Thursday, April 30, 2009

Trading Lab Recap - Breakouts

Market has been a tough nut to crack! Why?
Has shown signs of a top, but has never followed through- stresses the importance of price confirmation. This is the drawback of taking anticipatory trades (which I sometimes do!)

Mixed Signals between Indices. They're out of sync:
$RUT broke out above resistance today
$NDX has been leading the entire time, but is now testing its 200 MA
$SPX hasn’t broken above 875 yet, but is close
$INDU weakest – hasn’t yet reached Jan / Feb highs
When market is out of sync, what could we do?

Treat it as a stock pickers market- Find relative strong stocks to go bullish
Could find relative weak stocks to go bearish (if you dare! – obviously hasn’t really worked recently)
B/c markets are out of sync, I would put more emphasis on the merits of individual charts.

Top Down Approach Finding Trades:
Does the $SPX have a definable pattern (bull retracement, bull breakout, ascending triangle, etc…)
Find a sector or stock with similar pattern (if SPY has consolidation- don’t look for retracement)
Recently the SPX has had a sideways consolidation (bullish breakout pattern)- Consequently you’ll have better luck finding bullish breakouts (GS, JWN, TGT) than bullish retracements recently.

Bullish Breakout Pattern

Trade Identification:
1. Stock is in an uptrend
2. Stock basing sideways close to a resistance level (tighter the consolidation, cleaner pattern)

Buy above resistance

1. Sell after stock rises 1 ATR
2. Sell at resistance

Trade Management:
1. Original stop could be placed beneath prior day’s low
2. Original stop could be placed beneath the base

Beta = measure of relative volatility. How volatile is the stock relative to (or vs.) the broader market (SPX)
SPX Beta = 1 SPX goes up 3%
XYZ Beta = 1 XYZ goes up 3%
ABC Beta = 2 ABC up 6%
MNO Beta = .5 MNO up 1.5%

Bullish on Health Care
Naked Put play
April 27th
Sell May 45 put for $4.50

I want the chart to confirm the trade. CELG was in a downtrend, thus we could have found better candidates for a naked put. Price Pays!
When selling Naked Puts, I Always sell OTM puts! (May 40)
It’s nice to have a support level between the current price & short strike, to decrease the odds that the stock falls to the short strike causing the put to move ITM.

Outlook: Bullish
Bull Call Spread (vertical debit spread)
Buy Sept.30 call
Sell Sept. 35 Call
Net Debit $2.45
Max Risk = $2.45
Max Reward = $2.55
Target: Exit when achieve 30% of max profit

Using September options is more conservative b/c you have 5 months for the stock to reach $35.
By going 5 months out, it also requires you to wait longer to make your money
A more aggressive approach for bull call spreads is to use less time (2 months or so)

Question: Do I have to have a net delta of +25 for a bull call spread?
Answer: Not necessarily- The most important variable is whether or not you believe the stock has the ability to reach the higher strike by expiration. If the net delta is less than +25, you’ll just make money a little bit slower.

INTC put calendar Neutral to bearish outlook on INTC, Implied Vol relatively cheap.
Strategy: Put Calendar spread (profits from neutral to bearish move & an increase in IV
Buy Jan 2010 17.50 puts
Sell May 15 puts

Revisit next week on managing put calendar & delta hedging

Earnings Announcement – Option premiums get juiced up prior to earnings (IV increases)
Allows me to do a much wider Iron Condor than usual
AFTER earnings – option premiums get smacked – volatility crush (IV decrease)
Placing Iron Condors presents a limited risk way for entering a short vol trade into earnings.
If after the earnings announcement the stock gaps up or down less than the options are pricing in, then Iron Condors can be profitable.

Wednesday, April 29, 2009


The indecision continues... and one direct result of this chop is realized volatility on the market has diminish significantly. How so? Well, one of the simplest measures of realized vol is the ATR (average true range). ATR is an indicator that compares trading ranges for successive time periods. The ATR I’m using calculates the average range per day for the last 14 days (14 days is typically the default). Currently it’s at about $2.10, which is the lowest it’s been since Jan 13 where it briefly touched $2.10. Before that you have to go all the way to end of Aug to get an ATR that low.
Keep in mind, ATR is NOT used to forecast direction or duration of movement. It merely measures level of activity or volatility. Low ATR levels signify quiet markets in small ranges. High ATR levels signify larger, faster moving markets in wider ranges. Although ATR doesn't predict direction, it does tend to peak at market bottoms and trough at market tops. As such, in retrospect it’s easy to point out how past market bottoms or tops have coincided with high (see Green Arrows and Circles) or low (see Red Arrows & Circles) ATR levels. The key is knowing what’s *high* enough to be a peak & what’s *low* enough to constitute a trough. Truth is you never really know until it turns (think $VIX in fall of last year- where the market bottom could have been, and was, erroneously called at VIX 30, 40, 50, 60, and on up to 80).

So, could the current low ATR be implying a short term top in the market? Potentially… But I wouldn’t be too quick to pass judgment, or I’d at least like to see the market tip its hand by finally breaking below some support levels. The current sideways action could just be coiled spring waiting to finally pop… resolving itself by a decisive breakout above 875 on SPX.


Tuesday, April 28, 2009


Last week's H&S on the SPX 60 min. was rendered moot with Friday's strong up day. We're now in more of a consolidation (time correction) on the daily. As a result the 30 min. is starting to get pretty choppy. The main question in my mind is whether or not we're forming a complex top before a deeper retracement, or just pausing before the next move up. I've already taken a few anticipatory trades, but would like to see the SPX break above either 875 or below 830 ish before I aggressively short (or adjust existing positions & get longer).


Sunday, April 26, 2009

MythBusters- Inexpensive Options are Cheap

Here's the second installment to our option myths series started last week.

Myth #2: Inexpensive Options are Cheap Options

Beginning option traders are often tempted to buy inexpensive options. The *inexpensiveness* of the options may be alluring these traders into thinking they are cheap, thus an obvious buy. The reality is just because they're inexpensive doesn’t mean they’re cheap.

For example, BAC is currently trading at $9.40 and the May 12.50 calls are trading at $.37. There’s no doubt that $.37 for an option is inexpensive… but is it cheap? Well, let's look at the facts. We have a mere 3 weeks to expiration and BAC would have to rise to $12.87 just for you to breakeven (assuming you hold to expiration). That’s a 37% move in a very short period of time. This suggests that the 12.50 calls are trading at a very high implied volatility (as an option trading for $.37 that far OTM with 3 weeks left would have to be). Under a lower vol scenario, those 12.50 calls could only be trading at $.05. So the bottom line is you can’t look at an options price to determine if it’s cheap. You have to take into account it's strike price, time to expiry, and current levels of Implied volatility.

