Are You Ready for Dec 7, 2007?

I wish to thank Kazal for posting a question in the Advanced System Trading forum in Profitstrategies discussion board, which reminded me the importance of Dec 7, 2007. Why is this day so important?  For those who have either attended Profitstrategies’ AIM Class or listened to Tom Gentile’s radio show, you should know that this day marks the beginning of the next 20-week bullish cycle.

For the benefit of our readers, let’s recapitulate what this cycle theory is about. Essentially, the market has the tendency to make a turn every 20 weeks. According to a study done by my colleague Jay Kappael, since 1967, during the 20-week bullish phase, there is a 76.4% probability that the market will go up from the first day to the last day of the bullish phase, followed by another 20-week of so-called “coin-flip” phase because the probability is reduced to 50%.

I started tracking this 40-week cycle theory since mid-2005 (thanks Tom Gentile, who taught me this valuable trading system) and I am truly amazed by the results. Let’s take a look of the results of the last five cycles (3 bullish cycles and 2 bearish cycles) on SPX, DJX and QQQQ:

Bullish Phase
Aug 19, 2005 to Jan 5, 2006
SPX       54.46 points or 4.47% ()
DJX       8.02 points or 7.96% ()
QQQQ  3.03 points or 7.79% ()

May 26, 2006 to Oct 12, 2006
SPX       90.12 points or 7.08% ()
DJX       7.36 points or 6.56% ()
QQQQ  2.77 points or 7.72% ()

Mar 2, 2007 to Jul 19, 2007
SPX       149.92 points or 10.68% ()
DJX       17.66 points or 14.44% ()
QQQQ   7.54 points or 17.63% ()

Bearish Phase
Jan 6, 2006 to May 25, 2006
SPX       -0.6 points or -0.05% ()
DJX       3.36 points or 3.09% ()
QQQQ     -2.9 points or -6.86% ()

Oct 13, 2006 to Mar 1, 2007
SPX       40.35 points or 2.96% ()
DJX       2.86 points or 2.39% ()
QQQQ  0.91 points or 2.16% ()

Isn’t the result amazing?  It’s “all-up” during the last 3 bullish phase. Is this a good trading system? I would say so because it offers a high probability repeatable trading pattern. Have you ever heard this saying before – “A full time trader does not need to trade full-time?”  I know some will object to this as they feel that they need to trade every single day. However, in my humble opinion, the beauty of this trading system is by concentrating on the bullish phase, we will only be exposed to the market risk for 5 months, and not everyday. Is it necessary to trade everyday?  Not for me given my preferred trading style.

What strategy should we use?

Now, you may ask what instrument we should use for this trading system. The following is a list of possible alternatives but never intended to be an exhaustive list.

Investing the Underlying Directly
Most investors may be tempted to invest in the underlying directly. Let’s rewind the clock to Mar 2, 2007. Suppose you decided to buy 100 shares of SPY at market open on Mar 2, 2007 (see Figure 1).

Figure 1: SPY on Mar 2, 2007

Buying 100 shares of SPY will cost $14,005, which is the maximum risk we will assume on this position although it offers an unlimited reward. As you note from the Greeks profile, this position makes a dollar-for-dollar move based on SPY’s movement. Since this is not an option, there are no Gamma, Vega and Theta risks but purely a directional risk. However, imagine SPX drops 50 points like what it did on Feb 27, 2007 and SPY would accordingly drop approximately 5 points. We will lose $500 on this position per 100 shares of SPY.

Using an In-the-Money Call Option

Instead of buying 100 shares of SPY directly, we can consider buying an in-the-money [ITM] call option on SPY. Here is the problem. The bullish cycle starting from Mar 2, 2007 would end on Jul 19, 2007. Ideally, we should buy an Aug SPY option because we just need 30 days more. Since Aug options are not available, we have no choice but to buy Sept SPY call option instead. Typically, I would look for an ITM option with at least 75 delta. So, in this example, I used a Sept 131 call for a debit of $14.40, out of which I would pay an extrinsic value of approximately $2.50 (see Figure 2).

Figure 2: SPY Sept 131 Call

As one option contract controls 100 shares, the cost of investment has been substantially reduced to only $1,440 (compared to $14,005 if we were to buy 100 shares of SPY directly). At the inception of this trade, based on the Greeks profile, we are effectively holding approximately 76 shares of SPY. Also, take note that since this is a Sept option, the gamma is low, and so is theta decay. That’s the thing – theta and gamma are always working opposite. How about Vega?  Since this is a long vega position, the position will gain $31 per 1% move in IV and vice versa, which in my opinion is fairly low and manageable.

Compared to a direct investment in SPY, if we are dead wrong, we will lose the maximum debit of $1,440. Yet, the position continues to give up potential unlimited upside but a limited downside.

Selling Something Against an ITM Option

Version 1: Creating a Sept Vertical Spread 

If we use a Sept 131 Call, can we sell something against it to reduce our risk?  Here is what Tom has discussed in his 7 habits series. We can use historical data to gauge the percentage move from the first day to the last day of the bullish cycle.  During the last bullish phase, SPX made approximately a 7% move. If we believe that the history will repeat itself, when SPX is trading at 1,400, a 7% move should be 1,498. Now, how about selling a Sept 149 Call against the Sept 131 Call? See Figure 3.

Figure 3: A Sept 131-149 Call Vertical

As shown in Platinum, if SPY can indeed make a 7% move during this bullish phase, we should be able to close the position with a 54% ROI. For this purpose, I have adjusted the days to expiration from 0 to 64 days so that the purple line represents the risk graph on the last day of the bullish cycle.

Version 2: Creating a Call Diagonal 

Some of us may know that in Optionetics, we do not advocate selling a far month option because the time decay is slow for such option and is not in our favour as a seller. Let’s look at the following option chain. Since SPY was slightly below 141 on Mar 2, 2007, the following call options would be considered as ATM option.

Table 1: Option Chain              

Suppose you consider selling the Sept 141 Call for $6.80. Can you instead sell a Mar 141 Call for $1.50. After March expiration, you can continue selling another front month ATM option and follow this process till July (i.e. the end of the bullish phase). Assuming that you can collect $1.50 for five rolls, or in total $7.50, you are still better off compared to selling a Sept option for $6.80. This is why I prefer to sell a front month option and roll it forward month after month.

In summary, there are many ways to Rome. The above are just some possible examples to take advantage of this repeatable trading pattern. As there are less than 2 months to go before we move to the next bullish cycle, if you are interested, I would encourage you to spend some time to do research and find out what strategy fits your trading personality.

Good trading!

Jack Wong 
Contributing Writer
Optionetics.com ~ Your Options Education Site