two options, so that all changes in the long call reflect the same growth as the underlying stock. This strategy may be employed without owning stock; or when shares are held but have declined in value, and the trader expects the price to rebound. I n this situation, the long synthetic stock position is a zero-cost method for gaining profit when the stock price moves higher.

3 The chart of Procter & Gamble showed price with very little movement from late to October to mid-january. A synthetic long stock position opened during this period would be likely experience a decline in the short put, and it could be left to expire worthless or closed to take profits. The morning star appearing in mid-january signaled a likely bull trend to follow. This would have been the time to leave a long call to gain profits. A short synthetic stock consists of a long put and a short call, at the same strike and preferably with strikes as close as possible to the current value per share. This position performs best when the stock price is expected to decline. Because the synthetic short involves a short call, it is most appropriate when the trader owns 100 shares for each short call. This reduces exercise risk in the even the stock price rises. However, a stock price decline leads to worthless expiration of the short call, or the ability to buy to close at a profit. At the same time, the long put increases point for point with declines in the stock price. Because the net cost of the synthetic short is zero or close to it, all in-the-money price declines represent equal offsetting advances in the long put value. Hewlett-Packard s chart revealed a very strong bearish tendency at the peak of a bullish run. The hanging man is a bearish signal, and it was followed by a large downward gap and a volume spike. Opening a synthetic short stock position at the point would be well-timed.

4 By the middle of February, the bearish trend had taken price from a high of $14.50 down to $9 per share, a 38% decline. This was the time to close the long put on one side of the synthetic short. The short call could be left to expire worthless, or closed to take profits. 3. Candlesticks for synthetic stock selection The synthetic stock strategy, whether long or short, should be entered based on a desire to hedge an equity position. Accordingly, the timing should rely on two attributes. First, the stock price should have undergone a strong trend, either bullish (for synthetic short stock timing) or bearish (for synthetic long stock timing). Second, rely on exceptionally clear and strong candlestick reversal signals and confirmation to time entry of a synthetic stock trade. 4. Condor and iron condor The condor is an advanced strategy involving four different strikes. It provides limited profit in exchange for limited loss potential. With expiration in the same month, the typical condor consists of a short call with a lower-strike long call; and a short call with a high-strike long call. The lower short call should be in the money, and the higher short call out of the money. This requires a net debit to open the position. For many traders, the condor is too complex; and considering that it requires a debit to open, the limited profit potential makes this a strategy with limited value. A variation involves a combined use of calls and puts, also employing four different strikes. In this variation, all four positions are out of the money. A long OTM short put is accompanied by a lower-strike OTM long put; and a short OTM call is accompanied by a higher OTM long call. Like the regular condor, the iron condor offers limited risk and profit, and is a neutral strategy. It may also be thought of as a combined bull put spread and bear call spread. 5. Butterfly and iron butterfly The butterfly spread is similar to the condor. It requires opening one set of middle-range strikes along with higher and lower strikes at the same time. As with all complex offsetting strategies, potential profits and losses are both limited. There are many combined possibilities to the butterfly involving long or short middle ranges and high/low ranges, as well as variation in use of calls, puts or both. The butterfly, like the condor, is a neutral strategy combining a bull spread and a bear spread. This also means that potential profit and loss are both limited. The difference between the two is that while condors involves four strikes, butterflies employ only three. A long call butterfly consists of a one ITM call, two short ATM calls, and one long OTM call. Because the short positions are in the middle strike, this may create a net credit or debit. The short butterfly reverses the long and short positions of calls at each strike, with the long positions in the middle and the short positions above and below. A long put butterfly is constructed in the same manner as the long call butterfly, and the short put butterfly reverses positions, with short puts at the money and long puts above and below.

