Wednesday, June 30, 2010

Rollin with My Puts

I received another question, this time from tjktrader, regarding how to manage long put positions when/if the market moves adversely. As is typically the case there isn't always one right way, but let's review a few adjustment ideas worth considering when playing with puts. The adjustments fall into two camps- ones you may use when the underlying moves adversely from the get-go causing the put to lose money and ones you may use once you've accumulated a decent chunk of profits on the put. The latter camp will be in focus today.

Suppose we purchased a SPY August 110 put option for $4.50 on June 23rd when the SPY was trading around $109. Given the precipitous fall in the market coupled with the sharp volatility surge over the last week, the put option has risen in value to $7.30 giving us a $280 unrealized gain. Not too shabby! Consider the risk graph displayed below. In this situation, how might a trader adjust the put to protect or hedge him/herself in case the SPY catches a bid and rallies back strong?
[Source: MachTrader]

First, adhere to the K.I.S.S. method and just sell the put to exit the trade. If you're of the opinion the market may bounce back strong and fear coughing up your hard earned gains, then there's nothing wrong with jumping ship with your captured booty.

Second, roll into a vertical put spread by selling a lower strike Aug put. Selling the lower strike put not only helps hedge your delta risk, but also theta and vega risk. Right now there are three ways you could start to give back profits: a rise in SPY, a drop in implied volatility, time decay. Suppose you sell the Aug 105 put for $4.60. Consider your new position in the risk graph below:
The delta risk has dropped from 70 to 20, theta has flipped from hurting your position to helping and your exposure to volatility has been largely eliminated. In addition, you can continue to accumulate profits up until about $510 and are guaranteed to capture at least a $10 profit regardless of how high the SPY may rally.

Yet another adjustments worth consideration is rolling to some type of calendar by selling a July option against the August put. We'll explore one such example tomorrow so stay tuned...

Tuesday, June 29, 2010

Risk Rockets and the Strategic Exit

I received a thoughtful question regarding my exit strategy on the SPY risk rocket introduced in Fire Up the Boosters. Those familiar with the original post will recall we entered this bullish play to exploit the breakout over $111 in the SPY. The initial target was $113.50 or one ATR above the entry price. The trade turned out to be a heart-breaker as the SPY made a healthy attempt at following through to the upside but fell just shy of the target when it topped out at $113.20.

After coming within a hairs breadth of capturing the profit, and seeing last Monday's gap get sold into with a vengeance, I opted to bail when the SPY returned to its breakout point of $111. It obviously would have been nice had I adjusted right on the open on Monday when the SPY was close to my target, but hey, hindsight's 20-20 (click chart to enlarge).

[Source: MachTrader]

While I had a chance to bail close to my break-even point in this scenario, what might traders do if the stock moves adversely from the get-go on this type of play? My typical default exit plan for virtually any and all directional bullish plays is to bail once I've been proven wrong. When trading based off of a price pattern, such as a breakout, being proven wrong usually occurs when the pattern fails. I usually draw a line in the sand under some type of support level and declare myself wrong if that level gets taken out.

As they say, there's nothing wrong with being wrong... there is something wrong with staying wrong.

I suppose trader's could hedge the risk rocket by selling in-the-money calls when the underlying moves south. Though in my experience most trader's are better off just exiting since hedging opens up a whole new can of worms.

For related posts, readers can check out:
Evolution of a Bullish Risk Rocket
Adjustment Thinking and the Salvation Syndrome

Sunday, June 27, 2010

EBAY... No Bids?

After breaking down selling put spreads, how about a few thoughts on buying them? Recently EBAY seems to have fallen out of favor as its stock price has experienced notable weakness relative to the tech sector and the overall market. What might be a strategic way of positioning oneself to profit from continued weakness in this online shopping mall? Options Action suggests purchasing an August 21-17 put spread for $1.00. Buying a put spread (also commonly, and perhaps redundantly, referred to as a bear put spread) consists of simultaneously buying a higher strike put while selling a lower strike put in the same month (click image to enlarge).

