What’s the News?

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I checked the future at 8 this morning. They were up. I found some good bullish trades and wrote orders on them. Thirty minutes later, everything began to change. The CPI numbers came out revealing an increase in inflation. The market entered a steep decline.

I canceled my orders before they could be filled. Later in the day, I took a look at them, happy that avoided what would have been rapid and significant loss.

Key take-away: Keep up with economic events. There are many economic calendars available online. Check one every morning and be ready to move quickly when the news surprises.

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Know Your Destination but Have an Alternate

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Subtitle: Divert early and avoid the rush.

When you fly sometimes you can’t get to where you want to go. When your destination becomes inaccessible, you need an alternate listed on your flight plan. I also told the pilots under my command that if ceiling or visibility at their destination fell below limits, they needed to divert while they still had plenty of fuel to easily reach the alternate. Plan A was to land at the assigned destination. Plan B was to land at an alternate. Any other plan would lead to catastrophe. When you open a new trade, you also need to have a destination and an alternate.

The destination for a trade is the level of profit you expect to receive. You may calculate it as a value associated with the price of the underlying, a profit level for the trade, or a time when you no longer want to be invested in the trade. You have the same choices when considering when to exit an unprofitable trade.

Setting the profit target. On vertical spreads I set my profit to 80% of my max profit. I may adjust that lower if the value of the option pops quickly. My thinking is that if I get a return of, say, 50% within a day on an option that won’t expire for another two weeks, why not turn that unrealized gain into a realized one. Take that money off the table and look for another great trade. Keep in mind that profit alone doesn’t fully evaluate a trade. Profit divided by time is the metric to use. Making 10% in a day is far better than making 10% in a year. Also recognize that as unrealized profit accumulates in a trade, the risk of loss increases. For example, imagine a vertical spread with a max profit of $50 and a max loss of $150. It’s gone well and if you close it after a few days, you will see a gain of $40. The risk on the trade is now $190 on the spread. Review trades every day to see of they still make sense in terms of risk and potential profit.

Setting an exit point to stem the loss. Despite their best diligence, all traders suffer trades that lose. Because losing is painful, it’s tough to exit with a loss as fear and greed commandeer your thought processes. Determine when to exit a trade should it go bad at the time you open it. I usually peg this exit point at the break-even point for a vertical spread. As the trade matures, I’ll adjust closer to the level of the short strike. I’ll never let a spread expire in the area between the short and long strikes. This is an important dictum, and a future post will analyze it in detail. For now, though, let’s look at some mechanics of trade management.

First things first. Submit an OCO orders for both exits when the trade opens. OCO is short for One Cancels Other, meaning that two conditional orders are submitted, one of which will control the exit at the profit, the other of which will execute the close to minimize loss. Different brokers and different platforms have various ways of issuing orders like this, but I’ll provide an example of how I set up such orders. I currently have a bull put vertical with Morgan Stanley (MS). The short strike is at 85, the long strike is at 83. I have 6 contracts. Max loss is $477, max gain is 123. DTE is September 16, 2022, this coming Friday. Here’s the profile for the trade.

MS Bull Put Vertical 85/83 9-16-22 DTE

I opened the MS trade last Thursday, September 8, and it has gone well. When I opened it, I submitted an OCO order consisting of two trades, one for profit, one to contain possible loss. The profit trade is a limit order at $0.08 which would return a net profit on the six contracts of $99 before considering fees. I set the loss containment level to close should the underlying (MS) descend to or below the breakeven level of $84.50, 80% of max profit. If I close the trade now, I would realize a gain of $60. I’m tempted to close it. Do the math: a $60 gain for four days of risking $477 yields a percentage profit of over 12%, which translates into an annual percentage of over 1100%. Closing early at this level merits consideration, but in the meantime our OCO orders have us covered as we mull over this trade. If the internet goes out, or I go off the grid for a few days, or just don’t feel like trading this coming week, I can do so with but one worry: what happens if MS descends to between the strike prices and expires there. That could be catastrophic, because I’d be committed to buy MS at the short strike price of $85, but I’d no longer have the option of buying MS at the long strike price of $83. In other words, risk would be significantly higher. The safest thing to do if I can’t monitor the trade would be to revise the loss containment upward to a point above the short strike point.

