For the record, this is not a “new” article. I have posted something very similar to this at various venues a few times since 2004. Still, I have found that none of this stuff ever seems to become “outdated.” I think this is because despite the quantum leap in trading knowledge and computer power in recent times, that pesky thing known as “human nature” remains relatively unchanged. So, repeating now:

One useful exercise for all traders and investors is once in awhile to go back to “basics”. To wit:

While I am very much an advocate of systematic trading, success or failure ultimately comes down to what goes on between the ears. So consider the following thoughts …

Too many traders enter the markets without the slightest realistic idea as to how they will succeed in the long run. Does that sound like a plan for success?

It is essential to trade in a manner that fits your own personality.

There is no “one best way” to trade.

The question that needs to be answered is simply what approach works best for you.

Some traders operate best using a very short-term timeframe. Others operate best using a very longtime timeframe. It is critical to understand your own preference. If you can’t bring yourself to hold a trade for more than a few days, it does you no good to use a longer-term trading approach. Likewise, if you have developed a successful longer-term approach and/or don’t have time to watch a quote screen, it is a mistake to try to day trade.

If you develop some set criteria for entering trades, and if you have some realistic reason to expect this criteria to generate good returns over time, and you follow that criteria consistently, you give yourself the best chance for success.

Your answer to the question “what criteria will I use to exit a trade at a loss” may have more of an impact on your ultimate success or failure as a trader than any other single factor.

The truest thing to know about trading is that there will be losing trades, and that you must be prepared to deal with them, both financially and psychologically.

The key to long term trading success is to select some method that you will use when you have money on the line and then to stick to it once you are actually trading.

Whenever you hear a successful trader say “what you need to do in order to succeed is…” what they should be saying is “what I need to do in order to succeed is…” What you need to do in order to succeed may be different. Likewise it is your responsibility to determine which ideas from other traders are useful to you and which are not (Warning: it’s not always an easy process).

Forming a comprehensive trading plan is your first step toward trading success.

Successful traders learn that the ability to identify the current trend is far more useful than a thousand predictions.

Most successful traders focus first on controlling risk, rather than on how much money they plan/hope to make. In other words, they take care of the losing trades, and the winning trades take care of themselves.

In the final analysis, proper risk control is ultimately what separates the winning traders from the losing traders.

The goal in trading is to make money of course. However, one tradeoff that needs to be considered is the relationship between total profitability and the volatility experienced along the way. If the day-to-day volatility is too great, this will often result in a trader “pulling the plug” at exactly the wrong time.

The ultimate goal is to maximize profitability while minimizing risk. This does not happen by chance. It takes planning, execution and discipline.

Your absolute #1 priority as a trader is to be able to come back and be a trader again tomorrow – never take any risk that might endanger that possibility.

The costliest mistakes in trading are usually made when the pain of losing money (and/or the fear of losing more money) becomes too great. Bottom line: never risk too much at one time.

If you “bet the ranch.” prepare to have your trading account “buy the farm.”

The most cruel paradox in trading is that short-term success can sow the seeds for long-term failure. Beware the trader who has unexpected success and then believes he or she has developed “the touch.”

If you decide that you will exit a particular trade if and when a certain set of criteria is met, then that is exactly what you need to do. The specific chain of events that cause your exit criteria to be met are completely irrelevant.

The markets do not know that you or long or short and do not move in a particular way simply to inflict pain upon you personally. It just seems that way sometimes.

The markets will frustrate you and inflict pain upon you from time to time. This is simply a fact of trading life. The real trick is to not inflict pain upon yourself.

When you succumb to fear or greed or ego, you become your own worst enemy. Knowing yourself as well as you do, do you really want you as your worst enemy?

Too many traders spend too much time saying things like “I should have gotten in sooner,” or “I should have held on longer,” “I can’t believe that stock reversed the minute I got out,” etc., etc., etc. The cure for this is to focus solely on the action of the market from the time you enter the trade until the time you exit the trade. What happened before you got in and after you got out is not important.

Another paradox: it is important to analyze your approach from time to time to see what’s working and what’s not. However, the danger is that if you are constantly tinkering with your existing approach, you may never truly develop the confidence you need to have in it in order to stick with it when the going gets tough.

In the long run, it is not any prediction you might make about what will happen next that will make the biggest difference in your success or failure, but rather how you react when things don’t go the way you expect them to.

Second-guessing a trading decision is the single most simple act in all of trading.

Make no mistake about it, letting a profit run can be a very difficult thing to do psychologically. However, if you are using a longer-term method – which requires at least an occasional “big winner” to offset a lot of small losses, it is imperative to avoid taking profits too soon. Remember the word “discipline.”

Likewise, watching a trade continue to pile on profits after you have exited prematurely is one of the most painful experiences in all of trading.

A lack of discipline can destroy even the most talented and well-prepared trader.

In the end, you – and you alone – are ultimately responsible for your own trading success or failure. Remind yourself of this from time to time.

Working past a really bad trading experience can be very difficult. The key is to understand and accept the simple fact that this is part of life as a trader and to not allow a bad experience to have a negative residual effect on your subsequent trades.

The great paradox of option buying:

Lesson A) to maximize your return on any single trade, buy an inexpensive out-of-the-money option.

Lesson B) to maximize your return in the long rung avoid lesson A.

To put it another way, to make money in the long run, avoid trying to make all the money in the world in the short run.

In choosing which option to buy an option buyer must decide which is more important to him or herself – greater upside potential (out-of-the-money) or a higher probability of profit (further in –the-money). There is no exact right or wrong answer. The problem is that too many traders never ask the question. They simply go for the greatest leverage.

In the long run, due to the negative effect of time decay, option buyers generally are better off reducing their leverage and buying options with some intrinsic value, rather than just buying cheap out-of-the-money options.

