Wang’s Happy Trading

Submitted by Optiondragon

Optiondragon GAP Trading Method

(Useful in two styles- Post-event I.V.(implied volatility) implosion gap trade and normal gaps)

Going into earnings season, being prepared for volatility and gap trades can prove lucrative. Practicing and preparing the mind for combat is no different than when trading and analyzing stocks and the markets. Gathering information about your opponents style and weaknesses and analyzing the fundamentals and technicals for equities requires objectivity, hawking scrutiny, attention to detail, and creative adaptation. Your style must adapt and exploit your target’s weaknesses or in this case profit potentials. By breaking an earnings event down into 3 parts and objectively analyzing the risk/reward ratios for each, one can more effectively manage the volatility of any event. Each also have different profit objectives and can be hybridized sequentially into one of the three option catalyst trades. Hybridizing is when you roll profits and/or restrangle, or readjust a hedge to an options position in order to adhere to risk management and/or to maximize potential profits. For example in the Pre-event I.V. Catalyst Trading Method, one tries to profit from an increase in implied volatility and intrinsic value in the options before a company’s earnings announcement. By profitably using this first method, one could roll the profits into (hybridization) the Direct Event Catalyst Method (i.e. earnings announcement, biotech data announcement) and recieve a “free” ride with the “houses” money in order to limit risk going into an event. Tonight I will talk about the Third Method, the Post-event I.V. Implosion Gap Trade which can also be adapted to a normal gap trade.

After an earnings catalyst or expected volatile event, usually the implied volatility of an option is dramatically reduced. The reason is that once the event or expected volatile event has passed, the I.V. premium value either disappears or greatly reduces in value. If the stock price moves immensely above the given strike price level, premium will be transferred and increased into the intrinsic value within the formula of the given option. This increase in intrinsic value will balance out the loss in the implied volatility value within its option formula thus supporting and possibly increasing the option price/value.

For example, if you pay $3 for an exactly at-the-money call option at $50 going into an earnings announcement, the implied volatility and time premium your paying is $3 ($1 time value and $2 implied volatility) and the intrinsic value premium is $0 since it is at exactly $50. If the stock price gaps up to $55 after the earnings announcement (can be a biotech event also) your $50 call option should be worth about $6.50= $5 intrinsic value plus $1 time value (depends on time to expiration) plus .50 (maybe) for implied volatility (was $2 before the event). The implied volatility premium implosion was balanced out by the increase or explosion in the intrinsic value within the option pricing formula of that call. One can take advantage of this post event I.V. implosion in the calls by buying the $55 call option on a gap trade pullback after the open at let’s say $1.00 which could be at the same price as of the closing before the earnings announcement. That’s right, after a $5 jump those $55 calls are at break even because of the collapse in I.V., a constant in time value and still $0 for intrinsic. Supply and demand factors also play into the liquidity and price action the next day as sellers that owned the $55 calls could depress the price of the option to $0.75 due to selling pressure from those overnight holders expecting more intrinsic value in the morning after the announcement. Seeing the support on the gap trade pattern with a bullish guidance and earnings report, I would buy the $55 calls on this price action and could profit from an increase of the intrinsic value above the $55 strike. I could also profit from a reacceleration of implied volatility in the option if the share price moves sharply up with volatility above the strike price level especially if there is alot of time premium left. Playing after the earnings allows you to see the “flop” (Texas Hold ‘em analogy) otherwise known better as more technical (price action, gap trade patterns) and fundamental (earnings report, key metrics) data.

I always want to analyze the earnings report for its fundamentals and key metrics, in order to help decide the directional bias I would have. I also look at pre-market technical charts such as that on “Google Finance extended trading(tab)” to analyze strength, weakness and price volume action.

Over several years I have honed and experimented with the art of the earnings catalyst and gap trading. An earnings catalyst can be broken into 3 separate plays. This is the third and last part of the three methods. Remember that these patterns are only a guideline and repeated pattern recognition is needed to imbed it into our implicit knowledge. You may want to print out and separate this bottom portion for constant reinforcement.

Optiondragon GAP Trading Method

(Useful in two styles- Post-event I.V.(implied volatility) implosion gap trade and normal gaps)

GAP PATTERNS

Dip, Pop and Pop
When the first move is a “dip,” I look for the first support level. Remember, if a gainer is going to hold its strength, we won’t see much profit-taking at the open, and plenty of buyers will be lined up to carry the stock to higher highs. So the pullback should remain shallow, meaning I am looking for support to form at the very first level down.
Gainers are usually opening far above any pivots, so for support levels, I will be watching things such as the premarket low, any nearby whole numbers, moving averages and sometimes the previous day’s intraday high. If the gap is large, first support should come in well above the previous day’s closing price. The opening price is the “make or break line” and is the most important pivot to either overtake or fail on.
I want to see a move up and over the open price — and a break above the premarket high — to confirm that the uptrend is continuing.

Pop and Pop
When the first move is a “pop” from open, I will wait for a pullback before going long, and I might even short the pop, depending on the size of the gap. The reason is a large gap, plus any early buying, creates a lot of incentive for profit-taking, so the first climb in that case will usually be more of a short-lived pop before a deeper pullback comes in.
For first resistance levels, I will be watching things such as the premarket high, any nearby whole numbers and any previous resistance levels on the daily chart that might be nearby. Remember, if a gainer is going to hold its strength, we won’t see many people taking profits. Any short will be a small scalp against the trend, but the safest trades with the most potential will be with the trend on a counter move with its reaction(make or break line) to the opening price.
From off that first top, the pullback should remain shallow if the uptrend is continuing, and it often bottoms at a higher low, near the open. Sometimes the premarket low might also act as a support barrier. That bottom is your best long opportunity or moves counter to the trend and catalyst sentiment. The next climb should then hit higher highs. We need that higher high to confirm a continuation of the uptrend; otherwise, we could have a double top, which could be a short opportunity.