The most inexpensive options you’re going to find are short term, out-of-the-money options. Statistically speaking they have the lowest probability (vs. longer term ATM or ITM options) of being worth anything at expiration. It’s priced inexpensive because it’s a low statistical bet. Thus, if you decide to buy it you better be sure the stock has the ability to reach the short strike price prior to expiration. Remember the options market is quite efficient so don’t think that you’re getting a steal of a deal if an option is cheapo.

In an intro to economics class I took in college I was introduced to a phrase that sheds some light on this scenario: “there’s no such thing as a free lunch”. Remember for everyone buying an option, there’s someone on the other side of the table selling it to them. Odds are if the option was such a great deal (read: too inexpensive), then option sellers would be asking more for them. So don’t be too quick to think that those selling these *inexpensive* options are idiots...

... you never know, the idiot may just be you.

On a completely unrelated note, there are still two people who e-mailed my mac account (which had an egregious error and deleted my e-mails) expressing interested in a free month of the trading labs (one of them was Juan something...). I lost those 2 e-mails, so if you could both send me another e-mail: I'll get you taken care of.


Thursday, April 23, 2009

Trading Lab - FREE month!

As many of you have noticed (and some have inquired about), each Wednesday I post notes of the strategies discussed in my weekly Trading Lab. I currently contract with the Wealth Intelligence Academy in providing these labs to their clients. I’ve really enjoyed moderating these labs and would like to invite any one that’s interested to join us. If you want FREE month’s access to the trading labs to get a feel for it and determine whether or not you want to become a subscriber, call the Wealth Intelligence Academy at 866-578-0144 and let them know you're interested in trying out my (Tyler Craig) lab. They will give you information for how to get signed up. Here’s an in depth overview of the lab.

What is a Trading Lab?
The Trading Labs are an hour long weekly stock group that meets via webinar. You will be able to dial into a conference call while being able to view my computer screen on your computer at home. This gives me the ability to pull up charts and other material on my computer, allowing you to see what I’m doing and participate as if you were sitting right next to me!

Here’s a breakdown of how the lab usually goes:
10 minutes – Market overview and preview of upcoming week
15-20 minutes- instruction on specific trading strategies or techniques (technical analysis or options trades)
25-30 minutes- Q & A / open forum for students to bring up questions on specific strategies or trades-

Topics Discussed
- Top Down analysis of Indices and Sectors
- Review of upcoming significant economic announcements
- Options Pricing and Theory
- Risk Graphs
- Option Spread trades
- Greeks
- Implied Volatility
- Technical Analysis (Price pattern characteristics and technical indicators)

See you in the lab!

Tweet Tweet

So I signed up for twitter late last year, but haven't really utilitized it much. However, I've had a change of heart (more like I've got more time), so I'll attempt to post a bit more if ya'll want to follow me click here.

Wednesday, April 22, 2009

Trading Lab Recap - Naked Puts

Selling Naked Puts
-Neutral to Bullish with High Implied Volatility
Structure: Sell a short term 4-6 week (higher rate of time decay) (less time for the stock to move against you), OTM (increase probability of profit) put option

When we buy options, we’re trying to predict where the market IS going to go. When we sell options (naked puts / calls) we’re trying to predict where the market ISN’T going to go!

If I sell a put, I obligate myself to buy the stock at the strike price. The person selling the put is essentially betting it’s not going to drop to the strike price.

Naked Put Example
USO @ $27.35
Sell to Open 26 put for $.90
Max Reward = .90
Theoretical Max Risk = $26 - .90 = $25.10
Breakeven = 26 - .90 = $25.10
Probability of Profit = 1 – delta (1 - .32 = .68) 68% prob of success
Margin Requirement?? 20-25% of stock price (5.40)
ROI = 90 / 540 = 16%

T1: Hold to expiry to realize max profit
T2: Buy To Close put when I’ve achieve 80% of max profit

Trade Management:
T1: Exit when stock breaks support
T2: Exit when stock reaches strike price
T3: I could ride to expiration & if the put is ITM, allow assignment- Go long shares of stock and sell covered calls
T4: Roll further OTM if stock breaks support or reaches strike (Sell 26 put, USO reaches 26 – buyback 26 put and sell 25 put)

Long Stock vs. Naked Put/Covered Call Combo
USO @ $27.35 Buy 100 shares – my risk is $27.35

Sell 26 put for $.90 - my risk is $25.10
At May expiration I go long 100 shares @ $25.10 cost basis
Sell June 26 call for $2
My new cost basis (after original naked put & covered call)
$23.10 (after a mere 3 ½ weeks)

Choosing Candidates:
Lower priced stocks ($30 or less)
Stocks I wouldn’t mind owning
Consider using ETF’s on Index or Sectors or Commodities

Choosing Strikes:
Sell OTM
Prob of profit > 80% ( sell delta of .20 or less)

Trades Reviewed
RUT @ $470
May 540 call - $2.68 Delta = .12
May 550 call - $1.83
Net Credit = $.85
Max Reward = $.85 (IF RUT is below 540)
Max risk =9.15 (IF RUT is above 550)
Exit the trade at around .15 or .20

XYZ @ $52
Bull Call Spread
July 50-55 call spread July 55 – 60 bull call spread
Buy 50 call 1 ITM
Sell 55 call 1 OTM
To realize max reward, I need XYZ to go up past $55

Head & Shoulders, Knees & Toes

Although the market retraced Tue & Wed as anticipated, I gotta admit I was getting a bit discouraged seeing the market, apparently unfazed by Monday's smackdown, march as high as it did yesterday (esp. the RUT and NDX). But just as I began to wonder why sometimes dang trendlines get no respect...

... my head & shoulders buddies came in and denied the bulls by smacking the 60 minute into a potential H & S pattern.
Remember a head & shoulders is a topping pattern portraying a shift of control from the bulls (higher pivot highs) to the bears (lower pivot highs). At this point, it is still a potential H & S pattern, but keep an eye on 828 (key support) and 861ish area (right shoulder). A clean break of 828 could confirm the pattern and signal more downside to come.. On the other hand breaking above 861ish would render the pattern moot and we'd have to reassess things.

So Far So Good...

The scenario we played out yesterday is still intact. We've retraced back up to the trendline, now we just need to see the plunge. If this action plays out, then we'll have a head & shoulder pattern on the 60 min chart to further confirm a short term top in the market.
Breaking above 875 would obviously negate this outlook, so if the market rally carries us that high... all bets are off. Mondays downdraft will turn out to be just another shallow retracement in this uptrend, and yet another dissappointment for the bewildered bears.

Tuesday, April 21, 2009

MythBusters- Option Volume

A few weeks ago Options Action took it upon themselves to debunk five common option myths. Let's take a looksie and elaborate...

1. Option volume is a directional indicator
2. Inexpensive options are cheap options
3. Never sell naked puts
4. It's cheaper to let options expire
5. Options are riskier than stock.

I'll tackle myth numero uno today and get to the rest later. The most common way that I've seen traders use option volume is by looking for huge increases in volume (number of contracts traded) in an effort to identify big traders that may "know something", such as a future take over, FDA announcement, or other news events likely to drastically move the stock. In other words, the options market is tipping its hand and hinting at a potential big move in the underlying stock.

