Please copy and paste this embed script to where you want to embed

HOW TO USE THE ELLIOTT WAVE PRINCIPLE TO IMPROVE YOUR OPTIONS TRADING STRATEGIES

COURSE 1:

Vertical Spreads

EWI eBook

How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies Course 1: Vertical Spreads By Wayne Gorman, Elliott Wave International Chapter 1 — Bull Call Spread and Bear Put Spread Chapter 2 — Bull Call Ladder and Bear Put Ladder Chapter 3 — Ratio Call Spread and Ratio Put Spread Chapter 4 — Bear Call Ladder and Bull Put Ladder Chapter 5 — Call Ratio Backspread and Put Ratio Backspread Chapter 6 — Questions and Answers

Introduction This eBook introduces the standard textbook definitions of various options strategies and then explains how to apply them in the context of Elliott wave analysis, using real-world price charts. My name is Wayne Gorman, and I am Senior Tutorial Instructor at Elliott Wave International. I have over 25 years of experience using the Wave Principle in trading, forecasting, and portfolio management. Every point of discussion in this course falls under the umbrella of “vertical spreads.” These are option strategies that are either all calls or all puts, with the same expiration date. The term “vertical” implies a sharp price movement in either direction. (“Range-bound” vertical spread strategies apply to sideways price action and are not covered in this course.) For this course, I chose five different vertical spread strategies and paired them with their bullish and bearish counterparts. Before we get to the material, I’d like to make two important points. First, the intent of this course is not necessarily to recommend using one or more of these particular strategies. The purpose is to teach how to formulate and execute these strategies by using the Elliott Wave Principle. And second, I’m not going to try to show whether these strategies are better or worse than going outright long or short in futures or cash. We will just deal with these option strategies on their own and look at how the Wave Principle helps us in terms of setting strikes, establishing expirations and managing the strategy from start to finish. Editor’s note: This webinar was originally presented live on August 28, 2008.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

1

Chapter 1 — Bull Call Spread and Bear Put Spread

Chapter 1 Bull Call Spread and Bear Put Spread

1.

Bull Call Spread

Buy 1 ATM Call

Sell 1 OTM Call

Net Debit

Moderately Bullish

Relatively Longer-Term Strategy, 3 to 6 Months

Maximum Risk Capped at Net Debit

Maximum Reward Capped at Strike Difference - Net Debit

Breakeven: Long Call Strike Price + Net Debit

Figure 1 The first strategy that we will look at is the “bull call spread.” To start with, I’ll give the standard definition seen in most options books or websites, as underscored by the abstract above: A longer-term strategy that lasts three to six months, this spread involves buying an at-the-money (ATM) call, and selling an out-of-the-money (OTM) call, resulting in a net debit. Time is of the essence. Maximum risk is capped at the net debit, and maximum reward is capped at the difference in strikes less the net debit. We have one break-even level — the long call strike plus the net debit. As we go along, we may deviate from this ideal with respect to the time until expiration, based on Elliott wave analysis (of course, for positive reasons, not for negative ones).

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

2

Chapter 1 — Bull Call Spread and Bear Put Spread

2.

Bear Put Spread

Buy 1 ATM Put

Sell 1 OTM Put

Net Debit

Moderately Bearish

Relatively Longer-Term Strategy, 3 to 6 Months

Maximum Risk Capped at Net Debit

Maximum Reward Capped at Strike Difference - Net Debit

Breakeven: Long Put Strike Price - Net Debit

Figure 2 The bearish counterpart is the “bear put spread” — same type of structure, except this time you’re betting on a decline in prices. The thumbnail sketch above fills in the rest: Buy an at-the-money put and sell an out-ofthe-money put, resulting in a net debit. Maximum risk is capped at the net debit. And maximum reward is, again, equal to the difference in the two strikes less the net debit. The breakeven is the long put strike price less the net debit. There is one key consideration regarding these strategies — they involve limited moves. By selling the put or call at a strike that’s further out of the money, we technically give up certain profit potential. However, since we’re predicting that the move is limited, we’re not really giving up anything, all the while reducing cost.

Figure 3 Now, let’s look at these strategies from an Elliott wave perspective. This table features the optimal Elliott wave attributes for using the bull call spread and bear put spread — key word being “optimal.” You could use these Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

3

Chapter 1 — Bull Call Spread and Bear Put Spread

strategies in other situations; these scenarios simply provide an ideal context. The left-hand column names six categories of wave type. And the right-hand side, their corresponding characteristics. Before we get to an actual trade setup, we must first examine the list’s individual parts: wave function, position, structure, degree, entry point, and prior wave at next lower degree. Function: From an Elliott wave standpoint, vertical spreads are best suited for limited moves such as those associated with reactionary or countertrend moves. What does that mean in terms of wave position? This would be the second and fourth waves within an impulse wave; a B wave within a zigzag, a flat or a triangle; the D wave of a triangle; and the X wave in a double zigzag, triple zigzag, or double-three, triple-three combination. Again, why are these wave positions good for these strategies? They’re limited. These countertrend moves can go only so far. Wave two always retraces less than 100% of wave one. Wave four can never end in the price territory of wave one. A “B” wave in a zigzag can never go beyond the start of wave “A.” And wave “D” in a contracting triangle can’t go beyond the previous wave “B.” On your X wave, however, the limitations are in terms of guidelines, not rules: the B wave in a flat could go beyond the start of A, and in some combinations the X wave could go beyond the start of wave W or wave Y. The best structure for these strategies is a zigzag, because we’re looking for a sharp move. The ideal situation would be for the price of the underlying asset to go right to the strike price of the out-of-the-money call or put that we sold, right at the expiration date. But certainly, it’s better to have purchased more time than we need than to run out of time. Preferably, the zigzag would occur at a fairly low degree. Why do I say that? This is because we’re looking for relatively small moves here. We’ve limited our profit potential. We’ve limited our upside potential. It’s hard to put an exact wave label in terms of Minor, Minute or Primary, because those can vary. But at the extremes, we’re not looking for Cycle or Supercycle degree with these strategies. We want to enter these strategies early in the wave position. Again, time is of the essence. We’re buying basically at-the-money. We want to get in as soon as possible to take advantage of this move. Finally, you need evidence that strongly suggests the entry point will precede a turn. For example: Before you go into a wave two or four, it would be ideal to see the previous wave at one lesser degree (i.e. the final leg of the preceding wave one or three) unfold as an ending diagonal, a truncated fifth, or a fifth wave extension — all patterns that imply an immediate and swift reversal in trend. If you don’t see any of these game-changers in the previous wave at one lesser degree, then you have to spot some other indication of change. This could be a reversal on the weekly bar chart or a completed five waves in the fifth wave. Whatever the scenario, there should be some evidence of a trend change before you can enter into the position. The one rule that is essential to applying this strategy and all the others in this eBook is this: Always rely on Elliott wave rules and guidelines. Now it’s time to see an example of how to use these strategies on an actual price chart.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

4

Chapter 1 — Bull Call Spread and Bear Put Spread

Figure 4 This is a futures weekly continuation bar chart of the euro against the U.S. dollar from 2005 to 2008. I’ve labeled the chart starting from the November 18, 2005, weekly low at $1.1661. From there, I’ve counted completed Intermediate waves (1) and (2), and a partial Intermediate wave (3). Intermediate wave (3) subdivides into Minor waves 1 and 2 (in red) and Minor wave 3 (not labeled on chart) subdivides into Minute waves 6 through 9 (circled in brown). That leaves us with an open ticket into Minute wave 0, so let’s blow up that leg of the advance.

Figure 5 We’re going to start trading on April 23, 2008, the last bar on the daily chart. This will be our entry point.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

5

Chapter 1 — Bull Call Spread and Bear Put Spread

Figure 6 Now I’ve attached some wave labels, and you can see we have a decisive move up in Minuette waves (i), (ii), and (iii) (in blue). Within Minuette wave (iii), I’m counting Subminuette waves i through v (in red) as one probable scenario. This brings us to the exciting part: Subminuette wave v contains five overlapping waves (circled numbers) with a wedge shape, the classic trait of a fifth-wave ending diagonal. This is an exciting event, because fifth-wave diagonals qualify as one of the key patterns that signal a swift and sharp reversal ahead. And, according to Elliott wave guidelines, the reversal will end at least where the diagonal began. In this case, that area is marked by the start of Subminuette wave iv (in red). Figure 7 So, what are we looking for? A sharp albeit limited decline for Minuette wave (iv) back to at least the start of the diagonal, and maybe even further beyond that. What if we’re wrong? Are there other possibilities? Yes, the ending fifth-wave diagonal scenario may instead be waves A and B of some type of flat structure. Even so, in a flat, wave C should still come down to where wave B began — a similar target zone as the diagonal scenario. In either case, the larger implication is the same – a move down. The one difference is time. If an ending diagonal is at hand, the decline will be swift; if it’s a flat structure, the drop may take longer to unfold.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

6

Chapter 1 — Bull Call Spread and Bear Put Spread

Figure 8 Another way to determine how far wave (iv) may go is to look at the market from a Fibonacci retracement point of view. Keep in mind that fourth waves are normally shallow and make .382 retracements. You can see in Figure 8 that the .382 area lands at $1.5362, within winking distance of the level where the diagonal began — $1.5273. Pretty close. Of course, wave (iv) could go further, in which case I’ve also labeled the three common runner-ups for Fibonacci retracement levels: .500, .618, and .786. However, since fourth waves can never end in the price territory of first waves, we can eliminate the .786 scenario. Figure 9 On this chart, drawing a trend channel doesn’t help in terms of price, but it does offer us a guide in terms of time. Figure 9 calls attention to the fact that we’re looking for a move that could happen fairly soon. Therefore, we don’t have to go out too far with respect to option expiration dates. We don’t have to go out six months, or even three months, to realize the same move. Keep in mind, we want to maximize yield or return on capital. The less money we spend by being able to select a shorter time period for our expiration date, the greater our return on capital will be if we can still achieve the same move within that time period.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

7

Chapter 1 — Bull Call Spread and Bear Put Spread

Figure 10 Ideally, we’ll hit the nail on the head here. However, Elliott wave analysis is about probabilities, which are never accurate 100% of the time. So, the last thing we need to do is prepare for a Plan B exit strategy, in case we’re wrong and the euro goes up. In Figure 10, I use the Fibonacci guideline of expansion for fifth waves to determine where one should get out to salvage this trade. According to this guideline, one possible scenario is wave five will be equal to .618 times the net distance traveled of waves one through three. And that comes up to $1.6230. So, if prices do go the opposite way and we have a net debit, that’s the one level to keep in mind to unwind the trade and recover whatever we can in terms of premium. Figure 11 Another useful guideline of Fibonacci analysis states that wave four often divides an entire impulse wave into either the Golden Section or two equal parts. On the chart, you can see that there’s a Golden Section if Subminuette wave v (red) ends at $1.5840. (We’ve already gone past that level.) The 50% divider comes out to $1.6191. So, if we’re wrong, this offers another possible area for wave v to travel. In terms of unwinding these trades, we’ll look around that $1.6200 level to warrant getting out of these positions.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

8

Chapter 1 — Bull Call Spread and Bear Put Spread

Figure 12 So, now that we have all the pieces in place, let’s examine the big picture. We’re going to do a bear put spread on April 23 (recall Figure 5). On that day, the price high was $1.5964, the low $1.5826, and the close $1.5854. Please Note: All of the option prices that I’m showing are closes. On our entry point of April 23, we’re buying an at-the-money June $1.5850 put at .0228. The June puts expire on June 6th, so we’re keeping this short, just about a month and a half. Next, we’re going to sell an out-ofthe-money June $1.5250 put at .0054. And why did I pick $1.5250? That’s our previously determined target from Figure 8, which is close to where the diagonal began at $1.5273. So, we’re going to look for a move to that level over the next month and a half. We end up with a net debit of 174 points, so our maximum risk is .0174; our maximum reward is .0426; and our breakeven comes out to $1.5676. I’m also showing the implied volatility at the time on the front contract — June. I’m not going to get into any analysis on implied volatility in this particular course. This is purely a directional price movement strategy. To review: We’re going to look to unwind the trade when we get to $1.5273 and, hopefully, that’ll happen right at expiration. If things go the other way, we’re going to look to get out and salvage something at $1.6235, based on those Fibonacci calculations for wave five. Figure 13 In Figure 13, we flash forward to see how the trade unfolded. The fifth-wave ending diagonal did indeed deliver a swift reversal (recall Figure 6). And, as you can see, we reached our target of $1.5273 on May 8th. From a risk point of view, there is no reason to stay in this position so we’re going to unwind the trade and close out on May 8th. We’ll sell the June $1.5850 puts at .0508; we’ll buy back the $1.5250 puts at .0123. We get a net credit of 385 points and a net profit of 211 points. Implied volatility did not change much — it was 10.3% (versus 10.6% on Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

9

Chapter 1 — Bull Call Spread and Bear Put Spread

April 23), so that worked in our favor. The “secret” to the trade’s success was its adherence to the ideal wave characteristics of a bear put spread strategy as identified in Figure 3. It was a countertrend move in a fourth wave of low degree (Minuette). We entered early. And, most importantly, the key to setting up everything was identifying that we had a fifth-wave ending diagonal in the prior wave at the next lower degree. As we know, this pattern implies a dramatic reversal ahead. Figure 14 So, we got out on May 8th, but the contract didn’t expire until June 6th. In Figure 14, you can see that our choice to exit early was the right one in order to satisfy the risk/reward ratio. We made a slight new high in Minuette wave (v) at $1.5988. (The previous high in Minuette wave (iii) was $1.5985.) This move unfolded as another fifth-wave ending diagonal, which, sure enough, was followed by a swift and sharp reversal to the downside.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

10

Chapter 2 Bull Call Ladder and Bear Put Ladder

1.

