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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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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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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.
Quality
Rational
Implementation
Defined risk
Knowing 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 profitting
What’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 expiration
A 10% return over a month is much better than 10% in a year
Divide return on risk by number of days until expiration. Decide what your minimum should be.
Trade’s profit adequately covers fees associated with it
Profit eaten by fees is not a profit
Most brokers charge a fee to open and close contracts. Do the math.
Choose issues that have an adequate number strikes to choose from
Low-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 side
Tomorrow and tomorrow and tomorrow creeps in this petty pace
Favor trades with a positive theta. If a trade goes theta negative, shed it like a snake’s skin.
Expected changes in volatility benefit the trade
Some 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 spread
Wide spreads cause you start out in the hole.
A 10% or greater difference between bid and ask price should be viewed skeptically.
High liquidity
Liquidity 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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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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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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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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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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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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So far, our focus and example trades have involved call contracts. I’ve displayed my preference for vertical spreads over naked options, and the spreads we’ve looked at have been credit spreads, which I also prefer. Other traders have different approaches and have demonstrated success with them.
Today, we are going to look at puts, which I think of as the flip side of call options. A call is a contract that specifies a buying price for an issue. Puts specify a selling price. Out of the money naked puts are seen as a bearish. They make a profit if the price of the underlying decreases. Stockholders may buy naked puts as insurance because they limit the loss on their holdings should their price descend the strike price of the put.
OTM put spreads, on the other hand, can be a bullish strategy. This morning I opened a bull put spread on Pure Package Storage (PSTG). A bull put spread is a credit spread that involves selling an OTM put while a further OTM put is bought. The spread I chose was to sell three September 16 puts at a strike of 28, while buying three puts at the 25 strike. The width of this vertical spread is three dollars. I received a favorable fill that brought me a $1.25 credit for each of the 300 shares in the contract. This trade consumed $900 of my buying power and cost $1.95 total in fees. The credit received is the max profit for the trade. The max loss is calculated by subtracting the credit from the difference between the two strikes ($3.00). So, the max risk is $1.75 per share. If the trade were to go well and expire OTM, the total profit before fees would be $375. Max loss at expiration would be $525. Here’s the profile for the trade when it opened at 0931 this morning:
PTSG profile at Open
The two vertical lines mark the breakeven point of the trade ($26.74), and the price of PTSG when we opened the trade ($29.75). After opening, the price of PTSG began to fall rapidly, as did the market in general. I decided to preserve what profit I could by closing the trade just 47 minutes after opening. Closing trades on the same day they open can have negative consequences for trading accounts with a balance of less than $25,000, so if you trade with a smaller account, make sure you understand the day trader pattern rules, which we’ll discuss in a later post. Nevertheless, I was able to buy back my vertical spreads at $95 per contract. The net gain per contract was $30, total gain for three contracts was $90. Total fees for opening and closing the contracts were $3.90, leaving a net gain of $86.10. The return on capital was around 9.5% for a trade that lasted than an hour.
We’ll discuss more about this trade in forthcoming posts.
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We might say that we got lucky on our SPY trades. But how lucky? Did we beat the odds? Or did the odds favor us? How can we tell? Can we explain our good fortune? Well, we can try.
Let’s begin by looking at the price chart for SPY.
SPY Support and Resistance
The chart above tracks the daily movement of SPY going back one year. The horizontal line marks our 426 strike on our trades. The solid vertical line marks the day we entered our trades. Notice the change in the pricing behavior that occurs in late April. Prior to late April, whenever SPY hit around the 426 level, it bounced back up. But after a decisive break of that level it struggled to regain it. The 426 level is an example of an area of support that once broken became a level of resistance. Some might ask what changed with SPY. A better question might be what changed with investors who had become unwilling to drive prices higher across the broad spectrum of stocks that make up the S&P 500. The likely answer is their rising concern about inflation and recession fears as well as worrisome international news about war in Europe and exacerbation of supply shortages in many areas that had been coalescing. A few days before our trade, the 426 level of resistance was finally tested. SPY briefly broke above 426, but notice that throughout its rise volume had been decreasing. Fewer and fewer investors believed in its climb. See how volume changes as SPY falls decisively in the few days prior to our trade. It seems as if the market had decided, at least for the time being, that SPY will go no higher than about 426. Beyond the level of resistance, we can also look at SPY’s volatility; that is, how much its price varies up and down over time.
We should look at two different kinds of volatility: historic (or realized) volatility and implied volatility. Historic volatility is how much the price of an issue has varied in the past. Implied volatility is how much investors think the price of an issue will vary in the future. Calculating historic volatility is straight forward. I’m not going to delve into the math, but determining the standard deviation of the highs and lows is where the calculation begins. Implied volatility is trickier because it purports to predict the future.
To calculate implied volatility, we turn to the pricing model that is used for options. For a more complete description of a widely used model, look at the Black-Shoals model on Wikipedia. The model, and derivatives of it, explain option pricing as a function of the price of the underlying asset, the strike price of the option, the time until expiration of the option, the risk-free interest rate, and (the unknown) implied volatility. In practice, the market determines the price of the option, so the only unknown is volatility, which can be derived through algebraic manipulation. In other words, implied volatility is a crowd-sourced value determined by the aggregated opinion of the relevant traders. When implied volatility increases, the price of an option increases. An interesting feature of implied volatility is that it is usually, though not always, higher than realized volatility, which suggests that options tend to be over-priced. In future posts we can examine why this is the case. For now, though, we can make practical use of this phenomenon by selling options where implied volatility exceeds historic volatility. The discrepancy between implied volatility and historic volatility is sometimes referred to as the volatility risk premium, a moniker that suggests the similarity between buying options and buying insurance. Both of the features we have so far discussed have focused on the opinion of those who were trading; the final feature we’ll consider is the volume of trades.
We briefly mentioned the role of volume earlier when discussing underlying price. In options, volume may be even more important. If many traders express an opinion on pricing by entering trades, we can have greater certainty in the validity of their opinions. The measure best used for this is open interest; that is, the number of contracts that are open. As I write this, 4963 contracts are open for the September 2, 426 strike. Since each contract represents two traders (the buyer and the seller), the pricing represents a 9926 instances where individual traders found agreement on pricing. The effect of this significantly large number is twofold: first, the interest level means that we should have little trouble finding someone to trade with us when we open and when we close the contract, and second, the bid-ask spread will be narrow. Spreads on SPY tend to be only one or two cents.
Key take-way: A trader’s success depends on what other traders are thinking and doing.