First, volume is relative. In other words, high volume for Microsoft (MSFT) options is completely different than high volume for Chipotle (CMG) options. So don't be too quick to think that 5000 contracts, which is most assuredly high volume for CMG, represents high volume for MSFT.

Second, for every buyer there is a seller. Consequently you can't merely look at the total amount of contracts that traded and discern whether they were buying or selling the options. Unfortunately you have to dig a bit deeper and see whether or not they traded on the ask (which implies the options were bought) or the bid (which implies the options were sold).
Furthermore, even if you found out they were bought or sold, the other caveat is you don't necessarily know what strategy they have on. Suppose you find out a big buyer came in and bought up a ton of out-of-the-money puts. While your initial thought would be they're placing a bearish bet, they may actually be bullish by already owning shares in the underlying stock and merely want to buy protection. Or perhaps they were entering a put vertical or calendar spread. Bottom line is it's tough to identify a huge increase in open interest or volume and know what it means. Some traders may enjoy using abnormal volume in their option trading, but it's not really my cup of tea. There's too much other, easier to discern, information I can use.

Third, for every good signal you get from abnormal option volume there are probably two or three signals that don't come to fruition. With all the take over chatter that's out there, you're bound to have numerous abnormal volume trades occuring as people speculate on the rumors, but in reality few big winners really occur. To be fair, I've never really traded off of abnormal options volume, so I have no idea what the rate of success would be or what exactly qualifies a good abnormal volume trade from a bad one. It just seems like random speculation to me.

Bottom Line: There are a ton of other signals I'd use on predicting stock direction before I'd ever assess abnormal option volume.


Bear Wedge Break

875 resistance turned out to be an opportunity to take profits on bullish trades and dabble with entering some bearish trades. With yesterdays downdraft, the S&P broke below the bearish wedge.... an obvious victory for the bears. Given the significance of the trendline break, I would expect to have more downside in the days to come. (click to enlarge)

In retrospect Friday or early monday would have been the best time to enter something bearish. Any time I miss these *ideal entries* I generally drill down to a smaller time frame, such as the hourly, to look for subsequent opportunities to jump in. The 60 min. chart is now in a downtrend- If it can muster a rally back up towards the trendline, that may provide a *second chance* for entering bearish trades.


Monday, April 20, 2009

The Trade-Off...

....Risk Reward vs. Probability of Profit

Anon posed a thoughtful question in response to last Thursday's post on credit spreads that I wanted to respond to today.

OK.. I will admit that this strategy [vertical spreads] is new to me, and I am intrigued as I also came across folks who favor Iron condor strategy. Given my background, help me get over the following psychological hump, if you will. I am a value player meaning buy low sell high (mainly stocks) but when I look at accepting $1 credit for $5 potential risk, I agonize. I understand one of the way to manage this risk is through position size and maybe rolling up/down. At the same time looking at the stock charts for any resistance/support areas.But still, how should I address my concern of risking $4 for a potential $1 reward?Any advice?

How do I incorporate risk-reward in my option trading?
First off, it depends on what type of option strategy your utilizing. One of the mistakes novices make is applying a rule they've heard about a specific strategy (such as buying call options) to a different strategy such as iron condors. Iron Condors, as well as any other options strategy are completely different animals, thus requiring seperate rules for entry, exit, and management. So make sure as you continue your education you specify which rules/techniques correlate with which strategies.

When stock trading, many traders look for price patterns that exhibit a 2:1 or 3:1 reward to risk ratio (or some other variation) to ensure that the potential reward is worth the risk. Calculating risk-reward is an integral part to evaluating stock trades because we're anticipating the stock to move either higher or lower. Assuming there's a 50-50 chance you're going to be right, you can expect to be wrong about half the time. In that type of scenario we would want to ensure that we're making more money on our winning trades, than the losses we incur on our losing trades. Hence the need for a 2 or 3:1 reward to risk ratio.

The one type of option trade where I can see the need for a 2 or 3:1 reward/risk ratio would be a directional call or put trade. You're odds for those are about as good as a normal stock trade, so I would want to see a decent R/R ratio. For the record, I generally use support/resistance in analyzing my targets and stops for directional call-put trades (although I rarely play them).

So what about Risk-Reward for Credit Spreads or Iron Condors?

To really understand option spreads you've got to consider probabilty of profit. Prob. of profit can be established by using Delta. The following table uses a $10 vertical spread to illustrate the tradeoff between probability of profit and risk-reward.

$10 Vertical Spread
Risk: $1 Reward: $9 Probability of Profit: 10%
Risk: $2 Reward: $8 Probability of Profit: 20%
Risk: $3 Reward: $7 Probability of Profit: 30%
. . . . . . . . .
Risk $7 Reward $3 Probability of Profit: 70%
Risk $8 Reward $2 Probability of Profit: 80%
Risk $9 Reward $1 Probability of Profit: 90%

While there may be situations where a $10 vertical spread deviates from the above table, the majority of the time the relationship between risk-reward and probability of profit will hold true. In short, the higher the probability of profit, the lower the maximum reward. Conversely, the lower the probability of profit, the higher the maximum reward. Typically when trading stocks, we can simply use risk-reward to determine whether or not a trade is worthwhile. Unfortunately many option strategies, require us also to assess the probability of profit. In the options world, it’s insufficient to simply know that one is risking $5 to make $10. We also need to establish the likelihood of realizing the $10. Let’s look at two extreme examples to illustrate the point.

For our first example, consider the following question. Would you risk $9 to make $1? Most traders would immediately answer with an emphatic no! After all, you would be taking on quite a bit of risk, for a paltry reward. However, let’s shed a little more light on this potential trade by further assuming that your probability of realizing the $1 gain is 95%. Would this influence your decision? It most definitely should! Given this extremely high probability of profit, this trade would be a winner in the long run, thus despite the small potential reward it would behoove us to take the trade.

For our second example, consider this question: Would you risk $1 to make $9? Most traders would answer to the affirmative! Moreover, it seems as if it’s a no brainer. However, let’s add the additional variable of probability of profit. Let’s assume the probability of realizing the $9 is 8%. How would this influence your answer? Hopefully it would cause you to avoid the trade and find a better one. Although the risk-reward makes the trade appear like a no-brainer, the small probability of profit better make you think twice! Given the measly probability of profit, this trade would be a loser in the long run.

Does this mean I only take trades with a positive Expected Value?

Not necessarily. I've highlighted many $10 spreads where I received a mere $1 credit and that probably had a negative expected value. The reason I'm comfortable taking the trade is because although the THEORETICAL risk is $9 (which makes it have a negative Expected Value), my MANAGED risk is probably around $3 or less (which would make it have a positive Expected Value). Moreover, by using delta hedging techniques I can further mitigate my risk if the stock makes an adverse move.