5 The iron butterfly combines calls and puts at three strikes. For example, an iron butterfly may consist of one OTM long put; one ATM short put; one ATM short call; and one OTM long call. The two ATM positions, both short, are at the same strike. The iron butterfly offers limited profit and loss; however, and movement in the underlying will create net profit in half of the positions, both long and short; and the short positions that do not move due to underlying changes in price will lose time value and can be closed at a profit or allowed to expire worthless. A final variety is the reverse iron butterfly. This is appropriate when you expect volatility to increase in the underlying, based on candlestick signals at the time the position is opened. Also called a short iron butterfly, positions of each option are reversed, with the two short positions both out of the money and the two long at the money. For example, a reverse iron butterfly may consist of a short OTM put; a long ATM put; a long ATM call; and a short OTM call. The two long positions are at the same strike. 6. Candlesticks for timing of condors and butterflies The ideal timing for entering any variety of condor or butterfly should depend on candlestick signals. However, all of these positions offer limited profit in exchange for limited possible loss, so for complex positions involving multiple options, the need to monitor changing premium levels is constant, for very little reward. The appropriate candlestick signal should be accompanied by confirmation; the timing relies on the state of the current trend. Because the offset of short and long is typical of condors and butterflies, these strategies are most appropriate when they result in a small net credit and when the underlying is in consolidation.

6 Apple s chart shows how consolidation formed at the end of August. It lasted six weeks. Opening a condor or butterfly during consolidation would have set up a time decay on all of the short sides, so these could be closed profitably or allowed to expire. The remaining long positions would be profitable on one side once the price moved out of consolidation; and the remaining long options would probably expire worthless. However, the combined profits from all of the short options plus half of the long options would be likely to create an overall net profit in the condor or butterfly. These strategies offer limited profit potential in exchange for limited maximum loss. However, they are defensive strategies that will not perform at the same level as other hedges. Both condor and butterfly are worth consideration in times when the future price movement of the stock is uncertain, but they are not likely to form a core of a consistently profitable strategy. 7. Box spreads A box spread is a more complex variety, in which both a bull spread and a bear spread are opened. For example, a trader opens a bull spread consisting of a short October 50 put and a long October 45 put; and at the same time, opens a bear spread consisting of a long October 55 call and a short October 50 call. This sets up limited middle-range profit zones in both, limited loss zones on both sides of the combined position, and limited profit zones on both sides. A trader

7 can profit from the box spread, but it is complex and profits (and losses) will be limited. However, the overall transaction cost of the box spread reduces the profit potential substantially. The appropriate timing for a box spread is similar to the timing for condor or butterfly spreads. When price is in consolidation, it is the most likely situation to profit from the box spread. However, it involves several different contracts, and maximum profit is always limited. Self-test 1. The protective put consists of: a) a short call and a long put opened together. b) a long put intended to protect paper profits. c) a short put opened at the same time as shares of stock are purchased. d) a long and short put straddle with the same expiration and different strikes. 2. Synthetic stock is a strategy that: a) involves buying stock that has not yet been issued but has a fixed price. b) doubles up on profits as long as the stock rises. c) is bullish or bearish and mirrors movement in the stock price. d) involves selling a short call and a short put to profit from time decay. 3. The condor consists of: a) four different options, two long and two short, with four different strikes. b) four different options, two long and two short, with three different strikes. c) long and short options with two strikes and different expiration dates. d) a combination of four options with different strikes and expirations. 4. The butterfly consists of: a) four different options, two long and two short, with four different strikes. b) four different options, two long and two short, with three different strikes. c) unlimited profit potential in exchange for limited maximum losses. d) unlimited loss potential in exchange for limited maximum profit. 5. A box spread is described as: a) any strategy in which profit and loss is confined to a narrow range (the box). b) a combination of a condor and a butterfly. c) a straddle that works like a spread. d) the simultaneous opening of both a bull spread and a bear spread Self-test 1. B 2. C 3. A 4. B 5. D

