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Applying Options to the Darvas Box Theory

In addition to the basic call option, I believe the following three options strategies are good alternatives:

  • Bull Call Spread
  • Calendar Spread
  • Straddle

Bull Call Spread

A bull call spread is a vertical spread entered using two call options, one with a lower strike (the long option) and one with a higher strike (the short option). The idea is to capture the full amount between the two strikes (that's the most you can hope to earn). The advantage that it costs less than a basic call option, but the upside potential is capped. This spread strategy is a good choice if you believe the stock is not likely to rise much more beyond the upper strike. Such a scenario might occur if the market is somewhat choppy (for example as it was for the second half of 2007).


Calendar Spread

A calendar spread as it applies to the Darvas box theory is an interesting beast. In general, one uses a calendar spread if one believes the stock will be moving within some well defined range for some period of time. Therefore, you would think that a calendar spread would be better used during box formation rather than the breakout. I suppose this is true, except that a priori there's no way to know that the box formation will take any amount of time at all.

One can use the calendar spread to our benefit in a couple of ways. First, like the bull call spread, the calendar spread reduces the overall cost basis, which in turn lowers the break even point. This is nice as it will improve our probability of profit from this trade. In addition, the lower cost allows us to lever up by buying multiple contracts. Second, if we set up the spread using options that are far apart in time and high enough in strike, we have the distinct advantage of being able to roll over the short month option.

Rolling over the short option lets us earn money selling the short month over and over until the time our long position expires. If the stock goes nowhere fast or falls in price, we can still make a tidy profit, if we can roll over at least once. The opposite is true for put options: you still want OTM strikes, but will profit when the stock moves up. If it moves down below your strike you will get assigned and lose your debit. It's almost free! I say almost because often times the short month is pretty cheap, and sometimes you don't get to roll over.


Straddle

I've already explained the basic concept of a straddle. The way a straddle can be used in the Darvas box theory system is both simple and ingenious. It's simple because a straddle lets us play both sides of the market. In that sense, we are market neutral: we can make money whether the stock moves up or down. The catch of course is that the stock has to move far enough for us to make money, otherwise we lose it. This is a huge disadvantage: we have to buy two options, which means twice the money of a basic one-sided option, and quite a bit more than the usual spread. However, if you are really unsure of the market direction, then a straddle might be a good way to go (although I still prefer spreads, only because I am poor).

The ingenious part comes once the stock has moved sufficiently for us to make a profit on one leg of the straddle. Once this occurs and we are satisfied with the gains we have achieved, we can sell the winning side and keep the losing side. Why? Because it really is free: we've already paid for the losing leg. So long as we are willing to let the losing leg expire worthless, then there is no further harm in keeping it. In fact, if the stock reverses during the life of the option, we stand to gain on both legs. Of course, if the stock continues to advance (or decline), the losing leg will be worth even less, so holding it does have some risk if you planned to sell it before it becomes worthless..

The gist is this: we have to be satisfied with the gains we have achieved, and not be emotional if the stock continues to advance (or decline) once we sell the winning leg. Then, we must be willing to let the losing leg expire worthless. Once these criteria are met, we can peacefully keep the losing leg and see if it provides us with some gains.

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