A Sign of Things to Come?

I've been tracking the RUT so far this morning. This puppies down over 3% in 20 minutes. It's been awhile since I've seen the RUT undergo a selloff of that magnitude that quickly. To me, this at least signals a short term shift in momentum/sentiment. As a result, I would anticipate this retracement to be deeper than any other we've developed since the March bottom. We shall see...


Sunday, April 19, 2009

Thoughts for the Week Ahead

To prep for next week, I wanted to offer up a review of the weekly & daily S&P 500 Index chart.

I've highlighted 875 in the S&P in a past post as an area of overhead resistance, that if reached could provide a short term top in the S&P. Friday's rally lifted the S&P to 875 (875.63 to be exact). The 875 area provides:

1. A prior double top
2. Prior lows and price congestion.

It makes all the sense in the world for the market strength to begin to abate (technically it's already been diminishing(e.g. bearish wedge). Assuming 875 holds as resistance, the market should move sideways at best, deep retracement at worse. Just remember there's a difference between what we think *should* happen and what *will* happen.... so wait for some price confirmation!

Crude Oil -I've posted a few naked put trades on USO in past posts. It's still performed relatively well over the last few weeks. The April puts I sold were bought back around $.20 and I subsequently sold more for May.
USO is currently forming a symmetrical triangle, so watch for breakout of the downtrendline to potentially signal the next move up.

I'm glad to see the comments section is beginning to come to life. We've been getting some really intelligent questions, so keep it up. For those of you who haven't been utilizing the comments section of this blog, no better time than the present to start participating! To access the comments, just click on "COMMENTS" at the end of any post.

Good luck on your trades this week!


Thursday, April 16, 2009

Mail Time

Let's tackle a question from Rohit, in response to my Stuck in a Rut post:

Thanks for the post. A question pls: for credit spreads like this one (bull put or the bear call), you would want time decay to work in your favor. In that case, wouldn't it be better to put these spreads on about 2 weeks before expiration? this way the time decay is the fastest and you gain the most. Am i thinking about this the right way? Thanks in advance.

Hey Rohit,

Let me preface my answer by stating that option trading involves trade-offs. Whether you're trading credit spreads, covered calls, naked puts, or any other option strategy under the sun, there will always be trade-offs between using long term vs. short term or ITM vs. OTM options. Because of these trade-offs its tough for anyone to really say whether one method is "better" than another. It comes down to personal preference and whether or not you're comfortable with the risk-reward characteristics of the method you choose. My recommendation for anyone trading options is to get to the point where you understand these trade-offs and the underlying rationale of each strategy. Don't take any thing I or any other person or resource says at face value... always ask "why?". When you understand the "why" you're well on your way to properly using options in your trading.

First off, credit spreads (Bull Put & Bear Call) are positive theta trades, thus you do indeed profit from time decay. Theta increases exponentially as we approach expiration. I've posted this time decay graph in my previous post on Theta, but it bears repeating:
Due to this rapid increase in time decay in the final few weeks to expiration it is quite alluring for option sellers to enter positive theta trades with only 1 or 2 weeks to expiry. In that regards, your thinking was correct. However there are a few trade-offs to entering a credit spread a mere 2 weeks to expiry vs. a longer time frame like 4-6 weeks.

Trade Off #1: Lower probability of profit or less premium
With only 2 weeks remaining, OTM options will not have as much value left. In my example, the RUT was trading at 430 and I entered a 5 1/2 week put spread 80 points OTM (350-340) for $1 credit. If I tried to enter a put spread that far OTM with 2 weeks remaining I probably would have only received around $.30 credit.... not nearly enough to make the trade worth it. Consequently, to make a 2 week put spread feasible, I would have to use closer to the money options if I wanted $1 credit. Let's assume I could sell a 390-380 put spread for a $1 credit. So the 4-6 week credit spread allowed me to go 80 pts. OTM for $1 credit, the 2 week credit spread only allowed me to go 40 pts. OTM for $1 credit.
Bottom Line: Entering a 2 week credit spread vs. longer term will bring in less credit (if using same strikes) or I'm going to have to use closer to the money strikes which diminishes my probability of profit.

Trade Off #2: Higher Gamma Risk
Gamma risk is tad bit more complicated to understand... so it may take time (and witnessing it play out in your own trades) to fully grasp the concept. Here's a quick primer on Gamma: Gamma is the rate of change of Delta, thus it measures how quickly my Delta will change. Gamma is highest for short term, ATM options and lower for long term ITM or OTM options. As Gamma increases it becomes increasingly difficult to manage your delta risk. Suppose I consistently delta hedge my option positions (to keep it neutral or within an acceptable range) by buying and selling stock. If the delta changes slowly (a low gamma), it is relatively easy to make adjustments (buy or short stock to get position delta back into my comfort zone) and I shouldn't have to adjust that often. On the other hand if delta changes rapidly (a high gamma), then I have to delta hedge much more frequently(a pain in the neck, especially if you've ever tried to delta hedge a short ATM option into expiration week).

One of the correlations between Gamma and Theta is they both increase as you get closer to expiration; so although entering credit spreads really close to expiry to capitalize on the higher theta is tempting, you significantly increase your gamma risk at the same time. This is often why option sellers close their short option positions a few days prior to expiration (sometimes even if there is still $.20 or $.30 left in an OTM option). It avoids having to hold those short positions when gamma is the highest.

So, my personal preference is to sell credits around 4-6 weeks out so that #1 I can go far enough OTM to receive an acceptable credit for a high enough probablity of profit and #2 I avoid the high gamma risk that arises close to expiration.

Some credit spread traders prefer to sell them even further out in time, like 13 weeks. This approach gives them the ability to sell credit spreads even further OTM, as well as further decrease gamma risk.

Now that you know the trade-offs, you simply need to decide what best fits your comfort level.

Tyler -

Trading Lab Recap - Debit vs. Credit Spreads

Day Trading
Larger time Frame – Daily
Main Time Frame- 5 minute
The 5 minute chart is more appropriate for a day trader than the 1 minute chart (unless scalping).
1 minute charts can whipsaw you in & out of trades
1 minute support/resistance levels aren’t near as significant as support-resistance on higher time frames (like a 5 min)

If entering Bullish day trades:
Make sure the 5 min trend is up – Buy retracement or Breakouts above resistance
If entering Bearish day trades:
Make sure the 5 min trend is down – Sell retracements or breakdowns below support

April 1st – Bull Call Spread
Buy to Open April 40.00
Sell to Open April 42.50

What’s the advantage to using April (2 weeks till expiry) options vs. June (2 months to expiry)
1. The main advantage is if the stock moves through the spread we only have to wait 2 weeks to make our money. By entering 2 weeks out, we’re turning a bull call spread from a position trade to more of a short term swing trade.
2. The main disadvantage is if the stock moves the wrong way, you lose money quickly. With only 2 weeks until expiration, there isn’t much time to allow the stock to come back if it moves adversely.
Using April: More aggressive
Using June: More conservative

If at expiration, NFLX is above $42.50
40-42.50 bull call spread expires ITM, resulting in my max profit
Long 100 shares @ $40
Short 100 shares @ $42.50

SPY @ $85
MAY Iron Condor
73-71 put spread Credit = .17
95-97 call spread Credit = .16
Net Credit = $.33
Max Reward = $.33
Max Risk = $1.67
73 put delta is 10 (90% probability of success on bull put)
95 call delta is 10 (90% probability of success on bear call)
Probability of Profit on Iron Condor: 1 – delta of short call – delta of short put
1 -.10 - .10 = 80%

$33 isn’t much profit if we take into consideration that we’re buying back either spread when their worth $.05 or less. This brings our potential profit down to $23. Tack commissions onto that & we’re not really making much at all!

