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

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 in- volve 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 sce- nario. This is an Elliott wave-labeled weekly continuation bar chart of natu- ral 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 ex- pansion 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 go- ing 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.

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 Fi- bonacci 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 expira- tion, 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 reason- able target.

Figure 48

Again, we can use the Fibonacci guide- line for fourth waves acting as divid- ers 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 expira- tion 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 sal- vage 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 ter- ritory 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.

Figure 50

Now that we have our price and time objectives for wave 0 and a well- built 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.

Figure 51

Let’s zoom ahead to see what hap- pened. 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.

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 pos- sibly 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.

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 impor- tant 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.

Figure 57

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

Chapter 6