TSLA trade setup using the Simplified S&P500 formula

I know this is jumping the gun, but even though I haven't written all my posts on the S&P500 formula I wanted to apply it to an ideal trade setup today.

Yesterday TSLA had a serious drop in price of just over 10%. Today the price opened under $120 and the put options were priced accordingly.

The Implied Volatility (IV) Rank was over 60, which is a good place for it to be with this sort of spread trading as a high relative IV drives the price of options up, it's one of the factors that directly affect the extrinsic value of a stock.

Here is the historic chart representing the distance from the price for spread strike entry relative to the time until expiry based on trading days, not calendar days and the successful trades... or at least trades when the price ended above the strike price. The pattern suggests that trades longer than 20 days may have crossed the strike then returned above by the end of the period which leads me to use a different strategy here, but the same spread type.

	40 Days	35 Days	30 Days	25 Days	20 Days	15 Days	10 Days	5 Days	Combined
Strike	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate	Win Rate
-5%	71.05%	76.92%	74.36%	71.79%	66.67%	74.36%	72.50%	77.50%	73.16%
-6%	73.68%	76.92%	76.92%	71.79%	69.23%	76.92%	72.50%	80.00%	74.76%
-7%	73.68%	82.05%	82.05%	76.92%	79.49%	76.92%	82.50%	87.50%	80.19%
-8%	78.95%	82.05%	84.62%	76.92%	79.49%	79.49%	90.00%	87.50%	82.43%
-9%	81.58%	82.05%	87.18%	87.18%	84.62%	82.05%	90.00%	92.50%	85.94%
-10%	81.58%	82.05%	87.18%	89.74%	87.18%	87.18%	95.00%	95.00%	88.18%
-11%	84.21%	84.62%	87.18%	92.31%	87.18%	89.74%	95.00%	97.50%	89.78%
-12%	86.84%	84.62%	89.74%	92.31%	89.74%	89.74%	95.00%	97.50%	90.73%
-13%	92.11%	84.62%	89.74%	92.31%	89.74%	94.87%	95.00%	100.00%	92.33%
-14%	94.74%	87.18%	89.74%	94.87%	89.74%	97.44%	95.00%	100.00%	93.61%
-15%	94.74%	87.18%	89.74%	97.44%	89.74%	100.00%	95.00%	100.00%	94.25%
-16%	94.74%	87.18%	89.74%	97.44%	92.31%	100.00%	95.00%	100.00%	94.57%
-17%	94.74%	89.74%	92.31%	100.00%	94.87%	100.00%	97.50%	100.00%	96.17%
-18%	94.74%	89.74%	92.31%	100.00%	94.87%	100.00%	97.50%	100.00%	96.17%
-19%	94.74%	94.87%	94.87%	100.00%	94.87%	100.00%	97.50%	100.00%	97.12%
-20%	94.74%	94.87%	94.87%	100.00%	94.87%	100.00%	100.00%	100.00%	97.44%
-21%	94.74%	97.44%	97.44%	100.00%	97.44%	100.00%	100.00%	100.00%	98.40%
-22%	94.74%	97.44%	97.44%	100.00%	97.44%	100.00%	100.00%	100.00%	98.40%

The trade entry was this morning at the open for the December 21 105/100 put spread (selling the 105 and buying the 100) for a credit of  75 cents.

This is basically making $75 on a $5 spread which is a $425 risk or a Return On Risk of 17.6% if the option is held to expiry... 31 calendar days (23 trading days on my charts). The 105 strike is about 13% OTM which has a historic win rate of almost 90% (the 20 day column above) or 92% (the 25 day column).

I might consider that the bottom of the spread is the determining number for the risk as that is maximum loss, and the 100 strike is closer to 17% lower than the price which pegs the historical odds between 95 and 100%

Strategy 1 might be to hold the trade through to expiry for the full return and take the slim chance that it might not work out OR aim for 50% profit taking which, with the action of the stock, could take as little as a week.... probably whichever comes first. At this writing (almost 3pm on the same day) the value of this spread has dropped to 55 cents, which is 26.6% profit already.

