NEW TRADE: SPX Bear Call Spread

Yesterday the SPX broke an important support level at around 800. At this point I am concerned that we might see a sustained decline, with 800 now acting as resistance. You can see on this daily chart where I think the support was. A look at the 15 minute chart underscores this point even more. After yesterday's opening slide, the price retraced to near 800 many times, but never really poked through or threatened it much.

At the same time, several of my bearish positions have hit profit targets and been taken off, so Deltas were getting a little long. All of this, plus my unquenchable thirst for more Theta led me to a fairly aggressive position in an SPX Bear Call spread: SOLD SPX MAR 890/900 CALL @1.20 CBOE. As I said, this was a pretty aggressive position (i.e. LARGE), but it was just right for balancing my Deltas while adding a large chunk of Theta. My plan is to leave this on to profit from any downside move, but I will remove it if we get to 810. That would be a significant penetration of the resistance line.

Closed Trade: OIH

You might remember that three days ago I opened a Bear Call Spread on OIH. It was right at the top of the recent channel and up against resistance. Today it hit a nice profit target and sold out for a nice gain. It may very well continue down to the support points at the bottom of the channel, but with more than 14% in three days I'll take what I have... time to ring the register!

Good Trading...

New Trade: OIH Bear Call Spread

SOLD OIH MAR 90/95 CALL @1.40

As you can see, OIH is right up against resistance. I sold the spread above with a stop right above today's doji, at $88. This trade had about 3:1 reward/risk ratio.

Good Trading...

Directional Spreads - Part Two: Profile of a Loser

In the last segment I discussed the setup and analysis for executing directional spread trades. Of course, there are MANY ways to do this; I just use one that seems to work for me, given my style of trading and time constraints. Once I decide that I like the setup, the market conditions, how it fits into my portfolio, and the risk/reward profile I go about executing the trade. There are just a few quick steps that I go through:

· Position Sizing: Generally, I will risk ½% of my account size on each trade. Depending on how much I like the trade, I may risk all of that or only part. In the case of ISRG you might remember that I was risking $40 for each contract. If I was willing to risk up to $200, I just do 5 contracts… simple.
· Execute the Trade: One of the many things I like about the ThinkOrSwim platform is that I can go directly from my risk/reward analysis to an order in just a couple of clicks. Once I have the risk/reward picture the way I like it, as described in Part One, I can just send the trade off for execution… quick.
· Set Alerts: As you know, my style of trading is to minimize the time requirements, so I try and automate everything I can. The first step is to set an alert, or sometimes a conditional order, at my stop price. In this case it was $107. I want to make sure that if ISRG hits that number I am out, so this goes in immediately. In this case it hit the next day (which I didn’t know would happen at the time).
· Set Exit Orders: By the same reasoning, I want to exit profitable trades in the same automated fashion, so I also immediately enter my exit orders for my target price. In this case I sold it for $1.90 and wanted to buy it back for around 70 cents. This order goes in right away.

That’s it! It all takes about 2 minutes, and then I just wait. In this case I waited one day and had to exit. There was a buyout rumor that hit the news the following day and the price spiked up. I have reviewed my analysis and I still like the trade... some just don't work out.

Good Trading…

Directional Spreads - Part One: Profile of a Loser

• The other day I put on a bearish directional spread on ISRG. This trade ended up being a loser, but reviewing the thinking behind the trade can be quite helpful and instructional. Now is a good time to review some of my rules for these spreads. As one might expect, these are directional, so they begin with a look at the chart. On the day I entered this trade, this was the pattern chart that I saw. While there are stronger patterns out there, this one is fairly clean. ISRG is in a nice down trend, making lower highs and lower lows. It's currently curling over at the top of the channel, bouncing nicely off the 20 day moving average.
  
  

Once I form an opinion about the direction of the trade, the next thing I do is pick a stop. In this case, the obvious point is right above the recent high, at about $107. My theory is that the pattern will continue down. If ISRG makes a new high above $107, my theory is wrong and I'll get out. Aside from my opinion about the stock's chart, there are two other factors that go into my decision about directional trades... the overall market direction, and my current portfolio requirements.

The Market: I like to enter directional trades with some inkling of what the market overall might do. As a proxy for "the market" I usually watch the good ole' SPX, like most people.


Portfolio Position: Specifically, I look at my overall portfolio deltas relative to my beliefs about the market as a whole. In this particular case I need some short deltas. I have taken several bearish trades off profitably and now my deltas are leaning a little long. As you know, under the current market conditions we can experience violent downswings, and I don’t want to be caught on the wrong side of that; so, I’m constantly evaluating my portfolio deltas and looking to keep them fairly balanced. I don’t mind leaning a little one way or the other if I believe we are in for a move in that direction, but I still like to keep a little hedge on.