Adjustments that can be made to bring in more credit on a SPY Iron Condor:
1. Try a $4 or $5 spread instead of a $2 spread. For example: 95 -99 call spread & 73 – 69 put spread
Wider spreads have more risk, but the risk can be mitigated by entering less contracts. For example, (10) $4 spreads is the exact same as (20) $2 spreads.
2. Instead of entering 4 weeks to expiry, we could enter 5 or 6 weeks to expiration. There will be more time value in the options, resulting in more credit.
3. Use credit spreads closer to the money (sell calls/puts with a higher delta)

Credit vs. Debit Spread… What’s the diff?
Bear Call & Bull Put vs. Bear Put & Bull Call

Bear Call & Bear Put Spreads using the same strike prices are synthetics (exact same risk-reward characteristics). In addition, changes in time and Implied volatility affect both the same.
If stock XYZ @ $50 and we’re Bearish, we may consider the following bear spreads.
45-40 Bear Call Spread Reward = $3 Risk = $2
45-40 Bear Put Spread Reward = $3 Risk = $2

If credit & debit spreads using same strikes have the exact same risk-reward profiles, what causes one to choose one over the other?

When entering vertical spreads I generally don’t like to short ITM options due to the risk of early assignment. As a result, when choosing which vertical spread (credit or debit) to use, I choose whichever one results in being short an OTM option. For example, if stock XYZ is trading at $50 and I want to place a 50-45 bear spread, I would use a put spread. On the other hand, if I place a 55-60 bear spread, I would use a call spread. In other words, if I use strikes below $50, I will do a put spread (OTM). If I use strikes above $50, I will do a call spread (OTM)


Wednesday, April 15, 2009

Double Top?

Last Wednesday I reviewed the slowing momentum in the S&P 500. Although it has formed higher pivot highs, the strength has begun to wane a bit. One of the price patterns that occur in a weakening uptrend is a Double Top. Think of a double top as two equal mountain peaks. This pattern helps convey the inability of the Bulls to push the stock above it's prior resistance level. The Dow and Transportation Index are close to forming double tops. A break of support (7750 on DOW) (2760 on TRAN) would confirm and complete the pattern.


Transportation Index:Tyler-

Tuesday, April 14, 2009

A Collection of Charts

Here are a few charts to mull over. The S&P 500 Index ended the day down 17 points or 2%. Given that the S&P is in the midst of an uptrend, we would give it the benefit of the doubt that it forms a higher pivot low. In the coming days I'll be watching the prior pivot low as 815. It's still a ways a way, but breaking below 815 will signal a reversal in the current uptrend.
Every retracement thus far has been quite shallow (2 days or less), followed by a resurgence of the bulls. The deeper the retracement, the weaker the market. So, in the next few days let's see how deep we retrace.

Stuck in a RUT

I've mentioned bull put spreads in past posts, one of which you can view here. Due to the recent bullishness in the market, I wanted to throw out a bull put trade example. To take advantage of the nice little uptrend in the RUT, I decided to sell some OTM put spreads a few days back. Here's a trade recap:The rationale for the put spread was to exploit the uptrend in the RUT. Since the March bottom, everytime the market has retraced 2 days, the bulls have returned in force, pushing the market back up to continue the uptrend. Not knowing whether or not the RUT would retrace a third day, I chose to sell the put spreads towards the end of the 2nd down day (april 7th). So far it's worked out rather well.

Trade Inception:
April 7th
May 350-340 put spread
Net Credit = $1
Max Reward = $1
Max Risk = $9

Rather than hold to expiry in an effort to realize the entire $1, My personal preference is to close the spread ASAP at $.20 or less. Currently the put spread is around $.40, so I'm still waiting for it to decay a bit more before closing the trade.


Monday, April 13, 2009

Roll Ups

Today I wanted to highlight a few management or adjustment techniques that can be used on bear call spreads when the market is in the midst of a strong bullish move. Be forewarned, there will be some math involved so hold your head still so nothing falls out!

Suppose when the RUT was trading around 420, I entered (10) April 470-480 bear call spreads.
(I'm making these numbers up for simplicity purposes so don't worry about checking them)
Sell to Open (10) April 470 calls for $3.50 apiece
Buy to Open (10) April 480 calls for $2.00 apiece
Net Credit = $1.50
Max Reward = $1.50
Max Risk = $8.50
470 call delta = 20
480 call delta = 14

Since the delta of the 470 call is 20, that implies there is an 80% chance the RUT will not reach 470 by expiration. Put another way, my probability of profit is 80%.

By assessing the delta on both the long and short calls, we can calculate our position's net delta. The net delta is -6 per spread (20-14). Since we entered 10 spreads that would bring our net delta to -60. This implies that we make $60 per $1 drop in the RUT and lose $60 per $1 rise in the RUT.

Suppose 2 weeks later RUT has risen to 460 putting us uncomfortably close to our short call spread. Here are the current numbers:
RUT @ 460
(10) April 470 calls trading @ $5.15
(10) April 480 calls trading @ $2.15
Current unrealized loss = $1.50 (3.00 - 1.50)
April 470 call delta = 45
April 480 call delta = 30
Positions net delta = -15 x 10 = -150

If we look at the current status of our RUT bear calls, you can see we're losing $150 per spread ($1500 total), and our delta exposure has nearly tripled from -60 to -150. Now instead of merely losing $60 per $1 increase in RUT, we're losing $150. Furthermore, my probability of profit has gone from 80% to 55%. Let's consider a few actions we could take to mitigate some of our remaining risk.

1. Close the entire position:
Buy to Close (10) 470 calls @ $5.15
Sell to Close (10) 480 calls @ $2.15

Although closing the trade will lock in the $150 loss, it removes any remaining risk. I have no more $$$ at risk and obviously because I've closed the trade, my delta is at 0. Losing $150 on a credit spread originally risking $850 is actually not that bad and takes the chances of a catastrophic loss off the table.