Let's see where this one goes.

Jeff.

S&P500 Simplified : Calls vs Puts

The first item to clarify when it comes to trading anything is that buying a security or derivative (option) involves forecasting the move in price. The move must be in favour of the trade and, with options, must make that favourable move in some chosen time frame. Considering that the price can go up, down or even sideways, a very base assumption is that just buying options I can be correct maybe a third of the time, although with stocks they can be held indefinitely so there is less of a time factor, perhaps it's fair to say that the odds are near 50%. There are strategies that can mitigate and help to produce larger winners than losers but, as I have found out, they are often not as simple as at first thought.

In my last post I had briefly outlined the difference between naked options and spreads, specifically trading the puts which can be a fairly neutral strategy in that the price of the underlying stock can move up, sideways and even down a certain amount and the trade will still produce a profit. This can change the base 33% odds to higher than 50%. Anything over 50% is the edge that can be used to produce more winning trades than losers but even that is often not enough to make a trade strategy profitable. More on the stats in the next post.

The main reason for choosing put spreads instead of call spreads has to do with the price skew between calls and puts. Today SPY closed at $179.87. Comparing the equal (more or less) strike distanced 190 call selling for 9 cents and the 170 put options selling for 51 cents. In the case of the credit spread, the higher priced option produces a higher profit trade.

A note about the pricing structure of the options used in this sort of strategy.

A put has intrinsic value when the stock price is below the strike. This value is equal to the difference between the strike and the price and changes in direct proportion to any changes in the price of the stock. The credit spread uses options that are OTM and do not have any intrinsic value.

In it's simplest form, the extrinsic or time value is a calculated price or premium based on the volatility of the stock (expected and historical range of price moves), proximity of the strike to the price and the time left until it's expiry. This value reduces or decays as the expiry date approaches, as the price wanders higher making the option farther OTM and as the volatility reduces. A credit spread uses this decaying extrinsic value in it's favour as the credit gained at the initial sale is kept as the options expire with a zero value at expiry. The only factor that can produce a losing trade is the price dropping below the put strike so a directional move up is better for the position but isn't critical. Time can only reduce and, while volatility can affect interim trade value, it won't matter as long as the price stays higher than the strike. A sharp reduction in volatility in a few days can turn the trade into a quick winner and can allow it to be closed early... but that is a whole other topic.

Here is the comparison between the two vertical spreads, a call and a put, with the same $5 width or spread, these are based on the SPY December 2013 monthly option prices:

Call Spread				Put Spread
$0.06		Net credit in green		$0.24
$0.03	Buy	195 strike
$0.09	Sell	190 strike
		SPY Price 179.87
		170 strike	Sell	$0.51
		165 strike	Buy	$0.27

In a 10 contract trade the call spread will produce $60 (1.2% Return On Capital, ROC) and the put spread $240 (4.8% ROR). This disparity is typical between OTM calls and puts on most any underlying stock or fund. That's an even 300% higher return.

This pushes me to look for an edge that favours a put credit spread even though I expect that there may be better odds in favour of the call spread, the reduced profitability won't make up for the difference... particularly in a small account..

Jeff.

S&P500 Simplified : Selling Naked Options vs Credit Spreads in SPY

Lately I've been tinkering with credit spreads and naked puts in SPY, more out of curiosity than anything else... that is until I did some extensive studying of the historical SPY data. More on that another time though.

I have dabbled in options before and made out very well.... and not so well in varied proportions. The one strategy that I did have a 100% success rate (albeit with not as many trades as would be needed to prove feasibility) with was the credit spread. It was short lived due to my need for continued testing of other strategies and styles of trading, which is now one of those hindsight stories.

The basic credit spread plan is to sell an out of the money option and buy a further out of the money option with the same expiry. The first is the profit and the second is the protection. The risk is fixed and is the difference in the strike prices less the premium collected. The trouble is getting enough premium difference between the two transactions to be profitable which made me consider the naked option.