Risk/Reward: This might be the most critical part of my analysis, and in this particular case, it is spectacular. I will talk more about this in an upcoming section, but in this case the risk if my stop was hit (at $107) was $40 per contract, but the credit and potential profit was $190. More than 4:1 ratio. The minimum I look for in this kind of trade is 2:1, so this one was great.

This is not the best technical setup that I trade on, but it’s not bad. I believe it’s better than 50% accurate, but the point is, it doesn’t matter. I could be wrong 75% of the time and, although it wouldn’t be fun, it would still be profitable! That’s remarkable. This is why I only take trades that are at least 2:1 risk/reward, and often look for better than that. Frankly, I don’t normally hold these spreads until expiration, and would probably buy it back with around $120 to $150 profit. Still, this is a great ratio and I would take trades like this all day long.

Quick Review:

- Setup: nice downtrend and at the top of the channel… pretty classic.
- Market: Not really sure in the short term… we might be in for a little bounce, but we’re clearly in a bear market.
- Portfolio: Need shorts.
- Risk/Reward: As good as it gets.

There is one final step that I take, which is more related to stock trades than indices or ETFs. I take a quick look for anything that might cause a surprise gap, such as earnings. That’s the one thing that can hurt us spread traders. This whole process, while it sounds lengthy, take less than 5 minutes. Once you do anything a lot it gets pretty easy.

Next Time: Executing the Trade

Good Trading…

New Trade: RUT Bear Call Spread

Sold RUT Mar 570/560 @ .65

This opens the first leg of my March Condors

Closing Trade: CECO Bull Put Spread

Today my target was hit and an order executed to close a vertical spread on CECO. This was another one that I opened before the blog started, so here's the opening trade on 1/7/09:


Sold CECO Bull Put Spread, 17.5/15 @ .81


As I've mentioned before, I put GTC orders in as soon as the trades go on. In this case I closed some of the spread at 60 cents, and some at 35 cents. My average price, the one that goes in my trading journal, was 53 cents.


Bought CECO Bull Put Spread, 17.5/15 @ .53


Very nice! After all commissions were paid this yielded a 13% profit in 20 days.

Good Trading...

Closed Trade: AZO Bull Put Spread

Today my target was hit to close a vertical spread on AZO. This was another one that I opened before the blog started. The opening trade was on 1/14/09:

Sold AZO Bull Put Spread, 125/120 @ 1.60

Bought AZO Bull Put Spread, 125/120 @ 1.17

After commissions were paid this yielded 10.9% profit in 13 days.

Good Trading...

Iron Condor - Part Two: Position Sizing

According to Van K. Tharp, "Perhaps the greatest secret to top trading and investing success is appropriate money management or what we now call position sizing. I call it a “secret” because few people seem to understand it, including people who’ve written books on the topic. Some people call it risk control; others call it diversification."

While Tharp doesn't write a lot about spread trading, at least not that I've seen, position sizing is no less important with Iron Condors and other vertical spreads. The main reason is that the size of your position defines the risk. There are a couple of ways to look at this with spread trades.



One method is to look at your risk as the total margin required for the trade. In other words, take the distance between your long and short strike and subtract your credit. For example, if I sell a 570/560 bear call spread in the RUT for .60, then my risk is $10.00 (570-560), minus .60, or $940. So if I only want to risk $940 then I would only do this one time. If I only wanted to risk $500 I might have to do it 5 times in the IWM (the ETF version of RUT, which is normally priced about 1/10 of RUT). Normally with a strategy like this, you would put the trade on and just let it ride until your defined exit, but not do any sort of adjustment along the way.


A quick word about strategies... I hesitate to call one approach "bad" or "good" because normally there are trade-offs to all of the different approaches. The markets are very efficient and so prices normally reflect the various approaches. The above approach is NOT the way I do it, but it doesn't make it wrong or bad. It's just not the way I approach position sizing and risk management.



My approach looks at the amount of loss that I can expect to take over time with a given set of trading rules. I have tested my rules over many years and I know that the max loss that I normally take is about 10% of the total position size. Therefore, if I want to risk no more than 1% on any given position, then I would allow up to 10% of my account to be traded in that position (10% risk of 10% position size equals 1%). Get it?



Scaling


Now that I know how much I want to risk in total on the Iron Condor position, I will typically manage risk further by scaling into positions. The exact timing has a lot to do with the chart, as you have seen in Part One, but usually I start looking for my first position at 50-55 days from expiration. The first position will normally be 1/2 of my total risk. The numbers above are what I use (10% of account size), so this first position will be about 5% of my account size for total margin required. It's never exact, as prices are always changing, but I get as close as I can. The reason I start with 1/2 is that I want to get a fair amount on as early as possible in order to take advantage of the time decay. Second and Third positions are then 1/4 (about 2.5%) each.