In the case of the EBAY spread, the best case scenario occurs if it resides beneath $17 by August expiration. The maximum profit for long put vertical spreads is equal to the distance between the strikes ($4 in this case) less the debit paid to enter. Consider the risk graphs below:
[Source: MachTrader]

One question worth considering is whether or not it is advantageous to sell the Aug 17 put which caps the profit potential. Why not just buy the Aug 21 put outright and have unlimited profit potential? The typical rationale for the superiority of the spread is it cheapens the trade while also hedging time and volatility risk. The problem I see with this particular spread on EBAY is the Aug 17 put only reduces the trade by $.25 When entering directional spreads I prefer to have the short option reduce the overall cost by around 1/3. At $.25 or about 1/5 the value of the long Aug 21 put, the Aug 17 put falls just a bit short. Shorting the 18 put is probably more up my alley.

Like most practitioners of technical analysis, I'm a fan of waiting to pull the trigger until after I have some type of catalyst. With EBAY currently sitting at long term technical support around $20.50, I'd prefer to see a breakdown before plunging into this type of play.

Wednesday, June 23, 2010

Breaking Down a Put Spread

Suppose you like the current fundamental and technical outlook on gold and are considering throwing in your lot with the ever hopeful gold bugs. But with the SPDR Gold Shares (GLD) trading at $121 per share, let's say you're a bit skittish at the hefty price tag. While bullish risk rockets or other long stock strategies may be outside your price range, the cheaper vertical spreads may be an alternative worth your consideration. Let's breakdown an out-of-the money put vertical sell on GLD.

In choosing which month to use when structuring this play, some traders opt for front month options which offer an alluring higher rate of time decay. But remember these short term options aren't always sunshine and lolly pops, as they also include the often forgotten (or at least downplayed) gamma risk. Those favoring lower gamma risk over a higher theta typically prefer using longer dated options such as two or three months out. We'll go ahead and use August in today's example.

When it comes to strike selection, traders are faced with the dilemma of either going for a higher net credit and lower probability of profit or a lower credit and higher probability of profit. Suppose we settle on a happy medium between the two by going far enough out-of-the-money to feel comfortable with the profit zone, but close enough to still receive a sufficient return. Consider the risk graph of the Aug 115-110 put spread below.

[Source: MachTrader]

Provided GLD remains above $115, we stand to gain $89. While traders can certainly hold to expiration to capture the whole enchilada, it's usually prudent to exit when the majority of the profit has been achieved.

For related posts, readers can check out:
Ratios, Ratios, and More Ratios
Public Enemy #1
Time to Shine?

Friday, June 18, 2010

The Ascension in Gold

Friday's surge in gold served as yet another breakout in a long line of bullish price patterns over the last few years. Today's chart highlights a few key technical levels the SPDR Gold Shares ETF has breached in its resilient march to recent highs. Whether or not the current breakout is followed by as strong of a run as past breaks remains to be seen. If history is any indication, it has not paid to bet against this pup when exhibiting this type of pattern.
[Source: MachTrader]

Friday's strength bode well for our GLD 121-124-127 butterfly as outlined in Rolling on the Fly. With a pop to $123, GLD settled nicely into our profit zone. While it would have been nice to have seen it nestle close to $124 into the close, it's rare to throw on a butterfly and see the stock pin right at the middle strike. Trader's using butterflies would be well served by learning to take partial profits.