The questions you need answers for:
* What is my reason for entering this trade?
* What is my objective in entering this trade?
* What is my maximum profit potential and what is the probability of achieving it?
* What is my maximum risk and what is the probability of achieving that?
* Will I need to adjust this position?
* If so, at what point do I need to adjust and what type of adjustment will likely be required?

Am I going to be able to keep track of this trade closely enough to avoid any potential disasters?

If you don’t have answers for these questions before entering a particular trade, this should be your warning not to take the trade in the first place.

Jay Kaeppel

I hate to sound paranoid but, boy, Murphy sure hates me.  On March 13^th I wrote an article titled “A Risky (but Darned Exciting) Strategy for T-Bond Traders.”  The simple idea detailed in the article is based on the fact that over the years t-bonds have gained a lot of ground during the last 5 trading days of the month and lost a lot of ground during all other trading days of the month.  I then detailed a strategy that simply involved buying a triple leveraged t-bond ETF and holding it during the last five trading days of each month.

The historical numbers look great.  The numbers for March 2015, on the other hand – not so much.

As you can see in Figure 1, ticker TMF cratered big time during the last five trading days of March 2015 and this 5-day period witnessed a decline of -3.8%.  Like I said, Murphy hates me.Figure 1 – Ticker TMF (courtesy: AIQ TradingExpert)

The Upshot

So what is the moral of the story here?  Well, in reality I don’t think there necessarily is one.  Although for the record please note the verbose use of the word “Risky” right in the very title of the original article.  Still, what happens during any one five day period in the financial markets is not really indicative of anything (other than the aforementioned incontrovertible fact that Murphy undeniably loathes my very existence. But I digress).

From the perspective of a trader considering the relative merits of a potential trading method (i.e., buying and holding a triple leveraged bond ETF during the last five trading days of every month):

-It is OK to say “I don’t really understand why this has worked in the past and I don’t know if it will work in the future, therefore I will choose not to use it.”

-It is OK to say “this looks like a very volatile approach to trading with potentially large swings in equity, therefore I will choose not to use it.”

-It is OK to say “short-term trading is not my thing, therefore I will choose not to use it.”

On the other hand:

-It IS NOT OK to say “well the darn didn’t work this month so obviously it is a stupid idea that I will discard without ever looking back and I don’t blame Murphy for hating the author’s guts.”

Like I said, what happens over the course of one “period” – whether very good, very bad , or somewhere in between – can be instructive in terms of illustrating the risks involved, however, it tells you nothing about the long-term prospects.  A close look at Figure 2 reveals that even this latest month’s “debacle” in no way negates the overall long-term trend.  In fact, for the record, the “system” is still up +8.1% for 2015.

Figure 2 – Growth of $1,000 holding TMF last five trading days of month versus all other trading days; April 2009 to present

Summary

Contrary to what many may tell you, there is nothing wrong with devoting trading capital to “risky” strategies.  In fact, they can turn out to be the thing that separates your own overall long-term performance from everyone else’s.  However, the keys are to:

1) Hold a reasonable level of confidence that it will be successful over time.

2) Devote and risk only a small portion of your trading capital to such strategies.

3) Go into these types of strategies with your eyes wide open and mentally prepared for periods like, well, March 2015 in t-bonds using a triple leveraged ETF.

Jay’s Trading Maxim #105: Don’t let any strategy put stars (or dollar signs) in your eyes.  If you are walking down the street and you trip and fall that is one thing.  If you are standing on a mountain top looking at the stars and you trip and fall that is something entirely different.

Jay Kaeppel

If you are of a certain demographic, and/or if you have been in the markets for a long time, and/or especially if you grew up in or around Chicago………even though we’ve all known this was inevitable, it’s still a little hard to believe.

As Silence Falls on Chicago Trading Pits, a Working-Class Portal Also Closes

R.I.P. doesn’t quite seem like the right sentiment for a place that created such noise and ferocious activity.

But nothing else really comes to mind/

Jay Kaeppel

In RSI Everything (Part 1) I detailed two indicators respectively dubbed “RSIAll” and “RSIROC”.  These two indicators make up half of a combined indicator I refer to as “RSI Everything”.

In Part 2 I will detail the last 2 RSI based indicators and then add them together to create one – OK, for lack of a better phrase – “Mega”  RSI indicator.  Traders may consider each of the four indicators separately, or combine them into one indicator as I do a little later in this piece.

Measure #3. RSIq2

I am not exactly how I came to name this one RSIq2, but for better or for worst there you have it.  The initial calculations for this RSI variation are very similar to those for RSIROC detailed in Part 1.  The primary difference is that this indicator uses a traditional 14-day RSI day window, and it adds an additional calculation to the mix at the end.  The AIQ code for the RSIq indicator appears below followed by the gist of it in English.

ThreeDayROCRSI14 is (RSI14-valresult(RSI14,3)).

RSIPlusROCRSI14 is (RSI14-50)+ThreeDayROCRSI14.

RSIROC14 is (expavg(RSIPlusROCRSI14, 2)).

RSI14mid50 is RSI14-50.

RSIq2 is (RSIROC14+RSI14mid50)*2.

In some semblance of English:

Line 1 subtracts the 14-day RSI value of 3 days ago from today’s 14-day RSI value (to essentially factor the trend of the 14-day RSI into the mix).

Line 2 subtracts 50 points from today’s 14-day RSI and then adds in the value calculated in line 1. (this creates an indicator that fluctuates above and below zero rather than using 50 as the midpoint as with the traditional RSI).

Line 3 creates a two-day exponential moving average of values calculated each day in Line 2 (i.e., yesterday’s RSIROC14 value is multiplied by 0.6667 and today’s RSIROC14 value is multiplied by 0.3333 and the two values are added together to create today’s RSIROC14 value.

