Taking Off the Training Wheels

Time comes when you’ll want to trade live rather than in simulated mode. Here are some things to consider as you contemplate this transition:

  • Don’t begin trading live until you become consistently successful trading paper.
  • Before applying any successful trading strategy in live trading, understand how and why it is successful. Being lucky is not a good strategy.
  • Use a live trading platform that is as close a match as possible to your simulated platform.
  • Learn all you can about differences between the simulated platform and the live trading platform. For instance, paper options trades on Thinkorswim are never subject to early assignment.
  • Do thorough tax planning. Understand how a standard margin investment account is different from a Roth IRA. Choose an account type that will be consistent with your best interests.
  • Don’t hesitate to return to the paper platform whenever your profits fall or turn into losses. Market behavior is dynamic. What worked last year may not work this work this year.
  • Don’t change your trading approach without returning to paper trading to test it thoroughly.
  • Start slow. Test the waters before you dive in.
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A Year of Paper Trading

[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]This week ends a full year of studying options by extensive paper trading using a variety of approaches. I’ve learned a lot about what kind of trader I am and the ways I can make a profit, at least on paper. It’s far more than can be thoroughly covered in a single blog post, but I can write a few headlines.

First, what I’ve learned about myself as a trader:

  • I am risk averse.
  • I’m better at predicting what will happen today and tomorrow than what will happen next week.
  • I am impatient to see results in my trading.
  • I will spend too much time on the trading platform.
  • I have become disenchanted with all the financial pundits and self-proclaimed experts.
  • Success in paper trading has given me a great deal of confidence that I can avoid losing. Still, I worry that I may not make a consistent profit.

Now, a random list of what I’ve learned about trading:

  • Vertical spreads are a good way to define the max risk of a trade. They also simplify determining a profit target.
  • When a trade turns bad, abandon it before you reach the max loss.
  • Always know what your acceptable risk is and at what level you will take a profit.
  • As the value of your trade increases, keep track of how the increase in value affects the trade’s risk profile. Adjust accordingly by scaling out of the trade or closing it.
  • A 2% return on a trade after a single day is better than a 10% return after five days.
  • Technical analysis of price charts is a belief system. It works only when a critical mass of traders think it will work. Volume can indicate if belief has hit a critical mass.
  • Think of those you trade with as customers. Try to understand their thinking, and use that understanding to your advantage.
  • Treat a trade like a negotiation. Submit limit orders at levels that work the range of premiums in the current market to your favor.
  • Learn how various order types work. Rely on conditional orders such as OCO (one cancels the other) orders, sequenced orders, etc. to simplify and organize trading activity. Doing this also adds a bit of automation to your trading process and helps provide some emotional distance to coolly analyze your trading plan away from the heat of the front lines.
  • Pay attention to corporate actions such as earnings reports, distributions and splits.
  • Understand volatility–both historical and implied. Volatility can be your friend or your enemy. Know if it’s on your side.
  • Trade the issues that others are trading. High open interest, high volume, and tight spreads make for successful trades.
  • Control risk on the portfolio level as well as on the trade level. Learn how to beta test your portfolio against an appropriate benchmark.
  • Review you’re trading activity frequently. Trading is a data-centric activity and the data you create as you trade may be the most valuable data you have for improving your acumen as a trader.
  • Find a small group of traders that you can meet with to discuss your progress and theirs as traders. Like many other things, enlightenment takes a village. And hanging out a bit with those who prosper in this curious trading game will broaden your understanding of the financial market and its potential for growing wealth.

Key take-away: Hopefully this year’s lessons can be a springboard to next year’s success.

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The E-Mini S&P 500 Futures (/ES)

[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]Trading a futures index like ES bears a lot of similarities to trading indices like SPX or XSP. But there are significant differences as well. Before you start trading futures contracts or their options, it would be wise to study them in a systematic way. Your broker may offer learning resources, and you can take courses elsewhere. The CME Group, a major marketplace for derivatives trading offers introductory and advanced courses in futures trading. Take a look at them before you jump into trading.

Option contracts on ES futures expire daily, Monday through Friday. You can buy and sell them overnight. They are highly liquid and tend to have lower margin requirements. You’ll have to apply to your brokerage to secure permission for trading futures and your broker may require your account to have a minimum balance. TD Ameritrade, for example, requires a balance of $25,000 for any account that has futures trading enabled.

ES options, like index options, are cash settled and cannot be exercised early. Because ES options trade 23/5, they may be attractive to traders who are unable to trade during the hours that the NYSE is active. They can also benefit traders who like to set up orders for overnight trading, or who wish to respond to reports that appear outside of normal trading hours, such as earnings reports and late-breaking news.

Key Take-away: Investors who fully understand futures have increased opportunities for profiting from trading.

