Directional Trading with OptimalTrader
By Rick Fortier
 
Although the data in this article is somewhat
dated, it is still a good example of the thought processes you might go through
when trading directionally. This article, dated in late 2002 is primarily
going to deal with the thought processes of going through technical analysis and how
to make the most profit by using options.
 
So here is my interpretation
of where the DOW is going using AdvancedGET, and how we might taken advantage of the situation. (http://www.advancedget.com)
 
First let’s look at the
daily chart.
 

 
The daily shows the end of
wave 5 on October 10th, and a reversal starting. The reversal which
takes us to the present is so far showing the first three waves, and the
beginning of a wave 4 pullback.
 
Let’s look at the current
wave in more detail using a 60 minute chart.
 

 
This chart and all charts
with less than a daily time frame, were built using HQuote (see my other
article,
www.deltaneutral.com/hquote) . On the chart we see a divergence in the oscillator on
the bottom of the image. This confirms the end of wave 5 going up has ended.
This is the wave 3 from the daily chart.
 
After the wave ends on
November 6th a new wave down begins (which is
actually wave 4 in the daily chart). This is where we are today.
 
So the question is, where do we go from here? Lets look at one smaller
timeframe chart (only available using data from the real-time version of GET
$$$, or using HQuote).
 

 
This is a ten minute chart
covering November 6th through the 11th. We can see that
wave 3 could go down to around 8200 and then go up to around 8420. Once it gets
to 8420, I see it going in one of two directions. Either the short term wave will pullback to 8420, and then go down, or the wave 4
pullback in this timeframe will fail to continue to go down and will continue
up.
 
To me the battle ground
will be at 8420. Which way it goes is a matter of speculation. The long term
trend starting March 20th is down, so that gives me a bias of down. Iraq also has until Friday to comply with the U.N.. Will this cause people to have the confidence to be
bullish or bearish?
 
So I would be bullish if
the DOW goes above 8420 after going down to 8200. Otherwise I see the market
going down after a wave 4 pullback to 8420.
 
So if we want an option
play to take advantage of this information, I think that we want to not lose
money if the market goes up, but make sure that we can make a profit with a
downside move.
 
So let’s look for a
strategy which will get to 7750 by mid January using OptionTrader software
which I wrote.
 

 
Select which task to
perform. Find possible trades for ONE stock.
 

 
Enter our search criteria.
 

 
Select all of the
strategies available on the Strategies screen. Click on Begin the Search.
 
After a while I get a list
of possible trades to evaluate.
 

 
Here is a list of the top
trades ranked by risk/reward at the time of our target date (not expiration of
the trade).
 

 
The first few are Call
Ratio Backspread Calendars, followed by what I call Forked Put Diagonals.
Following that are some diagonals and a combo trade consisting of a deep in the
money call in combination with synthetic short stock.
 
I will pick a few and show
the Risk Graphs. I don’t want to turn this into blatant advertisement. But in
order to pick the best trade we need to compare them. The other standard
strategies (single options, vertical spreads, calendars, straddles, etc..) are also searched. But in this situation, none of them
were the top trades.
 
The CRBS Calendar:
 

 
The Forked Put Diagonal:
 

 
The Put Diagonal:
 

 
The Deep ITM Call with
Synthetic Short Stock:
 

 
These graphs should be
accurate if the following conditions hold true:
-
You can split the bid ask on entry and exit
-
Your forecast implied volatility is accurate.
 
So you have to play with
the graphs and try different implied volatilities to see how a drop in
volatility will effect the graph.
 
I really like the Put
Diagonal because no matter how low it goes it does not have a lower break even,
so it can’t forseeably lose money if the DOW plunges. It also has a nice peak
so that if the DOW trades in a range then some nice profits could be made.
 
Until next time,
Rick
rick@deltaneutral.com
 
This article is for educational purposes only. Any
trades which readers of this article may do are done at their own risk.
 
Copyright © 2006, Rick Fortier