After the first position is on I will look to add additional positions by watching the chart in the following week. Over time the position ends up with various spreads on at different strikes, hopefully giving me the full position, but also with the widest possible space between short strikes. Below is an example of the Analyze page from my ThinkOrSwim account which describes my current position (as of 1/23). It might not make complete sense at first, just remember you are looking at the middle of the trading time. In other words, several legs have been put on and taken off so far, since the whole thing started around 12/22.




So that's the position sizing story. It's actually really easy once you get the rules down and understand what is at risk.


Next Time - Part Three: Choosing the Strikes

Iron Condor - Part One: Entry

Today I begin a multi-part series of articles on how I trade Iron Condors. This first segment will be dedicated to the entry setup that I look for and the specific timing of the entry. I don't really plan on spending any time on what an Iron Condor is, or the basics of the trade, but if you are not familiar with them Investopedia has a nice article explaining how a basic iron condor is set up.

Every Condor trade I enter begins with a look at the price chart and implied volatility. I'll get to more about the strikes I choose in a future segment, but because they tend to be far out of the money my chart reading doesn't have to be perfect. There is a lot of forgiveness with these trades. In broad terms, I am looking for one of two patterns. Either the market is ranging, or trending, and depending on what I see I will make the trade differently.

Flat Entry:

On 12/22/08 I was ready to put on a condor for the February expiration so I went to the RUT price chart. Here's a picture of what I saw:

You'll notice that it's a nice, calm, very flat price trend. The market is not in a strong uptrend or downtrend. I prefer to "leg" into condors, but in cases like this it's begging for a nice evenly spread condor with both sides put on at the same time. I don't have a picture handy, but if you go look at implied volatility (I like to use the RVX for this), you will also notice it was coming down nicely at the same time... a great trend for vertical spreads like Iron Condors, which profit from decreasing IV.

Again, I'll talk about the details of positions sizing, how I choose strikes, my adjustment plan, and more in future segments, but this is where I start.

Legging In:

In contrast to the flat entry, I started to add to my RUT condors on 1/2 and 1/16 by legging into some more positions. Part of my position sizing segment will address how I "scale into" positions and why, but basically I gradually enter positions in order to spread my risk over time. By putting on each side, either the bear side or the bull side, when price movement favors us I feel like I pick up a much wider spread between short strikes and a nice advantage.

On 1/2 (yellow circle) I noticed that we had just finished two nice "green" (up) days. In a bear market, especially with the strength of the current one, we rarely see more than a couple of up days in a row. With that little rally I sold a bear call spread on the 560/550 strikes. Did I call the exact top of the market? Nope. But I don't need to. As I said, these are far out of the money and very forgiving.

on 1/15 (second yellow circle) you'll see that the opposite happened. There had been a strong down trend over the past few days, RSI (one of the few indicators I use) had plummeted, and a nice green hammer had formed. So, on 1/16 I entered the bull put spread side of the Condor, completing it. And so it goes... I added another bear position after the big up day on 1/22. I don't know yet how all of these will play out, and I will have to manage them, but that's the basic entry picture that I look for.

Next Time - Part Two: Position Sizing

New Trade: RUT Call Spread

Today the market rallied pretty hard, sucking up all the losses of yesterday. I sold the call spread leg of my iron condor on the RUT. Specifically, the trade was:

RUT Bear Call Spread 540/530 @ .50

I haven't yet shared my condor rules on the blog, but this is a far out of the money spread that I will allow a lot of room on. The credit of .50 is the minimum I will accept on a condor for one side. The other thing I should note is that I leg into my condors. Lately we have not had more than one or two green days at a time, so with a rally this hard I decided to pull the trigger.

Going Vertical...

Yesterday I mentioned that I put on some new vertical spreads, so I thought I might take a moment and share my trading rules for this type of trade. Generally speaking, I do three types of trades:

• 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...

New Trade: FE Bear Spread, ORB Bear Spread

Today I was looking for a way to get some negative deltas, with the market in a hard down trend. I put orders in this morning which filled as follows:

FE Bear Call Spread, 55/50 @ 1.55
- Stop at 51.00

ORB Bear Call Spread, 20/17.5 @.80
- Stop at 18.20

Both are in a nice down trend, and both gave me risk/reward of greater than 2:1. That is my minimum for a vertical credit spread. You'll notice that I also have stop... always. If these prices get hit I get out. I don't like to use a contigent order, since the spreads are sometimes too wide, so I usually use an alert that tells me when the stop is hit, then I get our manually and work the spread a little. We'll see how they play out.