Trend Technician

If you’ve been paying attention to the crisis in Greece, you’re probably curious like I am what’s going to happen there. I’m not sure however that you need a strong opinion in order to make money on it.

The Crisis

Ultimately the crisis in Greece boils down to two things:

• The Greeks spent too much and lied about it.
• The other Euro states don’t want them to default, but don’t really want to bail them out.

Germany, the Euro country in the best position to bail them out wants to see serious improvements in their fiscal policy and serious cuts before they extend help.  In fact they’re hoping that just hinting around about giving aid will be enough to calm the bond market down.  It’s not clear however that their populace will put up with the idea of bailing out Greece so that Greeks can retire 10 years before them.  This of course highlights some of the conundrums the EU faces.

The Likely Outcome

Most people think some kind of bail-out will be worked out.  Greece will agree to spending cuts and other criteria and the most fiscally fit EU countries will help them out.  Order will be restored and faith in the EU will be revived.  In fact this is almost assured, because if they don’t bail out Greece, Portugal will probably default right behind them and several countries after that.  The EU can’t afford that kind of crisis so they will help, even though they won’t like it.

If you’re confident in this outcome, you could simply buy calls on the FXE.  Once order is restored in the European Union, the currency rebound and you’ll rake in the easy money.  Of course that’s assuming a lot of things.

The Black Swan

In his book The Black Swan, the author argues (I’m poorly summarizing here), that people by their nature underestimate the likelihood of the improbable.  Because of this you should always bet on the improbable because you’re getting better value for your money.  This is of course a painful strategy to accept, since most of your bets will be losers.  Of course your winners will be magnificent.

In the case of Greece, there is an interesting opportunity to just assume something interesting is going to happen.  Simply buy slightly out of the money calls and slightly out of the money puts.  If order is restored and the FXE rises, the gains should offset your losses on the puts.  If something unforeseen happens, then you will make a fortune on your puts, more than offsetting your losses in the long position.  The only situation in which you lose heavily is if the EU manages to punt the issue down the line and keep the FXE where it is.  So if you think this is a possibility then you probably wouldn’t want to make this trade.

Photo Credit: alaskapine

You’ll find that most techniques for trading are not rocket science. In fact most of the difference between traders who make money and traders who lose money is about discipline, not about technique. That being said, there are some approaches that I feel can help broaden your toolbox and could be a missing component for some traders. Today I’m going to talk about what I call the “Triple Call Technique.”

I utilize this approach in several situations:

• One is in a market like now, where I lack conviction and I feel that overall the issue I’m looking at might be trading in a line.  In cases where I’d like to go long something, but I’m feeling very risk averse this method can be great.  It works particularly well going long on issues that pay a high dividend.
• Another is when I’m looking to hedge a position.  Typically when I’m hedging I’m trying to pick the issue most likely to benefit if I’m wrong and give myself a small upside on that position.  This can also be useful in markets like today’s where I tend to lack conviction in any fundamental sense.
• Finally I can use this in auto-trading systems where I’m trying to build up a position in something over time.  I have a tendency to employ this with ETFs to gain exposure to a certain position over time.

Ultimately the crux of the system is pretty simple.  Let’s assume I’m going long but it can be used in exactly the same way to go short.  This only works with stocks and ETFs in which you can sell options, so they typically can’t be thinly traded.  Typically I set up some type of automated system that will notify when certain criteria are met.  One great approach is to use Market Club’s Trade Traingle system and get notifed whenever a particular score is hit.  You could also consider using any indicator or combination of indicators, even something as simple as Moving Average crossovers.  Once my signal is hit, I take my position and then immediately sell calls as follows:

• 1/3 I sell a deep in the money call.
• 1/3 I sell a slightly out of the money call.
• 1/3 I leave uncovered.

If I’m hedging or otherwise particularly skeptical of the position, I will sometimes not take the uncovered position at all.  What you’ve essentially done by doing this is get your cost basis down but severely limit your upside.  If the intent of the position is to hedge another position this can be perfect.  Additionally if this is a position where you’re likely to get out if it runs very far anyway, then a limited upside isn’t really a liability, since it should be offsetting the limited risk as set by your stop.  Meanwhile you’re risk is significantly curtailed.   Let’s take an example from today’s prices:

Suppose I want to gain exposure to international sales to offset a bias in my other trading positions.  To do this I set a series of watches on Market Club to let me know when any of a series of stocks hits a score of 90.  If you’d like to get a FREE score for a stock just sign up here.  As of today PM is has a score of 90, which is a strong uptrend so let’s use that as my buy signal.  Phillip Morris International closed today at $48.18.  Now let’s start with my in the money call.  Assuming we’re using Dec calls, here are my possible selection:

With these options available, you might be surprised to learn I would take the $43 strike price option. By taking that on 1/3 of my position, I would make 0.88% in 2 months as long as the price stays above 43. If it plummets and goes to $41 then it has brought my price for that block down to $42.67. This makes my hedge less painful if I’m right.

On the second third of my position I would sell a $50 strike price call for $1.20.  Then I would leave the final third uncovered.  The net result of all this is that my average price is $45.94.  Let’s look at what I gain or lose at various prices:

As you can see, the net effect is that if the stock goes down a lot we lose less than we would have otherwise. If the stock stays about flat you make more than you would have and if the stock goes up you make less than you would have otherwise. Ultimately it dampens your effects in either direction. If I did this over a significant period of time with automatic trading signals and a selection of appropriate stocks, I could build up significant exposure without nearly as much risk.  When trying to build up a position, or in unconvincing market the key components are:

1.) Using an Automatic Trade Indicator
2.) Selling staggered options on portions of your position.

When hedging you should simply take the position to offset your other positions.  You can see the many applications, especially in environments where you are risk averse.

Photo Credit: Corey Leopold