Unlike the MS trade, my IBM trade is not doing well. I opened it on the 6th, last Tuesday. It’s a bear call vertical with a short strike of 130 and a long strike of 131 expiring on Friday of this week. The trade consists of 6 contracts. I used the same technique described above to use an OCO order set to set up my exit points. Here’s its profile.

IBM Bear Call Vertical 130/131 9-16-22 DTE

Since the opening of this trade, IBM has tracked the broader market as it rallied over the last three days. It’s movement towards the losing side of this trade is worrisome. The max loss on this trade is $462. I could wait and see if things turn around. After all, time is on my side. If I do nothing and MS doesn’t go higher, the trade will return a good profit. Generally, I’ll hang onto a trade as long as theta is positive and I’m not concerned about assignment on the short strike. But what if the rally continues? Then I have two choices. The obvious one is to close the trade and swallow the loss well before it hits the max. Currently, that would amount to a loss of $84 before fees. There is a less obvious course I could take. What happens if we open a bull put vertical to counter the loss? Let’s take a look at what happens to our profile.

IBM Iron Condor

Combining an OTM bull put vertical with an OTM bear call vertical results in a trading profile that’s called an Iron Condor (IC). Many traders, myself included, treat an iron condor as two separate vertical spreads. Our max risk on the trade is now $360 and the max gain is $240. The high side breakeven point has moved higher to $130.40, giving a little more breathing space. There is a risk that MS could see a spike in volatility, reaching the upper loss area of the profile and then descending to the lower loss area. Technical analysis might provide a basis for judging which approach will do more to minimize what what appears to be a likely loss.

Loss mitigation. Over the weekend IBM continue its upward trajectory and exceeded the level I’d set to limit loss on the trade. What happened with IBM demonstrates what some traders refer to as weekend risk or after hours risk. I knew that my order to close the IBM trade at market would result in a loss, and I was resigned to it. The best I could do was to mitigate by trying to offset the loss with a gain that could be achieved by opening a new bullish trade. Within a couple of minutes after market open, I succeeded in opening a bull put spread with strikes at 127 and 126 for a per contract credit of $0.24. At the same time my stop loss exit closed the original contract at market for $0.61. My net per contract loss on the original trade was $0.38, which amounted to a total loss on the 600 shares involved of $228. About an hour and a half later I saw that I could close my second trade for $0.09, a profit of $0.15. This action left me with a combined net loss on IBM of $0.23 per share for both trades. Multiplying that loss by the 600 shares involved left a loss of $138. Quick action this morning recovered a significant amount of the loss on the original trade. It’s never good to lose money on a trade, but losing less is always better than losing more. Notice in this example, The $138 loss is considerably less than the maximum risk of $462 I had accepted on the original trade. You never want a trade to get close to max loss.

Key take-away: Establish exits both for profit and to mitigate loss when you open a trade. Update exits as conditions change, not on the basis of fear or greed.

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To Boldly Go, You Need a Log

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Stardate CE09.09.2022

Logs are tedius things, and I’ve done a lot of thinking on how to ease the pain of having to record each trade and various details about it. Eventually, I came up with a radical approach: I rely on my account statement to do the recording, while I determine how to analyze it. To make this approach work, you need to get your record of trades in spreadsheet form. The specifics of how to do that will depend on your broker and your trading platform. I favor using Excel, but any decent spreadsheet application should work. What’s important is that you learn how to use more advanced features on the spreadsheet. Be able to use formulas to calculate fields and be able to import external data into your spreadsheet. If you have skills in using databases, such as MYSQL or MSSQL, you might consider uploading your spreadsheet data to the database and using the database’s query language to reveal insights.

When you trade, you create data, and data is the currency of our age. So save it, but intuitive analysis also has a place in trading. I’m not talking about superstition or lucky hunches. Scientific studies start with a hypothesis, which is rigorously tested. So should you. If you think profit can be made by trading options on stocks that show decending implied volatility, test it by trading such issues on a paper account. Your bottom line over time will support or negate your hypothesis. Do you think you have technical skills that forecast price action? Test yourself by looking at a chart segment from last month or last quarter and seeing if your expections regarding levels of support or resistance hold up. You might consider using an idea log for recording your intuitions and ideas about how they might be tested. Periodically read old entries in the log. See how your thoughts have changed, how they’ve improved as you’ve gained more experience and learned more things.

