Directional Trading

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 10^th, 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 6^th 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 6^th through the 11^th. 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 20^th 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.