Line 4 once again subtracts 50 from today’s 14-day RSI value.

Line 5 simply adds together the values calculated in Lines 3 and 4 and then multiplies the sum by 2 to arrive at the RSIq2 value.

An example of RSIq2 plotted again an actual security appears in Figure 1.  Figure 1 – Ticker SPY with RSIq2 indicator (Courtesy: AIQ TradingExpert)

In general, readings below -64 in an uptrend signal a potentially oversold situation and readings above 64 in a downtrend signal a potentially overbought situation.  But as with all of these indicators, traders are encouraged to experiment with different “cutoff” values and also with various entry triggers.

Measure #4. Tom DeMark’s Range Expansion Index (TDREI)

Tom Demark is a well known analyst and system and indicator developer.  One limitation of the RSI indicator is that if price moves up or down the RSI will fluctuate even if price movement is not very meaningful.  DeMark’s REI is an attempt to reduce the influence of price movements that are little more than “noise”.  Rather than just noting the change in price from close to close each day, REI compares the high or low of certain days to the high or lower of certain other previous days to update the indicator value each day.  The AIQ code for TDREI is as follows:

Hitoday is [high].

H2 is val([high], 2).

H5 is val([high], 5).

H6 is val([high], 6).

Lotoday is [low].

L2x is val([low], 2).

L5 is val([low], 5).

L6 is val([low], 6).

Closetoday is [close].

C7 is val([close], 7).

C8 is val([close], 8).

TD1 is [high] – h2.

TD2 is [low] – l2x.

TD3 is iff(([high] >= l5 or [high] >= l6) and ([low] <= h5 or [low] <= h6), 1, 0).

TD4 is iff((h2 >= c7 or h2 >= c8) and (l2x <=c7 or l2x <=c8), 1, 0).

TD6 is td1 + td2.

TD5 is iff((td3 + td4) >=1, td6, 0).

TD7 is abs(td1) + abs(td2).

TDREI is ((td5 + valresult(td5, 1) + valresult(td5, 2) + valresult(td5, 3) + valresult(td5, 4)) / (td7 + valresult(td7, 1) + valresult(td7, 2) +valresult(td7, 3) + valresult(td7, 4))) * 100.

I am not going to attempt to explain the REI calculations.  If you want to know the particulars please follow this link: www.Google.com.  Then type in DeMark Range Expansion Index.

Figure 2 displays ticker XLF with the REI indicator plotted below.Figure 2 – Ticker XLE with DeMark’s REI indicator (Courtesy: AIQ Trading Expert)

As with the previous indicators I’ve discussed the general idea is about the same – i.e., negative readings within an uptrend signal potential buying opportunities, positive readings within a downtrend signal potential shorting opportunities.

RSI Everything

So we have now detailed four different (albeit similar) RSI based indicators.  Typically the next question many traders will ask is “which one is the best to use for trading?”  And in fact some traders may have better success focusing on one of the four indicators rather than combining them as we are about to do next.  But the reality is that each indicator gives its fair share of excellent trading signals and its fair share of just plain wrong trading signals.  So for the purposes of this exercise instead of trying to “choose” we will instead “combine.”

The indicator I call RSIEverything is calculated simply by summing the daily value for each of the following indicators and dividing by four:

*RSIAll-50

*RSIROC

*RSIq

*REI

The first two were detailed here and the second two are detailed above.

Figures 3 through 6 display RSIEverything plotted against a handful of various securities. Figure 3 – Ticker XLE with RSI Everything (Courtesy AIQ TradingExpert)Figure 4 – Ticker SPY with RSI Everything (Courtesy AIQ TradingExpert)Figure 5 – Ticker TLT with RSI Everything (Courtesy AIQ TradingExpert) Figure 6 – Ticker WYNN with RSI Everything (Courtesy AIQ TradingExpert)

Summary

As with any oscillator the bad news is that there is no one magic cutoff value that – once reached – guarantees that a price reversal is imminent.  Still, much money can be made by “buying the pullback in an advance’ and/or shorting the rally in a decline.

Looking for a buying opportunity when:

1) Price is above the 200-day moving average and;

2) RSI Everything is below ???  -32?  -48?  -64?

Appears to make sense.  So does looking for a shorting opportunity when:

1) Price is below the 200-day moving average and;

2) RSI Everyting is above +32? +48? +64?

The key questions for a trader to answer are “what indicator cutoff values to use to signal an opportunity” and “enter immediately or wait for a reversal or a breakout above the latest high (or the latest 2-day high”?  etc.

Which reminds me to mention:

Jay’s Trading Maxim #65: Getting an indicator to signal “buy” or “sell” is the easy part. In the long run, how and when you actually enter into a new trade and how you manage that trade once entered is what separates the winners from the losers.

Jay Kaeppel

A long time ago a friend of mine worked for a professional sports franchise.  However, as low man on the totem pole he didn’t make a lot of money.  So to supplement things he got a job at a small local television station as the Producer for a show that featured local bowling on Sunday mornings.  No, seriously.  And he wasn’t the only guy trying to “make it.”  The guy who was hired as the actual on air broadcaster had aspirations too.  So he would routinely treat each frame as something akin to the ninth inning of the seventh game of the World Series.  As a result he sometimes went a little overboard on the hyperbole.  To wit:  One day when the “local legend” – a woman who had won every local bowling title and award that was ever created – stepped up to the line with her ball in hand, the broadcaster intoned for all (roughly 12) viewers to hear, “Anything that you can do with a bowling ball, this woman has done!”

My poor friend almost peed his pants.