Key take-away: As Yogi Berra said, “Life is a learning experience only if you learn.”

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Let’s Get Technical

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The market has had a couple good days. Weekly options are expiring today. Major economic events are happening next week. How will investors be thinking today? We can try to divine their thoughts by looking at their actions as reflected in the movement of broad market indexes such as SPX, which tracks with the S&P 500. Here’s a chart of its price action over the last 6 months aggregated into one-day candles.

SPX 6-month 1-day Chart Before Market Open 9-9-22

We’ve seen an uptick on the last two days. Technical traders would recognize the green candle on Wednesday as forming a CAHOLD pattern, meaning that the close on Wednesday was higher than the close of the previous low day, which would be taken as a bullish pattern. That bullishness seems to have been confirmed in Thursday’s trading.

I’ve drawn two horizontal lines on the chart to indicate levels of support and resistance. These lines identify areas where price changes seem to hang up. The line above the current price is a level of resistance, the lower line is a level of support. As price changes, these lines can represent either support or resistance, suggesting areas where the price might linger. Use your own eye to draw a horizontal line based on yesterday’s close. Do you see a vague area where prices tend to pivot up or down? If so, maybe you’ve identified a secondary area of support/resistance. So what can we expect today?

We may get some clarity today when the market opens and we see price breaking up or down. As I write this about half an hour before the market opens, the S&P futures are up around almost a full percent, suggesting prices may break upward. But remember that overnight trading is light, and often it fails to forecast what will happen during normal trading hours. If the market continues its upward momentum, it is likely to stall a bit below the 4100 level, which is marked by the upper horizontal line. If upward momentum reverses, SPX will likely pause in its downward trend around the 3900 level. Give some thought to how these insights might help determine the desired parameters of an option trade today.

I’ll update this post later today.

The market opened 15 minutes ago and SPX gapped up at open and kept rising, going above the secondary resistance level we noted above. Traders may attend to the emerging three day reversal of SPX’s decline over the last three weeks and view it through the lens of Fibonacci retracement. The chart below focuses on the last six weeks of our SPX chart and adds Fibonacci based lines of support and resisance to it. Notice that the 38.2% Fibonacci line resides in an area that we previously identified as one of “vague support/resistance.”

Fibonnaci Lines for SPX 9-9-22

Traders who buy into a Fibonacci analysis and are less committed to the bullishness shown this week, may begin selling as price approaches the 38.2% Fibonacci line, which would cause the price rise to pause. More bullish traders may provide more energy to propel the price to higher levels of resistance. For now, it appears unlikely that the SPX will close below Wednesday’s high. We’ll see.

It’s four o’clock and normal trading hours are ending SPX is at 4067, almost midway between the two estimates we made this morning regarding the level of resistance we thought we might see. See the chart below. Was our forecast the result of luck or skill? We don’t know that, but we do know this: it was the result of a defined process that is repeatable by us or by anyone else who has read this post. The scientific method is based not only on empirical data, but also on replicability of the process used to test our hypothesis.

SPX One-Minute Chart for Today

Key take-away: Areas of price support and resistance suggest what traders may do, but there is no guarantee that they will always forecast correctly.

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You’re the Judge at Beauty Contest

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It’s a contest where stock and ETF compete for your approval. What criteria will you apply to select the real beauties?

Today we’ll summarize qualities that the limited trading experience reported in this blog suggest a trade has some appeal. We’ll provide a sometimes tongue-in-cheek, sometimes worthwhile, rationale for each quality and how you might design a trade to make it more attractive.