8 Hour Two 1. Candlesticks for advanced strategies Candlesticks work in all types of chart durations. However, they are especially valuable when considering entry to an advanced strategy. This includes the strategies discussed in this section. Seek candlestick signals with strong signal strength; for example, in a two-session offsetting signal such as an engulfing, longer relative sizes of each session sessions tend to be stronger indicators than signals that barely meet the criteria of the signal. Another guideline for timing of reversals is strong confirmation. As a general rule, strong reversal (meaning solid signals) combined with equally strong confirmation increases confidence about the reversal forecast. 2. Candlesticks and trend movement It is equally important to equate the candlestick reversal with proximity in the trend. The closer to resistance or support the signal appears, the more likely it is to succeed. Compared to signals occurring at mid-range, the strong proximity of signals at the borders of trading ranges are the most reliable ones. When signals develop and move through resistance or support, especially if price gaps are part of the signal, tend to be particularly strong. As long as confirmation occurs in the form of other candlesticks, technical signals such as double tops or bottoms, volume, or momentum, reversal likelihood is at its highest point. Don t overlook the importance of consolidation. Traders tend to focus on bull and bear trends, but for many stocks, consolidation takes up a larger portion of a chart than these dynamic trends. If you think of consolidation as a third type of trend, it also makes sense to identify profitable option strategies and also to look for signals forecasting breakout (including short-term reversals, triangles and wedges, Bollinger squeeze, and island clusters). Within this consolidation period, also consider a new definition of reversal. Not only a reversal of price, but a reversal of trend, applies and candlestick reversals moving from consolidation to either bull or bear is a valid indicator. 3. Long pure volatility (long straddles, long strangles) Option strategies can be broken into specific types of signals. Among these are long strategies designed to exploit volatility. These include straddles and strangles. A problem with two-part long strategies is that they tend to be expensive, especially if volatility is high. You need substantial movement in either direction, not only to overcome the cost of the position, but also to offset time decay. Candlestick signals to spark a long pure volatility strategy should be exceptionally strong and appear at the most advantageous proximity appearing in consolidation but when also accompanied with strong breakout signals (especially when breakout appears likely but the direction is not clear).

Consolidation presents many opportunities for long pure volatility positions. On the chart of Clorox, two consolidation plateau patterns appeared, one after the other.

9 Consolidation presents many opportunities for long pure volatility positions. On the chart of Clorox, two consolidation plateau patterns appeared, one after the other. In the middle of the first one, a bullish doji star marked the timing for a long straddle or strangle. As expected, price broke out above resistance, making the first straddle or strangle successful. However, another consolidation pattern appeared. The original entry could be closed or rolled at this point. A double bullish engulfing presented another opportunity for short-term gains. Price did move briefly above the newly established resistance price of about $129, moving up as high as $132 per share. This was an opportunity for another long pure volatility move with a fast close once resistance was broken. This price pattern makes the point that long pure volatility is higher-risk than many other strategies. This does not diminish the conservative value of the strategy, but given the volatility it does require the ability to enter and exit quickly due to the pattern in price. 4. Long leaning volatility (long call and put ratio spreads; long call and put ratio backspreads) Another category is when the chart is leaning toward long volatility, and a long options strategy will produce profits as long as price movement is strong enough. Strategies that work in this situation include ratio spreads and long call or put backspreads.

The chart of CVS Health reveals a much different type of price pattern. Consolidation extended from mid-november to mid-february, with two important price flags.

10 The chart of CVS Health reveals a much different type of price pattern. Consolidation extended from mid-november to mid-february, with two important price flags. First was the island cluster, a short-term grouping of price offset by gaps on both sides. In this case, the cluster moved price above resistance with a fast retreat. The second event was a very steep move below support, culminating with a bullish piercing lines signal. This forecast a likely move back above resistance and out of consolidation. Although this happened as expected, the end of the chart was inconclusive. Over the month following (not shown), price did continue rising to the level of $104 per share, or seven points higher. However, a ratio spread or backspread opened at any point during this chart would be at risk. Closing once price moved above resistance would make sense. There appeared an equal chance for price to continue upward or to retreat back into the consolidation range. It is especially noteworthy that momentum did not register any instances of overbought or oversold during the period shown. 5. Short pure volatility (short straddles and strangles; butterfly; box spread; condor) Like the long volatility condition, some trends are more appropriate for short pure volatility. These include straddles or strangles, butterflies, box spreads and condors.