Bull Call Ladder (Long Call Ladder)

Buy 1 ATM Call

Sell 1 OTM Call

Sell 1 Further OTM Call

Net Debit

Moderately Bullish

Relatively Shorter-Term Strategy, 1 Month

Maximum Risk is Uncapped

Maximum Reward Capped at Middle Strike - Lower Strike - Net Debit

Breakeven: Long Strike + Net Debit

Breakeven: Total of Short Strikes - Long Strike - Net Debit

Figure 15 The next strategy is the “bull call ladder,” sometimes referred to as the long call ladder. (And of course its counterpart, the “bear put ladder.”) Figure 15 lists the major aspects of this strategy: We buy an at-the-money call (or an in-the-money call), sell an out-of-the-money call, and sell a further out-of-the-money call. This is a moderately bullish, short-term (about one month) approach that produces a net debit. Maximum risk is uncapped. We have an uncovered option with the further OTM short call. The maximum reward that we can make is the difference between the middle strike and the lower strike, less the net debit. And, we have two breakevens: The long strike plus the net debit, and then, the total of the short strikes minus the long strike minus the net debit. Initially, as prices rise, we’ll break even just by moving up to cover the net debit. Of course, our maximum profit will be at the first OTM short call strike, and we come up to our next breakeven after the second OTM short call strike, after which point we begin to lose money. I want to say a few things about uncapped risk, because there are two pairs of strategies in this course that have uncapped risk: the bull call ladder and bear put ladder, and the ratio call spread and ratio put spread. This is not academic. This is real and true. In options, the notion of a “stop loss” is not as safe as it is with futures. If you want to exit a position at a certain level, either where the price of the underlying asset is trading or at a certain premium, you can put an order into a broker. However, there’s no guarantee that you’re going to get out on a dime. As a matter of fact, if it’s a fast-moving market, you may not even get a quote in options. And so, I’m not going to use the term “stop-loss order” with options because it’s misleading. It implies that you can achieve some type of immediate liquidation at a specific price point, but you really can’t. Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

11

Chapter 2 — Bull Call Ladder and Bear Put Ladder

On paper, this strategy is akin to an extension of the bull call spread. We’re getting a little bit more income on the second short call, and we’re creating a second higher breakeven for ourselves. We’re also keeping the strategy short-term, because with uncapped risk we don’t want to allow for too much time. And, of course, with the bear put ladder, we have the same type of structure except that we’re betting on prices to decline (see Figure 16)

2.

Bear Put Ladder (Long Put Ladder)

Buy 1 ATM Put

Sell 1 OTM Put

Sell 1 Further OTM Put

Net Debit

Moderately Bearish

Relatively Shorter-Term Strategy, 1 Month

Maximum Risk Uncapped

Maximum Reward Capped at Higher Strike - Middle Strike - Net Debit

Breakeven: Long Strike Price - Net Debit

Breakeven: Total of Short Strikes - Long Strike - Net Debit

Figure 16

Figure 17 So, what are the optimal Elliott wave characteristics for a bull call ladder and a bear put ladder? Well, again, we’re talking about a countertrend move. We have limited profit potential, and, of course, we have uncapped risk. Wave position is exactly the same as the previous pair of structures: Waves 2, 4, B, D, and X, and we’re Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

12

Chapter 2 — Bull Call Ladder and Bear Put Ladder

looking for a zigzag. We want to get this over quickly and get out. We want a sharp move. We want to enter in the middle stages of those wave positions, either Wave C of 2 or Wave Y of 2, for example, because we don’t have much time to work with. And of course, the pièce de résistance — a provocative wave prior at next lower degree: i.e. an ending diagonal, truncated fifth or fifth-wave extension that will lead to a swift and sharp reversal. The final point can’t be overstated: “Always rely on Elliott wave rules and guidelines.” In particular, wave 2 always retraces less than 100% of wave 1; wave 4 can never end in the price territory of wave 1; and wave B of a zigzag can never go beyond the start of wave A. Once more, I’m not necessarily recommending that you all go out and use this strategy. It’s a strategy that some people employ. But if you’re going to go there, you might as well know how to improve it by using Elliott wave analysis. Figure 18 Now, let’s look at an example. Figure 18 is an Elliott wave-labeled chart of the NASDAQ 100 from October 2007 to March 2008. As you can see, we have completed Minor waves 1, 2, 3, 4, and 5 (red) of Intermediate wave (1) (blue). Within Minor wave 5, we see a familiar formation: a fifth-wave ending diagonal (the same pattern we saw in Figure 4 of the euro/U.S. dollar). As we already learned, ending diagonals are one of three patterns that precede a dramatic reversal. The other significant development is a gap up from March 17th to March 18th, after the culmination of the ending diagonal. If we were doing an outright long futures trade, this area (in and around March 17) would represent the most promising entry point. Keep in mind, however, that during this part of the lesson, we are not going to simulate all trading possibilities. We’ll wait until we reach the proper juncture to do a bull call ladder or bear put ladder. Based on what we know about ending diagonals, the next likely move will be up and sharp. The option strategy of choice is a bull call spread; this time, in the opposite direction of what we did on the euro. And the outside target is where the diagonal began, which is at 1,876.75, the end of Minor wave 4. Let’s see what happens.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

13

Chapter 2 — Bull Call Ladder and Bear Put Ladder

Figure 19 Figure 19 shows that we did, in fact, make a swift reversal back to (and even beyond) where the diagonal began. The move unfolded as Minute waves 6 through 0 of Minor wave A (red) of Intermediate wave (2) (blue). Had we done a bull call spread, the trade would have been a success. Assume that we got the move, did the bull call spread and we got out. Now what? Unless our wave count is totally wrong, Intermediate wave (2) is now under way. We have a countertrend move of small degree. We know that wave 2 always retraces less than 100% of wave 1, which would help to deal with uncapped risk situations. Ultimately, the setup is ideal for a bull call ladder. We want to earn some premium on the uncovered short call, but we also want a good amount of distance between our entry point and the second breakeven. Hopefully, in this case, our upper limit or breakeven will be in the area where wave (2) can never go. If we enter the bull call ladder too low relative to the expected move, our second breakeven will be within range of wave (2), and we could lose money. If we sold an out-ofthe-money call much further up to avoid losing money, we wouldn’t get much premium for it at all. We have to find a compromise between these two objectives. So, we have to do the bull call ladder at least in the middle of the anticipated upward price move. The anticipation is, of course, for a Minor wave B down followed by Minor wave C up. Figure 20 Figure 20 shows that Minor wave A within wave (2) has retraced .382 of Intermediate wave (1) at 1,894 (the exact .382 level was 1,893.25). This is important, because second waves do NOT make shallow retracements. They generally carve out much deeper ground, such as .500, .618, .786 and so on, as high as possible while staying below the start of wave one. So we’re going to plan for the C wave within wave (2), and we’re going to look for a much deeper retracement. I’ve added a Fibonacci table to the chart to identify the potential upside targets for Minor wave C. So, let’s move ahead. Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

14

Chapter 2 — Bull Call Ladder and Bear Put Ladder

Figure 21 I’ve labeled the ensuing price action Minor wave B. It made about a 50% retracement of wave A. We’ve also gapped up, which could be the start of wave C. But, we need to be certain. There are a couple of guidelines we can use here to lead us forward. First, Minor waves A and B look to be forming a zigzag; this is a simple three-wave pattern labeled a-b-c in which the subdivisions are 5-3-5. And, in a zigzag, the most common relationship for wave C is that wave C equals wave A. Another guideline is that wave C may also equal 1.618 times wave A. In this case, Minor wave C equals Minor wave A at 2,006.50. The .618 is 2,032 — very close. Minor wave C equals 1.618 times wave A at 2,145.50. So, we will eliminate the higher Fibonacci retracement level of .786 (at 2,130.50) and 1.618 times the length of wave A (at 2,145) and turn our eyes down to the 2,000-2,032 area for a likely target, because we have a Fibonacci cluster there. Figure 22 Based on our analysis, we’re going to do a bull call ladder on April 16, 2008. Remember that I am using “closing” option prices specifically. On April 16, the futures price closed at 1,862.50. So, we’re going to buy a slightly in-the-money June 1850 call at 84 points. We’re going to sell an out-of-the-money June 2010 call at 18.50 points — right around the area where Minor wave C equals A, and close to the .618 retracement level. This is where we expect wave (2) to end. The June contract expires on June 20, 2008. As you can see in Figure 22, there is also a short out-of-the-money June 2050 call at 11 points. The purpose of this second short call is to produce more income with manageable risk. The result is a second breakeven that is beyond the .786 retracement of 2,130.50. (.786 is about the maximum retracement for second waves, but it is possible for second waves to Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

15

Chapter 2 — Bull Call Ladder and Bear Put Ladder

experience a 99% retracement.) So, the goal is to get a decent amount of premium that reduces the net debit, and create a high second breakeven level that provides a cushion against that uncovered short call, in case prices go past the 2,050 area where we’re exposed. I have a net debit of 54.50 points. My maximum risk is still uncapped: Maximum risk on a down move is 54.50 points, on an up move it’s uncapped, and maximum reward is 105.50 points. The lower breakeven is 1,904.50. The upper breakeven is 2,155.50, which is based on the gain the strategy would make — between the buy call and first sell call — as prices move up, less the net debit. That breakeven is also beyond the .786 retracement of 2,130.50, an area where wave (2) is unlikely to go. Ideally, if it’s a fast-moving market and prices abruptly skyrocket or plunge, I would call my broker to exit at 2,010 or unwind at 1,780. But, if he can’t get me out, I still know that after 2,010, there are 145 more points of upward movement before the market reaches 2,155 — and that’s just breakeven. A move below 1,781.50, the low of Minor wave B, would negate the wave count, and I would look to close out the position. Footnote: I selected these particular strikes based on the Elliott wave analysis and the market premiums that were available. In the end, after doing several calculations, they were the best I could do for this trade. Implied volatility is 24.6%. Figure 23 In Figure 23, you can see that we did indeed move up in what looks like Minor wave C. And, on May 13, we hit our objective of 2,010. So, what do we do now? That’s easy: We get out. There is no other reason to stay in this trade anymore. It’s a high-risk trade, and when you read the options literature, you’ll probably see a number of people who aren’t in favor of this type of strategy. Assuming we can get out and it’s not a fast-moving market, we close on May 13. These are the prices: I sold the June 1850 calls at 168.50 points and bought back the other June calls — one strike at 50.75 points and the other at 31.25 points. We had a net credit of 86.50. The implied volatility was 20.4%. And we had a net profit of 32.00 points, producing a return on investment of 59 percent. As always, the question remains: Did we capitalize on the opportunity at hand? The next chart has the answer.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

16

Chapter 2 — Bull Call Ladder and Bear Put Ladder

Figure 24 Minor wave C of Intermediate wave (2) finally peaked at 2,062.75, very near the previously cited .618 level of 2,032 and then prices turned down. So, as others in the trading world might say to us, “You got lucky on that one.” However, we know that along with a little luck, we also had some good Elliott wave analysis to help us.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

17

Chapter 3 Ratio Call Spread and Ratio Put Spread 1.

Ratio Call Spread

Buy 1 ITM Call

Sell 2 OTM Calls (Same Strike)

Net Credit or Debit

Neutral to Moderately Bullish

Relatively Shorter-Term Strategy, 1 Month

Maximum Risk is Uncapped

Maximum Reward Capped at Difference in Strikes + / - Net Premium

Breakeven: Long Call Strike + Net Debit or - Net Credit

Breakeven: Short Call Strike + Maximum Reward / No. of Uncovered Calls

Figure 25

2.

Ratio Put Spread

Buy 1 ITM Put

Sell 2 OTM Puts (Same Strike)

Net Credit or Debit

Neutral to Moderately Bearish

Relatively Shorter-Term Strategy, 1 Month

Maximum Risk Uncapped

Maximum Reward Capped at Difference in Strikes + / - Net Premium

Breakeven: Long Put Price - Net Debit or + Net Credit

Breakeven: Short Put Strike - Maximum Reward / No. of Uncovered Puts

Figure 26 Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

18

Chapter 3 — Ratio Call Spread and Ratio Put Spread

The third pair of strategies is the “ratio call spread” and the “ratio put spread” — similar to the bull call ladder, bear put ladder pair. With a ratio call spread, you’re buying an in-the-money (ITM) call and you’re selling two out-of-the-money calls at the same strike. You may have a net credit or debit. Your market outlook is neutral to moderately bullish and short-term, about one month. The ratio put spread has the same overall structure, but you use puts instead of calls, because you would be neutral to moderately bearish. Now, let’s talk about risk. I can’t stress the level of exposure here enough. Maximum risk is uncapped. However, your short strikes are closer to the money than the short strikes of the bull call ladder and bear put ladder, which had the short strikes spread out. In other words, the out-of-the-money puts and calls are more vulnerable, and your uncapped risk is more severe.

