Monday, June 18, 2012

How to Use Options to Play a Volume Pocket (AKA a “Kirby”).

How to Use Options to Play a Volume Pocket (AKA a “Kirby”).

A long, long time ago, and I can still remember, (no I’m not listening to American Pie right now), I learned technical analysis. It was way back in the dark ages of charting before computers. I can remember sitting in a classroom listening to our instructor Ralph Accompora going over the basics of TA. We actually would chart stocks by hand on graph paper, posting the data gleaned from the morning’s newspaper. Analysis techniques were very basic; there were no Bollinger Bands or Ultimate Indicators. It was pretty much price….levels, trendlines and volume, that’s it. Sitting next to me was an older gent who, try as he might just could not draw a straight line. One day I leaned over to him and whispered “Abe, you need to find a different career” and he must have listened because he never came back to class again. However he did find his true calling!

 Anyway many years later, computers appeared on the scene, and with it Computrac, Trackdata, then Metastock & Supercharts (which later became Tradestation), and with them a myriad of new ways of analyzing derivatives of price. I used Supercharts and still use TradeStation today (though they piss me off a lot). TradeStation doesn’t have the type of volume analysis needed to find these Kirby’s, the only one I am aware of is stockCharts.com though I am sure there are others, so the chart below is from Stockcharts.com.
Soon after I started following the Goat I would read him write of a Kirby. And very often those stocks that he pointed out with Kirbys would rocket. So I decided to do a little investigating.  Goat has a page on his site that explains it with a couple of videos and if you stop by there he has a free trial available. bit.ly/IU7OLz   Essentially, volume is charted on the left side of the page instead of the bottom. There is no time component to the volume totals, it is entirely plotted against the priced that it traded at, somewhat akin to market Profile. At points where a large amount of volume traded at particular levels, the volume bars extend far toward the right. At levels where little volume traded the bars remain close to the left edge.  Areas of little volume in between areas of high volume are known as pockets. They are usually created when price either gaps through or trades quickly through price zones allowing little volume to be traded at those areas. The levels where a large amount of volume has traded tend to act like magnets drawing price toward them once price is inside the pocket. So once price has broken through into a pocket, a good target is the upper boundary of the pocket.
One of the most difficult things about trading is determining “when to sell”. These Kirby pockets give a trader a firm exit point. Price won’t always stop there, and sometimes won’t even get there, but there will usually be at least a stalling of upward momentum if price hits previous levels of high volume. Note below on the PCLN chart the pocket opens up at just over 660 and heavy volume (where the pocket closes) doesn’t appear till around 712.

So that’s the TA behind the Kirby, this brings us to options. Let’s take a look at how we might play this. The great thing is we have an end point in mind. All too often traders, especially newer one find a stock they like and then they pick an option to buy based on how much that particular option costs. A pure $ based decision. Then to compound the problem they don’t know have a level where that they think the stock is going other than “up”. The lure of unlimited gains is tempting but really is farfetched. The problem with just buying an option is multi faceted. One, they are usually priced to perfection by the market makers and their models and the speed in which their algorithms sweep the bids and offers when a price change occurs virtually eliminates any edge a trader could expect playing against them. Two, decay can wipe out any profit and turn the trade into a loss should the stock not move upward immediately. And three, even if the trader is correct on direction, without velocity and amplitude he may still lose on the trade at expiration even if the stock has moved toward up. The way around this problem is by using spreads. Capping ones profit reduces a traders initial debit, lowering the level that the stock needs to rise to breakeven. Selling more contracts than bought while creating unlimited risk can reduce that level even further. However that is an advanced strategy and is not recommended for traders without significant experience in options and adequate capital to withstand large losses. Lets look at PCLN. In case where a pocket opens at 660.50 and closes at around 712, what are some possibilities? Before we break them down, it is important that I state that this is a trade comparison only and is not a recommendation to buy or sell any equity or option. Please see disclaimer on my twitter page.