Anyway, the only reason I bring this up is that as a still non-recovering “numbers geek” (“Hi, my name is Jay”), I sometimes feel like “anything you can do with a couple of numbers, I’ve done it.”  One case in point is the simple RSI (Relative Strength Index) indicator. Created by Welles Wilder I’m guessing 40 some odd years ago, this simple oscillator has helped to trigger roughly a bazillion trades.  But some of us are not content to leave well enough alone.  And so for better or worse we torture the darn thing until it is “different” (and hopefully – though not necessarily – better, for “better” is in the eye of the beholder).  So (True Confession Time) I have an indicator I follow that I’ve called RSI Everything (for reasons that will become painfully obvious very soon), which combines four, um, variations, on the venerable RSI.  i will cover the first two in this article .

There are many ways to calculate these things but in this article I will be including code from AIQ Expert Design Studio.  Not much in the way of “rocket science” so the indicators can be easily adapted by those of you using one of the roughly twelve bazillion other charting packages available these days.

Measure #1. RSIAll

Figure 1 displays ticker AAPL with the 2-day, 3-day and 4-day RSI indicators drawn below the bar chart with the values for each appear in the lower right hand corner. Figure 1 – AAPL with 2-day, 3-day and 4-day RSI indicators (Courtesy: AIQ TradingExpert)

In a nutshell, the 2-day is more sensitive than the 3-day and the 3-day is more sensitive than the 4-day.  Most traders pick their “favorite” day window and stick with it.  Nothing wrong with that.  But RSIAll is calculated simply by taking the latest value for the 2-day, 3-day and 4-day RSI and dividing by three.  This appears in Figure 2.Figure 2 – AAPL with RSIAll indicator (Courtesy: AIQ TradingExpert)

In a nutshell, low RSIAll readings within an uptrend are considered “bullish”, while high RSIAll reading within a downtrend are considered “bearish.”  Of course, the trick is defining how low is “low” and how high is “high”.  As with most indicators there are no “magic numbers.”  That being said, 15 on the oversold side and 85 on the overbought side are probably a good place to start.

The AIQ Code for RSIAll is as follows:

Define days2 3.

U2 is [close]-val([close],1).

D2 is val([close],1)-[close].

AvgU2 is ExpAvg(iff(U2>0,U2,0),days2).

AvgD2 is ExpAvg(iff(D2>=0,D2,0),days2).

RSI2 is 100-(100/(1+(AvgU2/AvgD2))).

Define days3 5.

U3 is [close]-val([close],1).

D3 is val([close],1)-[close].

AvgU3 is ExpAvg(iff(U3>0,U3,0),days3).

AvgD3 is ExpAvg(iff(D3>=0,D3,0),days3).

RSI3 is 100-(100/(1+(AvgU3/AvgD3))).

Define days4 7.

U4 is [close]-val([close],1).

D4 is val([close],1)-[close].

AvgU4 is ExpAvg(iff(U4>0,U4,0),days4).

AvgD4 is ExpAvg(iff(D4>=0,D4,0),days4).

RSI4 is 100-(100/(1+(AvgU4/AvgD4))).

RSIAll is (RSI2+RSI3+RSI4)/3.

Measure #2. RSIROC

OK, for the record RSIROC is an abbreviation of another indicator I concocted with an even more arcane name titled RSIROCExpAve.  The code (and a relatively weak attempt at an explanation in English) follows below:

ThreeDayROCRSI is (RSI3-valresult(RSI3,3)).

RSIPlusROCRSI is (RSI3-50)+ThreeDayROCRSI.

RSIROC is (expavg(RSIPlusROCRSI, 2)).

So what is that all about?  This indicator basically builds in the 3-change in the RSI indicator itself to measure the momentum of RSI.  OK, here goes:

Line 1 subtracts the 3-day RSI value from 3 days ago from today’s 3-day RSI value.

Line 2 subtracts 50 points from today’s 3-day RSI and then adds in the value calculated above.

Line 3 creates a two-day exponential moving average of values calculated each day in Line 2 (i.e., yesterday’s RSIROC value is multiplied by 0.6667 and today’s RSIPlusROCRSI value is multiplied by 0.3333 and the two values are added together to create today’s RSIROC value.

Example:

-Yesterday’s RSIROC value was 45

-Today’s 3-day RSI is 30

-3-day value three days go was 60 then:

ThreeDayROCRSI = (30-60) or -30

RSIPlusROCRSI is (30-50) + (-30) = -50

RSIROCExpAve is ((45 * 0.6667) + (-50 * 0.3333) = 13.33

Ticker GOOG with the RSIROC indicator plotted appears in Figure 3. Figure 3 – Ticker GOOG with indicator RSIROC (Courtesy: AIQ TradingExpert)

In a nutshell, the higher above 0 the RSIROC reading the more overbought the security in question, and the lower below 0 the RSIROC reading the more oversold the security in question.  Readings of +60 or more and -60 or less seem like reasonable areas of “extreme” readings.  The most likely use for this indicator is to look for low readings when price is above the 200-day moving average (as a potential buying opportunity) and for high trading when price is below the 200-day moving average (as a potential shorting opportunity).

n RSI Everything Part 2 I will detail the other two parts of the indicator and how the pieces go together.

In the meantime, don’t try anything crazy with a bowling ball.

Jay Kaeppel

There are few things that can make a stock price “pop” or “drop” more quickly or harder than an earnings announcement.  A favorable earnings announcement can make a stock gap sharply higher from one trading day to the next and an unfavorable earnings announcement can have just the opposite effect.  As a result manner traders look to “play” earnings announcement by entering into an options position in advance of the announcement.

This is especially true with stocks that develop a history of making dramatic earnings announcements followed by big stock price movements.  Some stocks that might fit in this category are AMZN, AAPL, BIDU, GOOG, NFLX, BIDU, FB, BWLD and CMG, to name a few.

