- Neutral Vertical Spreads (Iron Condors)
- Neutral Calendar Spreads
- Directional Vertical Spreads
The trades I put on yesterday were an example of that. I'm not going to spend any time talking about what a vertical spread is, since you probably know that if you're reading this. If not, here is a good spot to learn the basics.
I suppose the first thing to tell you about vertical spreads is why I do them. There are a couple of reasons. First, I like the risk/reward. It isn't always the case, but generally speaking it is better than a straight stock trade. Second, is a nifty little thing called "Theta" (aka time decay). Because I have time decay working in my favor, I don't have to be exactly right in picking direction, so long as I'm not too wrong. Now that you know why I like these spreads, let me tell you a little about my rules for choosing and managing my trades. There are a few steps that I go through for each trade:
Watchlist: Entering a trade is all technical analysis. I'm an average technical analyst at best, but I know how to look at a trend. I simply look for trades in the direction of the trend, that have made a decent pullback, usually to somewhere between the 20 and 50-day MA. There is no magic in that, it just seems to be a place where trends saw-tooth their way up or down. I'll talk more about my technical analysis in another post, but hopefully you get the basic picture. Once I find the right picture it goes on my watchlist. I keep a watchlist of long and short candidates all the time.
Risk/Reward: When I am considering trades on my watchlist, I will do a quick risk/reward analysis. I will also post more about this in a future post, but here is the basic idea... I choose my stop-out point first. I then use the analysis tool on the platform of my favorite broker - ThinkOrSwim - to help me estimate the loss when I hit the stop point. That loss is what I consider my "risk". I then look for the "reward" at expiration using the same tool. This needs to me at least twice the risk. While 2:1 is my minimum, I frequently see 3:1 or more. 2:1 is pretty easy if your stops are not too far away.
Position Size: Once I have the risk/reward established I will choose my position size. I don't like to bet more than 1% of my account on any one trade, but generally it is much smaller. Lately I have been sizing at about 1/3 that amount. If things are trending well and I am winning trades regularly I will allow myself to go up to 1%, but in these crazy market times, I like the smaller amounts of risk.
Trigger: I always have a trigger (such as taking out the high of the previous day) to confirm my analysis. Once this is hit I place my order. Sometimes I will do this as a contingent order so I don't have to watch it. Once I am in the trade my management rules come into play, and they are actuall pretty simple.
Loss Exit: If my stop is hit, I get out... no hesitating.
Risk Avoidance: Once I am up a bit, I will adjust my position in order to take my risk down to near zero. There are two ways to do this. If the market moves very fast in my favor, and there is a lot of room between the current price and my stop, I will move my stop up to breakeven. The other approach is to sell enough of my position to cover the remaining risk. For example, I will frequently sell 1/2 my position once 2/3 of my risk is earned. So... (examples are always easier for me) if I have $600 at risk (based on my definition of "risk" above) and I am up $400, I will close 1/2 my position. If you do the math on that you will see that it reduces my risk to near zero. I have pocketed enough to cover the loss on the remaining amount if it should hit my stop.
The remainder of the position I usually just hold until expiration. Sometimes I will close it out and pocket the profit early if I have a good technical reason, but usually I just let time decay work its magic.
Well, this is getting to be a crazy long post, so I'll stop for now, but that gives you at least a high level picture of how I do my directional vertical spreads.
Good Trading...
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