School Hard: A Tale of Two Triangles

Two direction-neutral plays, both structured as long iron condors, expired on Dec. 21. Both symbols were in the midst of symmetrical triangles, a chart construction that lends itself to strategies that profit if the price goes nowhere.

An iron condor is built out of two short vertical spreads: A bull put spread and a bear call spread. Together they provide a zone of maximum profit that drops off into losses at both the high end and the low end.

If the price stays in the zone, the trader lets the iron condor expire and pockets the credits earned when the position was opened. If it drifts above or below, then the trader either closes the position for a less-than-maximum profit or for a loss.

Closing the iron condor prior to expiration always means giving up some potential profit.

C remained within its zone of maximum profit and expired worthless. It provided a 30.9% yield on risk over the 36-day lifespan of the position, or 313.2% annualized.

CAT was trickier. On the last day of trading before expiration it moved decisively above the zone of profitability. By that point, the options were no longer liquid. I had no choice but to allow them to be exercised, a process that dumped short shares of the stock in my account. I liquidated the shares for a loss on Monday, Dec. 23.

In setting my exit points, I used the zone of maximum profit rather than the boundaries of the triangle, focusing on the position rather than the chart. This, as it turned out, wasn't the best approach, but it wasn't wrong, either.

Click on chart to enlarge.

CAT 180 days 2-hour bars

The price broke above the profit zone on Dec. 1, dropped back, and then above it again, never to return. I could have mitigated my loss had I exited on the first break above the zone.

But I wouldn't have had a chance to do that had I imposed a strict-exit rule at the profit-zone boundaries. CAT dropped briefly below the zone on Nov. 21, and that would have triggered an exit.

The price moved decisively above the upper boundary of the triangle on Dec. 12. Had I exited at that point, I would have pocketed a decent profit, but not the maximum. But I would never have made it to that point. CAT moved above the triangle on Dec. 6 and below it on Dec. 4. 

CAT provided an abundance of whipsaws, and I don't see how any rule could have reasonably handled them so as to give a chance for attaining maximum profit while steering clear of the options being exercised.

The Elliott wave count would have helped. Triangles under the Elliott rules touch the boundaries five times, in an A-B-C-D-E zig-zag pattern. Double touches occasionally happen, just to confuse the picture.

CAT touched the triangle boundaries five times before I entered the position, including a double touch, so Elliott would have told me to steer clear of the trade.

Wise advice, in retrospect.

Counting both the options and the shares resulting from their exercise, plus the results of an earlier position that was rolled forward, CAT produced a 0.5% loss on risk, or negative 5.9% annualized.

I never like to lose, but on the other hand, half a percent is cheap tuition for an experience that deepened my knowledge for triangle plays. School hard indeed.

References

My shorter-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading. 

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.