Figure 27 I’m not going to go through a trading strategy on these, but if one were to use them, it’s of great value to know the “optimal” Elliott wave characteristics. Figure 27 provides a complete list of these. Function: Clearly countertrend and at the next two higher degrees, at least, because you have significant uncapped risk. In other words, not just wave two of an impulse wave. You would, for example, do this in a wave two of a wave three so that even the next two degrees are moving in the direction of the main trend. Since you’re heavily betting on a countertrend move, this buys you more insurance against the countertrend move somehow morphing into a main trend move. Position: Only waves two or four. Structure: Zigzag. Degree: Relatively low. Entry Point: The latter stages of the wave position; i.e. wave three of C of wave 2. Prior at the next lower degree: The same as always: An ending diagonal, truncated fifth wave, fifth-wave extension, etc. I would rely on rules only for second and fourth waves, due to the uncapped risks. Those are: Wave 2 always retraces less than 100% of wave 1, and the end of wave 4 can never enter the price territory of wave 1.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

19

Chapter 3 — Ratio Call Spread and Ratio Put Spread

Figure 28 Ultimately, the ratio call/put spreads are most likely for those traders who just can’t stay out of the market — they always have to do something. Whether the high level of risk is worth it is best visualized in this chart of the NASDAQ 100. Look familiar? Well, this is Figure 21 from the previous bull call ladder section. Remember that we were able to create a breakeven rate that was way up there, almost as far as wave two could go. With the ratio spreads, though, you want to get in almost near the end so that you can push the breakeven up even further to protect yourself.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

20

Chapter 4 Bear Call Ladder and Bull Put Ladder 1.

Bear Call Ladder (Short Call Ladder)

Sell 1 ATM Call

Buy 1 OTM Call

Buy 1 Further OTM Call

Net Credit

Bullish

Relatively Longer-Term Strategy, 3 to 6 Months

Maximum Risk Capped at Difference of First Two Strikes - Net Credit

Maximum Reward Uncapped

Breakeven: Short Call Strike + Net Credit

Breakeven: Higher Long Call Strike + Maximum Risk Amount

Figure 29 Up next: The “bear call ladder,” also known as a “short call ladder.” In options literature, people may categorize this strategy as somewhat ambiguous and confusing. Are you bullish? Are you bearish? You’re selling an at-themoney call, but you’re also buying two different out-of-the-money calls. What’s going on? Well, the really interesting thing is that this strategy fits Elliott wave like a glove. The reason being: Wave patterns are often ambiguous and warrant an alternate labeling. The alternate wave count may be telling you to lean in the opposite direction, and that’s where this strategy helps. First, we’ll go over the basics as they appear in Figure 29. The bear call ladder is bullish. It’s a relatively longerterm strategy — about three to six months. You should be able to squeeze out a net credit on this. You sell an in-the-money or at-the-money call, buy an out-of-the-money (OTM) call and buy a further out-of-the-money (OTM) call. Your maximum risk is capped; it’s the difference of the first two strikes minus the net credit. Notice, maximum reward is uncapped — this is the biggest contrast with the bull call spread. It’s also going to make a big difference in what kind of wave positions we choose. We have two breakevens: the short call strike plus the net credit, and the higher long call strike plus the maximum risk amount (in the area beyond the further OTM call). In a nutshell, we’re betting on a big move up. Our bias is in the direction of the main trend. Either way, though, we have some protection if prices move down or sideways. We only get hurt if prices go in the direction of the main trend but only for a small move. In other words, we’re sacrificing a small up move in exchange for a big up move, a sideways move or a down move. Not a bad deal, but you have to be able to structure the trade so that it generates a net credit. Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

21

Chapter 4 — Bear Call Ladder and Bull Put Ladder

2.

Bull Put Ladder (Short Put Ladder)

Sell 1 ATM Put

Buy 1 OTM Put

Buy 1 Further OTM Put

Net Credit

Bearish

Relatively Longerter-Term Strategy, 3 to 6 Months

Maximum Risk Capped at Difference of First Two Strikes - Net Credit

Maximum Reward Uncapped

Breakeven: Short Put Strike - Net Credit

Breakeven: Lower Long Put Strike - Maximum Risk Amount

Figure 30 Figure 30 shows the same details for the bull put ladder, also known as the short put ladder. Again, it’s the same structure except now you’re betting on prices to fall. So, you’re selling an at-the-money or in-the-money (ITM) put, buying an out-of-the-money put, buying one further out-of-the-money put, and generating a net credit.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

22

Chapter 4 — Bear Call Ladder and Bull Put Ladder

Figure 31 Now it’s time to reveal the ideal Elliott wave context in which to implement this particular strategy. Function: The three strategies up to this point have all required short, sudden countertrend moves. Here, however, we’re talking about actionary waves, which are those that move in the direction of the main trend. Position: Impulse waves — waves one, three, and five — are the strongest types of waves. Within those, waves three and five are highly preferable, as they are prime breeding grounds for extensions. Wave one can be extended, but it’s not common. The other factor against using this strategy for wave one is that wave one occurs right at a turning point. You may not be sure whether you’ve really turned or are still in a countertrend move. Degree: Of course, is high. Don’t get hung up on the actual degree labels — it’s basically a big move. Entry Point: For waves three and five, after a shallow wave two or four due to the possibility of a flat. The only time you should use this for wave one is after a key reversal, if ever. The truth is, you normally are not going to get the huge move in wave one that you get in waves three and five. It’s important to understand why this strategy is so suitable to Elliott wave analysis. Often when a move is relatively small or drawn out for a long period of time, it’s difficult to gauge its end. For example: How do you know when a shallow wave two is over and thus marking the start of a powerful third wave, or whether it’s unfolding as an expanded flat? Maybe a triangle in wave 4 has ended, but you’re not sure because prices continue to move sideways. So, around every corner of ambiguity, this strategy lies in wait. The wave prior at the next lower degree is the same as previous strategies.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

23

Chapter 4 — Bear Call Ladder and Bull Put Ladder

Figure 32 Let’s go through a trading scenario where we use one of these strategies in a situation of ambiguity. This is an Elliott wave-labeled weekly continuation bar chart of heating oil. Let’s count up from the 2007 low: we have Minor waves 1 and 2 (red), a big extended 3, and now maybe 4. Keep in mind, heating oil is a commodity. We know that in commodities the fifth wave is often extended. We already have an extended third, so chances are we won’t get a repeat performance in the fifth — but we could. That small possibility is enough to move us forward. The chief question to answer is whether wave four has ended. Maybe the small rise from Minor wave 4 is part of an expanded flat and we come back down. Or, maybe we’re going to skyrocket up in wave five. The first step into figuring that out is to look at the retracement made by Minor wave 4. Figure 33 Figure 33 overlays a Fibonacci retracement table to the chart of heating oil. As you can see, wave 4 has made a .236 retracement of wave three. That is acceptable, albeit shallow. Far more common to fourth waves is a .382 retracement of wave three. But again, .236 is still adequate.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

24

Chapter 4 — Bear Call Ladder and Bull Put Ladder

Figure 34 The next order of business is to assess where we could go in Minor wave 5. In Figure 34, I’ve calculated two common Fibonacci projection points by multiplying the net distance traveled of waves 1 through 3 by .382 and .618. We get 3.5247 and 3.9421, respectively.

Figure 35 Those are possible targets for wave five. Another thing we can do is use the Fibonacci dividers that we discussed early on in section one (bull call spread/ bear put spread) and illustrated in Figure 11. To reiterate: Wave four often divides the entire impulse wave into either the Golden Section or two equal parts. The chart above identifies those two areas in the case of heating oil. The Golden Section would bring wave 5 to 3.7116, and two equal parts would bring wave 5 to 4.2448. This handy guideline gives us two more targets for this particular strategy.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

25

Chapter 4 — Bear Call Ladder and Bull Put Ladder

Figure 36 What about time? Here again we can use Fibonacci analysis to estimate when wave 5 will end. As a guideline, wave five can equal the time it took to finish waves one through three multiplied by .382, .5, or .618. In Figure 36, you can see where these dates fall into the future on the weekly bar chart. Our entry point is April 11, 2008, so in sequential order .382 comes out to the week ending September 12, 2008; .5 comes out to the week ending October 31, 2008; and .618 comes out to the week ending December 19, 2008. So, now we have a reasonable time reference.

Figure 37 With price and time targets in place, we can now set the wheels of this trade strategy in motion. We’re going to do a bear call ladder on April 11th. In Figure 37, the daily chart of heating oil is blown up to magnify the price point of interest — the up leg rising out of Minor wave 4. Make no mistake, this move is unclear. The initial drop could just be wave A of 4, making the rise wave B (leading to a drop in wave C). Maybe we get lucky and we skyrocket in wave 5. Or, the way we lose the most, wave 5 barely bounces. This is the chance we take. So, let’s get to the numbers. I’ve sold the September 300 calls at 31.40. On April 11th, the high was 3.2376 and the low was 3.1557. If you’re confused by the “300” calls, don’t be. The puts and calls that I’m dealing on are quoted based on the price (on the right side of the chart) times 100. For example, 3.00 would be quoted as 300 (3.00 times 100). That’s how these options are quoted, so from this point forward I’ll refer to the prices in the same manner. The September op-

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

26

Chapter 4 — Bear Call Ladder and Bull Put Ladder

tions expire on August 26, 2008, close to the .382 time relationship. That gives us about five months, a suitable stretch of time since this is NOT a short-term strategy. Remember, we’re looking for a big move at a relatively high degree. The 300 calls were in-the-money. We were trading around 315-323. I’m going to buy the out-ofthe-money September 330 calls at 18.11. If there is just a small up move, I will be giving up 30 points, but we knew we had to sacrifice a small move to implement this strategy. Then I’m buying further out-of-the-money September 350 calls at 12.68. Why 350? If you recall, we said that if wave 5 were .382 times waves 1 through 3, then it would go up to 352.47 (see Figure 34). We’re looking for wave 5 to go at least to 352, with the potential to go much higher. The maximum risk is capped at 29.39. The maximum reward is technically uncapped, but 395 is a good target, and at 395 we would make 15.61 points. Again, 395 comes directly from the analysis in Figure 34; wave five commonly equals .618 times the net distance traveled of waves one through three. That target came out to 394.21. Let’s sum it up. At minimum, we should get up to 352. The lower breakeven is 300.61. The higher breakeven is 379.39. The implied volatility is 35.85 percent. And, we’re doing this all on April 11th. If prices collapse past this wave 4, we have the net credit. We really don’t have to do anything. We could just walk away. So, let’s see what happened. Figure 38 In Figure 38, you can see that we did, indeed, get a big move up. This is now May 15, and we made a high of 372.28 the previous day — this is actually around the area where wave 5 would form the Golden Section. (Recall Figure 35 and the guideline of wave four as a Fibonacci divider.) We still haven’t gotten to 395, and it looks quite possible that wave five could extend. So, we can afford to hold onto this position for a little while longer. The next chart reveals whether the decision to stay in this trade and hold out for further gains was the right one.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

27

Chapter 4 — Bear Call Ladder and Bull Put Ladder

Figure 39 Yes, we skyrocketed up even further. The last bar on this chart, May 22nd, has a high at 401.53 and a low of 390.80, so we got to that 395 level. It’s time to unwind and get out. So, let’s see how we did. We bought back the September 300 calls at 102.45, sold the 330 calls at 74.74 and sold the 350 calls at 58.14. We earned a net credit of 30.43 points. The implied volatility was 40.49%, however that’s a bit misleading. That was still on the June contract, which had about two weeks to run. The September contract was really down to around 34% — so no major change there. Finally, this trade produced a net profit of 31.04 points. Figure 40 Bear in mind, the key to this strategy was not just the wave count. It was using Fibonacci analysis to give us an approximation of what we would expect. And, if we pan out a bit further, we can see how close our projection came to reality. Our exit day was May 22nd. On the chart in Figure 40, that date correlates to the peak of Minuette wave (iii) (blue) of Minor wave 5. After that, there was Minuette wave (iv) and (v), the latter of which unfolded as a fifthwave diagonal. As we have repeatedly learned from the first three sections of this course, fifth-wave diagonals precede dramatic reversals. And that’s exactly what occurred here.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

28

Chapter 5 Call Ratio Backspread and Put Ratio Backspread

1.

Call Ratio Backspread

Sell 1 ITM Call

Buy 2 OTM Calls (Same Strike)

Net Debit

Agressively Bullish

Relatively Longer-Term Strategy, 6 Months

Maximum Risk Capped at Difference of First Two Strikes + Net Debit

Maximum Reward Uncapped

Breakeven: Higher Long Call Strike + Maximum Risk Amount

Figure 41 The last strategy we will go over is the “call ratio backspread” and its bearish counterpart the “put ratio backspread.” These are like the previous strategies we looked at — the bear call ladder and the bull put ladder — only they are a lot more aggressive. Let’s go over the details for the call ratio backspread as shown in Figure 41. We’re selling one in-the-money (ITM) call, buying two out-of-the-money (OTM) calls, and we normally have a net debit. Unlike the bear call ladder, we’re buying these two OTM calls at the same strike, and it’s not that far out of the money. If you recall, in the ladder strategy we would buy one lower call and then a much higher call. The call ratio backspread is a relatively long-term strategy, about six months. Here, maximum risk is capped at the difference of the first two strikes plus the net debit. Maximum reward is technically uncapped. I say “technically” because nothing goes to infinity. If we assume a net debit, we just have one breakeven: the higher long call strike plus the maximum risk amount.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

29

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

2.