For related posts, readers can check out:
Evolution of a Bullish Risk Rocket
Christmas Musings and a Trade Journal

Thursday, June 17, 2010

Fire Up the Boosters

Like most chartists, I'm continually on the lookout for quality patterns stacking the odds in my favor while providing favorable risk/reward entries. Entering the market at random times is not only silly, it's usually a one way ticket to the poorhouse. Whether you're an Elliot Wave practitioner, a Fibonnaci fanatic, or a volatility and sentiment analyzer, we're all attempting to find an exploitable edge and bring order to the seemingly random market. All too often traders miss the mark by bouncing from one trading style to another instead of honing in on one approach. Don't make the mistake of becoming a jack of all trades and master of none. As I've mentioned before I'm a simple man when it comes to technical analysis and believe that less is more. Usually the cleaner the chart the better.

Speaking of strategic entries, I'm thinking the market may have provided participants wanting to join the bullish throng with one such entry point during Tuesday's breakout. I took the opportunity to enter a bullish risk rocket on the SPY during the surge in anticipation of some more upside over the coming days. Suppose we purchased 100 shares at $111 and bought two July 113 calls for $1.65 apiece (click image to enlarge).

As is typically the case with these risk rockets, we're looking for a one average true range (ATR) profit before unloading the stock. At trade inception the SPY had an ATR around $2.50, putting our profit target at $113.50 (111+2.50). Once the target is reached and the gain on the stock locked in, we'll consider rolling the remaining calls to some type of risk free spread. I'll follow up with an update when needed.

[Addendum: The exit for today's SPY Risk Rocket can be found here]

For related posts, readers can check out:
Adjustment Thinking and the Salvation Syndrome
The Sling Shot
Risk Rocket

Wednesday, June 16, 2010

VIX Settlement and Term Structure

June VIX options expired today with a settlement value of 26.11. Long time readers know the settlement price can be viewed a couple different ways. First, the CBOE usually publishes the price within a few hours of the open on its Index Settlement Value page. Second, you can view the price in a charting platform using the VIX's settlement ticker symbol $VRO. If you take the charting route, keep in mind the settlement value is simply one value per month. Since it doesn't have an Open, Close, High, or Low, you can't view it very well on a bar or candle chart. So stick to a line chart and you should be fine. One of the benefits of using the chart versus the CBOE page is having the ability to simultaneously see past VIX settlement values to better grasp how the VIX has progressed over time.
[Source: MachTrader]

A survey of the current volatility landscape shows the VIX futures in contango with the July's at a 2.5 point premium and the Aug's at a 3.35 point premium to the VIX cash. Given the precipitous drop in volatility this week, it's not surprising the futures are now above the cash and in contango. Remember, the futures are pricing in any type of mean reversion expected to take place between now and then. A quick assessment of the term structure simply shows us the expected mean is higher than the current VIX cash. Whether or not the futures have it right remains to be seen (click image to enlarge).

For related posts, readers can check out:
Settlin' Them VIX Options
VIX Options
Lessons Learned from a VIX Put Matrix


After remaining range bound for seventeen trading days, the SPX was finally able to muster enough momentum to breakout. While it remains to be seen how much follow through we experience over the coming days, the bulls definitely scored a victory with yesterday's pop which did some notable technical damage to the downtrend in place over the last two months. Just as we looked at potential downside targets in last week's On the Brink, let's highlight a few key resistance levels looming overhead.
[Source: MachTrader]

Fibonnaci traders considering retracement levels between the April 1220 high and June 1040 low are likely to point out the 50% and 61.8% retracements residing at 1130 and 1150. Skeptics of the whole fib approach could consider the 50 day moving average around 1140 and especially the prior pivot high at 1170. Either way, from current levels the SPX has room to run if it wants to.

One potential fly in the ointment I see that may sour any immediate follow through to yesterday's breakout is the fact that the SPX is up 75 points in six days. It wouldn't surprise me to see a bit of churning to digest this overbought pressure. What I, as well as any other chartists calling yesterday a breakout, would not want to see is a plunge right back into the trading range.