2. Close a portion (such as 1/2) of the spreads.
Buy to Close (5) 470 calls @ $5.15
Sell to Close (5) 480 calls @ $2.15

What has closing 1/2 of the trade done to my risk? It's cut it in half. My delta exposure has gone from -150 to -75. Although holding a position with -150 of delta may have been outside of my comfort zone, -75 may be acceptable. Obviously we would only want to hold on to the remaining 5 bear call spreads if we think the RUT had a chance of remaining below 470. If you're all out bullish on the RUT, then simply close ALL of your 470-480 bear spreads.

3. Roll up
Given the huge run up in the RUT, let's assume we no longer believe it will stay beneath 470-480, but we do think it may stay beneath 490. We roll up our 470-480 call spreads to 490-500 call spreads. Let's analyze the numbers.

Buy to Close (10) 470 April calls for $5.15
Sell to Close (10) 480 April calls for $2.15
This will lock in a $1500 loss
470 April call delta = 45
480 April call delta = 30
Prob of profit = 55%
Net Delta = -15 x 10 = -150

Sell to Open (10) 490 April calls for $3.00
Buy to Open (10) 500 April calls for $1.50
$150 net credit x 10 = $1500 net credit
490 call delta = 20
500 call delta = 14
Prob of Profit = 80%
Net Delta = -6 x 10 = -60

By rolling up the spread to 490-500, I have gained the following 3 advantages:
1. Increased my probability of profit to from 55% to 80%, as now the stock need merely to stay beneath 490 (not 470).
2. Lowered my delta exposure from -150 to -60.
3. Put myself in a position to potentially make back $150 (x10) of the loss from closing the original trade.

What's the trade-off to rolling up?

The biggest trade-off to rolling up vs. maintaining the original position is I can't make as much money. Remember the original 470-480 call spread had $3.00 of credit left. The 490-500 only had $1.50. However, at this point in the trade trying to eke out a profit should be the least of my worries. My biggest priority is to reduce the remaining risk in the trade and avoid a huge loss. Rolling up does both. My delta risk is reduced and my probability of profit is drastically increased, thereby drastically decreasing my probability of a huge loss.

The only times I've really regretted rolling up are when the stock continues to rise, resulting in a loss on not only the first call spread, but also the second. This is akin to adding salt to the wound or insult to injury. Consequently, rolling up should only be used if you're outlook is still somewhat neutral to bearish. If the maket is that bullish, don't fight the trend - simply do something bullish.


Thursday, April 9, 2009

Trading Lab Recap - Money & Portfolio Management

Here are the notes from last night's trading lab:

Trading Axioms
Consistent results require a consistent approach
To succeed we must last!
We can’t last if we blow up our account

Money Management principles:

1. Risk per trade: Define what % of account you’re willing to risk in any one trade. Keep it small!
2. Time Diversification: don’t enter all your new (uni-directional) trades on the same day
For example:
Bull Put Spreads (10 contracts) Enter 5 today and remaining 5 a few days later
This helps reduce market risk
3. Price Diversification : Scale in (multiple contracts or shares)
5 contracts @ $1.00 If I can enter more later at a better price, I will. In a week I add 5 more contracts @ $2.00 Average spread is now @ $1.50
4. Strategy Diversification:
Aggressive approach: Play one side of market at all times
For example:
If market bias is Bullish: Have all bullish trades
If market bias is Bearish: Have all bearish trades

Conservative approach: Play multiple sides of market at all times
For example:
If market bias is Bullish: 3 bullish trades, 1 bearish, 1 neutral
If market bias is Bearish: 3 bearish trades, 1 bullish, 1 neutral

Portfolio Management

If in March my posture is Bullish:
My portfolio is positive delta possessing primary bullish trades:
10 bull put spreads

If in April, my outlook changes from bullish to mildly bullish-neutral, I adjust my portfolio to mildly delta positive to delta neutral. I could:
1. Close a portion of my bullish trades, tighten up stops, lock in gains, etc.
2. Enter some bearish trades (5 or 10 bear call spreads), thereby rolling my put spreads into iron condors

Remember this table:

Positive Delta (Bullish): Long Stock, Long Calls, Short Puts
Negative Delta (Bearish): Short Stock, Long Puts, Short Calls

Virtual Trades Discussed:

FCX March 26th @ $43
Bear Call Spread
Sell April 40 call $4.70
Buy April 45 call $2.11
Net Credit = $2.54
Max Reward = $2.54
Max Risk = $2.46
Breakeven = 40 + 2.46 = 42.46

Rationale for trade
Expecting a pullback on broader market (drag down FCX)
FCX was at resistance & potentially overbought
If I was expecting sideways movement (should have used OTM options)
If I was expecting downward move in price, then using an ITM call spread may have been okay


Wednesday, April 8, 2009

Slow Momo

We’re seeing some slowing momo (read: momentum) in the current uptrend in the $SPX, implying that the strength of the uptrend is waning a bit.
The SPX staged a (1) big run, then less of a run (2), then even less of a run (3).

Given the huge run-up in the markets we’ve seen over the past month, it shouldn’t be surprising to see some slackening in the strength of the bulls. The fluid move down from 800 to 666 in the S&P 500 didn’t leave much overhead resistance- making it easy for the market to snap back from 666 to 800 +. However now that were around 825 + there is quite a bit of overhead resistance or supply that the market has to digest if it wants to make its way higher.
When the market approaches a resistance zone it typically results in some type of correction as the market absorbs the selling pressure; resulting in either a time correction (choppy sideways price action), or a price correction (deep retracement in price). What have we seen so far... price or time correction? Although we’ve seen some pretty big up and down days over the last few weeks, the reality is we haven’t really gained any ground. On March 23, the SPX closed at 823 – Today, 2 ½ weeks later, the SPX closed at 825.
Smells like time correction to me...

Now, this isn't to say the market can't work it's way higher- cause it very well may. We are entering earnings season and there's always the chance that companies knock their earnings out of the ball park, especially with some pretty low expectations already baked into the cake. However, the slowing momentum does temper my enthusiasm about allowing my overall portfolio to get too bullish at this stage in the game.

For those of you unfamiliar with measuring momentum here's a quick overview. Momentum can be defined as the distance between pivots. In an uptrend we assess the pivot highs, in a downtrend we look at the pivot lows. If the distance between pivots is increasing, the trend is increasing in momentum. Conversely, if the distance is decreasing, the trend is decreasing in momentum.

Protective Put Hedging Example

Allow me to continue Monday’s post on how one can use options to lower their position delta by offering a protective put example. Suppose we are currently long 100 shares of AAPL which we purchased at $105. With AAPL currently residing at $115, we’re sitting on an unrealized gain of $1000. What is our position delta? You guessed it, + 100. This means that my positions P/L will increase $100 for every $1 increase in AAPL stock, and will decrease $100 for every $1 decrease.
To lower my net delta - thereby lowering my exposure- I could buy a protective put. Let’s assume I purchased a May 105 put for $4.00. The delta on the put is currently -27. If I add the -27 delta of the put to my stocks +100 delta it reduces the net delta to +73. Thus, if the stock drops $1, rather than giving back $100 of my $1000 gain, I only give back $73. Furthermore, the delta on the put will increase as the stock falls (it’s getting closer to the money), which will decrease my positions delta incrementally. For example:

AAPL @ $115 Net Delta = +73
AAPL @ $114 Net Delta = +71
AAPL @ $113 Net Delta = +68
AAPL @ $112 Net Delta = +64
Etc… If you are ever considering using options to hedge but don’t yet understand risk graphs, simply look at what adding an options positions does to your existing position’s delta. If it increases it, then adding the option is making your position more sensitive a downward move in price. If it decreases it (like our protective put did) then adding the option is making your position less sensitive to a downward move in price.