Keeping an Eye on Implied Volaility

One phenomenon that tends to occur to the options on these stocks prior to an earnings announcement is referred to as the “volatility spike”.  In a nutshell, due to abnormally strong demand for options on the stock – especially shorter-term options that expire shortly after the earnings announcement – the time premium in those options soars as the option writers wisely demand larger than normal premiums for assuming the risk of writing the options in the first place.  This spike in time premium is reflected in higher implied volatility levels for the options.

Simply buying options when implied volatility is extremely high is generally a dangerous idea because typically, once the earnings news is out – be it good, bad or otherwise – implied volatility falls sharply and the options see a lot of time premium that was built into their prices vanish.  This phenomenon is typically referred to as a “volatility crush.” On the flip side, writing options prior to an earnings announcement for a volatile stock is also very risky because if the stock gaps the wrong way after the earnings announcement, extremely large losses can ensue.

So what follows is a discussion of “one way” to play earnings using options.  This method essentially involves buy a potentially expensive straddle or strangle (i.e., buying both a call and a put) while offsetting some of the cost by selling a shorter-term very richly priced straddle or strangle.

The Steps

To illustrate the steps in this example strategy we will use the unparelleed analysis tools available at www.OptionsAnalysis.com

Step #1: Identify a stock or group of stocks that have a history of:

1. Experiencing large price movement following earnings announcement
2. Experiencing volatility spikes prior to earnings announcements

See NFLX in Figures 1 and 2.Figure 1 – NFLX often experiences large price movements after earnings (Courtesy: www.OptionsAnalysis.com)

Figure 2 – Implied volatility for NFLX often spikes before earnings and then crashes afterwards

Step #2: Find the two option expiration cycles that:

1. Expire at least 2 trading days after the expected announcement
2. Have at least 50 days left until expiration

In Figure 3 we see that for NFLX this is the Oct14 Week4 and the December options (with 11 and 74 days left until expiration, respectively). Figure 3 – Oct week 4 options have 11 days left, Dec options have 73 left to expire (Courtesy: www.OptionsAnalysis.com)

Step #3: Find the put first put option in the shorter term cycle that has a delta of greater than -45 (i.e., closer to 0, -44, -43, -42, etc.).  Note that put’s strike price.  The goal is to sell a call option roughly equidistant from the stock price as is the put we just found.  HOWEVER, we want to trade the same strike prices in the longer-term options, so you need to make sure the strike prices you find in the shorter-term options are also available in the longer-term options.  Consider Figure 4. 

Figure 4 – Options to trade for NFLX (Courtesy: www.OptionsAnalysis.com)

In Figure 4 note that on the right hand side in the Oct14 Week 4 put options, the first strike to have a delta under -45 is the 452.50 strike price.  However, there is no 452.50 strike price available in the December series.  So we will use the 450 and 465 strike prices.

Also note that at times it may be impossible to match up strike prices without going relatively far out-of-the-money.  Rule of thumb: if the trade doesn’t come together fairly easily, don’t chase it.  Move on to another potential opportunity.

Step #4: Compare the implied volatility levels of the near-term options versus the longer-term options.  If the IV for the shorter-term options is NOT at least 30% higher than the longer term options DO NOTE proceed.  Skip this stock and look for another opportunity.

In Figure 5 under the heading “IV%” we see that the implied volatility for the near-term options are at least 30% above the IV for the longer-term options

IMPORTANT NOTE: The higher the IV of the shorter-term options relative to the longer-term options the better the opportunity (as long as the IV on the longer-term options is not also in the stratosphere).  In essence we are using the sales of the more expensive shorter-term options to help finance the purchase of the longer-term options.

Step #5: Sell two of the near-term puts and two of the near-term calls.

Step #6: At the same time buy three of the longer-term options.

See Figures 5 and 6.  NOTE: It is not uncommon for high IV options and/or longer term options to have wide bid/ask spreads.  It is recommended that you place limit orders and attempt to enter the entire position at one time using a limit order.  See Figure 5. Figure 5 – NFLX trade particulars (Courtesy: www.OptionsAnalysis.com)Figure 6 – NFLX earnings trade risk graph (Courtesy: www.OptionsAnalysis.com)

A couple of important NOTES from Figures 5 and 6.

1. At times this method will require a fairly large commitment of cash in order to enter the position. In Figure 5 we see that the 3x3x2x2 spread will require an “Entry Debit” of $7,9985 to enter. This is not an insignificant amount of money.
2. At the same time, because we will be exiting the trade shortly after earnings – and well before the longer-term options expire – the actual likely risk on the trade will typically be only a fraction of the Entry Debit.
3. In Figure 5 we see a “Max Risk” value of $653.97. This number can increase or decrease depending on the action of implied volatility after the earnings announcement. Nevertheless, the point here is that the actual dollars at risk is almost invariably far less than the Entry Debit – i.e., the cot to enter the trade.

Step #7: If the position happens to generate a profit you deem acceptable prior to the earnings announcement, go ahead and take your profit.

Step#8: If you hold the position through earnings look to take a profit prior to the expiration of the shorter-term options.

Figure 7 shows the status of our NFLX trade at the close on the day of the earnings announcement (which will occur after the close of trading). Figure 7 – NFLX position at close prior to earnings announcement (Courtesy: www.OptionsAnalysis.com)

Note that in Figure 7 the “Rate of Return” shows 50.2%.  Note also that this figure is based on comparing the current Open Profit to the “Max Risk” listed for the trade (which based changes in IV since the trade was entered is now listed as $298.75, down from the original $653.97 value reflected in Figure 5.  Remember I said that this value can increase or decrease).  If we calculate the open profit as $ Profit ($150) divided by Entry Debit ($7,985) then the open profit % is just 1.9%.  As a result we will most likely want to hold the position through the next day.

