[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]
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.
[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]
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.
[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]
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.
[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]
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%.
[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]
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.
[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]
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.
[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]
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.
[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]
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.
[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]
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.
[responsivevoice_button rate=”0.9″ pitch=”0.5″ volume=”0.8″ voice=”US English Female” buttontext=”Play”]
Last week we bought (that is, went long on) an ITM call. This week we’ll watch what happens when we go short on an OTM call. A trader who goes short on a call can also be referred to as the writer of the option contract.
When I first began trading options, it took a while to get my head around the idea that I could write a contract to sell something I didn’t have. But there are everyday examples of people doing this outside of the option market. Some months ago, I contracted to have a house built. The builder signed a contract for its sale to me even though construction had not begun. He had obligated himself to sell a house at a certain price, and now he’s legally bound to deliver it to me, despite increased costs in material and labor. A trader who goes short on a call faces a risk similar to the risk my builder has taken on.
The buyer of an option can exercise the call at any time. As a trader who wrote the short call, you could be assigned to cough up the contracted number shares at the strike price and do so no matter how much the underlying price soars. That means that your max risk as the writer of a call is unlimited. That’s why I would never, never advise anyone to trade naked short calls. We’ll discuss more about naked shorts as time goes on.
Meanwhile, let me digress into a story. You may recall the earlier posting about the volatility of Gamestop (GME). Gamestop was a struggling company, and some professional investors thought it was a safe bet that its stock would tank. So many thought so that in aggregation they shorted more shares of GME than actually existed. When GME’s stock soared on the wings of retail traders associated with the subreddit r/WallStreetBets, it was the beginning of the end for Melvin Capital, a major investment fund that had managed twelve and half billion dollars. Read the gory details on Wikipedia. The moral of the story: before you short, make sure you have access to the shares you might need to cover your obligation.
It’s Monday morning, and I’ve made two trades with September 2, 2022, expirations. Both trades are on the SPDR S&P 500 ETF Trust (SPY). This underlying is an Exchange Traded Fund (ETF) that mirrors the S&P 500. It’s a high volume, high liquidity fund with tight bid ask spreads. These are not imaginary trades, but they are paper trades. It’s only monopoly money, but the numbers all reflect real-world conditions.
The first trade is a naked OTM call with a strike of $426. The order filled at $2.12. The analyze tab on TOS provides a profile of this trade. The x-axis is the price of the underlying and the y-axis is the profit/loss on the trade. The blue line corresponds to the value of the trade at expiration and the purple line displays the value of the trade at any intermediate day prior to expiration in a purple line. The gray shaded area of the charts marks an area within 1 standard deviation of the price of the underlying given its volatility. I have found the analyze tab to be extremely useful, and I highly recommend you learn more about its use. You should be able to find a lot about it online.
Naked Short Call
This naked short call is neutral to bearish. As long as the price of SPY stays below our strike of 426, we stand to profit $212.00–the credit we received when we opened the trade. But if the price for SPY rises above the strike, we will find ourselves in dangerous territory. This trade has an undefined risk. It could theoretically cause us to lose more money in our account. That’s why our broker has reserved $7383 of our capital to cover this trade. The broker will increase that amount should the trade move against us. If your account doesn’t have the funds to cover the amount that needs to be reserved, you will receive a margin call.
Let’s look at the second trade, which consists of two option contracts rather than one. In this trade we will also sell the 426 call, but we will define our risk by buying a 427 call. Here’s the profile:
Short Call Vertical OTM Spread
The short leg of this spread brought in a credit of $2.07, the long leg cost us $1.80. So we received a net credit of $0.27 per share. Our max profit is $27 for the trade. Our max loss is $73. Since this trade involves two contracts, our transaction fee will total $1.30. Because this trade has a defined risk, the broker has reserved only $100 of our capital.
Let’s judge the capital efficiency of our two trades by comparing how much profit can be received for each dollar the broker will reserve to cover the trade.
Naked Call
Vertical Spread
Req’d Funds
7383
100
Max Profit
212
27
Profit per Dollar
$0.0287
$.27
Capital Efficiency
Sometimes you’ll hear the cost of an option referred to as a premium, the same as the payments on an insurance policy. In the case of the long leg on our vertical spread the comparison to insurance is totally applicable, because it dramatically reduces our risk in addition to freeing up capital to employ in other investments. Before ending this post, I should point out that some trading accounts won’t allow a naked short option.
Key take-away: don’t walk naked in the marketplace.
Morning has dawned on August 23. Overnight futures were flat and in the first half hour of trading the S&P has moved little. Yesterday, after we opened our two bearish biased trades, the S&P had one of its biggest declines of the season, losing over 2%. I’ll track these trades through to expiration, updating this post every morning around 10 o’clock and at market close. The results will appear at the end of the post, and I’ll insert a running commentary starting at this point.
The characteristic of the options that we are trying to profit from in this trade is time decay, also known as theta. The biggest risk factor is the possibility that the SPY will soar above the 426 strike we’ve sold. Because we’re doing an academic exercise, I’ve forgone the trade selection and management practices that I’d normally employ. Most important among these would be to have established at the time of the trade an exit point for taking profit and a second exit point for limiting loss should the trade turn against us. One technique we could use for establishing a profit target is to pick a percentage of our max gain and close the trade when that is achieved. A technique for stopping further loss is to close the trade when the underlying price climbs above our short strike.