For related posts, readers can check out:
The Market is Vewy Vewy Quiet
Old King Kol

Tuesday, June 15, 2010

Exiting the Volatility Fray

Last week's Entering the Volatility Fray marked my first stab at playing VXX options. After experimenting with a few different strategies, I settled on call ratio spreads. Three key factors went into my decision. First, VXX options had some pretty steep upside skew making the OTM calls relatively expensive. Second, volatility had reached lofty enough levels to make me a seller. Third, call ratio spreads give me quite a bit of leeway due to the large profit zone.

I ended up exiting the trade yesterday once I had captured the majority of the original credit received. I originally sold the spread for $140 credit and exited yesterday at $20. With a scant $20 left and about five weeks remaining until expiration, it was a no brainer exit. Since the SPX held the 1050 level and staged a nice little rally, we've seen fear dissipate out of the markets a bit. Not surprisingly, VXX stock has come in and has seen an easing in demand for its out-of-the money calls. Take a look at the following two skew charts displaying the vol levels of the July 40 strike calls at trade inception as well as when I exited.

[Source: Livevol Pro]
I originally sold the 40 calls when they traded at an implied vol of 108%. The 7 point drop to 101% coupled with the notable drop in VXX stock quickly depressed the calls involved in the trade providing me with a swift exit.

For related posts, readers can check out:
Volatility Skew and Ratio Spreads
Gaming the Gold Bugs

Monday, June 14, 2010

From One Extreme to the Other

[Source: MachTrader]

Since illustrating 1050 and 1105 as two key levels in June 2nd's Lines in the Sand post, this trading range has proved quite resilient. Just as the bulls thought a break to the upside was imminent on the eve of the Employment Report, the bears (including myself) thought 1050 was toast last week. But alas, both prognostications have proven unfruitful so far. I suppose this illustrates the importance of waiting for confirmation. While it's fair to speculate as to whether we're going to breakout or not, it's usually prudent to wait for some type of price confirmation before allocating any capital to the idea.

Stock Repair to the Rescue

To say BP has been beat silly over the last month is quite an understatement to say the least. Trying to pick a bottom in this has been like nailing jello to a tree and serves as yet another example of the futility of bottom fishing. So what about those longer term investors who purchased shares in the $50 range and find themselves way underwater? While my first inclination is to question their sanity for allowing a position to drop 50% without jumping ship, let's see if we can lend a helping hand by outlining a stock repair strategy suggested by the Options Action gang on Friday.

Most traditional investors wanting to remain long BP in an attempt to recoup losses really only have two choices. First, they could hold on and hope BP rises back north of $50 - a scenario I find highly unlikely anytime soon. Second, they could double down by purchasing more shares at current levels. The advantage of doubling down is dropping their average cost basis (break-even) to the low 40's. While it is smart to attempt lowering the break-even to increase your probability of recouping loss, doubling your risk at the same time can be a tough pill to swallow. Wouldn't it be nice to lower the break-even without adding risk? Look no further than the stock repair strategy.

This repair strategy can be entered by simply adding a 1x2 call ratio spread to your long stock position. You can think of it as selling a covered call and buying a call spread simultaneously. Suppose our original purchase price of BP was $50 giving us the following risk graph:
[Source: MachTrader]

We have a current unrealized loss of $1900 and need a $19 rise to reach our break-even point.

To enter a repair strategy we could buy one Oct. 36 call for $4.30 while selling two Oct. 41 calls for $2.25 apiece. We're essentially selling an Oct. 41 covered call and buying an Oct. 36-41 call spread. Because the credit received from selling the two 41 calls was sufficient to pay for the long 36 call, this repair strategy can be entered at no additional out of pocket cost. Now let's see if it improved our break-even by assessing the new risk graph:

In the new position, we now only need a rise to $41 instead of $50 to recoup the loss. Though it is ideal to recoup the entire loss, this specific repair falls $280 short. But, let's be honest. Any trader in their right mind would love to turn a $1900 loss into $280. Keep in mind this strategy does nothing to decreasing remaining downside risk, so it's not really a hedging strategy as much as it is a repair helping you make money back quicker.