Put Ratio Backspread

Sell 1 ITM Put

Buy 2 OTM Puts (Same Strike)

Net Debit

Agressively Bearish

Relatively Longer-Term Strategy, 6 Months

Maximum Risk Capped at Difference of First Two Strikes + Net Debit

Maximum Reward Uncapped

Breakeven: Lower Long Put Strike + Maximum Risk Amount

Figure 42 Figure 42 covers its counterpart on the bear side: — the “put ratio backspread.” Again, it’s the same type of structure as the “ladders,” only much more aggressive.

Figure 43 Now let’s look at the optimal Elliott wave characteristics. Function: Clearly actionary, in the direction of the main trend. We don’t have a net credit on this; just a net expense or debit. Position: Looking for an impulse, i.e. third or fifth wave and, hopefully, an extension. Degree: High. We want a big move. Entry Point: This is another interesting difference from the “ladder” strategies. We’re not looking for shallow twos or shallow fours anymore. We’re looking for a deep wave two or relatively deep wave four, so we can position ourselves Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

30

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

aggressively. We do not want ambiguity. We want clarity and confidence. Nothing is 100% airtight, but we want the signs to strongly suggest that we’re going into a third wave or fifth wave. Maybe we’ve just completed an expanded flat or we’re right at the final E wave of a triangle before going into the next impulse wave. Perhaps we’re ending a series of overlapping ones and twos. The point is that ALL of these scenarios, when they involve ensuing third or fifth waves, can lead to extensions. And, an extension is exactly what we want here. As always, you will look for three types of structures in the wave prior at next lower degree: ending diagonals, truncated fifths, fifth-wave extensions, or other equally compelling evidence of a reversal. Figure 44 So, let’s look at the last trading scenario. This is an Elliott wave-labeled weekly continuation bar chart of natural gas. We’re going to start trading in the week ending March 28, 2008. As you can see, our interpretation is that a contracting triangle [Minor waves A, B, C, D, E (red)] ended forming Intermediate wave (X). From there, we started what appears to be an impulse for Minute waves 6, 7, 8, and 9 (blue). Figure 45 Figure 45 displays a Fibonacci expansion to show the possibilities for wave 0 (not shown on chart) after a deep retracement in Minute wave 9. Remember, a relatively shallow fourth wave is a deal breaker for using the call ratio backspread strategy, since it’s an indication the fourth wave may not be over. We don’t want ambiguity. We want a big move quickly, and there are compelling reasons to believe a big move is exactly what we’re going to get soon. First, there is a deep completed fourth wave as opposed to a more drawn out expanded flat in wave four. Also, natural gas is a commodity, and fifth waves are often extended in commodities. We haven’t had an extension up to this point (waves 6 and 8 are short), so we are definitely due for one. Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

31

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

The next thing to look at is how far this Minute wave 0 could go. Well, as we learned in the previous section, wave five often equals the net distance traveled of waves one through three multiplied by .382 or .618. The .382 level comes to 9.984. As you can see in Figure 46, which shows action up to the week ending March 28, 2008, we’ve already gone above 10.000. The high a couple of weeks earlier was 10.294, thus the .382 is not going to work. So, we can rightfully expect wave 0 to at least equal .618 times the net distance traveled of waves one through three. That comes out to 10.800. If wave 0 is extended, it should equal 1.618 times the net distance traveled of waves one through three, or 14.256. So, note those points: 10.800 at minimum and 14.256 as a possible extension. Figure 46 If we want to amass a few more targets for Minute wave 0, we can always consult another familiar Fibonacci guideline for fourth waves. This states that the beginning (or end) of wave four often divides the entire price range of waves one through five into the Golden Section or two equal parts. As you can see in Figure 46, the former area comes to 12.43 for the end of wave 0, and the latter to 13.75. Seeing that 13.75 is relatively close to 14.256, we’re going to keep those two levels in mind as possible termination points for Minute wave 0. Figure 47 Now, what about time? This is a Fibonacci time zone chart. Our starting point is the beginning of Minute wave 6. From there, we see each Fibonacci number of weeks: 2, 3, 5, 8, 13, 21, 34, and 55. We know we’re going to have to go further out on our expiration, probably around six months from our exact trading date, which is March 27, 2008. So, somewhere between 34 weeks (August 15, 2008) and 55 weeks (January 9, 2009) seems like a reasonable target.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

32

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 48 Again, we can use the Fibonacci guideline for fourth waves acting as dividers to accrue a few more objectives in regard to time. This chart shows that if Minute wave 0 ends on August 1, 2008, the end of Minute wave 9 will have divided the entire time duration of waves 6 through 0 into the Golden Section, i.e., .382 for the amount of time to the end of wave 9 and .618 for the remaining amount of time to the end of wave 0. We had August 15th in the previous time chart, so it looks like we’re going to need at least until August in terms of our expiration date. Figure 49 Before we start the trade, we need to prepare for a plan B exit strategy in case prices fall. If we’re wrong, we would look to unwind to try and salvage something in terms of premium. As we can see in Figure 49, Minute wave 9 made a deep retracement of Minute wave 8 at 8.664 — near the .618 level of 8.610. We know that wave four cannot end in the price territory of wave one and that the top of wave 6 came to 8.481. So in terms of unwinding the trade, we’ll look at those levels.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

33

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 50 Now that we have our price and time objectives for wave 0 and a wellbuilt exit strategy, we can confidently begin the trade. The last daily bar in Figure 50 falls on March 27, 2008, where the market traded from 9.645 to 9.346. So, we’re going to do the call ratio backspread on that date. We’re going to use the September calls, which expire on August 26th. Ideally, we’ll unwind the trade at least a month prior to expiration, before our exposure to time decay accelerates. So, let’s get to the numbers. On March 27, sell one in-the-money September 9.00 call at a premium of 1.571, and buy two out-of-the-money September 9.500 calls at a premium of 1.310 per each call. Net debit is 1.049. (Risk note: each one point is $10,000 a contract.) Our maximum risk is 1.549. Maximum reward is uncapped, but if Minute wave 0 gets to 13.750, our reward would equal 2.701. Now, why did I pick these strikes and end up with this type of situation? The key is the breakeven point: 11.049. If you recall, we said that at a minimum wave 0 would equal .618 times the net distance traveled of waves one through three — at 10.800 (see Figure 45). What I was attempting to do here is structure the option trade so that I minimize the net debit and bring the breakeven as close to 10.800 as possible. Then, if we get the bigger wave or the extension, we’re going to be in profit territory. Implied volatility is 38.17%. And, as a target, we are looking at two main objectives: 13.75, where wave four divides the entire price range of waves one through five into two equal parts (see Figure 46), and 14.256, where an extended wave 0 equals 1.618 times the net distance traveled of waves one through three (see Figure 45). On the downside, we unwind at 8.480. Remember Figure 49 identified our exit point as the top of wave 6 at 8.481. So, I went one tick below that level to establish where we would get out.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

34

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 51 Let’s zoom ahead to see what happened. We did get a big move up. At this juncture, the high on the very last bar of the chart is 10.844. So, we have now achieved the 10.800 minimum established in Figure 45. But it looks like we have greater potential. Keep in mind that we’re looking for about 13.750 and on up to 14.256. So, we’re going to keep the position.

Figure 52 Again, we moved up even further. Now, the high so far is 11.794 — still not quite at our target. We’re going to stay in and ride this out.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

35

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 53 In Figure 53, I’ve labeled the upward progress from the March 20 low as Minuette waves (i), (ii), (iii), and (iv) (red). I’ve also drawn a trend channel to delineate how much higher Minuette wave (v) of Minute wave 0 could possibly go. Let’s follow the channel and see where it takes us.

Figure 54 There certainly was more “UP” to this uptrend. The high on this chart is 13.694, just six ticks away from the initial 13.750 target. From there, you’ll notice that we’ve come down, raising the question as to whether the wave 0 rally is over. We got close to 13.750, but certainly not the secondary target of 14.256. The objective thing to do is to wait and see if we break the lower part of the trend channel. If that occurs, it’s time to get out.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

36

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 55 Indeed, in Figure 55 you can see that prices penetrated the lower boundary of the trend channel. There is no longer any reason to hold onto this position. So, on this date, July 8, 2008, and at this price level (we reached a high of 12.970) we close out this call ratio backspread. In the lower right hand corner, you can see all the particulars of the close in green. The most important detail is that we have a net credit of 2.503 points and a net profit of 1.454 points. This is a great example of how the key to riding out a trade is not just in counting waves and sticking to your target. We also used the guideline of channeling and waited for a break of the trend channel before closing out our position. Of course, we would have done much better had we gotten out at the top of Minuette wave (v) (red) of Minute wave 0, but we waited to see if the market continued to extend. Figure 56 If you want to see what happened after that, Figure 56 shows that there was a swift and sharp decline. That was to be expected because the entire move from the March 20, 2008, low of Minute wave 9 was an extended fifth [Minuette waves (i) through (v) (red)]. And what do we have after an extended fifth? A dramatic reversal.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

37

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 57 To cap things off, here’s a quick reference guide to all five pairs of trading strategies covered in this course.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

38

Chapter 6 Questions and Answers Q. Why don’t you use a bull call spread for fifth-wave ending diagonals? Gorman: Although diagonals are, by definition, “actionary” waves, there is very little action actually going on. In fifth-wave diagonals, you probably don’t even know you’re in the pattern until you’ve seen waves one, two and three, or until you’ve had three consecutive zigzags that are slowly moving in the direction of the main trend. In other words, diagonals use up a lot of time to make relatively little progress. The best use you can make of a diagonal is to go for the next move after it ends. Remember: diagonals often precede dramatic reversals. Q. Are these strategies suitable for triangles? Gorman: No. All of the vertical spread strategies discussed in this course are for directional moves only: either up or down. Triangles are sideways patterns. Now, if it’s a certain wave within that triangle, then yes. As we know, triangles are made up of zigzags, and three of the structures we spoke of in this course are best suited for zigzags: bull call spread/bear put spread, bull call ladder/bear put ladder, and ratio call spread/ratio put spread. However, for triangles themselves, absolutely not. Q. Could you better explain the use of Fibonacci time relationships? Gorman: During this course, I concentrated on three main Fibonacci time relationships. They are as follows: 1. In terms of time, wave five will be equal to .618 times the net time duration of waves one through three. 2. Wave four — either the beginning of wave four or the end of wave four — will divide waves one through five into the Golden Section (.382, .618) or in half (two equal parts). 3. The entire time of waves one through five (in terms of trading days or weeks) will be a Fibonacci number; those are: 2, 3, 5, 8, 13, 21, 34, 55 and so on.... There are several sources in which you can find expansive material on Fibonacci time relationships. Right off the top are these references: Elliott Wave Principle — Key to Market Behavior by Frost and Prechter; Bob Prechter’s Beautiful Pictures; and the online trading course featured on our website, elliottwave.com, titled, “How to Spot Turning Points Using Fibonacci.” Q. How do you keep track of all of your alternate counts, and how many alternates will the analysis track? Gorman: You probably would have, at the most, two alternate counts. You have your main count and one alternate in case the main count does not materialize. I would say maybe one more after that. With all the charting systems that people have today, it’s not difficult to keep track of those counts. Also simplifying things is the easy access to annotation tools and the ability to save information.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

39

Chapter 6 —Questions and Answers

Q. In Chapter 5 on ratio backspreads, you predicted a fifth wave by using the movements of waves one through four. How did you do this? Gorman: First, let me say there are many Fibonacci relationships. If you like this type of analysis, I highly recommend Bob Prechter’s Beautiful Pictures. As for the matter at hand — I used the second Fibonacci time relationship as described in question number 4 above. To reiterate: the end of wave four will often divide waves one through five into either the Golden Section (.382 or .618) or in half (two equal parts). So when I was looking at the end of wave four, I was looking at how that would divide the entire sequence. I wasn’t multiplying one through four times some number. Q. What charting system do you use? Gorman: All of the charts in this course were made with Genesis FT. We also use CQG at Elliott Wave International. Q. Are there strategies you can use to trade expanded corrections? Gorman: Well, if it’s a correction and it’s expanded, the analogy is really the triangle or possibly a flat — a double-three flat. And those really are sideways or range-bound trades. These entail certain types of butterflies, condors, and/or other similar strategies. In options literature, they are referred to as “income” strategies, because you’re trying to generate income in the absence of a big price move up or down. With no more questions on the table, I’ll end on this final note: If you’re interested in resources about options, one good book is called The Bible of Options Strategies by Guy Cohen. And in terms of Elliott wave and Elliott wave patterns, we have a number of resources at our website. We have online courses on all the different patterns, Fibonacci, individual stocks, and other technical indicators.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

40

EWI eBook

How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies Course 1: Vertical Spreads By Wayne Gorman, Senior Tutorial Instructor, Elliott Wave International

© 2009 Elliott Wave International

Published by New Classics Library

For information, address the publisher: New Classics Library Post Office Box 1618 Gainesville, Georgia 30503 US www.elliottwave.com ISBN: 978-0-932750-36-5

View more...
COURSE 1:

Vertical Spreads

EWI eBook

How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies Course 1: Vertical Spreads By Wayne Gorman, Elliott Wave International Chapter 1 — Bull Call Spread and Bear Put Spread Chapter 2 — Bull Call Ladder and Bear Put Ladder Chapter 3 — Ratio Call Spread and Ratio Put Spread Chapter 4 — Bear Call Ladder and Bull Put Ladder Chapter 5 — Call Ratio Backspread and Put Ratio Backspread Chapter 6 — Questions and Answers

Introduction This eBook introduces the standard textbook definitions of various options strategies and then explains how to apply them in the context of Elliott wave analysis, using real-world price charts. My name is Wayne Gorman, and I am Senior Tutorial Instructor at Elliott Wave International. I have over 25 years of experience using the Wave Principle in trading, forecasting, and portfolio management. Every point of discussion in this course falls under the umbrella of “vertical spreads.” These are option strategies that are either all calls or all puts, with the same expiration date. The term “vertical” implies a sharp price movement in either direction. (“Range-bound” vertical spread strategies apply to sideways price action and are not covered in this course.) For this course, I chose five different vertical spread strategies and paired them with their bullish and bearish counterparts. Before we get to the material, I’d like to make two important points. First, the intent of this course is not necessarily to recommend using one or more of these particular strategies. The purpose is to teach how to formulate and execute these strategies by using the Elliott Wave Principle. And second, I’m not going to try to show whether these strategies are better or worse than going outright long or short in futures or cash. We will just deal with these option strategies on their own and look at how the Wave Principle helps us in terms of setting strikes, establishing expirations and managing the strategy from start to finish. Editor’s note: This webinar was originally presented live on August 28, 2008.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

1

Chapter 1 — Bull Call Spread and Bear Put Spread

Chapter 1 Bull Call Spread and Bear Put Spread

1.