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Trading Options on an Index

[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]Play Trading an index is a different game. The best known and most traded index is SPX. You can’t buy shares of the SPX, but you can buy and sell options. And many, many people do. Since the SPX doesn’t have shares, options on it cannot be exercised, which means they cannot be assigned. At expiration settlement is made in cash. Consider what that means when you sell a vertical spread. In a normally settled American option that is settled by the exercise of ITM contracts at expiration, you may find yourself in the uncomfortable situation where the short leg of a vertical spread is ITM while the long leg is OTM and expiring worthless. This means that the spread will now longer have a defined risk. See an earlier post for a detailed example of this risk.

Strikes on SPX are $5 wide, and option contracts are expensive; however, bid-ask ATM spreads typically run less than 5%. APX options with their high volume and volatility provide many opportunities for traders who follow the S&P 500. The SPX offers contracts that expire every day Monday through Friday.

A less pricey choice for trading an S&P 500 index is XSP, which trades at price 10% of XPS with dollar wide strikes. It has lower volumes than SPX, but narrow spreads. It offers contracts that expire on Monday, Wednesday, and Friday every week. NDX and RUT are similar cash-settled European style options that serve the Nasdaq and Russell indices.

A similar trading choice is to trade /ES, the E-mini S&P 500 futures. Trading options on futures has additional twists that I’ll discuss in later posts.

Key Take-away: Trading options on indices differs significantly from trading options on equities or EFTs. Be sure you understand the differences.

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Selling High Buying Low

[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]Here’s a trade from last week. It consisted of two credit spreads. One was a put spread, the other was a call spread The strikes for each spread were 1 dollar wide. I based the limit order on althe price action associated with each of the spreads which are displayed in the lower pane of the chart below. Both orders were filled at limit yielding a total credit of $1.46. At expiration, one spread was ITM, the other was OTM. The ITM spread had one dollar of intrinsic value, which goes in the loss column. The OTM spread expired worthless. Subtracting the one dollar from the 1.46 gain yeilds a profit of $46 on the trade with fees totalling $2.60 for a net gain of $43.40. The trade was open for about 45 minutes. Total risk for the trade was around $25.

Key take-away: Take advantage of volatility in spread pricing to open trades at a favorable level.

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Profit and Risk

[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]The box spread SPY written about in yesterday’s post has expired. SPY closed at $362.79. The call side of the spread expired OTM and the put expired ITM. We had received a combined credit on the spread for $130 ($40 on the call side, $90 on the put side). Because the call side was OTM, it expired worthless, and we kept the $40 credit. The put side, however, expired ITM on both legs, meaning that it retained its extrinsic value (the difference between the strikes of the spread) after expiration. The spread has us buying 100 shares of SPY at $383 per share and selling 100 shares at $382 per share–a net loss of $100. The $90 credit we received when we opened the put spread gave counterbalanced the loss at expiration, and our final loss on the put side of this trade was only $10. The table below summarizes what I’ve just described.

Option typeStrikeOpen price per contractClosing price per contractP/l
Short Call383153 credit0+153
Long Call382113 debit0-113
Short Put383680 credit-38300-37620
Long Put382590 debit+38200+37610
Net$130-$100$30
SPY Trade Summary Before Transaction Fees

What would have happened if SPY at expired at $382.50? Then the short put would still be ITM, but the long put would be OTM. The short put would obligate us to buy 100 shares of SPY at a cost of $38,300. Meanwhile, the long put would expire worthless. We could, however, sell the 100 shares of SPY that we’ve been assigned at the market price when trading resumes on Monday morning. Unfortunately, we don’t know what level SPY will open at on Monday. We could get lucky, and maybe SPY will open higher than yesterday’s close. Or it could open yet lower. We can not longer define the risk we have taken on. On May 13, 2019, the S&P 500 gapped down 3.35%. An overnight loss of this magnitude on holdings of $38,300 would be $1283.05. The net $130 credit received on the four trade contracts would reduce this loss to $1153.05.

A final point: Remember that American options can be exercised early, which means that short contracts can be assigned early.

Key take-aware: Thoroughly and continuously consider potential assignment risks when managing trades. Don’t be like 1ronyman.

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Risk-Free Profit or Disaster?

[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]Below are orders for two vertical spreads on SPY that I submitted yesterday:

SPY Orders Submitted 10-6-22 AM

When these orders were submitted, SPY ranged between 375 and 378. The P/L profiles for each of these orders is worth our attention:

SPY Put Spread
SPY Call Spread

Notice that the two spreads compliment one another. Look at what happens when we combine them. I’ll refer to the resulting complex trade as a box spread:

SPY Box Spread

Both of the orders were filled later in the morning, and gave us a position that maintains a $27 profit line no matter what the price of the underlying is. We’ve done the same kind of trade early this week with SPX, which is cash settled. SPY, however, works like a standard American option, which is settled with shares in the SPY ETF. After market closes, we’ll take a look at how things worked out.

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Stretching Your (Iron Condor) Wings

[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]We’ve been experimenting with SPX 0DTE iron condors (ICs) for a while with mixed success. To improve the performance of our trades, we’ve considered opening them during later trading hours, when the markets have settled down, and increasing the distance between our short strikes. The disadvantage of doing these things increases the max on risk and decreases max profit. Partly, these consequences result from time rushing towards expiration.