For a more detailed look at the stock repair strategy, CBOE has a solid write up than can be found here.

Thursday, June 10, 2010

Rolling on the Fly

Due to GLD's recent failure to breakout to new highs, I rolled the call spread outlined in Evolution of a Bullish Risk Rocket to a butterfly. Those familiar with the original post are aware that we were already in a risk free June 121-124 bull call spread. In fact, our minimum reward came out to $132. Given the already advantageous position we were in, why bother with further adjusting into a butterfly? Though I could cite several added benefits, let's focus on two.

1. A Higher Minimum Reward: In order to roll the long call spread to a fly, we added a short call spread. The credit received from selling this spread directly increases our minimum reward.
2. Profit Zone Shifts: The fly's risk graph provides superior profits at GLD's current price versus the original call spread. This downward shift of the graph puts me in a better position if GLD fails to rise above 124 by June expiration.

Consider the original call spread's risk graph:
[Source: MachTrader]
Consider the new butterfly's graph:

The only outcome that will result in the fly under performing the original call spread will be if GLD rises past $125 by next Friday (June expiration). While anything is possible, it's fair to say a surge of that magnitude with only a week remaining is highly unlikely.

For related posts, readers can check out:
Adjustment Thinking and the Salvation Syndrome
Decision Trees
The Sling Shot

Wednesday, June 9, 2010

An Option Sellers Dilemma

Let's tackle a question I received from Dave earlier today.

You've mentioned before that it might not be a good idea to hold options into expiration due to gamma risk. Do you ever just let them expire worthless or do you always exit? I have two bear call spreads, one is a little over $10 OTM while the other is $15 OTM. Both are virtually worthless, but it would cost $.10 plus commission to close them. In this case would you hold to expiration to avoid commission or do you never hold into expiration?

This is a scenario that faces all option sellers at one point or another. Whether you sell covered calls, naked puts, or credit spreads, you'll eventually face the dilemma of deciding whether to buy back short options when you've captured the majority of the profit or ride to expiration in an effort to lock in the last few pennies. The obvious allure of hanging on until expiration is capturing that last $.10 plus avoiding paying the pesky commissions which are unfortunately a necessary evil. As you mention, the treacherous risk lurking in the shadows around expiration is gamma. While it seems like a "sure thing" that your bear call spreads will expire worthless, the market has a merciless track record of reminding traders there's no such thing as a sure thing. Don't rule out the chance that the stock you're trading could make a kamikaze run for your short call spread over the remaining week. Due to the high gamma of short term options, they can increase rapidly in price if they start to move close to the money.

Traders who continually hold short options into expiration will inevitably face a scenario where they end up having to buy back those $.05 or $.10 options for $1 or $2. All it takes is one huge adverse move close to expiration to wipe out the additional few bucks you gained from the past five or ten trades. After experiencing a few of these gut wrenching disasters, most experienced traders opt to simply avoid the high gamma drama that plays out close to expiration by closing short options early. They value the peace of mind that comes with this approach more than the extra few bucks they may make by riding to expiration. At the end of the day, it's really up to you as to which route best fits your risk tolerance.

For related posts, readers can check out:
Public Enemy #1
Gamma vs. Theta
Gamma vs. Theta II

Tuesday, June 8, 2010

Entering the Volatility Fray

Traders wishing to trade volatility gained yet another weapon to their arsenal with the CBOE's recent roll out of options on the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). As with any new trading product, I've been watching the trading volumes on both to see what type of traction they gain and whether or not they offer sufficient liquidity to merit a place in my personal trading toolbox. In assessing liquidity I'm primarily interested in whether or not the vehicle under scrutiny offers a tight enough bid-ask spread. If the spreads are wide enough to drive a Mack truck through, I'm not interested. Perhaps we could pin up SPY options as the poster child since they offer super tight penny spreads due their tremendous liquidity.