Bull Call Spread

Buy 1 ATM Call

Sell 1 OTM Call

Net Debit

Moderately Bullish

Relatively Longer-Term Strategy, 3 to 6 Months

Maximum Risk Capped at Net Debit

Maximum Reward Capped at Strike Difference - Net Debit

Breakeven: Long Call Strike Price + Net Debit

Figure 1 The first strategy that we will look at is the “bull call spread.” To start with, I’ll give the standard definition seen in most options books or websites, as underscored by the abstract above: A longer-term strategy that lasts three to six months, this spread involves buying an at-the-money (ATM) call, and selling an out-of-the-money (OTM) call, resulting in a net debit. Time is of the essence. Maximum risk is capped at the net debit, and maximum reward is capped at the difference in strikes less the net debit. We have one break-even level — the long call strike plus the net debit. As we go along, we may deviate from this ideal with respect to the time until expiration, based on Elliott wave analysis (of course, for positive reasons, not for negative ones).

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

2

Chapter 1 — Bull Call Spread and Bear Put Spread

2.

Bear Put Spread

Buy 1 ATM Put

Sell 1 OTM Put

Net Debit

Moderately Bearish

Relatively Longer-Term Strategy, 3 to 6 Months

Maximum Risk Capped at Net Debit

Maximum Reward Capped at Strike Difference - Net Debit

Breakeven: Long Put Strike Price - Net Debit

Figure 2 The bearish counterpart is the “bear put spread” — same type of structure, except this time you’re betting on a decline in prices. The thumbnail sketch above fills in the rest: Buy an at-the-money put and sell an out-ofthe-money put, resulting in a net debit. Maximum risk is capped at the net debit. And maximum reward is, again, equal to the difference in the two strikes less the net debit. The breakeven is the long put strike price less the net debit. There is one key consideration regarding these strategies — they involve limited moves. By selling the put or call at a strike that’s further out of the money, we technically give up certain profit potential. However, since we’re predicting that the move is limited, we’re not really giving up anything, all the while reducing cost.

Figure 3 Now, let’s look at these strategies from an Elliott wave perspective. This table features the optimal Elliott wave attributes for using the bull call spread and bear put spread — key word being “optimal.” You could use these Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

3

Chapter 1 — Bull Call Spread and Bear Put Spread

strategies in other situations; these scenarios simply provide an ideal context. The left-hand column names six categories of wave type. And the right-hand side, their corresponding characteristics. Before we get to an actual trade setup, we must first examine the list’s individual parts: wave function, position, structure, degree, entry point, and prior wave at next lower degree. Function: From an Elliott wave standpoint, vertical spreads are best suited for limited moves such as those associated with reactionary or countertrend moves. What does that mean in terms of wave position? This would be the second and fourth waves within an impulse wave; a B wave within a zigzag, a flat or a triangle; the D wave of a triangle; and the X wave in a double zigzag, triple zigzag, or double-three, triple-three combination. Again, why are these wave positions good for these strategies? They’re limited. These countertrend moves can go only so far. Wave two always retraces less than 100% of wave one. Wave four can never end in the price territory of wave one. A “B” wave in a zigzag can never go beyond the start of wave “A.” And wave “D” in a contracting triangle can’t go beyond the previous wave “B.” On your X wave, however, the limitations are in terms of guidelines, not rules: the B wave in a flat could go beyond the start of A, and in some combinations the X wave could go beyond the start of wave W or wave Y. The best structure for these strategies is a zigzag, because we’re looking for a sharp move. The ideal situation would be for the price of the underlying asset to go right to the strike price of the out-of-the-money call or put that we sold, right at the expiration date. But certainly, it’s better to have purchased more time than we need than to run out of time. Preferably, the zigzag would occur at a fairly low degree. Why do I say that? This is because we’re looking for relatively small moves here. We’ve limited our profit potential. We’ve limited our upside potential. It’s hard to put an exact wave label in terms of Minor, Minute or Primary, because those can vary. But at the extremes, we’re not looking for Cycle or Supercycle degree with these strategies. We want to enter these strategies early in the wave position. Again, time is of the essence. We’re buying basically at-the-money. We want to get in as soon as possible to take advantage of this move. Finally, you need evidence that strongly suggests the entry point will precede a turn. For example: Before you go into a wave two or four, it would be ideal to see the previous wave at one lesser degree (i.e. the final leg of the preceding wave one or three) unfold as an ending diagonal, a truncated fifth, or a fifth wave extension — all patterns that imply an immediate and swift reversal in trend. If you don’t see any of these game-changers in the previous wave at one lesser degree, then you have to spot some other indication of change. This could be a reversal on the weekly bar chart or a completed five waves in the fifth wave. Whatever the scenario, there should be some evidence of a trend change before you can enter into the position. The one rule that is essential to applying this strategy and all the others in this eBook is this: Always rely on Elliott wave rules and guidelines. Now it’s time to see an example of how to use these strategies on an actual price chart.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

4

Chapter 1 — Bull Call Spread and Bear Put Spread

Figure 4 This is a futures weekly continuation bar chart of the euro against the U.S. dollar from 2005 to 2008. I’ve labeled the chart starting from the November 18, 2005, weekly low at $1.1661. From there, I’ve counted completed Intermediate waves (1) and (2), and a partial Intermediate wave (3). Intermediate wave (3) subdivides into Minor waves 1 and 2 (in red) and Minor wave 3 (not labeled on chart) subdivides into Minute waves 6 through 9 (circled in brown). That leaves us with an open ticket into Minute wave 0, so let’s blow up that leg of the advance.

Figure 5 We’re going to start trading on April 23, 2008, the last bar on the daily chart. This will be our entry point.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

5

Chapter 1 — Bull Call Spread and Bear Put Spread

Figure 6 Now I’ve attached some wave labels, and you can see we have a decisive move up in Minuette waves (i), (ii), and (iii) (in blue). Within Minuette wave (iii), I’m counting Subminuette waves i through v (in red) as one probable scenario. This brings us to the exciting part: Subminuette wave v contains five overlapping waves (circled numbers) with a wedge shape, the classic trait of a fifth-wave ending diagonal. This is an exciting event, because fifth-wave diagonals qualify as one of the key patterns that signal a swift and sharp reversal ahead. And, according to Elliott wave guidelines, the reversal will end at least where the diagonal began. In this case, that area is marked by the start of Subminuette wave iv (in red). Figure 7 So, what are we looking for? A sharp albeit limited decline for Minuette wave (iv) back to at least the start of the diagonal, and maybe even further beyond that. What if we’re wrong? Are there other possibilities? Yes, the ending fifth-wave diagonal scenario may instead be waves A and B of some type of flat structure. Even so, in a flat, wave C should still come down to where wave B began — a similar target zone as the diagonal scenario. In either case, the larger implication is the same – a move down. The one difference is time. If an ending diagonal is at hand, the decline will be swift; if it’s a flat structure, the drop may take longer to unfold.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

6

Chapter 1 — Bull Call Spread and Bear Put Spread

Figure 8 Another way to determine how far wave (iv) may go is to look at the market from a Fibonacci retracement point of view. Keep in mind that fourth waves are normally shallow and make .382 retracements. You can see in Figure 8 that the .382 area lands at $1.5362, within winking distance of the level where the diagonal began — $1.5273. Pretty close. Of course, wave (iv) could go further, in which case I’ve also labeled the three common runner-ups for Fibonacci retracement levels: .500, .618, and .786. However, since fourth waves can never end in the price territory of first waves, we can eliminate the .786 scenario. Figure 9 On this chart, drawing a trend channel doesn’t help in terms of price, but it does offer us a guide in terms of time. Figure 9 calls attention to the fact that we’re looking for a move that could happen fairly soon. Therefore, we don’t have to go out too far with respect to option expiration dates. We don’t have to go out six months, or even three months, to realize the same move. Keep in mind, we want to maximize yield or return on capital. The less money we spend by being able to select a shorter time period for our expiration date, the greater our return on capital will be if we can still achieve the same move within that time period.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

7

Chapter 1 — Bull Call Spread and Bear Put Spread

Figure 10 Ideally, we’ll hit the nail on the head here. However, Elliott wave analysis is about probabilities, which are never accurate 100% of the time. So, the last thing we need to do is prepare for a Plan B exit strategy, in case we’re wrong and the euro goes up. In Figure 10, I use the Fibonacci guideline of expansion for fifth waves to determine where one should get out to salvage this trade. According to this guideline, one possible scenario is wave five will be equal to .618 times the net distance traveled of waves one through three. And that comes up to $1.6230. So, if prices do go the opposite way and we have a net debit, that’s the one level to keep in mind to unwind the trade and recover whatever we can in terms of premium. Figure 11 Another useful guideline of Fibonacci analysis states that wave four often divides an entire impulse wave into either the Golden Section or two equal parts. On the chart, you can see that there’s a Golden Section if Subminuette wave v (red) ends at $1.5840. (We’ve already gone past that level.) The 50% divider comes out to $1.6191. So, if we’re wrong, this offers another possible area for wave v to travel. In terms of unwinding these trades, we’ll look around that $1.6200 level to warrant getting out of these positions.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

8

Chapter 1 — Bull Call Spread and Bear Put Spread

Figure 12 So, now that we have all the pieces in place, let’s examine the big picture. We’re going to do a bear put spread on April 23 (recall Figure 5). On that day, the price high was $1.5964, the low $1.5826, and the close $1.5854. Please Note: All of the option prices that I’m showing are closes. On our entry point of April 23, we’re buying an at-the-money June $1.5850 put at .0228. The June puts expire on June 6th, so we’re keeping this short, just about a month and a half. Next, we’re going to sell an out-ofthe-money June $1.5250 put at .0054. And why did I pick $1.5250? That’s our previously determined target from Figure 8, which is close to where the diagonal began at $1.5273. So, we’re going to look for a move to that level over the next month and a half. We end up with a net debit of 174 points, so our maximum risk is .0174; our maximum reward is .0426; and our breakeven comes out to $1.5676. I’m also showing the implied volatility at the time on the front contract — June. I’m not going to get into any analysis on implied volatility in this particular course. This is purely a directional price movement strategy. To review: We’re going to look to unwind the trade when we get to $1.5273 and, hopefully, that’ll happen right at expiration. If things go the other way, we’re going to look to get out and salvage something at $1.6235, based on those Fibonacci calculations for wave five. Figure 13 In Figure 13, we flash forward to see how the trade unfolded. The fifth-wave ending diagonal did indeed deliver a swift reversal (recall Figure 6). And, as you can see, we reached our target of $1.5273 on May 8th. From a risk point of view, there is no reason to stay in this position so we’re going to unwind the trade and close out on May 8th. We’ll sell the June $1.5850 puts at .0508; we’ll buy back the $1.5250 puts at .0123. We get a net credit of 385 points and a net profit of 211 points. Implied volatility did not change much — it was 10.3% (versus 10.6% on Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

9

Chapter 1 — Bull Call Spread and Bear Put Spread

April 23), so that worked in our favor. The “secret” to the trade’s success was its adherence to the ideal wave characteristics of a bear put spread strategy as identified in Figure 3. It was a countertrend move in a fourth wave of low degree (Minuette). We entered early. And, most importantly, the key to setting up everything was identifying that we had a fifth-wave ending diagonal in the prior wave at the next lower degree. As we know, this pattern implies a dramatic reversal ahead. Figure 14 So, we got out on May 8th, but the contract didn’t expire until June 6th. In Figure 14, you can see that our choice to exit early was the right one in order to satisfy the risk/reward ratio. We made a slight new high in Minuette wave (v) at $1.5988. (The previous high in Minuette wave (iii) was $1.5985.) This move unfolded as another fifth-wave ending diagonal, which, sure enough, was followed by a swift and sharp reversal to the downside.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

10

Chapter 2 Bull Call Ladder and Bear Put Ladder

1.

