Friday, October 10, 2014

Rules for very short term trades

Regular readers will know that I'm not at all averse to changing how I trade. As a pragmatist, I'm looking for what works now and in the future, not for what the conventional wisdom says or for what has worked in the past but perhaps no longer meets market conditions.

One issue I've looked at over time is how to cover the range of trades. There's money to be made in the markets by active speculators, who think in terms of positions lasting months, but also for long-term traders whose horizon is years out (think Warren Buffet) and hair-trigger traders who think in terms of days, or at most a few weeks.

My initial rule set, based on the Turtle trading method, covered the active speculator portion of the game. My positions tend to last several months, unless they fail quickly, in which case I exit immediately upon receiving a signal that the position isn't behaving as expected. That way of trading is embodied in my poorly named shorter-term trading rules, which can be read here.

As the market neared what appears to be many to be a peak, the pool of potential trades under those rules began to dry up. I was heavily in cash, and that's not where I wanted to be.

So I studied the advantages of positions held for the longer term, both in terms of the lower long-term capital gains tax rate and the ability to benefit from dividends. The result was my longer-term trading rules, which can be read here.

Those two rule sets combined still leave a gaping hole in the trading: Earnings season. Semi-officially, each quarters earnings season kicks off when Alcoa Inc. (AA) announces its earnings, and event followed by a flood of announcements that takes six weeks or so to abate.

Under my shorter-term rule set, I'm forbidden from opening a new position in a stock within 30 days prior to an earnings announcement. During the season, this shrinks my available trades to near zero.

So I began searching for the best way to profit from the earnings announcement.

This is tougher than it looks. Stock prices move sharply after earnings, but not always. Positive earnings can be followed by a price decline, and negative earnings by a rise, but not always. Analysts always have an expected result prior to earnings, and that consensus is available, but sometimes its right and sometimes its wrong, and sometimes the price is unchanged if the target is hit, and sometimes it moves wildly if the target is hit.

A private trader must always remember that no knows the future. It is utterly unknowable, and if someone claims to have the secret, hang on to your wallet and walk away.

I concluded that price expectations are of no use. One aspect of the markets, however, appears to be fairly consistent. Implied volatility rises when there is greater interest in a symbol, and falls when that interest wanes.

With earnings, and other events, such as major product announcements (think Apple's amazing dog-and-pony shows), interest peaks the day of the event, or perhaps the day before, and then collapses after the event is over. Implied volatility, my theory went, ought to do the same.

I went to the charts to see if my theory would pan out, using my eyes rather than a spreadsheet, and indeed, it seemed to work that way.

In stock options, there are structures, such as short vertical spreads, that profit when implied volatility declines. The "short" part means that the spread is sold for a credit, and then bought back for a lower price or allowed to expire ignominiously.

The decline in the value of an options with the passage of time is called time decay, or theta. Time decay reaches its maximum in the last week before an option expires. That fact defines my tradable universe: Symbols that, in addition to their regular options that expire each month, have weekly options -- weeklys -- that like a Mayfly live their brief seven-day span and depart.

So I had a chart pattern: Implied volatility that was high by recent standard and that had already hooked down at the start of a decline. I had a universe of symbols: Stocks and exchange-traded funds supporting weekly options. And I had a timeframe: A few days surrounding a scheduled event.

That gave me the material I need to write a rule set, and here it is:

I'll be reporting on trades under this rule set using the same vehicles as I do my other trades: Prospects, Finalists, and analysis, and Outcomes, with the same reporting of results as I do now. Profitable or not, it promises to be an interesting venture, what that I hope to enjoy to the fullest, as i do all of my trading.

-- Tim Bovee, Portland, Oregon, Oct. 10, 2014

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 decisions for his or her own account, and take responsibility for the consequences.

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