PCLN
660
Max Debit
1000
Kirby
91 -
94.5
Long Opt
Contracts
Price
Short Opt
Contracts
Price
Net
Debit
Long ATM
Jul 660
1
25.45
Jul 710
0
2545
Long Vertical
Jul 660
1
25.45
Jul 710
-1
7.45
1800
Long 1x2 Ratio
Jul 660
1
25.45
Jul 710
-2
7.45
1055
PnL
660
670
680
690
700
710
720
730
740
750
760
(2545.00)
(1545.00)
(545.00)
455.00
1455.00
2455.00
3455.00
4455.00
5455.00
6455.00
7455.00
(1800.00)
(800.00)
200.00
1200.00
2200.00
3200.00
3200.00
3200.00
3200.00
3200.00
3200.00
(1055.00)
(55.00)
945.00
1945.00
2945.00
3945.00
2945.00
1945.00
945.00
(55.00)
(1055.00)


So the potential trades in PCLN, assuming it enters the Kirby are shown in the top grouping. All options listed are calls and the PnL (profit and Loss) shown in the bottom grouping is at expiration. The prices listed are the midpoints of Friday nights close and will be somewhat different on Monday. Note that straight call trade is long 1 contract, long vertical is 1 spread and the 1x2 ratio is long 1 contract and short 2 contracts.
Downside
1)      All trades lose 100% below 660 at expiration.

Breakeven
1)      Straight Long 1 options at 25.45. This trade will break even on a close at expiration at 685.45.
2)      The long 660/710 vertical. This trade will break even on a close at expiration at 678.00.
3)      The 1x2 ratio.  This trade will break even on a close at expiration at 670.55.

Upside
1)      Straight Long 1 options at 25.45. This trade profits $2455 with PCLN at 710 at expo and profits increase $100 per point above.
2)      The long 660/710 vertical. This trade profits $3200 with PCLN at 710 at expo  and that is the maximum profit.
3)      The 1x2 ratio.  This trade profits $3945 with PCLN at 710 at expo and that is max profit. Profit is reduced by $100 per point above 710 and trade is a loser above 749.45. This trade has unlimited potential loss on the upside.

It is important that a trader be aware that sometimes price may enter into the Kirby only to be rejected. Notice that PCLN has flirted with the Kirby three times recently only to sell off. Will the fourth time work? Only time will tell, which in and of itself advocates for a spread........ Only you can decide what your particular risk tolerance is. Trade well!

Disclaimer
This is not investment advice. Raymond (Randy) Reis is not a registered investment advisor. Under no circumstances should any content from this website or Twitter be used or interpreted as a recommendation for any investment or trading approach to the markets. Trading and investing can be hazardous to your wealth. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This is strictly for educational and informational purposes only. Mr. Reis may have numerous positions within the market at any given time that are not disclosed of at the time of publication. All opinions expressed by Mr. Reis are subject to change without notice, and you should always obtain current information and perform the appropriate due diligence before making any investment or trading decision.
All efforts are made to ensure that the information contained within the site is factual and accurate - however, Mr. Reis does not guarantee its accuracy under any circumstances.
Mr. Reis has chosen to disclose the vast majority of his positions in the market to qualify his research. While he strives to maintain as objective as possible, the fact that he is also an active participant will inevitably influence his perspective.

2 comments:

  1. You could also consider out of the money call butterflies. It adds upside risk but then your risk/reward ratio gets a lot better. And as you head into the Kirby(r) you will come into a sweet spot of theta. On top of that the fly is vega negative so as we rally, volatility falls and you profit with that as well.

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  2. Hi Steve, thanks for the comment. I'm a big fan of your site and your IWO Brunch videos. Yes I love butterflies, in fact I just did a post on them recently where I highlighted a trade I did on the AAPL 600/620/640 fly. But with a decided anticipated ceiling (the top of the Kirby) providing resistance, I chose not to increase the debit by adding the far OTM call. In fact, on some occasions I will trade a 1x3 ratio in a situation like that if the OTM vol is high enough, but we both know the risks of a trade like that so that was left out.... Given that I had touched on Fly's already I wanted to emphasise differences between the three trades listed. And there are other spreads possible to take advantage of the Kirby too. As you stated re: the anticipated vega fall and increase in theta, that will positively affect both of the spreads listed too, to an extent even greater than a fly since there is no long far OTM call owned. I disagree however that the fly would "add" upside risk, though I think that was a typo as it actually would reduce upside risk by eliminating the negative net call count, though it would add to the debit. Again thank you for your input!

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