Bull Call Ladder (Long Call Ladder)

Buy 1 ATM Call

Sell 1 OTM Call

Sell 1 Further OTM Call

Net Debit

Moderately Bullish

Relatively Shorter-Term Strategy, 1 Month

Maximum Risk is Uncapped

Maximum Reward Capped at Middle Strike - Lower Strike - Net Debit

Breakeven: Long Strike + Net Debit

Breakeven: Total of Short Strikes - Long Strike - Net Debit

Figure 15 The next strategy is the “bull call ladder,” sometimes referred to as the long call ladder. (And of course its counterpart, the “bear put ladder.”) Figure 15 lists the major aspects of this strategy: We buy an at-the-money call (or an in-the-money call), sell an out-of-the-money call, and sell a further out-of-the-money call. This is a moderately bullish, short-term (about one month) approach that produces a net debit. Maximum risk is uncapped. We have an uncovered option with the further OTM short call. The maximum reward that we can make is the difference between the middle strike and the lower strike, less the net debit. And, we have two breakevens: The long strike plus the net debit, and then, the total of the short strikes minus the long strike minus the net debit. Initially, as prices rise, we’ll break even just by moving up to cover the net debit. Of course, our maximum profit will be at the first OTM short call strike, and we come up to our next breakeven after the second OTM short call strike, after which point we begin to lose money. I want to say a few things about uncapped risk, because there are two pairs of strategies in this course that have uncapped risk: the bull call ladder and bear put ladder, and the ratio call spread and ratio put spread. This is not academic. This is real and true. In options, the notion of a “stop loss” is not as safe as it is with futures. If you want to exit a position at a certain level, either where the price of the underlying asset is trading or at a certain premium, you can put an order into a broker. However, there’s no guarantee that you’re going to get out on a dime. As a matter of fact, if it’s a fast-moving market, you may not even get a quote in options. And so, I’m not going to use the term “stop-loss order” with options because it’s misleading. It implies that you can achieve some type of immediate liquidation at a specific price point, but you really can’t. Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

11

Chapter 2 — Bull Call Ladder and Bear Put Ladder

On paper, this strategy is akin to an extension of the bull call spread. We’re getting a little bit more income on the second short call, and we’re creating a second higher breakeven for ourselves. We’re also keeping the strategy short-term, because with uncapped risk we don’t want to allow for too much time. And, of course, with the bear put ladder, we have the same type of structure except that we’re betting on prices to decline (see Figure 16)

2.

Bear Put Ladder (Long Put Ladder)

Buy 1 ATM Put

Sell 1 OTM Put

Sell 1 Further OTM Put

Net Debit

Moderately Bearish

Relatively Shorter-Term Strategy, 1 Month

Maximum Risk Uncapped

Maximum Reward Capped at Higher Strike - Middle Strike - Net Debit

Breakeven: Long Strike Price - Net Debit

Breakeven: Total of Short Strikes - Long Strike - Net Debit

Figure 16

Figure 17 So, what are the optimal Elliott wave characteristics for a bull call ladder and a bear put ladder? Well, again, we’re talking about a countertrend move. We have limited profit potential, and, of course, we have uncapped risk. Wave position is exactly the same as the previous pair of structures: Waves 2, 4, B, D, and X, and we’re Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

12

Chapter 2 — Bull Call Ladder and Bear Put Ladder

looking for a zigzag. We want to get this over quickly and get out. We want a sharp move. We want to enter in the middle stages of those wave positions, either Wave C of 2 or Wave Y of 2, for example, because we don’t have much time to work with. And of course, the pièce de résistance — a provocative wave prior at next lower degree: i.e. an ending diagonal, truncated fifth or fifth-wave extension that will lead to a swift and sharp reversal. The final point can’t be overstated: “Always rely on Elliott wave rules and guidelines.” In particular, wave 2 always retraces less than 100% of wave 1; wave 4 can never end in the price territory of wave 1; and wave B of a zigzag can never go beyond the start of wave A. Once more, I’m not necessarily recommending that you all go out and use this strategy. It’s a strategy that some people employ. But if you’re going to go there, you might as well know how to improve it by using Elliott wave analysis. Figure 18 Now, let’s look at an example. Figure 18 is an Elliott wave-labeled chart of the NASDAQ 100 from October 2007 to March 2008. As you can see, we have completed Minor waves 1, 2, 3, 4, and 5 (red) of Intermediate wave (1) (blue). Within Minor wave 5, we see a familiar formation: a fifth-wave ending diagonal (the same pattern we saw in Figure 4 of the euro/U.S. dollar). As we already learned, ending diagonals are one of three patterns that precede a dramatic reversal. The other significant development is a gap up from March 17th to March 18th, after the culmination of the ending diagonal. If we were doing an outright long futures trade, this area (in and around March 17) would represent the most promising entry point. Keep in mind, however, that during this part of the lesson, we are not going to simulate all trading possibilities. We’ll wait until we reach the proper juncture to do a bull call ladder or bear put ladder. Based on what we know about ending diagonals, the next likely move will be up and sharp. The option strategy of choice is a bull call spread; this time, in the opposite direction of what we did on the euro. And the outside target is where the diagonal began, which is at 1,876.75, the end of Minor wave 4. Let’s see what happens.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

13

Chapter 2 — Bull Call Ladder and Bear Put Ladder

Figure 19 Figure 19 shows that we did, in fact, make a swift reversal back to (and even beyond) where the diagonal began. The move unfolded as Minute waves 6 through 0 of Minor wave A (red) of Intermediate wave (2) (blue). Had we done a bull call spread, the trade would have been a success. Assume that we got the move, did the bull call spread and we got out. Now what? Unless our wave count is totally wrong, Intermediate wave (2) is now under way. We have a countertrend move of small degree. We know that wave 2 always retraces less than 100% of wave 1, which would help to deal with uncapped risk situations. Ultimately, the setup is ideal for a bull call ladder. We want to earn some premium on the uncovered short call, but we also want a good amount of distance between our entry point and the second breakeven. Hopefully, in this case, our upper limit or breakeven will be in the area where wave (2) can never go. If we enter the bull call ladder too low relative to the expected move, our second breakeven will be within range of wave (2), and we could lose money. If we sold an out-ofthe-money call much further up to avoid losing money, we wouldn’t get much premium for it at all. We have to find a compromise between these two objectives. So, we have to do the bull call ladder at least in the middle of the anticipated upward price move. The anticipation is, of course, for a Minor wave B down followed by Minor wave C up. Figure 20 Figure 20 shows that Minor wave A within wave (2) has retraced .382 of Intermediate wave (1) at 1,894 (the exact .382 level was 1,893.25). This is important, because second waves do NOT make shallow retracements. They generally carve out much deeper ground, such as .500, .618, .786 and so on, as high as possible while staying below the start of wave one. So we’re going to plan for the C wave within wave (2), and we’re going to look for a much deeper retracement. I’ve added a Fibonacci table to the chart to identify the potential upside targets for Minor wave C. So, let’s move ahead. Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

14

Chapter 2 — Bull Call Ladder and Bear Put Ladder

Figure 21 I’ve labeled the ensuing price action Minor wave B. It made about a 50% retracement of wave A. We’ve also gapped up, which could be the start of wave C. But, we need to be certain. There are a couple of guidelines we can use here to lead us forward. First, Minor waves A and B look to be forming a zigzag; this is a simple three-wave pattern labeled a-b-c in which the subdivisions are 5-3-5. And, in a zigzag, the most common relationship for wave C is that wave C equals wave A. Another guideline is that wave C may also equal 1.618 times wave A. In this case, Minor wave C equals Minor wave A at 2,006.50. The .618 is 2,032 — very close. Minor wave C equals 1.618 times wave A at 2,145.50. So, we will eliminate the higher Fibonacci retracement level of .786 (at 2,130.50) and 1.618 times the length of wave A (at 2,145) and turn our eyes down to the 2,000-2,032 area for a likely target, because we have a Fibonacci cluster there. Figure 22 Based on our analysis, we’re going to do a bull call ladder on April 16, 2008. Remember that I am using “closing” option prices specifically. On April 16, the futures price closed at 1,862.50. So, we’re going to buy a slightly in-the-money June 1850 call at 84 points. We’re going to sell an out-of-the-money June 2010 call at 18.50 points — right around the area where Minor wave C equals A, and close to the .618 retracement level. This is where we expect wave (2) to end. The June contract expires on June 20, 2008. As you can see in Figure 22, there is also a short out-of-the-money June 2050 call at 11 points. The purpose of this second short call is to produce more income with manageable risk. The result is a second breakeven that is beyond the .786 retracement of 2,130.50. (.786 is about the maximum retracement for second waves, but it is possible for second waves to Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

15

Chapter 2 — Bull Call Ladder and Bear Put Ladder

experience a 99% retracement.) So, the goal is to get a decent amount of premium that reduces the net debit, and create a high second breakeven level that provides a cushion against that uncovered short call, in case prices go past the 2,050 area where we’re exposed. I have a net debit of 54.50 points. My maximum risk is still uncapped: Maximum risk on a down move is 54.50 points, on an up move it’s uncapped, and maximum reward is 105.50 points. The lower breakeven is 1,904.50. The upper breakeven is 2,155.50, which is based on the gain the strategy would make — between the buy call and first sell call — as prices move up, less the net debit. That breakeven is also beyond the .786 retracement of 2,130.50, an area where wave (2) is unlikely to go. Ideally, if it’s a fast-moving market and prices abruptly skyrocket or plunge, I would call my broker to exit at 2,010 or unwind at 1,780. But, if he can’t get me out, I still know that after 2,010, there are 145 more points of upward movement before the market reaches 2,155 — and that’s just breakeven. A move below 1,781.50, the low of Minor wave B, would negate the wave count, and I would look to close out the position. Footnote: I selected these particular strikes based on the Elliott wave analysis and the market premiums that were available. In the end, after doing several calculations, they were the best I could do for this trade. Implied volatility is 24.6%. Figure 23 In Figure 23, you can see that we did indeed move up in what looks like Minor wave C. And, on May 13, we hit our objective of 2,010. So, what do we do now? That’s easy: We get out. There is no other reason to stay in this trade anymore. It’s a high-risk trade, and when you read the options literature, you’ll probably see a number of people who aren’t in favor of this type of strategy. Assuming we can get out and it’s not a fast-moving market, we close on May 13. These are the prices: I sold the June 1850 calls at 168.50 points and bought back the other June calls — one strike at 50.75 points and the other at 31.25 points. We had a net credit of 86.50. The implied volatility was 20.4%. And we had a net profit of 32.00 points, producing a return on investment of 59 percent. As always, the question remains: Did we capitalize on the opportunity at hand? The next chart has the answer.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

16

Chapter 2 — Bull Call Ladder and Bear Put Ladder

Figure 24 Minor wave C of Intermediate wave (2) finally peaked at 2,062.75, very near the previously cited .618 level of 2,032 and then prices turned down. So, as others in the trading world might say to us, “You got lucky on that one.” However, we know that along with a little luck, we also had some good Elliott wave analysis to help us.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

17

Chapter 3 Ratio Call Spread and Ratio Put Spread 1.

Ratio Call Spread

Buy 1 ITM Call

Sell 2 OTM Calls (Same Strike)

Net Credit or Debit

Neutral to Moderately Bullish

Relatively Shorter-Term Strategy, 1 Month

Maximum Risk is Uncapped

Maximum Reward Capped at Difference in Strikes + / - Net Premium

Breakeven: Long Call Strike + Net Debit or - Net Credit

Breakeven: Short Call Strike + Maximum Reward / No. of Uncovered Calls

Figure 25

2.

Ratio Put Spread

Buy 1 ITM Put

Sell 2 OTM Puts (Same Strike)

Net Credit or Debit

Neutral to Moderately Bearish

Relatively Shorter-Term Strategy, 1 Month

Maximum Risk Uncapped

Maximum Reward Capped at Difference in Strikes + / - Net Premium

Breakeven: Long Put Price - Net Debit or + Net Credit

Breakeven: Short Put Strike - Maximum Reward / No. of Uncovered Puts

Figure 26 Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

18

Chapter 3 — Ratio Call Spread and Ratio Put Spread

The third pair of strategies is the “ratio call spread” and the “ratio put spread” — similar to the bull call ladder, bear put ladder pair. With a ratio call spread, you’re buying an in-the-money (ITM) call and you’re selling two out-of-the-money calls at the same strike. You may have a net credit or debit. Your market outlook is neutral to moderately bullish and short-term, about one month. The ratio put spread has the same overall structure, but you use puts instead of calls, because you would be neutral to moderately bearish. Now, let’s talk about risk. I can’t stress the level of exposure here enough. Maximum risk is uncapped. However, your short strikes are closer to the money than the short strikes of the bull call ladder and bear put ladder, which had the short strikes spread out. In other words, the out-of-the-money puts and calls are more vulnerable, and your uncapped risk is more severe.