QualityRationalImplementation
Defined riskKnowing max risk makes portolio management easier. Keeping risk on individual trades means you can make more trades, increasing the diversity of your portfolio and mitigating risk. Don’t sell single options
High probability of profittingWhat’s better than making a profit?Learn to use the tools on your trading platform that provide probability of success. Learn about the inverse relationship between profitability and risk and decide how you want to balance these opposing qualities.
Acceptable return on risk over time to expirationA 10% return over a month is much better than 10% in a yearDivide return on risk by number of days until expiration. Decide what your minimum should be.
Trade’s profit adequately covers fees associated with itProfit eaten by fees is not a profitMost brokers charge a fee to open and close contracts. Do the math.
Choose issues that have an adequate number strikes to choose fromLow-priced issues have few choices making it hard to find the delta levels you prefer to trade at.You probably won’t many decent trades on issues priced below $20. Check it out and decide where you’ll set your metric.
Time decay is on your sideTomorrow and tomorrow and tomorrow creeps in this petty paceFavor trades with a positive theta. If a trade goes theta negative, shed it like a snake’s skin.
Expected changes in volatility benefit the tradeSome trades can benefit from increasing volatitly, others from decreases in it.Check how historical and implied volatilty run in the issue under consideration. Learn about IV rank and IV percentile. Regression toward the mean provides statistical support for predicting if volatility will increase or decrease. Pay attention to how volatitility changes over earnings periods.
Technical analysis reveals levels of support and resistance that compliment the trade.Other traders will be using technical analysis to inform their decisions. Having insights into their thinking is valuable.Use the chart aggregation period you expect other traders are using. Learn how to use appropriate indicators that can aid in analysis. Take an online course in technical analysis.
Tight bid-ask spreadWide spreads cause you start out in the hole. A 10% or greater difference between bid and ask price should be viewed skeptically.
High liquidityLiquidity means that your are likely to have your orders filled quickly.Use the bid-ask spread as well as open interest and volume to identify highly liquid options.
Criteria for a Beautiful Trade

Key take-away: Beauty is in the eye of the beholder. Train your eye to see it.

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The Way the Wind Blows

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Knowing the velocity of the wind is only part of what Orville and Wilber Wright needed when they first took off at Kitty Hawk. The also needed needed to know the wind’s direction.

Implied volatility (IV), only tells us how much the price of the underlying is expected to change. Of course, we want more than that. We want the expected direction of the change, but the best we can do is to make an educated guess.

We make many educated guesses throughout our lives. Our guesses may begin with the assumption of a standard distribution on the outcome of some event. A baseball player has a .300 batting average, so we expect that he’ll get on base a little less than a third of the times he’s at bat. But there may be particularities that will shift our expectation. We might want to know how well he has done against a certain pitcher, or in a particular stadium. We may consider the effect of a recent injury or layoff from the game. The pricing model for options assumes a normal distribution in price variations, and that’s a very suspect assumption. To find perturbations in volatility, traders often turn to price charts.

Divining how the price of an issue may change by looking at the charts gets into the area of technical analysis, something that you’ll find a lot written about. The vocabulary is extensive and intimidating: dojis, engulfing candles, cup and handle, double-top, head and shoulders, Fibonacci retracement–and who knows how far this list goes on. I’ve come to doubt that there is anything intrinsically predictive about any of these patterns. What matters is that other traders buy into them, and so they become self-fulfilling proficies. If you’ve played with the aggregation settings on price charts, you know that the patterns you see on a 5-minute chart differ from those on a 1-week chart. So look at the chart that most other traders of the options you’re interested in are using.For expirations between 5 and 50 days, most will probably be attending to one-day aggregations over a period of three to six months. Those who want to exit a trade the day they open it will probably use 1 to 5 to 15 minute aggregations. As we noted in an early post, you may be able to identify levels of support and resistance that give insight into the ranges traders expect. You might also use an indicator such as the directional movement index (DMI) indicator, which attempts to quantify how the stock is trending. You should take time to study other indicators as well.

Many traders pay attention to moving averages and various indicators based upon them. Because they’ll often make judgments about issues based on these indicators, you might look at some of the more popular ones as a way to gather insights into how they’re evaluating the underlying issues. Changes in volume associated with movement in such indicators might suggest how strongly traders are buying into this movement in the indicators.

Key take-away: To make an educated guess about which way a stock will move, look at price action the way other traders are looking at it. Know which way the wind is blowing before you take off.

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Lions on the Beach

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In Ernest Hemingway’s Old Man and the Sea the aging Santiago dreams about lions on the beach, a metaphor that captures an old man’s nostalgia for his youth. An old man myself, I dream of aircraft cockpits and the dizzying array of gauges facing me when I first learned to fly jets. I wondered then how I could keep track of all those dials. My instructor gave me a single-line answer: “one at a time.” It’s simple, but profound advice–especially in our multi-tasking lives. Parents, teachers, and family elders had told me the same thing in other contexts, but I needed to hear it again.

