For the record, I am one of those guys who typically likes to develop his own trading methods. Call it pride, stubbornness, or just plain paranoia, but I like to know that the any method I may use fits with my own personality. Of course, it is still important to keep an open mind and to consider new ideas when they pop up in front of you. One that I like a lot is a trading method developed by a former colleague of mine. His name is John Broussard and he is the developer of www.OptionsAnalysis.com
John developed a system called “Darknet” for trading stocks and/or options based on his own proprietary trading logic. John was kind enough to share the trading logic with me. I am not at liberty to disclose it here (partly because I am still not entirely sure I understand what he was talking about. Which come to think of it, is probably why he was comfortable sharing the logic with me in the first place. But I digress).
In any event, while a few of the calculations, ahem, “push my limits of understanding”, I understand the concept well enough and have explored it enough to start following signals on a small list of stocks and indexes that I follow. To put it as succinctly as possible, Darknet looks for “several sets of regression channels to line up” in order to generate a trading signal. The reason the name is Darknet is because the criteria used to generate the signals is not visible to the human eye just from looking at a standard bar chart.
In any event, following a “buy” signal I look for a call option to purchase using the “% to Double” routine at www.OptionsAnalysis.com. The call option ostensibly is held until the system generates a “sell” (as in, exit a long position, not enter a short position). Since I only follow a handful of tickers there are not a lot of signals, but for illustrative purposes let me highlight a recent signal.
Figure 1 – Darknet signals for ticker BIIB (courtesy www.OptionsAnalysis.com)
Let’s take a look at entering an option trade for the most recent signal at the far right hand side of Figure 1. Figure 2 displays the output from the % to Double routine. The first trade listed is the December 2013 240 call, which has 42 days left until option expiration. A person who wanted to be more conservative could buy the third option listed – the January 2014 240 call option – which has 70 days left until option expiration.
Figure 2 – BIIB Call trades ranked buy Bullish % to Double (courtesy www.OptionsAnalysis.com)
Let’s say we were willing to commit up to $2,500 to a trade and are comfortable trading the option with only 42 days left until expiration rather than the one with 70 days left. The risk curves for this trade – buying 2 of the December 240 call – appear in Figures 3 and 4. Figure 3 – BIIB December 240 Call (courtesy www.OptionsAnalysis.com)
Figure 4 – Risk Curves for BIIB December 240 Call (courtesy www.OptionsAnalysis.com)
As with any long call position, the underlying security ultimately must rise in price in order for the trade to make money. Also, time decay begins to accelerate in the month before expiration and this option has only 42 days left until expiration when the position is entered. So the bottom line is that in this example, if BIIB does anything other than rally in the reasonably near future, the trade stands to lose money.
Well you didn’t think I was going to show you a losing trade, did you? With a glance back at Figure 1 we see that BIIB rallied and that a sell signal was generated on 12/5/13. At this point, the trade I highlighted could have been exited with a profit of +271.2% as shown in Figure 5. Needless to say, not every trade works out as well as this one. Still, it does grab one’s attention regarding the possibilities.
Figure 5 – BIIB December 240 call at time of Darknet sell signal (courtesy www.OptionsAnalysis.com)
Don’t Forgot about Alternative Endings
In my analysis, the raw buy and sell signals from Darknet – in highly technical terms that we quantitative types like to throw around – “look pretty darn good” to me. Of course, as with any trading method no trade or series of trades is certain to generate a profit. So traders still must engage in the same old mundane and boring risk management (i.e., position sizing) and position management (i.e., when to exit with a profit, when to exit with a loss and when to consider adjusting a trade).
Which leads to one last point, remember that when you trade options you don’t necessarily have to “wait around for a sell signal.” In many cases there can be opportunities to adjust an existing position in order to lock in profits and/or reduce risk. As always, there are a lot of way to play.
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