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In the fourth part of this series, we will be going through the actual trade on our "Hot stock in a Hot sector". Part three focused on creating the trade in OptionGear, as well as overlaying risk graphs. I would strongly suggest you read parts 1, 2 and 3 of the series so you can learn how we chose the sector, stock and trade for our case study. The stock is DO (Diamond Offshore Drilling).
The trade I ended up entering in our case study was an OTM (out of the money) Modifly. A modifly is a "modified butterfly". There are many ways in which butterflies can be modified – strike widths wider or narrower, different strike widths between the long and the body and the body and OTM tail wing, buying and selling in different ratios (but of course never sell more than you're buying!). The Masters ICT and Expert/Advanced seminars by Optionetics really go into this topic deeply, but for now, the type of Modifly I used was one where the distance between the ‘closest to ATM’ long and the body was wider than the distance from the body to the OTM tail.
The result this achieves is that it gives the butterfly more of a bullish bias, and also if volatility fell when the stock rose, then a volatility crush would work in my favour, in a certain area of the fly, and time decay (theta) is also on my side in this part of the fly.
Let’s have a look at the stock and trade, on the day the trade was entered.
Chart 1
click chart for more detail
The stock was trading at $130.59 (at the close of the day) and we entered our 135 / 155 / 170 June 08 Modifly, in a 1 / 2 / 1 ratio. Notice the larger width between 135 and 155, than between 155 and 170. The trade was entered for a $4.25 debit, or $425 (per butterfly). The stock went sideways for a few days and then proceeded to shoot up. On May 19 the stock had come up into the mouth of the fly, where the trade could be sold for a profit. In our case study, I exited for a $6.75 credit. This is a profit of $2.50, and as a return on our risk in the trade (of $4.25), this is a return on investment of 59% in 2 weeks. Not bad! Lets have a look at the risk graph now, just before we close the trade.
Chart 2
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Could we have made more if DO continued up? Yes. Could we have lost our profit if DO suddenly retraced? Yes. So how can you decide when to take a profit? One way is to consult our original view on the stock, and with that lets go back to the original chart in ProfitSource and look at the Elliott Wave TAPP and the range projection.
Chart 3
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Look how close the stock has come to our price projection, and a lot earlier than we thought. This could be reason enough to exit. You won’t go broke taking profit. Don’t go through with the classic "If only I stayed in longer..." Remember our plan – it was to trade the stock up to the Elliott Wave TAPP, because we were in a strong stock, in a strong sector – and it did what we expected it to do. Also consider the risk graph and the Greeks. We weren’t in a long call here, but rather a butterfly, so there’s a limit to the amount we can make solely off direction.
I trust this series has been both educational and fun!
Manage your trade plan!
Matt Baker
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