A Go-to Option Strategy for Year-End
01/11/2012 6:00 am EST
This week, options expert Josip Causic focuses on that low-volume week between Christmas and New Years and how traders can profit by knowing the past history of price action during that week.
In all of our OTA courses, regardless of which asset class, we teach the importance of record keeping. For those faithful enough to do this, after several years of trading and recording both winners and losers, you will have a valuable bank of data.
Then, based on that data bank, a trader could make some very interesting observations about the market, as well as about one’s performance, such as in which quarter over the years they tend to perform the best and which quarter the worst. This kind of scrutiny can also be done with a monthly or even a weekly focus rather than just quarterly.
One particularly interesting thing I have observed in my trading during that low-volume week between Christmas and New Years is as follows: the bear call (short vertical) tends to work almost impeccably within that specific week.
See related: The Bear Call Option Strategy
Without giving too many statistics, I will focus on some facts which might be quite revealing. For those traders who want to know the exact strike prices for a bear call I have selected in the past, I suggest reading this previous MoneyShow.com article.
Gathering the facts could be quite easy if one utilizes TradeStation (TS). On TS, under the Insert tab, when on the Chart Analysis window, we can select the functionality "Paint Bar." From all the choices given by Paint Bar, we can specifically select "First Bar of Year."
The chart below shows the daily chart of the iShares Russell 2000 Index Fund (IWM) with the painted pink bars being the first trading session of the year. Whereas the focus of this article is on that low-volume week between Christmas and New Years, notice the yellow oval on the volume for the last five daily trading sessions of each year.
Anyone using technical analysis should be able to verify the accuracy of the facts listed in the table below.
Basically, between 2001 and 2010, IWM on the last trading session was down (painted a red bar) nine out of ten times; the only exception being 2008, which was an abnormal year due to the subprime crash.
This means that on the last day of the year, we should not be getting long for the short term. I shall come back in a moment to what this insight means for us option traders.
However, if on the chart, the time interval gets changed from daily bars to weekly, the Paint Bar functionality will still show in pink the first (weekly) bar of the year, while the bar before would be of that low-volume week between Christmas and New Years.
In this case, statistical data can be pulled out again and we can observe that a majority of the time, the weekly bar of the last week of the year tends to end up red.
In six out of the ten years, the weekly bars were red. The years on which the weekly bars for IWM were green are listed above. Just because those were green bars does not mean that short verticals would have been an incorrect strategy.
The next valid point to be made is that a bear call should be done based on technical analysis and the sold leg should be above resistance, which means that we should be selling an out-of-the-money (OTM) leg. (The article referenced on Page 1, however, involved a bear call that had sold an at-the-money (ATM) leg, which is somewhat aggressive.)
For instance, on the current daily chart of IWM, resistance is below $76; hence, the sale of a 76 call could be done and then the purchase of a higher leg would be technically supported.
Assuming that at the end of the year there tends to be a drop, it would be reasonable to expect that the $76 level of resistance will not be easily broken. On the ES, that level of resistance is 1260 to 1266; on OEX and XEO, it would be 575. All the majors are facing similar levels, and building on the previous observation that the volume is low, the bearish bet sounds logical.
It is beyond the scope of this article to elaborate on the extent of the drop, yet a valid assumption is made that historically, there tends to be a pullback. In the case of 2011, for an IWM bear call with a sold 76 call and protection with a higher strike price, the price action that is expected at the close of Friday, Dec. 30 would be lower than 76, period. How much lower is truly irrelevant because the payout is the same. The payout truly depends on where the bear call entry was made.
In the second day of our Professional Trader course, we teach three possible short entries. The figure below is taken straight out of the manual, Day 2, slide 88. Only some minor modifications were made.
The first entry (#1) is considered the most aggressive because there is no confirmation that the price action will indeed turn around and head lower. In such case, the risk is greater, which is disadvantageous to us.
The second short entry (#2) is entered after price is no longer rapidly climbing up into resistance, but instead when it is slowing down. On the charts, this would be represented by multiple doji candles (which is very much what IWM was doing on 12/26/2011).
The #2 entry is considered moderately risky, while the third (#3) is the conservative entry. However, if we wait for the #3 entry, especially when selling short verticals, we might have already missed the rich premium that was there when there was less certainty. Due to that uncertainty, think of it as volatility, the premium was juicier.
Although a pro trader short entry could be used when trading options, a trader needs to be aware of the inner workings of the option premium. There are three option “Greeks” that we need to keep in mind: the Delta (intrinsic value and direction), Theta (time until the expiry), and Vega (volatility of both overall market and the individual underlying).
See related: Know Your Option “Greeks”
The short entries #1 and #2 are superior to #3 for a bear call with less than a week until the expiry.
In conclusion, a trader may want to revisit this article just before Christmas next year and review whether or not to add this end-of-year strategy to their trading arsenal.
By Josip Causic, instructor, Online Trading Academy