Trading options, like piloting a plane, is a complex task with many facets. The lessons life has taught you will all come into play as you learn to trade, and surely somewhere along the way you’ve learned that doing anything well requires singular focus. In trading, you have to bring that narrow focus to various facets of every trade. Today we’ll bring it to our short bull vertical on LULU.

On Friday, we decided to trade LULU based upon the market’s positive after hours response to its earnings report. We didn’t closely examine how well the performance of the underlying supported any further entry criteria, which was probably reckless. We received a favorable fill on our order and it was soon tempting to close the trade at considerable profit, but we held onto it rather than logging a day trade.

Every morning I check my open trades to determine if they should be closed. One way of performing this analysis to answer the question, “Would I still enter this trade under the current circumstances?” This question requires an articulation of our criteria for entering a trade.

Our first consideration in entering a trade involves the selection of an underlying issue. We were drawn to LULU because of its earnings report, but other criteria can also be important. I like to seek equities that have higher historical volatility than implied volatility. I like the current implied volatility to be higher than it typically has been, but I also like implied volatility to be on the decline. Price action is also important, and here I rely on levels of support and resistance visible over the last 3-6 months on one-day candles. If the issue significantly satisfies my criteria, I seek out contracts on the option chain that have tight bid-ask spreads, a high probability of success, and present the opportunity for return on risk that exceeds 1% per day. Future posts will explain why these are my criteria. Many successful traders find fortune with other criteria. You’ll have to develop your own criteria.

We’ll begin our consideration of LULU by looking at this morning’s chart.

LULU 30 Minute Candles From Before Through After Release of Earnings Report.

In the chart above, the blue and red circles mark the release of LULU’s earnings report. Over the holiday weekend in after hours trading we’re seeing some retracement in share price, specifically a decline of about a third of the gain realized in Friday’s trading. At the close of option trading on Friday our unrealized gain on our short put vertical was at $156, 82% of the max we could receive. Given LULU’s decline over the weekend, we can expect expect to see that profit fall as trading begins this morning, so I”m submitting a closing order before the market opens. Generally, I like to reach 80% of max gain, so I’ll price the closing order at that level. The credit we received for the trade was $188. Eighty-eight percent of 188 is about $150. We’d achieve that profit if we bought back our trade for $.38 per share. Another way of looking at this transaction is that when we opened the trade, we sold the spread for $1.88 per share. Subtracting our $.38 buying price at close yields a gain of $1.50 per share.

I’ll update this post later today.

The market opened six minutes ago and we closed LULU for $.33. Our profit was $1.55 per share, $155 for the trade. We paid $1.90 in fees for a net profit of $1,53.10. The time from open to close for the trade was four days, three of which were over the holiday weekend. Our return on risk was well over 200%.

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It’s Greek

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If you’ve read anything beyond this blog about options, you’ve seen a lot of references to “The Greeks.” These are names for five metrics that describe how options respond to various factors. They give option traders insights into the risk associated with a particular option. We first mentioned the Greek theta in an earlier post on extrinsic value. Theta describes how much an option’s value declines due to the passage of time. We’ve also alluded to the fact that changes in the price of the underlying have an even greater effect than time decay on an option’s value. The Greek delta quantifies how much impact price change will affect the price of an option. It answers the question “How much will the price of an option change if the underlying’s price changes by one dollar.” The image below shows the option chain for Amazon’s calls and puts expiring on September 9, 2022. The yellow shaded areas are ITM options, the unshaded areas are OTM. The strike level that is closest to the underlying price is at the money (ATM). An interesting feature of delta is that it can be a proxy for the chances of an option to expire ITM. Notice that the ATM options have deltas of .50, a value that represents the 50/50 possibility that the underlying will be above or below its current pricing at expiration. Delta can also be helpful in hedging, a topic we will address in future posts.

Option Chain Displaying Delta

I use the delta as part of my process in selecting options. I like to deal with options that have high probability of expiring profitably. So if I’m bullish, I might sell a put with a delta around -.25. Remember that when you sell a put, you receive a credit. If this short put expires OTM, the option will expire worthless and you will pocket the credit received. The image below shows the profile for a bull put spread based on the 123 strike. You should understand that the purchase of the 122 strike was a hedge to limit the risk of the short put.