Unlike the long combination of options, short combinations yield income and will yield profits as long as prices remain in a zone keeping options out of the money.

11 Unlike the long combination of options, short combinations yield income and will yield profits as long as prices remain in a zone keeping options out of the money. This requires a relatively wide trading range that has held for a period of time. Time Warner presented a strong case for a short pure volatility play. This is based on the radical price movement displayed at two points on this chart. Both were instances of exceptionally high volatility in price along with high volume. In the first case, a modest decline followed after a delay; in the second case, a stronger bullish move followed the short-term volatility. This pattern is ideal for short pure volatility strategies, especially short straddles or strangles. 6. Short leaning volatility (short call and put ratio spreads; short call and put ratio backspreads) A moderately volatile chart is appropriate for ratio spreads and backspreads. The ideal condition is during a period of consolidation showing no immediate signals of breakout. The combination short position creates very strong short-term profits as long as no breakout occurs. However, the chart has to be monitored so that exposed positions can be closed when breakout signals appear.

Campbell Soup experienced a consolidation from late November through mid-january. Ratio spreads and backspreads would work well in this situation.

12 Campbell Soup experienced a consolidation from late November through mid-january. Ratio spreads and backspreads would work well in this situation. Short-side positions lose time value and could be closed at a profit within this extended period. This particular chart was difficult to read, however. In early December, the two consecutive sessions with upper shadows breaking resistance, hinted at the possibility of a strong bearish move. That did not materialize, and there were signs that it would not. Specifically, the lack of any confirming signals revealed that the double top was probably not going to lead to a strong bearish move. To the contrary, the bullish side-by-side white lines, a continuation signal, indicated a likely bullish move, which did occur immediately. This was the point to close any short calls involved in this strategy. 7. Options arbitrage (long and short calendar spreads and ratio calendar spreads) A final situation is one in which the future direction of price is unclear. In this case, an arbitrage strategy provides great potential. Either long or short calendar spreads and ratio calendar spreads are relatively low-risk approaches enabling traders to exploit uncertainty in the stock chart.

13 The chart of Suntrust Banks demonstrates how uncertainty makes prediction difficult in some cases. This price pattern shows good timing for an arbitrate position, because future price direction is impossible to predict. In fact, all of the signals identified were failed signals bullish signs that led to bearish moves, and bearish signs resulting in bullish price moves. This failure of signals has to be expected to occur in some cases. At such times, a trader has to rely on the strength of reversal and confirmation in many forms price, volume, and momentum. However, generally speaking, relying on candlestick reversal signals and strong confirmation is the best way to build a system in which trades are well timed, both for entry and exit. Self-test 1. Signal strength is defined as strong when: a) offsetting sessions in two-part signals are wide rather than narrow. b) they appear in mid-range between resistance or support. c) substantial price gaps have occurred, but not elsewhere.

14 d) fundamental news is especially strong during a session. 2. Consolidation has to be treated as: a) a non-trend, a pause in which buyers and sellers are uncertain about the price. b) agreement between buyers and sellers that the current range-bound price is appropriate. c) a third type of trend that can be tracked and breakout can be forecast. d) a plateau within a long-term trend, leading to resumption of the previous price direction to follow. 3. Long two-part strategies, such as long straddles or strangles, tend to be: a) Cheap because of the offsetting sides. b) Cheap because both sides are out of the money. c) Expensive because they require substantial price movement to overcome both price and time decay. d) Expensive because both sides are in the money. 4. Short pure volatility strategies will be profitable as long as: a) the underlying price remains highly volatile. b) the underlying price remains within the zone between strikes. c) premium received is high enough to ensure an overall net profit no matter how much movement occurs in the underlying price. d) technical signals support rapid decline in time value. 5. Option arbitrage is deigned to: a) create future profits based on entering long and short sides of a trade on different exchanges. b) ensure offset between limited profit and limited loss. c) create profits based on poor-performing stock prices and well-priced options. d) create profits when future underlying price direction is uncertain. Answers to self-test 1. A 2. C 3. C 4. B 5. D

Winged and Ratio Spreads

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