Figure 27 I’m not going to go through a trading strategy on these, but if one were to use them, it’s of great value to know the “optimal” Elliott wave characteristics. Figure 27 provides a complete list of these. Function: Clearly countertrend and at the next two higher degrees, at least, because you have significant uncapped risk. In other words, not just wave two of an impulse wave. You would, for example, do this in a wave two of a wave three so that even the next two degrees are moving in the direction of the main trend. Since you’re heavily betting on a countertrend move, this buys you more insurance against the countertrend move somehow morphing into a main trend move. Position: Only waves two or four. Structure: Zigzag. Degree: Relatively low. Entry Point: The latter stages of the wave position; i.e. wave three of C of wave 2. Prior at the next lower degree: The same as always: An ending diagonal, truncated fifth wave, fifth-wave extension, etc. I would rely on rules only for second and fourth waves, due to the uncapped risks. Those are: Wave 2 always retraces less than 100% of wave 1, and the end of wave 4 can never enter the price territory of wave 1.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

19

Chapter 3 — Ratio Call Spread and Ratio Put Spread

Figure 28 Ultimately, the ratio call/put spreads are most likely for those traders who just can’t stay out of the market — they always have to do something. Whether the high level of risk is worth it is best visualized in this chart of the NASDAQ 100. Look familiar? Well, this is Figure 21 from the previous bull call ladder section. Remember that we were able to create a breakeven rate that was way up there, almost as far as wave two could go. With the ratio spreads, though, you want to get in almost near the end so that you can push the breakeven up even further to protect yourself.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

20

Chapter 4 Bear Call Ladder and Bull Put Ladder 1.

Bear Call Ladder (Short Call Ladder)

Sell 1 ATM Call

Buy 1 OTM Call

Buy 1 Further OTM Call

Net Credit

Bullish

Relatively Longer-Term Strategy, 3 to 6 Months

Maximum Risk Capped at Difference of First Two Strikes - Net Credit

Maximum Reward Uncapped

Breakeven: Short Call Strike + Net Credit

Breakeven: Higher Long Call Strike + Maximum Risk Amount

Figure 29 Up next: The “bear call ladder,” also known as a “short call ladder.” In options literature, people may categorize this strategy as somewhat ambiguous and confusing. Are you bullish? Are you bearish? You’re selling an at-themoney call, but you’re also buying two different out-of-the-money calls. What’s going on? Well, the really interesting thing is that this strategy fits Elliott wave like a glove. The reason being: Wave patterns are often ambiguous and warrant an alternate labeling. The alternate wave count may be telling you to lean in the opposite direction, and that’s where this strategy helps. First, we’ll go over the basics as they appear in Figure 29. The bear call ladder is bullish. It’s a relatively longerterm strategy — about three to six months. You should be able to squeeze out a net credit on this. You sell an in-the-money or at-the-money call, buy an out-of-the-money (OTM) call and buy a further out-of-the-money (OTM) call. Your maximum risk is capped; it’s the difference of the first two strikes minus the net credit. Notice, maximum reward is uncapped — this is the biggest contrast with the bull call spread. It’s also going to make a big difference in what kind of wave positions we choose. We have two breakevens: the short call strike plus the net credit, and the higher long call strike plus the maximum risk amount (in the area beyond the further OTM call). In a nutshell, we’re betting on a big move up. Our bias is in the direction of the main trend. Either way, though, we have some protection if prices move down or sideways. We only get hurt if prices go in the direction of the main trend but only for a small move. In other words, we’re sacrificing a small up move in exchange for a big up move, a sideways move or a down move. Not a bad deal, but you have to be able to structure the trade so that it generates a net credit. Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

21

Chapter 4 — Bear Call Ladder and Bull Put Ladder

2.

Bull Put Ladder (Short Put Ladder)

Sell 1 ATM Put

Buy 1 OTM Put

Buy 1 Further OTM Put

Net Credit

Bearish

Relatively Longerter-Term Strategy, 3 to 6 Months

Maximum Risk Capped at Difference of First Two Strikes - Net Credit

Maximum Reward Uncapped

Breakeven: Short Put Strike - Net Credit

Breakeven: Lower Long Put Strike - Maximum Risk Amount

Figure 30 Figure 30 shows the same details for the bull put ladder, also known as the short put ladder. Again, it’s the same structure except now you’re betting on prices to fall. So, you’re selling an at-the-money or in-the-money (ITM) put, buying an out-of-the-money put, buying one further out-of-the-money put, and generating a net credit.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

22

Chapter 4 — Bear Call Ladder and Bull Put Ladder

Figure 31 Now it’s time to reveal the ideal Elliott wave context in which to implement this particular strategy. Function: The three strategies up to this point have all required short, sudden countertrend moves. Here, however, we’re talking about actionary waves, which are those that move in the direction of the main trend. Position: Impulse waves — waves one, three, and five — are the strongest types of waves. Within those, waves three and five are highly preferable, as they are prime breeding grounds for extensions. Wave one can be extended, but it’s not common. The other factor against using this strategy for wave one is that wave one occurs right at a turning point. You may not be sure whether you’ve really turned or are still in a countertrend move. Degree: Of course, is high. Don’t get hung up on the actual degree labels — it’s basically a big move. Entry Point: For waves three and five, after a shallow wave two or four due to the possibility of a flat. The only time you should use this for wave one is after a key reversal, if ever. The truth is, you normally are not going to get the huge move in wave one that you get in waves three and five. It’s important to understand why this strategy is so suitable to Elliott wave analysis. Often when a move is relatively small or drawn out for a long period of time, it’s difficult to gauge its end. For example: How do you know when a shallow wave two is over and thus marking the start of a powerful third wave, or whether it’s unfolding as an expanded flat? Maybe a triangle in wave 4 has ended, but you’re not sure because prices continue to move sideways. So, around every corner of ambiguity, this strategy lies in wait. The wave prior at the next lower degree is the same as previous strategies.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

23

Chapter 4 — Bear Call Ladder and Bull Put Ladder

Figure 32 Let’s go through a trading scenario where we use one of these strategies in a situation of ambiguity. This is an Elliott wave-labeled weekly continuation bar chart of heating oil. Let’s count up from the 2007 low: we have Minor waves 1 and 2 (red), a big extended 3, and now maybe 4. Keep in mind, heating oil is a commodity. We know that in commodities the fifth wave is often extended. We already have an extended third, so chances are we won’t get a repeat performance in the fifth — but we could. That small possibility is enough to move us forward. The chief question to answer is whether wave four has ended. Maybe the small rise from Minor wave 4 is part of an expanded flat and we come back down. Or, maybe we’re going to skyrocket up in wave five. The first step into figuring that out is to look at the retracement made by Minor wave 4. Figure 33 Figure 33 overlays a Fibonacci retracement table to the chart of heating oil. As you can see, wave 4 has made a .236 retracement of wave three. That is acceptable, albeit shallow. Far more common to fourth waves is a .382 retracement of wave three. But again, .236 is still adequate.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

24

Chapter 4 — Bear Call Ladder and Bull Put Ladder

Figure 34 The next order of business is to assess where we could go in Minor wave 5. In Figure 34, I’ve calculated two common Fibonacci projection points by multiplying the net distance traveled of waves 1 through 3 by .382 and .618. We get 3.5247 and 3.9421, respectively.

Figure 35 Those are possible targets for wave five. Another thing we can do is use the Fibonacci dividers that we discussed early on in section one (bull call spread/ bear put spread) and illustrated in Figure 11. To reiterate: Wave four often divides the entire impulse wave into either the Golden Section or two equal parts. The chart above identifies those two areas in the case of heating oil. The Golden Section would bring wave 5 to 3.7116, and two equal parts would bring wave 5 to 4.2448. This handy guideline gives us two more targets for this particular strategy.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

25

Chapter 4 — Bear Call Ladder and Bull Put Ladder

Figure 36 What about time? Here again we can use Fibonacci analysis to estimate when wave 5 will end. As a guideline, wave five can equal the time it took to finish waves one through three multiplied by .382, .5, or .618. In Figure 36, you can see where these dates fall into the future on the weekly bar chart. Our entry point is April 11, 2008, so in sequential order .382 comes out to the week ending September 12, 2008; .5 comes out to the week ending October 31, 2008; and .618 comes out to the week ending December 19, 2008. So, now we have a reasonable time reference.

Figure 37 With price and time targets in place, we can now set the wheels of this trade strategy in motion. We’re going to do a bear call ladder on April 11th. In Figure 37, the daily chart of heating oil is blown up to magnify the price point of interest — the up leg rising out of Minor wave 4. Make no mistake, this move is unclear. The initial drop could just be wave A of 4, making the rise wave B (leading to a drop in wave C). Maybe we get lucky and we skyrocket in wave 5. Or, the way we lose the most, wave 5 barely bounces. This is the chance we take. So, let’s get to the numbers. I’ve sold the September 300 calls at 31.40. On April 11th, the high was 3.2376 and the low was 3.1557. If you’re confused by the “300” calls, don’t be. The puts and calls that I’m dealing on are quoted based on the price (on the right side of the chart) times 100. For example, 3.00 would be quoted as 300 (3.00 times 100). That’s how these options are quoted, so from this point forward I’ll refer to the prices in the same manner. The September op-

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

26

Chapter 4 — Bear Call Ladder and Bull Put Ladder

tions expire on August 26, 2008, close to the .382 time relationship. That gives us about five months, a suitable stretch of time since this is NOT a short-term strategy. Remember, we’re looking for a big move at a relatively high degree. The 300 calls were in-the-money. We were trading around 315-323. I’m going to buy the out-ofthe-money September 330 calls at 18.11. If there is just a small up move, I will be giving up 30 points, but we knew we had to sacrifice a small move to implement this strategy. Then I’m buying further out-of-the-money September 350 calls at 12.68. Why 350? If you recall, we said that if wave 5 were .382 times waves 1 through 3, then it would go up to 352.47 (see Figure 34). We’re looking for wave 5 to go at least to 352, with the potential to go much higher. The maximum risk is capped at 29.39. The maximum reward is technically uncapped, but 395 is a good target, and at 395 we would make 15.61 points. Again, 395 comes directly from the analysis in Figure 34; wave five commonly equals .618 times the net distance traveled of waves one through three. That target came out to 394.21. Let’s sum it up. At minimum, we should get up to 352. The lower breakeven is 300.61. The higher breakeven is 379.39. The implied volatility is 35.85 percent. And, we’re doing this all on April 11th. If prices collapse past this wave 4, we have the net credit. We really don’t have to do anything. We could just walk away. So, let’s see what happened. Figure 38 In Figure 38, you can see that we did, indeed, get a big move up. This is now May 15, and we made a high of 372.28 the previous day — this is actually around the area where wave 5 would form the Golden Section. (Recall Figure 35 and the guideline of wave four as a Fibonacci divider.) We still haven’t gotten to 395, and it looks quite possible that wave five could extend. So, we can afford to hold onto this position for a little while longer. The next chart reveals whether the decision to stay in this trade and hold out for further gains was the right one.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

27

Chapter 4 — Bear Call Ladder and Bull Put Ladder

Figure 39 Yes, we skyrocketed up even further. The last bar on this chart, May 22nd, has a high at 401.53 and a low of 390.80, so we got to that 395 level. It’s time to unwind and get out. So, let’s see how we did. We bought back the September 300 calls at 102.45, sold the 330 calls at 74.74 and sold the 350 calls at 58.14. We earned a net credit of 30.43 points. The implied volatility was 40.49%, however that’s a bit misleading. That was still on the June contract, which had about two weeks to run. The September contract was really down to around 34% — so no major change there. Finally, this trade produced a net profit of 31.04 points. Figure 40 Bear in mind, the key to this strategy was not just the wave count. It was using Fibonacci analysis to give us an approximation of what we would expect. And, if we pan out a bit further, we can see how close our projection came to reality. Our exit day was May 22nd. On the chart in Figure 40, that date correlates to the peak of Minuette wave (iii) (blue) of Minor wave 5. After that, there was Minuette wave (iv) and (v), the latter of which unfolded as a fifthwave diagonal. As we have repeatedly learned from the first three sections of this course, fifth-wave diagonals precede dramatic reversals. And that’s exactly what occurred here.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

28

Chapter 5 Call Ratio Backspread and Put Ratio Backspread

1.

Call Ratio Backspread

Sell 1 ITM Call

Buy 2 OTM Calls (Same Strike)

Net Debit

Agressively Bullish

Relatively Longer-Term Strategy, 6 Months

Maximum Risk Capped at Difference of First Two Strikes + Net Debit

Maximum Reward Uncapped

Breakeven: Higher Long Call Strike + Maximum Risk Amount

Figure 41 The last strategy we will go over is the “call ratio backspread” and its bearish counterpart the “put ratio backspread.” These are like the previous strategies we looked at — the bear call ladder and the bull put ladder — only they are a lot more aggressive. Let’s go over the details for the call ratio backspread as shown in Figure 41. We’re selling one in-the-money (ITM) call, buying two out-of-the-money (OTM) calls, and we normally have a net debit. Unlike the bear call ladder, we’re buying these two OTM calls at the same strike, and it’s not that far out of the money. If you recall, in the ladder strategy we would buy one lower call and then a much higher call. The call ratio backspread is a relatively long-term strategy, about six months. Here, maximum risk is capped at the difference of the first two strikes plus the net debit. Maximum reward is technically uncapped. I say “technically” because nothing goes to infinity. If we assume a net debit, we just have one breakeven: the higher long call strike plus the maximum risk amount.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

29

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

2.