We’ll have more Greeks to discuss in later posts.

Key take-away: Delta is a metric that provides valuable insights for selecting trades.

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Fish or Cut Bait

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Previous posts covered single options and vertical spreads. We initiated a few trades and followed them on their paths to profit or loss. If you are reading this because you want to try your hand at option trading, you should already have or be close to opening a brokerage account and installing a trading platform on your computer.

I’ve tried to keep my posts broker and platform agnostic, though my trading preference has been to use TD Ameritrade’s ecosystem of trading tools. I’m less agnostic about trading hardware. I think trading on a phone is painful both because of the small screen and the relatively slow downloading speeds of 4G. This summer I’ve been using a small laptop with a 14-inch screen. It has been adequate, and I appreciate its portability. On occasion, I’ve had to rely on my phone’s hotspot to connect to the internet. That has worked, but it wasn’t much fun. I prefer to have a dual screen setup with 24- or 27-inch monitors and fast broadband access. I’ve found fast wireless networks work well with my style of trading. If you want to do high-speed day trading, you might have to limit yourself to a wired connection.

If you’ve read previous posts, I’m sure you’ve noticed the math used in evaluating trades is tedious. Good trading platforms will do the math for you. They also provide advanced charting and trade analysis capabilities as well as essential portfolio management tools.

Before you risk real money, thoroughly learn your trading platform and take plenty of time to practice trading using a trading simulator, also called a paper account. Overlearn your approach to trading. It might take a year of paper trading to reach confidence and proficiency levels appropriate for live trading.

Key takeaway: A lot of hands-on practice on an appropriate platform with a good brokerage is an essential prerequisite to live trading and potential profits.

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Living in the Past

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I want to examine yesterday’s trade (PSTG bull put spread with strikes at 25 and 28). I was drawn to it because PSTG’s earnings report was published after the market closed on Wednesday, and its earnings exceeded expectations. Trading into an earnings report can be tricky and risky. These reports, which include both earnings from the previous quarter and expectations for the future have an outsized effect on share price. That often translates into high volatility leading into the report. At earnings time traders expect a sudden change in price, but don’t know if the change will be up or down. After the report’s release, implied volatility returns to more normal levels for the underlying. PSTG released their report two minutes after the market closed on Wednesday, and it inspired investor confidence during after hours trading. When the market closed on Wednesday, PSTG traded at 28.97. Just before the market opened on Thursday, it traded at 30.14.

An interesting feature of option prices is that they don’t change overnight. While orders for trades may be entered, they aren’t executed until the market opens. This means that a sharp rise in the underlying leaves OTM puts overpriced. The market will quickly correct for this situation, but it takes some time to do so. Until it does so, you may get a favorable fill on an order as we did yesterday morning.

Unfortunately, the overnight euphoria over the positive earnings report quickly wore off and the price of the underlying plunged below our short 28 strike. I closed the trade quickly to salvage the remaining gain rather than accept the risk of PSTG’s decent into unprofitable territory. I’d make the same decision again, even though PSTG began to rise in the afternoon, and had I waited until this morning to close, I’d have seen a $65 profit on the trade.

Key take-away: if you think a trade is going to lose money, close it and have no regrets.

This morning I tried to repeat the kind of earnings play described in the previous paragraph. This time it was Lululemon (LULU) with a very positive afterhours earnings report. I sold one bull put vertical for $188 net credit. LULU has continued to climb, and I could close it at max profit less than a half hour after opening it. I’m going to let this one run because, I’m not seeing the kind of quick decline in value that we experienced with PSTG. This also provides a good opportunity to talk about day trader pattern trading (DTP).

For the official FINRA (Financial Industry Regulatory Authority) rules on DTP check out their website. Accounts less than $25000 cannot exceed three day trades during any five-business-day period. A trade that is both opened and closed on the same day is considered a day trade. Brokers have some latitude in how they implement FINRA’s policy, so before you day trade, do check your broker’s policy. The DTP rules surely discriminate against small-time traders, but rules are rules, and if you dance close to them you risk stumbling over the line, and your trading activities will be restricted.

Key take-away: If you open and close a trade on the same trading day, keep track of it.

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