Given the current status of the VXZ options, I wouldn't touch them with a ten foot pole. With the spreads as wide as they are, why bother? VXX options, on the other hand, are starting to look a bit more tempting. Like most semi-liquid options, the front month is seeing the most action and thus offering the tightest spreads. Currently the ATM June call is trading at $1.95 by $2.15. At $.20, the spread is certainly tight enough to warrant playing with in my opinion. Venturing further along the expiration curve offers less liquidity and wider spreads. I suspect as volume builds, we'll see the spreads continue to come in.

Currently we're seeing a decent amount of upside skew in VXX options, where higher strike calls are trading at higher vol levels than lower strike calls. Those familiar with VIX options shouldn't find this all that revealing as VIX options have historically seen a decent amount of upside vol skew due to the higher demand for OTM calls versus OTM puts. Consider the following skew chart of the VXX July options.

[Source: Livevol Pro]

Today marked my first attempt at trading VXX options. To exploit the relative expensiveness of the OTM calls as well as a neutral to bearish move in the underlying, I entered a July call ratio spread by buying a 37 call and selling two 40 calls.
[Source: MachTrader]

As long as we remain below 37 between now and July expiration, I stand to gain the net credit received at trade inception. A slow drift higher would also prove beneficial provided it doesn't occur too quick. Due to the extra short calls there is upside gamma risk if a continued rise in volatility gets out of hand. But given the already elevated state of volatility futures I'm relatively comfortable placing my bets we don't go that much higher over the next few weeks.

For related posts, readers can check out
Reflections on VXX
Goldman Sacked

The Lending Merry-Go-Round

Confused about all the bailouts? Let's break 'em down...

Monday, June 7, 2010

On the Brink

After holding firm for a few days, the lower line in the sand outlined in last week's post seems ready to give way. Though the bulls gave it a valiant effort trying to breach the 1105 SPX resistance level last week, the employment report ushered in yet another surge in selling pressure. With today's close of 1050, the SPX is knocking on the door of a breakdown below a significant weekly pivot. Assuming we see more follow through to the downside, this break will serve as yet one more nail in the market's technical deterioration coffin and would be the first time we've broken a weekly pivot low since the March 2009 Bear Market low.

Today's graphic highlight's a weekly chart of the S&P 500 with two sets of fibonnaci retracements displayed. The first set of fibs spans from the 2007 market top (1576) to the 2009 market bottom (666) and is displayed in blue. The other spans from the recent 2010 highs (1219) to the 2009 market bottom (666) and is displayed in dark green. While I'm not an avid fan of using fibonnaci retracements on smaller time frames, I do find them quite effective when identifying key levels that may act as support or resistance on the weekly chart. Following 1050, the next two downside targets on my radar are 1015 and 950 (click image to enlarge).

[Source: MachTrader]

Today's surge in gold certainly helped our GLD June 121-124 call spread outlined in Evolution of a Bullish Risk Rocket. If GLD is able to muster up another dollar or two rise we should be in prime position to roll into a butterfly or condor by adding a short call spread to our position.

For related posts, check out:

Wednesday, June 2, 2010

Lines in the Sand

After spoiling chartists with a clean and easily definable head and shoulders and bear retracement pattern over the last month, it seems the S&P has returned to murky waters. Since bottoming out last week the S&P 500 Index has thus far settled into a choppy range between 1050 and 1105. In my own attempt at simplifying charting I'm a staunch believer in the notion that less is more. I often use simple horizontal lines in highlighting key support or resistance levels. These lines in the sand represent pivotal points in the chart that if broken would change my short term outlook. Currently the two closest benchmarks reside at 1050 and 1105.

So long as we meander between these levels I will maintain my lack of conviction as to the direction of the next short to intermediate term move in the SPX. On the other hand, once we break above or below either level I'll be anticipating some follow through (click image to enlarge).