Figure 8 reflects the risk curves as of the close of trading on the day of the earnings announcement. Figure 8 – Risk curves just prior to earnings announcement (Courtesy: www.OptionsAnalysis.com)

So what happened next?  The earnings announcement was not a happy one for NFLX stock holders.  After closing on 10/15 at $448.59 a share, the stock opened on 10/16 at $332.73 – almost $116 lower – before rebounding to close the day at $361.70.

The option position as of the close on 10/16 in reflected in Figures 9 and 10.Figure 9 – NFLX position day after earnings (Courtesy: www.OptionsAnalysis.com)Figure 10 – NFLX risk curves day after earnings (Courtesy: www.OptionsAnalysis.com)

At this point the option position is showing a profit of $1,143. This represents a gain of 14.3% based on a commitment of $7985 to enter the trade.  The trader would most likely consider exiting the entire position and taking a profit of 14.3% in 9 calendar days.

One other alternative to consider is to leave all or a part of the longer-term position on as a long straddle or strangle.  Not however that the longer you hold this position the greater the loss potential as time decay eats away at both the long call and the long put.

Summary

Certainly not every trade will work out and generate a profit.  A few things to keep in mind:

1. If there is not a wide disparity in the implied volatility of the short-term options versus the long-term options you should avoid the temptation to enter a trade “just because”. The disparity in IV is what gives this trade an “edge” as long as…
2. …the IV for the longer-term options is not excessively high (because they are susceptible to a volatility crush as well) but the IV for the shorter term options has exploded.
3. If you cannot get filled at your limit price you should bypass the trade.
4. There is clearly some “work” involved in executing this strategy.

In a nutshell, we are looking for the best opportunities, which is why we start by focusing on volatile stocks which tend to experience large price movements.

In sum, the above represents a slightly advanced example of just “one way” to play earnings announcement using options.  You are encouraged to do some research of your own before engaging in this type of trading activity, especially if you are new to options trading.

Jay Kaeppel

Before I detail any sort of “strategy” (and please note that the use of the word “strategy” and the lack of the words “mechanical trading system guaranteed to generate obscene profits ad infinitum into the future”) let me address a few questions that have come up since I wrote this article.

Last week I wrote about the tendency for t-bonds to perform well during the last five trading days of the month – particularly when compared to all other days (which actually show a fairly sizable net loss).

I got a number of questions so rather than going through them one by one, let me put the following “things” out there:

*As always I am not advocating that a trader use this idea as a mechanical “system” (although I am about to do that just for fun), I am just letting you know what I’ve seen.

*One gnawing caveat is that – as a few alert readers pointed out – the bond market has been in a relentless bull market for, oh, about 30 years or so.  The next 30 years are unlikely to be quite as good for bonds as the past 30 years.  Still, the fact that the overall treasury bond market has been in an overall long-term bullish trend this does not exactly explain the fact that the last five days of the month “made a lot of money” while all the other trading days of the month “lost a lot of money.”  In other words, all the other days of the month occurred within the context of the same bull market as the last five days of the month.  So how does bonds being in a long-term uptrend explain this difference?

*Several readers asked if there is a reason “why” this tendency has persisted.  And I am very tempted to try to offer up with some plausible, logical, intelligent, well thought out, economically viable reason in order to “solidify my bonafides” (which sounds like something that might need medical supervision, but I digress).  But as I guy from the South Side I once knew would say, “I got nuttin’”.  Sorry folks, I’m just a “numbers geek.”  One alert reader posited that it is due to “Month end window dressing bond buying.”  Which makes good sense to me.  But again, I’m just a numbers guy.

*Several readers asked if there are good days for going short. I may write about this in the future but in a nutshell here is what I have found:

Yes, certain trading days of the month have shown a net loss over the past 30 years. The caveat is that they are sort of random throughout the month.  Personally I put more faith in a tendency that persists over five contiguous days (i.e., the bullish trend during the last 5 days of the month) – even if I can’t really explain why it matters – than in one that picks out a day here and a day there.  Not exactly scientific but there you have it.

Trading with TMF

Alright thrill seekers, better strap yourself in.  Ticker TMF (Direxion Daily 20+ Year Treasury Bull 3X ETF) is the an ETF that seeks to track the daily performance of the long-term treasury bonds times 3.  So if t-bonds go up 1% today then n theory ticker TMF should gain 3%.  You already see where I am going with this don’t you?  So if you had a method for identifying bullish periods for treasury bonds you could buy TMF instead of a standard bond fund or ETF and make three times as much money, right?

Well, again, in theory, yes.  But how about in practice?  Let’s take a look.

Under the category of “It’s Kind of a Short Track Record”, TMF started trading on 4/16/2009.  So let’s look at the following:

*How has TMF performed during the last 5 trading days of the month

*How has TMF performed during “all other trading days”

The answer is fairly stark and appears in Figure 1. Figure 1 – Growth of $1,000 invested in TMF during last 5 days of each month (blue) versus Growth of $1,000 invested in TMF during all other days (red); 4/16/2009 through 3/6/2015

For the record:

*$1,000 invested in TMF during bullish days grew to $4,217 (+322%).

*$1,000 invested in TMF during all other days declined to $329 (-67%)

As I am wont to point out, these types of contrasting performances are what we “quantitative types” typically refer to as “statistically significant.”

To highlight the stark contract in performance consider the annual results displayed in Figure 2 (note: there are no slippage or commission deductions included so real-world number would almost certainly be reduced).

 Figure 2 – Annual Results (TMF Last 5 Days of Month versus all other days)

*-starting on 4/16/2009

**-ending on 3/6/2015

Let me make two general statements regarding these results:

1) These number sure are darned exciting!