8-23-22 1600. The market hardly moved today, which was good news for our trade. The gains recorded below for today are almost entirely due to time decay; that is, theta. Notice that the gain for the naked call approximated 10 times the gain for the vertical spread, even though, the buying power required for the vertical spread is only $100 vs. the $6952, which is the new reserve for the naked call. For the capital required used in the naked spread we could have bought 69 spreads. You can calculate what our profit would be on the spread by multiplying our spread profit by 69. As the equity we have in the naked call changes, we can expect to see variation in the buying power, but the capital efficiency of the spread will usually be many times greater than that of the naked call.
8-24-22 1000. Overnight futures were flat, and have continued flat so far this morning. Our gains in both trades continue to be a product of time decay. Can you think of another case when money can be made by the decrease in value of an asset over time? Where the business model itself is to make money on an asset that depreciates? Sure. That’s how car dealerships make a considerable portion of their profits. Sell a new car for $30,000. Buy it back on a trade-in for $20,000 after depreciation has had its way with it. One could argue that the recycling industry similarly earns profit. The value of an aluminum can exceeds its material cost when it seals a beverage. When empty, the can’s value to many people becomes negative, and they are happy to throw it away or give it away. But the aluminum in the can continues to have intrinsic value, which, in large quantities, can become significant.
8-24-22 1600. The changes in value for our trades reflect a movement in the underlying price as well as the shortening of time till expiration. Implied Volatility decreased slightly today, but the main factor that our trades lost value was the increasing price of the underlying. At the end of the day, the price of a share of SPY will control the lion’s share of our profit pie.
8-25-22 1000. SPY reflects the upward movement of the S&P this morning. Again we’re seeing what happens when the underlying price moves against our trade. Although our equity in these trades has decreased, if the price of SPY remains less than $426, we will achieve the maximum profit at expiration. Although, we will let these trades run through to expiration as an academic exercise, we should be interested in what our chances of success are. We can gain insight into our probabilities for success by using probability anlysis tool available on TOS’s Analyze tab.
SPY Probabilities at Expiration
The image above shows a cone that encloses an area that projects price levels into the future using a probability range of 68.27%. Recall from high school math that 68% equates to about one standard deviation on a normal distribution. The lower orange dotted horizontal line marks SPY’s current price and the upper line marks our strike price. The table below the graph displays percentages associated with the price levels marked by the orange lines and option expiration dates. From this table we see that there is a probability of 26.54% that our option will expire above the strike price. We can conclude, then that at this moment we have a 73.46% probability of achieving maximum gain on our trade. However, the chart doesn’t tell us anything about how SPY’s price might vary between now and expiration. For that we need to find out what the chances are that SPY will touch above our strike price. The analyze tab can calculate that too for us.
Probability of Touching
Using the probability of touching image reveals that there is a 49.09% chance that sometime in the next 8 days that SPY may reach our strike price. We’ll see what happens.
8-25-2022 1600. The SPY soared this afternoon, and our trades continued to suffer.
8-26-2022 1000. SPY gave back a little bit of yesterday’s gains. It’s still trading at a level that promises a good gain on both of our trades. Next week as time decay wraps up, we should begin to see profitability in both trades, provided SPY continues to trade at or below its current level. As I’m composing this, the Fed Chair has just made an announcement that the market is interpreting as hawkish, and SPY is falling in response. If this decline continues throughout the day, we can expect to see gains at market close.
8-26-2022 1600. The S&P suffered its biggest one-day drop since mid-June, and the value of our trades soared. If this were a real trade, I would close both trades and take the profit, but we will hold out for the last pennies of profit just to see what happens. Ordinarily, if a trade returns 80% of its max profit, I’ll close. Other traders have different criteria that they use. Recall the max risk we began with for these trades. That risk is now elevated by our unrealized gains. For the spread, that means we are now risking $100 to make another $2. It doesn’t seem worth it. The market lost 3.3% today. That was enough to scare a lot of people into selling. Over the weekend some cooling of the passions that spurred this selling might embolden some to pick up bargains when the market reopens on Monday, especially if after hours trading this weekend shows upward movement.
8-29-2022 1000. SPY seems to have stalled just above 400 and may be reversing. The value of our trades continues to climb. There’s very little extra profit that we could wring from them. Holding onto them at this point offers almost nothing but continued risk. But we’ll take these trades all the way.
8-29-20220 1600. Little movement in the market. No change in the value of our trades, because they have very little growth potential.
8-30-2022 1000. Our trades remain static, will continue on so unless SPY pops higher.
Change of plan. I know I said we’d stay with these trades to the bitter end, but given that we’ve wrung out almost all of the profit potential, I just don’t see the purpose of locking up capital for very little potential gain.
Date
Time
Mark
Naked Call P/L
Vertical Spread P/L
8-23-22
1000
413.88
65
6
8-23-22
1600
412.51
98
10
8-24-22
1000
412.39
118
12
8-24-22
1600
413.64
114
10
8-25-22
1000
416.46
66
4
8-25-22
1600
419.43
8
-4
8-26-22
1000
418.55
24
-1
8-26-22
1600
405.14
200
25
8-29-22
1000
402.96
206
26
8–29-22
1600
402.63
206
26
8-30-22
1000
402.24
206
26
8-30-22
Trade closed due its success
Trade P/L Status
Below is an analysis of our trades’ successes. In both cases, we see very respectable gains that benefitted greatly from the leverage that options provide. The defined risk and capital efficiency of the vertical spread makes it my favorite. Keep in mind, though, that had the SPY moved decisively in the other direction, both of these sweet trades would have quickly soured. Our next post will more extensively explore factors that contributed to their success.
