Tuesday, April 20, 2010

The Sling Shot

Recently I’ve been playing around with a directional strategy, informally dubbed the sling shot, that I was introduced to by one of my trading colleagues. It’s a neat little strategy which incorporates some of the adjustment techniques introduced in Adjustment Thinking and the Salvation Syndrome as well as Adjusting in Action: Long Call to Call Spreads and can be used for those with a knack for forecasting price direction. In an attempt to exploit the bullish retracement in oil last week (as highlighted in Crude Retracement ), I entered a sling shot on the United States Oil Fund (USO).

The structure of the trade involves simultaneously purchasing shares of stock and OTM call(s). Typically you unload the shares after achieving a 1 ATR profit. Ideally this 1 ATR profit pays for most, if not all, of the cost of the call options. In other words, we’re using the profit from the stock portion of the trade to finance the purchase of the call options. Upon selling the shares of stock you could either remain long the calls or roll them into a spread to further reduce your risk. Let’s take a look at the play in action using USO.

On April 13th, I purchase 100 shares of stock for $40.70 and 2 May 43 calls for $.55 apiece (click image to enlarge).

After rising around $1 (a little over 1 ATR) over the next day and a half, I sold the stock for a $100 profit. This $100 profit paid for all but $10 of the cost of the long 43 call options, which took the risk from virtually unlimited (due to the long stock) down to $10. Though I didn’t lock in any gains, the adjustment succeeded in lowering the overall position cost and reducing risk.

If I was aggressively bullish on USO I could have simply remained in the long call options. However, given that I wasn’t that bullish I instead opted to roll the long calls into a call spread by selling the May 45 call options for $.40 apiece. By receiving an additional $40 of premium, My $10 of risk remaining in the trade turned into a minimum reward of $30. This time the adjustment did lock in gains.

Though USO has since dropped back in price resulting in giving back some of the unrealized gains, my original risk capital has been taken off the table. The crux of the trade as I see it is getting the first ATR move in your favor. Once you’ve locked in the profit on the stock, the risk-reward payoff as outlined in the risk graph improves dramatically. Going forward I’ll periodically come back to the sling shot to shed further insight.