2) Committing to buy and hold a triple leverage fund for five contiguous day NO MATTER WHAT and to also commit to do so every single month NOT MATTER WHAT is clearly a risky strategy fraught with great peril and should only be considered by people who clearly understand the risks involved.

Summary

So is buying and holding ticker TMF for the last 5 trading days of every single month a viable trading method.? I will leave you to draw your own conclusions.  For the record (CYA Alert) I am in no way recommending that you do so.  But if you do wish to consider it remember that a strategy such as this belongs squarely in the “High Risk, Do Not Bet the Ranch No Matter How Tempting” category.  So please remember:

Jay’s Trading Maxim #313: When considering seasonal trends in the financial markets, always remember that past is prologue.  Except when it’s not.

Jay Kaeppel

A short one this time around.  Anyway, many traders are familiar with the effects of seasonality in the stock market.  If you would like to know more may I recommend this link?  But far fewer traders are aware that bonds have displayed several meaningful and useful seasonal trends.  For example….

The Best Time of Month to Hold Bonds

Let’s make this as simple as possible.  The best period of the month for t-bonds is (drum roll please):

*The last five trading days of the month

Well it doesn’t get much simpler than that does it?  But don’t take my word for it, consider some results.  For our test I am using a “continuous” t-bonds futures contract.  This particular data series is built by each day adding the daily change in the front-month t-bond futures contract.  Ultimately it is not the price reflected that matters so much as it is the daily gain or loss.

For a t-bond futures contract a gain of $1 in the futures contract price equals $1,000 gain in contract value (if long, or a $1,000 loss for the day if holding a short position). So if t-bond futures are trading at a price of 100 then the actual contract value is $100,000.  If price rises the next day to 101 then the contract value rises to $101,000 and the net change is +$1,000.

Results

Figure 1 displays the growth of holding long one t-bond futures contract during the last five trading days of each month starting on 12/31/1983.  Please note that these figures include no slippage or commissions so these do not represent “real world” returns.  Still, the purpose here is not to advocate this as a standalone strategy.  The purpose here is simply to highlight a trend.  See if anything jumps out at you in Figure 1. Figure 1 – Long one t-bond futures last 5 trading days of month (12/83 through 2/2015)

Anyone notice a trend?  Now the truth is that this is by no means a straight line advance and certainly bonds do not make money during the last five days of every month.  In addition, if you deduct something for slippage and commissions this line will look less attractive.  Still, to gain a slightly greater appreciation, consider what has happened during what we “quantitative types” scientifically refer to as “all the other days.”

Figure 2 includes the same equity curve for the last five trading days of the month as shown in Figure 1.  It also includes the performance generated by hold a long position in t-bond futures during all trading days EXCEPT the last five trading days of the month.

 Figure 2 – T-bond performance during last 5 trading days of month (blue) versus t-bond performance during all other days (red); 12/1983 through 2/2015

Notice any difference?  For the record, performance differences of this magnitude are what we quantitative types refer to as “statistically significant.”

For the record, if we look at rolling 5-year rates of return:

-The 5-year return for the “Last Five Days” period has showed a gain 87% of the time

-The 5-year return for “All the Other Days” has showed a gain 39% of the time

In a future installment we’ll look at some ways for non futures traders to take advantage of these trends.

ADDENDUM

OK, after I posted this originally I got ambitious (it happens once in a while) and out of curiosity went back and subtracted $75 for slippage and commission each month during the last 5 trading days of each month.  The results appear in Figure 3.

Figure 3 – T-Bonds last five trading days of month with no slippage or commissions (blue); T-Bonds last five trading days of month minus $75 slippage and commission each month (red); 12/1983-2/2014

While the results are obviously less, the key point is that the overall favorable trend remains in force.  While I still am not necessarily advocating this as a standalone strategy, there does appear to be “something there.”

Jay Kaeppel

In a recent article I wrote about an indicator that I read about somewhere that I had written down only as “MVCI”.  Well, thanks to alert reader Gary, I have come to learn that I read about in the March 2013 issue of one of my favorite magazines, “Technical Analysis of Stocks and Commodities.”

MVCI stands for Modified Chartmill Value Indicator (if you try to say that three times fast you will come to learn why someone had the good sense to shorten it to MVCI.  But I digress).  I don’t know if he invested the indicator or not, but the article (actually it was a series of 3 articles) was written by Dirk Vandycke.  So kudos to him.

The first article was in the January 2013 issue which would have come out sometime in December 2012.  So let’s take a look at “real-time” performance since then.  First a quick (“quick” in this instance is roughly defined as “approximately 256 steps and calculations, give or take”) review of how MVCI is calculated.

The MVCI Indicator Calculations

OK, what follows is a list of a fairly lengthy set of calculations.  If you are not a “numbers geek” you might consider skipping down to the actual results.

A = Daily High

B = Daily Low

C  = Daily Close

D = 200-day moving average of daily closing prices

E = Daily True High

F = Daily True Low

G = Daily True Range (E-F)

H = Average Daily Price (A + B) / 2

I  = 15-day Average of H

J = 15-day Average of G

K = MVCI = (C-I) / (J * Square Root of 2))

L = Buy Signal Cutoff Value

M = # days to hold a long position

In (slightly long-winded) English, the indicator is calculated by:

1) Subtracting the 15-day average of the average daily price (defined as( [high]+[low]/2)) from today’s closing price, and dividing that result by;

2) The 15-day average of the Average True Range times the square root of 2

The default value for variable L is -0.51.  The default value for M is 22 days.

A “Buy Signal” occurs when:

1) The closing price for SPY is above its 200-day simple moving average AND;

2) The MVCI value for that day is -0.51 or less.  So when a buy signal occurs the trader buys SPY and holds it for 22 trading days.