While nothing can be done about the passage of time, we haven’t yet considered a way to get better pricing on our trades. We have treated ICs as two separate vertical spreads, which we have ordered with limit pricing, but we’ve not followed a process for using data to establish the price to use on those orders. Until yesterday’s successful trade.

Yesterday we waited until 1:45 to send in our orders. We used the ATR based on the amount of time left until expiration to determine strike prices, and we looked at the volatility in contract pricing to provide guidance on how to set the limit price on our orders.

At 1:45 SPX closed at 3768, which will be about where we’d like to center the IC. Since SPX trades at strikes with five dollar increments, we could use either 3765 or 3770 as the mid point between the two short strikes. The ATR was about 32 for the time remaining until expiration, suggesting short strikes of 3730 and 3800. Finally, we needed to set our limit price for each leg.The way to do this in Thinkorswim is to set the option panel to display vertical spreads, right click on the desired contract and display it on the charting page. The candles there will tell you the range that the spread is trading in. Armed with the knowledge of what traders are willing to pay for the contract you wish to sell, provides good guidance for setting the limit price. After going through this process and considering my personal goal of achieving $110 profit before fees on the IC, I submitted the following orders:

SPX Order

The put order filled withing two minutes, and the call order within nine minutes. At the end of the day, the trade made $110 and cost $2.60 in fees. Max risk for each of the verticals was $465. Using the trade management practices discussed in earlier posts, our expected max loss would have been much less.

Key take-away: Do some market research. When buying a contract, set the limit price at the level that frugal traders are paying; sell contracts for what the market will bear.

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A Surprising Win

[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]

Yesterday’s trades provided a too-good-to-be-true profit. Today we’ll take a close look at what happened. Our trading activity was complicated. It involved three vertical credit spreads. We’ll look at them and see what happened.

First, let’s review the two trades that formed our iron condor. We received a combined credit of $145, which we expected would have been our profit had both legs of IC expired with the SPX priced between the two short strikes.

SPX Iron Condor

SPX closed yesterday at 3585.62, which was below the short strike of 3600 on the put side of our IC. When the price of SPX hit 3600, an order to close the put vertical was automatically submitted and received the following fill:

SPX Stop Order Fill

The order gave us debit of $140, leaving us with with a $5.00 profit. Fees would have been $3.90 (6*$0.65). Our net was a paltry $1.10, after the call side of the trade expired worthless. The mechanics here are the same as what we experienced last week on Thursday’s trade.

I watched the trade late in the afternoon as the SPX’s price slide closer and closer to the 3600 stop, and decided to try something new. I opened a third credit spread that I’ll call the Rescue Trade. Here’s what I ordered:

Rescue Trade Order

The concept behind this order is complicated. You might notice that it uses the same strike prices as the put spread from our original trade. Except instead of trading puts, it trades calls. This is a bearish spread that returns its max profit when the underlying trades below the 3595 short strike. That profit begins to decline when SPX’s price rises above 3595 and the trade reaches max loss at 3600. This is the exact opposite of how the complimentary put spread reacts to price change.

When I wrote the order, high gamma drove SPX option prices up and down wildly. I chose $4.75 as my limit price in hopes that this credit would not only cover the likely loss on the put spread spread, but add to our overall profit. I really didn’t expect to get a fill on this order. However, submitting the order was risk free. If it didn’t fill, the original trading plan would complete and we’d either make our intended profit or break close to even when the put spread struck out. If the order filled, we stood to make a handy profit. I was amazed when the order filled a little over 15 minutes after it was submitted. It filled at $5.70, well above the limit price. I think this fill is too good to be true, that it may be some artifact of the paper trading environment we are experimenting in. And I’m not even sure that we would have gotten the $4.75 fill I requested on the limit order.

Here’s a rundown of all the trades:

Trade Summary

The call trades all expired worthless, leaving us with our credits for them. The put vertical stopped out at a loss. Adding the credits and subtracting the debits gives a net profit of $575 before applying transaction fees.

Yes, it makes me giddy, but I’d be negligent not warn that what I’ve done here would have risked assignment and exercise at expiration in an underlying that wasn’t cash settled.

Key take-way: Don’t let giddiness distract from managing risk, but be willing to assume marginal risk to save a trade.

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Another SPX 0DTE IC, Another New Trick

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The trade, constructed from a put and a call credit spread opened a little before 1:30 this afternoon:

SPX IC 9-30-22

Stop losses were set at the short strikes. My technique is to initiate a close at market when a short strike is reached. This may not be the best way to do it, but for now, I’ll be consistent. The short strike levels are selected to have similar deltas and so that the distance between them is double the ATR for the time remaining until market close.

As the last hour of trading approached, SPX was driving dangerously close to our short put strike. I decided to try something new. I opened an order to sell a long ITM call spread that compliments the short put spread on our IC. I’ll describe this more fully this weekend. I expect that we will gain a profit of $215 today on the six verticals we’ve opened. Fees will be less than $10.

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