Monday, April 6, 2009

Options 101: Hedging Revisited

Options are superb vehicles that can be used either for speculation or hedging. In other words, they can be used to take on risk or to offset risk.

The two most basic ways one can use options in speculating are buying a call option or buying a put option. When buying either calls or puts, the buyer is essentially betting on the future direction of the stock. If the stock makes the right sized move in the right amount of time, the option buyer stands to gain a tidy sum. Unfortunately, if the underlying doesn’t make the right sized move in the right amount of time, the option buyer stands to lose his entire investment. There is nothing fundamentally wrong or dangerous with speculating as long as it is conducted in correlation with proper money management techniques, such as only risking a small percentage of your account in any one trade.

Hedging can be thought of as reducing or offsetting risks that you’ve already accumulated. By hedging, one can lessen their exposure to an adverse move in a security they already own. Suppose you bought 500 shares of AAPL at $85 on March 10th. Currently AAPL is trading around $115, resulting in a $30 or 35% unrealized gain. Now, the dilemma that presents itself, and will always present itself, is that of knowing when to take profits. We’d like to protect our well earned gains, yet leave room for more upside potential. One of the problems with merely using a stop loss is it fails to protect you against gaps. Fortunately, options provide some very efficient ways of hedging and solving the aforementioned dilemma.

Let’s explain the concept of hedging in terms of delta. For a complete review of delta see my previous post here. Just remember, delta measures a position's sensitivity to a $1 move in the underlying.

Current Position:
Long 500 shares of AAPL: Delta = +500 (I lose $500 if AAPL drops $1)

We’ve already explained that hedging is a way to reduce risk. My current position holds +500 of delta risk. If I lower my position delta, I lower my risk. So, how can I take my +500 delta down to say +250 delta?

Method #1 – the No Brainer
Sometimes simplicity is superior! The first thing I could do is sell 250 shares of stock.

Current Position: Long 500 shares of AAPL: Delta +500
Adjustment: Sell 250 shares of AAPL: Delta -250
New Position: 250 shares of AAPL remain: Delta = +250

Given the adjustment, has my risk been reduced? Hopefully you’re answering with a resounding yes! Now I only lose $250 per $1 drop in the stock, as opposed to the $500 I would have lost pre-adjustment. Furthermore, I’ve locked in part of my gain and still have upside profit potential.

Method #2 – Use Options
Rather than recommending one specific strategy for hedging, let me expound on the rationale behind delta hedging. Once you understand the theory, there are a myriad of ways you can lower your position delta, thereby lowering your risk. I’ve shown the following table in past posts, but it bears repeating.

Positive Delta: Long stock, Long Calls, Short Puts
Negative Delta: Short stock, Long Puts, Short Calls

Since our position is positive delta, we would take one of the three “Negative Delta” actions to hedge. Method #1 already involved selling stock (the equivalent to shorting stock). In the options arena we could either buy puts or put spread or sell calls or call spreads. When Implied Volatility is high, I’d prefer buying put spreads, or selling calls and call spreads versus buying puts outright. Conversely when IV is low, I’d probably just buy puts outright.

Tyler -

Friday, April 3, 2009

Mail Time

TIA asked me a few questions that I wanted to respond to in today’s post.

"Excellent resource and good examples. I not only learn from your posts but also hope I can make some dough...question for you: You like to play collecting the premiums strategy, but how do you know what stock to get into to execute this strategy? Do you also do fundamental research or let the charts do the work for you? Also do you go for stocks above a minimum price such as say $20 . Also do you go for 6months options if you want to collect the premiums and at the same time, if stock moves against you, you don't mind buying it at the strike price? (e.g. you sold a naked put)"

Hey TIA,
Thanks for the questions. See my responses below:

"You like to play collecting the premiums strategy, but how do you know what stock to get into to execute this strategy?"

I’m assuming when you say “collecting the premiums strategy” you’re referring to strategies like selling naked puts, covered calls, and perhaps credit spreads (bull puts and bear calls). My preferences for picking stocks differ on each strategy, so I’ll assume you’re asking about naked puts.

First off, I’ve already written quite a few posts on selling naked puts (click on the hyperlink if you want to see them). Here’s my naked put selling summary:

1. I only sell naked puts on cheaper stocks/ETF’s (probably around $30 or below). If it’s a higher priced stock, I’ll simply sell a put spread (bull put spread that is), to limit the risk and margin requirement.
2. I prefer selling options with 3 to 6 weeks to expiration to exploit the higher time decay
3. When choosing which strike price, I sell as far OTM as possible, but still bring in sufficient credit (around $1 for me)
4. Three reason I’ve used USO in my examples are:

a. It’s an ETF that tracks a commodity (crude oil), which I know isn’t going to $0. Selling a naked put on a financial is one thing, but using a commodity ETF is something different altogether IMO.
b. Cheap price
c. Wouldn’t be the worst thing if I get assigned.

"Do you also do fundamental research or let the charts do the work for you?"

I primarily focus on the charts. The cornerstone of technical analysis is that “Market Action Discounts Everything”. In other words, all variables that can possibly influence the price such as fundamental, psychological, political factors, or anything else- is already reflected in the price of the security. If that’s the case, then all we really need to do is analyze the price action. The following mantra has helped me in my trading, “Focus on the what, not the why!” The price action portrays the “what”, the news and market pundits try to pontificate on the “why”. Leave it to the jugheads to try to explain every little market move… to me it causes too much analyzing, resulting in second guessing when the charts have already given a solid signal.

"Also do you go for stocks above a minimum price such as say $20."

This is completely personal preference. Through your practicing you should get a good feel of what price range you want to focus on. Sometimes it depends on what option strategy you’re implementing. For my personal price filters, I tend to stay away from stocks under $20 or $15. I don’t mind trading higher priced stocks or indexes though, as they provide a lot more strike prices to choose from when spread trading. I did a previous post on the differences between stock and ETF/index options that I’d recommend taking a look at.