Put Ratio Backspread

Sell 1 ITM Put

Buy 2 OTM Puts (Same Strike)

Net Debit

Agressively Bearish

Relatively Longer-Term Strategy, 6 Months

Maximum Risk Capped at Difference of First Two Strikes + Net Debit

Maximum Reward Uncapped

Breakeven: Lower Long Put Strike + Maximum Risk Amount

Figure 42 Figure 42 covers its counterpart on the bear side: — the “put ratio backspread.” Again, it’s the same type of structure as the “ladders,” only much more aggressive.

Figure 43 Now let’s look at the optimal Elliott wave characteristics. Function: Clearly actionary, in the direction of the main trend. We don’t have a net credit on this; just a net expense or debit. Position: Looking for an impulse, i.e. third or fifth wave and, hopefully, an extension. Degree: High. We want a big move. Entry Point: This is another interesting difference from the “ladder” strategies. We’re not looking for shallow twos or shallow fours anymore. We’re looking for a deep wave two or relatively deep wave four, so we can position ourselves Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

30

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

aggressively. We do not want ambiguity. We want clarity and confidence. Nothing is 100% airtight, but we want the signs to strongly suggest that we’re going into a third wave or fifth wave. Maybe we’ve just completed an expanded flat or we’re right at the final E wave of a triangle before going into the next impulse wave. Perhaps we’re ending a series of overlapping ones and twos. The point is that ALL of these scenarios, when they involve ensuing third or fifth waves, can lead to extensions. And, an extension is exactly what we want here. As always, you will look for three types of structures in the wave prior at next lower degree: ending diagonals, truncated fifths, fifth-wave extensions, or other equally compelling evidence of a reversal. Figure 44 So, let’s look at the last trading scenario. This is an Elliott wave-labeled weekly continuation bar chart of natural gas. We’re going to start trading in the week ending March 28, 2008. As you can see, our interpretation is that a contracting triangle [Minor waves A, B, C, D, E (red)] ended forming Intermediate wave (X). From there, we started what appears to be an impulse for Minute waves 6, 7, 8, and 9 (blue). Figure 45 Figure 45 displays a Fibonacci expansion to show the possibilities for wave 0 (not shown on chart) after a deep retracement in Minute wave 9. Remember, a relatively shallow fourth wave is a deal breaker for using the call ratio backspread strategy, since it’s an indication the fourth wave may not be over. We don’t want ambiguity. We want a big move quickly, and there are compelling reasons to believe a big move is exactly what we’re going to get soon. First, there is a deep completed fourth wave as opposed to a more drawn out expanded flat in wave four. Also, natural gas is a commodity, and fifth waves are often extended in commodities. We haven’t had an extension up to this point (waves 6 and 8 are short), so we are definitely due for one. Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

31

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

The next thing to look at is how far this Minute wave 0 could go. Well, as we learned in the previous section, wave five often equals the net distance traveled of waves one through three multiplied by .382 or .618. The .382 level comes to 9.984. As you can see in Figure 46, which shows action up to the week ending March 28, 2008, we’ve already gone above 10.000. The high a couple of weeks earlier was 10.294, thus the .382 is not going to work. So, we can rightfully expect wave 0 to at least equal .618 times the net distance traveled of waves one through three. That comes out to 10.800. If wave 0 is extended, it should equal 1.618 times the net distance traveled of waves one through three, or 14.256. So, note those points: 10.800 at minimum and 14.256 as a possible extension. Figure 46 If we want to amass a few more targets for Minute wave 0, we can always consult another familiar Fibonacci guideline for fourth waves. This states that the beginning (or end) of wave four often divides the entire price range of waves one through five into the Golden Section or two equal parts. As you can see in Figure 46, the former area comes to 12.43 for the end of wave 0, and the latter to 13.75. Seeing that 13.75 is relatively close to 14.256, we’re going to keep those two levels in mind as possible termination points for Minute wave 0. Figure 47 Now, what about time? This is a Fibonacci time zone chart. Our starting point is the beginning of Minute wave 6. From there, we see each Fibonacci number of weeks: 2, 3, 5, 8, 13, 21, 34, and 55. We know we’re going to have to go further out on our expiration, probably around six months from our exact trading date, which is March 27, 2008. So, somewhere between 34 weeks (August 15, 2008) and 55 weeks (January 9, 2009) seems like a reasonable target.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

32

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 48 Again, we can use the Fibonacci guideline for fourth waves acting as dividers to accrue a few more objectives in regard to time. This chart shows that if Minute wave 0 ends on August 1, 2008, the end of Minute wave 9 will have divided the entire time duration of waves 6 through 0 into the Golden Section, i.e., .382 for the amount of time to the end of wave 9 and .618 for the remaining amount of time to the end of wave 0. We had August 15th in the previous time chart, so it looks like we’re going to need at least until August in terms of our expiration date. Figure 49 Before we start the trade, we need to prepare for a plan B exit strategy in case prices fall. If we’re wrong, we would look to unwind to try and salvage something in terms of premium. As we can see in Figure 49, Minute wave 9 made a deep retracement of Minute wave 8 at 8.664 — near the .618 level of 8.610. We know that wave four cannot end in the price territory of wave one and that the top of wave 6 came to 8.481. So in terms of unwinding the trade, we’ll look at those levels.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

33

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 50 Now that we have our price and time objectives for wave 0 and a wellbuilt exit strategy, we can confidently begin the trade. The last daily bar in Figure 50 falls on March 27, 2008, where the market traded from 9.645 to 9.346. So, we’re going to do the call ratio backspread on that date. We’re going to use the September calls, which expire on August 26th. Ideally, we’ll unwind the trade at least a month prior to expiration, before our exposure to time decay accelerates. So, let’s get to the numbers. On March 27, sell one in-the-money September 9.00 call at a premium of 1.571, and buy two out-of-the-money September 9.500 calls at a premium of 1.310 per each call. Net debit is 1.049. (Risk note: each one point is $10,000 a contract.) Our maximum risk is 1.549. Maximum reward is uncapped, but if Minute wave 0 gets to 13.750, our reward would equal 2.701. Now, why did I pick these strikes and end up with this type of situation? The key is the breakeven point: 11.049. If you recall, we said that at a minimum wave 0 would equal .618 times the net distance traveled of waves one through three — at 10.800 (see Figure 45). What I was attempting to do here is structure the option trade so that I minimize the net debit and bring the breakeven as close to 10.800 as possible. Then, if we get the bigger wave or the extension, we’re going to be in profit territory. Implied volatility is 38.17%. And, as a target, we are looking at two main objectives: 13.75, where wave four divides the entire price range of waves one through five into two equal parts (see Figure 46), and 14.256, where an extended wave 0 equals 1.618 times the net distance traveled of waves one through three (see Figure 45). On the downside, we unwind at 8.480. Remember Figure 49 identified our exit point as the top of wave 6 at 8.481. So, I went one tick below that level to establish where we would get out.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

34

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 51 Let’s zoom ahead to see what happened. We did get a big move up. At this juncture, the high on the very last bar of the chart is 10.844. So, we have now achieved the 10.800 minimum established in Figure 45. But it looks like we have greater potential. Keep in mind that we’re looking for about 13.750 and on up to 14.256. So, we’re going to keep the position.

Figure 52 Again, we moved up even further. Now, the high so far is 11.794 — still not quite at our target. We’re going to stay in and ride this out.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

35

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 53 In Figure 53, I’ve labeled the upward progress from the March 20 low as Minuette waves (i), (ii), (iii), and (iv) (red). I’ve also drawn a trend channel to delineate how much higher Minuette wave (v) of Minute wave 0 could possibly go. Let’s follow the channel and see where it takes us.

Figure 54 There certainly was more “UP” to this uptrend. The high on this chart is 13.694, just six ticks away from the initial 13.750 target. From there, you’ll notice that we’ve come down, raising the question as to whether the wave 0 rally is over. We got close to 13.750, but certainly not the secondary target of 14.256. The objective thing to do is to wait and see if we break the lower part of the trend channel. If that occurs, it’s time to get out.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

36

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 55 Indeed, in Figure 55 you can see that prices penetrated the lower boundary of the trend channel. There is no longer any reason to hold onto this position. So, on this date, July 8, 2008, and at this price level (we reached a high of 12.970) we close out this call ratio backspread. In the lower right hand corner, you can see all the particulars of the close in green. The most important detail is that we have a net credit of 2.503 points and a net profit of 1.454 points. This is a great example of how the key to riding out a trade is not just in counting waves and sticking to your target. We also used the guideline of channeling and waited for a break of the trend channel before closing out our position. Of course, we would have done much better had we gotten out at the top of Minuette wave (v) (red) of Minute wave 0, but we waited to see if the market continued to extend. Figure 56 If you want to see what happened after that, Figure 56 shows that there was a swift and sharp decline. That was to be expected because the entire move from the March 20, 2008, low of Minute wave 9 was an extended fifth [Minuette waves (i) through (v) (red)]. And what do we have after an extended fifth? A dramatic reversal.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

37

Chapter 5 —Call Ratio Backspread and Put Ratio Backspread

Figure 57 To cap things off, here’s a quick reference guide to all five pairs of trading strategies covered in this course.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

38

Chapter 6 Questions and Answers Q. Why don’t you use a bull call spread for fifth-wave ending diagonals? Gorman: Although diagonals are, by definition, “actionary” waves, there is very little action actually going on. In fifth-wave diagonals, you probably don’t even know you’re in the pattern until you’ve seen waves one, two and three, or until you’ve had three consecutive zigzags that are slowly moving in the direction of the main trend. In other words, diagonals use up a lot of time to make relatively little progress. The best use you can make of a diagonal is to go for the next move after it ends. Remember: diagonals often precede dramatic reversals. Q. Are these strategies suitable for triangles? Gorman: No. All of the vertical spread strategies discussed in this course are for directional moves only: either up or down. Triangles are sideways patterns. Now, if it’s a certain wave within that triangle, then yes. As we know, triangles are made up of zigzags, and three of the structures we spoke of in this course are best suited for zigzags: bull call spread/bear put spread, bull call ladder/bear put ladder, and ratio call spread/ratio put spread. However, for triangles themselves, absolutely not. Q. Could you better explain the use of Fibonacci time relationships? Gorman: During this course, I concentrated on three main Fibonacci time relationships. They are as follows: 1. In terms of time, wave five will be equal to .618 times the net time duration of waves one through three. 2. Wave four — either the beginning of wave four or the end of wave four — will divide waves one through five into the Golden Section (.382, .618) or in half (two equal parts). 3. The entire time of waves one through five (in terms of trading days or weeks) will be a Fibonacci number; those are: 2, 3, 5, 8, 13, 21, 34, 55 and so on.... There are several sources in which you can find expansive material on Fibonacci time relationships. Right off the top are these references: Elliott Wave Principle — Key to Market Behavior by Frost and Prechter; Bob Prechter’s Beautiful Pictures; and the online trading course featured on our website, elliottwave.com, titled, “How to Spot Turning Points Using Fibonacci.” Q. How do you keep track of all of your alternate counts, and how many alternates will the analysis track? Gorman: You probably would have, at the most, two alternate counts. You have your main count and one alternate in case the main count does not materialize. I would say maybe one more after that. With all the charting systems that people have today, it’s not difficult to keep track of those counts. Also simplifying things is the easy access to annotation tools and the ability to save information.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

39

Chapter 6 —Questions and Answers

Q. In Chapter 5 on ratio backspreads, you predicted a fifth wave by using the movements of waves one through four. How did you do this? Gorman: First, let me say there are many Fibonacci relationships. If you like this type of analysis, I highly recommend Bob Prechter’s Beautiful Pictures. As for the matter at hand — I used the second Fibonacci time relationship as described in question number 4 above. To reiterate: the end of wave four will often divide waves one through five into either the Golden Section (.382 or .618) or in half (two equal parts). So when I was looking at the end of wave four, I was looking at how that would divide the entire sequence. I wasn’t multiplying one through four times some number. Q. What charting system do you use? Gorman: All of the charts in this course were made with Genesis FT. We also use CQG at Elliott Wave International. Q. Are there strategies you can use to trade expanded corrections? Gorman: Well, if it’s a correction and it’s expanded, the analogy is really the triangle or possibly a flat — a double-three flat. And those really are sideways or range-bound trades. These entail certain types of butterflies, condors, and/or other similar strategies. In options literature, they are referred to as “income” strategies, because you’re trying to generate income in the absence of a big price move up or down. With no more questions on the table, I’ll end on this final note: If you’re interested in resources about options, one good book is called The Bible of Options Strategies by Guy Cohen. And in terms of Elliott wave and Elliott wave patterns, we have a number of resources at our website. We have online courses on all the different patterns, Fibonacci, individual stocks, and other technical indicators.

Get intensive forecasts for the markets you follow in any region, any market, and on any time frame. Visit: http://www.elliottwave.com/wave/traderforecasts © 2009 Elliott Wave International

40

EWI eBook

How to Use the Elliott Wave Principle to Improve Your Options Trading Strategies Course 1: Vertical Spreads By Wayne Gorman, Senior Tutorial Instructor, Elliott Wave International

© 2009 Elliott Wave International

Published by New Classics Library

For information, address the publisher: New Classics Library Post Office Box 1618 Gainesville, Georgia 30503 US www.elliottwave.com ISBN: 978-0-932750-36-5

Thank you for interesting in our services. We are a non-profit group that run this website to share documents. We need your help to maintenance this website.