If MVCI drops below -0.51 during these 22 days then the 22 day holding period starts again at 22, i.e., positions can be held for longer than 22 days.

MVCI Real Time

For this test we will start with the first buy signal after the article would have appeared.  That signal occurred on 12/28/2012. We will assume a long position in SPX when the indicator is on a buy signal and that no interest is earned while out of the market.  We will also compare these results to buying and holding SPX.

A graph showing the percentage growth of an initial equal investment in both the “system” I jut described and SPX buy-and-hold appears in Figure 1.  This chart extends from 12/28/2012 through 3/6/2015.Figure 1 – % Growth using MVCI (blue) versus SPX Buy-and-hold (red) since 12/28/12

For the record:

MVCI % growth = +62.2%

SPX % Growth = 51.7%

Also, it is worth noting that at 11 buy signals (FYI: a “new” buy signal that occurs before an existing 22 day holding period is up is NOT considered a new signal, only an extension of the existing signal.  In other words, there were far more than 11 dates that triggered a “Buy” signal, but for our purposes they simply extend the existing position another 22 trading days) since 12/28/2012 have generated a profit.

Summary

So can we draw any conclusions regarding these of MVCI?  Maybe not.  Other than to say “so far so good” or “I like what I see.”  In any event, it looks to me like there my be something “there.”

And in the world of trading, “There” can be a pretty good place to be.

Jay Kaeppel

A while back I wrote about some “VIX-like” indicators that can be applied to stocks, ETF, futures, etc.  Well, today let’s add one more to the mix.  This one – which for (clear) lack of a better name –I refer to as VixRSI14x (Note to myself: you really have to come up with a better way of naming these things).

It combines a “vix-like” indicator with the standard 14-day RSI.  Also, whereas VIX moves higher as price declines, I flip this one on its head to create negative indicator readings align with price declines and oversold conditions.

The Calculations

A word of warning: if indicator calculations make your head hurt you might want to skip this section and go down to the charts below. The VIXRSI14x indicator combines the standard 14-day Welles Wilder RSI with Larry Williams VixFix indicator as follows.

A = Highest close in last 22 trading days

B = A – today’s low

C = (((B – A) / A) * 100) + 50

VixFix = C

The 14-day RSI is calculated using the standard Wilder RSI formula found in most charting programs (AIQ TradingExpert code is found below)

VixRSI14 is calculated as follows:

D = 3-day exponential average of Daily VixFix readings

E = 3-day exponential average of daily 14-day RSI readings

F =D/E

VixRSI14 = F

This indicator as designed will typically rise in value as prices decline.  In order to create an overbought/.oversold indicator that moves in line with price, the value is inverted as follows:

VixRSI14x = ((1/VixRSI14)*100)-100.

(Hey I warned you to skip ahead to the charts)

The following is code or AIQ TradingExpert Design Studio:

!VixFix calculations

hivalclose is hival([close],22).

vixfix is (((hivalclose-[low])/hivalclose)*100)+50.

!14-day Rsi calculations

Define days14 27.

U14 is [close]-val([close],1).

D14 is val([close],1)-[close].

AvgU14 is ExpAvg(iff(U14>0,U14,0),days14).

AvgD14 is ExpAvg(iff(D14>=0,D14,0),days14).

RSI14 is 100-(100/(1+(AvgU14/AvgD14))).

VixRSI14 is expavg(vixfix,3)/expavg(RSI14,3).

VixRSI14x is ((1/VixRSI14)*100)-100.

The Resulting Indicator

Now I would like to claim that VixRSI14x is a highly accurate timing tool that picks tops and bottoms with uncanny accuracy.  And the truth is, at times it sorta does.  On the other side of the coin one could probably make an argument that this is just one more “Overbought/Oversold” indicator.  I will leave the more industrious to draw their own conclusions.

A few “suggestions” for highlighting potential bullish opportunities:

1) Consider looking for situations when SPY is oversold or bouncing off of a low as a catalyst to look for buy signals among the stocks and/or ETFs you follow (One possibility is to look for VixRSI14x to drop below -16 and then turn up).

2) When looking at individual stocks and ETFs look for upside reversals from -32 or below.

3) Look for signals on stocks/ETF that are above their 200-day moving averages.

4) Consider taking profits on the first good “pop” and letting the rest ride.

A Few Charts

On 2/2/15 the VixRSI14x indicator for ticker SPY reversed to the upside after dropping below-16. See Figure 1.Figure 1 – SPY with -16 or lower oversold VixRSI14x signals (Courtesy: AIQ TradingExpert)

A sampling of stocks that met the criteria listed above on 2/2/15 appears in Figures 2 through 5 below.Figure 2 – Ticker UNTD (Courtesy: AIQ TradingExpert)

Figure 3 – Ticker VRSN (Courtesy: AIQ TradingExpert)

Figure 4 – Ticker WDC (Courtesy: AIQ TradingExpert)

Figure 5 – Ticker YHOO; no upside follow through from multiple signals  (Courtesy: AIQ TradingExpert)

Some of these experienced an immediate “pop”, while others – most notably YHOO – have gone nowhere.  This is fairly typical.  As with most things in trading, some signals work while others do not. As with any kind of oversold indicator there is never any guarantee that every signal for every stock will be followed by rainbows and unicorns.  This suggests that industrious traders might consider looking for some sort of “confirming” indicator to highlight trades that they believe have the best potential for moving higher.

Summary

So is “VixRSI14x” the “next big thing”, or simply just another oscillator that rises when price rises and falls when price falls?  My experience suggest that it is “someplace in between.”

My experience also suggests that that  is not necessarily a bad place to be.

Jay Kaeppel