"Also do you go for 6months options if you want to collect the premiums and at the same time, if stock moves against you, you don't mind buying it at the strike price? (e.g. you sold a naked put)"

Not sure what prompted you to specify “6 months” vs. say 5 or 4 month options? But here’s the rationale when choosing which month to sell on a naked put. Shorter term options experience a higher rate of time decay, usually resulting in quicker profits. Another benefit of selling short term options is that not as much can go wrong. Consider this: Can a stock drop further in 4 weeks or 6 months? Some may prefer to sell 2 or 3 month puts to bring in more premium, but this is a matter of personal preference. I’d rather sell (6) 1 month puts, than (1) 6 month put.
You don’t necessarily have to sell naked puts with the mindset that you’re going to allow assignment and buy shares of the stock. It’s very easy to exit the trade prior to expiration if the stock has dropped significantly.


Thursday, April 2, 2009

Bare Naked Oil Puts

I wanted to follow up yesterday’s chart of the USO with a strategy overview. The USO had a nice 4 day retracement into a potential area of support. With this price pattern, I'm looking to enter bullish trades. Due in part to the low price of USO, as well as my willingness to accumulate shares at these price levels, let’s assume I sold some April naked puts.

Which Strike:
Choosing which strike price to sell is a matter of personal preference. Most traders sell either at- or out-of-the-money options to increase their probability of profit. The further out-of-the-money the option, the higher the probability of success. Keep in mind that as options move further OTM, they decrease in value. I try to look for the “goldilocks scenario”. In other words, not too close to the current price, yet not so far away that I don’t receive sufficient premium (which for me is around $1). The only times I’ll accept less than $1 are if the stock price is cheapo (like $20 or less). As many of you probably know it’s pretty tough to sell an OTM option on a $10 stock for $1.

Which Month:
Due to the higher theta I stick with selling puts with 2-6 weeks to expiration, which covers either front month or 2nd month options. This is why we chose to sell April puts on USO.

Sell Apr 27 put option for $1
Max Reward = $1
Theoretical Max Risk = $26
Breakeven = $26
Probability of Profit = 1 - .17 = 83%

Are naked puts the best bullish strategy?

Let's answer that by asking this: Can anyone really argue whether or not one strategy or approach is the "best" one?

No siree!

Here’s the deal. There isn’t one right strategy for any situation. It comes down to risk tolerance, account size, personal preference, yada yada yada…
Although naked puts work great in some scenarios, many traders prefer other bullish strategies, such as long calls or bull spreads. I’ll be the first to admit that sometimes naked puts are a crummy way of getting bullish, particularly when the stock skyrockets. Remember short naked puts only afford a limited (and sometimes quite small) reward. Long calls offer unlimited reward.

If after selling a naked put the stock jumps 10% the next day... you bet I’m wishing I bought calls.

But that’s not the point.
The point is I’m comfortable and satisfied with the risk-reward characteristics of a naked put, so regardless of the outcome I shouldn’t be disappointed or second guess myself.


CNBC Alert!

Leave it to CNBC and the “market pros” to call the rally “real” after we bounced 26% off the lows and the SPX is up almost 70 points from its last pivot low. Nice timing… sheesh.

But wait…
There’s more…

“Using the Fibonacci numbers sequence to predict stock movements, Hager says 8,330 and 9,313 will be critical resistance levels for the Dow, with 10,220 seen as a breakthrough that will firmly establish the potential to challenge the historic high of 14,164 on Oct. 9, 2007.”

Sounds easy right? After all, we merely need to pierce 10,220 then we can “establish the potential to challenge the historic highs of 14,164.”

Are you kidding me? What’s his time horizon…10 years?

Don’t get me wrong… it’s great to point out key resistance levels, but dang... give your viewers some context here.

Sometimes the manure they put out is "udder" nonsense.


Trading Lab Recap - Choosing Strikes for Bear Put Spreads

With the bear put spread and all debit spreads, we can increase/decrease the risk-reward ratio, and probability of profit by changing the strike prices we use. Let’s look at 3 bear put spreads on CNX.

CNX is currently trading at $26.32

Bear Put #1
Buy May 30 put for $5.70 1st strike ITM
Sell May 25 put for $2.70 1st strike OTM
Net Debit = $3.00
Max Risk = $3.00
Max Reward = $2 (5 – 3)
Breakeven = $27 (30 – 3)
To realize max profit, we need the stock below $25

Bear Put #2
Buy 25 put for $2.70 1st strike OTM
Sell 20 put for $1.00 2nd strikes OTM
Net Debit/ Max Risk = $1.70
Max Reward = (5 – 1.70) = $3.30
Breakeven = 25 – 1.70 = $23.30
Cheaper – less risk- more potential reward
To realize max profit, we need the stock below $20

Bear Put #3
Buy 35 put for $10.00 2nd strike ITM
Sell 30 put for $6.00 1st strike ITM
Net Debit = $4.00
Max Risk =$4.00
Max Reward = $1 (5 – 4)
Breakeven = $31
To realize max profit we need the stock below $30

How do I choose which strike prices to use?
Starting out, most debit spread traders probably use the following strikes:
Buy 1st strike ITM, sell 1st Strike OTM

Out-of-the-money bear put spread: Buy 1 strike OTM, sell 2 strikes OTM
OTM bear put spreads are cheaper, have less capital at risk, have more potential reward, but require the stock to drop in price more b/c they have a lower breakeven

In-the-money bear put spread: Buy 2 strikes ITM, sell 1 Strike ITM
ITM bear put spreads are more expensive, have less potential reward, but doesn’t require the stock to drop as much in price b/c they have a higher breakeven

My personal preference is to use OTM debit spreads. I’m willing to accept a lower breakeven (stock has to move more), in return for a lower risk – higher reward trade.

My odds of being assigned are high when:
Short option is ITM
Short options has little to no extrinsic value left
If it comes to the point where the short put (bear put spread) has little to no extrinsic value left, that means you’ve made almost all your profit

Trade Reviews:
AZO $166
Outlook: Bullish
Strategy: Bull Put Spread
Sold APR 145 @$1.89
Buy APR 135 @$.91
Net Credit = $1
Max Reward = $1
Theoretical Max Risk = $9

2 types of risk:
Theoretical Risk (if trade goes completely wrong & I hold all the way to expiration)
Managed Risk (how much I could lose based on my stop loss)

1: Hold to expiration to realize enter $1 profit
2: Exit early when achieved 80% of max profit

Trade Management
1: Exit if stock breaks support
2: Exit when lose 30% of max risk
Why would I be willing to risk $9 to make $1? B/c the probability of profit was around 90%.

Wednesday, April 1, 2009

Black Gold

Morning folks! I wanted to follow up on one of the ETF's I reviewed in Monday's video.

The USO, United States Oil Fund, has been in a short term uptrend comprised of higher pivot highs and higher pivot lows since February. Over the last 5 days it has put in a bullish retracement pattern. Today's gap down caused the stock to fall to it's 50 day moving average.

From a fibonnaci retracement perspective, the USO has now retraced between 38.2% and 50% of its move from Feb 18th to March 26th. As mentioned last night, this is usually an area where buyers start to step in and accumulate shares.
We've also got some prior price congestion that may start to provide support in this area.

Tyler -