Every catalyst news stock is different, but they do follow similar patterns. Knowing those patterns prepares us with an instant game plan when we recognize them occurring which is retained as implicit knowledge for use and helps recognition when in the zone(Yoda State). And even when they break from a pattern, we can use those red flags to create new opportunities.

*The patterns could present themselves in different timeframes and could be seen in the 3 min, and/or 10 min and/or sometimes the 60 min.

* On a GAP DOWN you reverse the rules.

*A breakdown of either formation is bearish and should be shorted.

*The bigger the pullback(drop) the weaker the trend.
Watching what type of pullback-shallow bullish; deep bearish

*Watch Open price reactions-the opening price is very important and should be a major pivot line(the make or break line).

* Create pivot lines for pre-market low, nearby whole or strike numbers, moving avg., previous day’s intraday high and analyze using Google Finance “extended trading” charts.

*Sentiment analysis with TRIN and TICK indicators as well as overall market indicators(VIX) are an important factor in analyzing the risk/reward ratio.

*Draw trendlines and try to catch the contra- move on a trend (i.e. buying a dip on a bullish report and a bullish trend formation).

*If flat lining with confirming volume occurs this portends strength. Watch for the sharp sell off breaking technicals.
Manage risk through asset allocation and formulating and adhering to stop losses.

*Read this before the open.

CLOSING

Bruce Lee is one of my favorite American icons and idols. I’ve always shared a special connection to him (Majored in Philosophy at U.W and lived in Seattle and buried here) and his work for the progression of civil rights. He was an excellent role model that I try to emulate at work and at play. He was a genius in his own right and his concepts also are adaptable in all aspects of life. Down below are his quotes and amazing physical feats.

Favorite Quotes adaptable to trading and life:

“Be like water making its way through cracks. Do not be assertive, but adjust to the object, and you shall find a way round or through it. If nothing within you stays rigid, outward things will disclose themselves.
Empty your mind, be formless. Shapeless, like water. If you put water into a cup, it becomes the cup. You put water into a bottle and it becomes the bottle. You put it in a teapot it becomes the teapot. Now, water can flow or it can crash. Be water my friend.”

“I’m not a master. I’m a student-master, meaning that I have the knowledge of a master and the expertise of a master, but I’m still learning. So I’m a student-master. I don’t believe in the word ‘master.’ I consider the master as such when they close the casket.”

“Do not deny the classical approach, simply as a reaction, or you will have created another pattern and trapped yourself there.”

“True observation begins when one is devoid of set patterns.”

“Forget about winning and losing; forget about pride and pain. Let your opponent graze your skin and you smash into his flesh; let him smash into your flesh and you fracture his bones; let him fracture your bones and you take his life. Do not be concerned with escaping safely - lay your life before him.”

“The other weakness is, when clans are formed, the people of a clan will hold their kind of martial art as the only truth and do not dare to reform or improve it. Thus they are confined in their own tiny little world. Their students become machines which imitate martial art forms.”

Physical feats
Lee’s phenomenal fitness meant he was capable of performing many exceptional physical feats. The following list are the physical feats that are documented and supported by reliable sources.

Lee’s striking speed from three feet with his hands down by his side reached five hundredths of a second.
Lee could spring a 235 lb (107 kg) opponent 15 feet (4.6 metres) away with a 1 inch punch.
Lee’s combat movements were at times too fast to be captured on film at 24fps, so many scenes were shot in 32fps to put Lee in slow motion. Normally martial arts films are sped up.
In a speed demonstration, Lee could snatch a dime off a person’s open palm before they could close it, and leave a penny behind.
Lee could perform push ups using only his thumbs
Lee would hold an elevated v-sit position for 30 minutes or longer.
Lee could throw grains of rice up into the air and then catch them in mid-flight using chopsticks.
Lee performed one-hand push-ups using only the thumb and index finger.
Lee performed 50 reps of one-arm chin-ups.
From a standing position, Lee could hold a 125 lb (57 kg) barbell straight out.
Lee could break wooden boards 6 inches (15 cm) thick.
Lee performed a side kick while training with James Coburn and broke a 150-lb (68 kg) punching bag
Lee could cause a 300-lb (136 kg) bag to fly towards and thump the ceiling with a side kick.
In a move that has been dubbed “Dragon Flag”, Lee could perform leg lifts with only his shoulder blades resting on the edge of a bench and suspend his legs and torso perfectly horizontal midair.
Lee could thrust his fingers through unopened steel cans of Coca-Cola, at a time before cans were made of the softer aluminum metal.
Lee could use one finger to leave dramatic indentations on pine wood.

Many Happy Thanks!

I will be analyzing the fundamentals and technicals of gold stocks AEM, NEM, ABX, and AUY in the coming week after I analyze the hot earnings for this week with a post so stay tuned my fellow readers (remember APOL and MOS). I thank you the reader, and Happy Trading members (so many to list) for the support over the past several months and thank Happy for providing me with the confidence and allowing my passion to pour forth. If you like our articles, love our site and virtual community please help Wang’s Happy Trading in boosting our FREE subscription emails by recommending it and/or forwarding this newsletter or email to others who would enjoy it and that they subscribe for free. Again THANKS!

Remember to please take good care of yourself because you are very dear to the heart to that special someone. I have a baby daughter on the way due on Feb. 1 and that would be the biggest bagger I would have ever scored (Definitley not hedging it!). I am a good option trader yet still only a student-soso master in life and in trading.

Best Wishes,

Optiondragon