Naked option selling looks much more lucrative up front as selling the option without the need for a protective leg purchase means that all of the premium collected is kept. This often allows the sold option to be farther out of the money and still be profitable. The trouble is that the risk is no longer defined.

With a naked put, if the price plummets the loss becomes the difference between the strike price of the put and the price of the underlying at expiry. Not that a stock is going to hit zero but a large down move could be a real problem. This is the point where my SPY study comes in to provide some historical context for the risk involved.

While the naked options look enticing for the reasons mentioned and the credit spreads look to be a safer bet, the upfront account management implications for both need to be considered and compared.

Account size.

A typical broker may have a $5,000 minimum account balance in order to trade credit spreads whereas $25,000 is required to sell naked options. This makes the credit spread more accessible to the small account holder or hobby trader. Anyone halfway serious can probably start with enough to choose either method but only if they are comfortable and confident in the plan and have at least $100,000 would they really be able to use naked option selling.

Margin requirements.

The credit spread requires the entire potential loss to be in the account... so, technically, margin is not even being used. With a spread that covers a $1 strike price range, this amounts to about $100 per contract and the margin does not change with the price of the underlying stock. This is also the entire amount risked, less the premium collected, on the trade. It will vary with how wide the spread is in increments of $100 per strike per contract. Because the protective put will be exercised to offset the naked put in a worst case scenario, there is no chance that there will be any assignment of the stock or ETF.

For a naked option this amount is more variable and is not the entire risk associated with the trade. For a $100 stock the margin required might be in the $1,500 range whereas a $200 stock could be around $3,000. It varies with how far out of the money the option is and how much premium was collected for it. The margin requirements also change with the stock price.

These differences make the credit spread a more viable trading method for those with small to medium accounts as naked option trades will tie up much more cash per transaction.

For example, a naked 140 put for November expiry sold for 19 cents on September 30th. 10 contracts would yield $170 after commissions but based on a margin requirement of $24,860 which is an ROI of 0.68%. That is one trade.

A credit spread between 141 and 135 strikes sold at the same time with the same expiry would yield 7 cents net. It would take 42 contracts in one trade to equal the cash return of the naked option using $25,000. The advantage is that four separate trades could be placed at varied times and dates which could be at different strikes based on the price movement and these can be staggered in a way to reduce the chance of a price move producing a loss. Four trades of 10 contracts each that I am currently tracking are from September 30th, October 3rd, 7th and 8th with 10 contracts per trade which can yield a combined $200 profit after commissions based on a margin requirement of $23,800 or an ROI of 0.84%.

A quick note, both the naked puts sold and the credit spreads that I track are set up such that they have a success rate of better than 98% over 20 years. Even then the few times that they were "losers" appear to have been easy to close before they were a total failure... which is more important with the naked options than the spreads.

(UPDATE: I am investigating strategies based on historical statistics and current data that will serve to increase the returns on risk and maybe even increase the probability of the trades being winners.)

Jeff.

The VTSO trade for SPY, active

If you read my last post it briefly outlined trade ideas based on the McClellan oscillator as a trigger and the chart indicated a trade to open on November 15th.

Here is the oscillator:

...and here is the current SPY daily chart:

Today the adjusted VTSO has the stop at $134.76. While this price is still below the entry price of $135.98 the loss, should the stop be triggered now, is not very great.

I toyed around with the idea of taking profits at 4%, 6% and 8% gains along the way but found that just leaving the VTSO run and adjusting it at those particular points in the trade is more profitable by about 10% overall. While the smaller realized gains serve to give the feeling of success, they are not necessary. Having said that, a target exit of 6 % has the best bang for the buck if I decided to go that route for a smaller sidebar trade.

Jeff.

The VTSO as a trade management tool for SPY profits

I have toyed around with all sorts of indicators in the past and found some nice correlations that could have turned into decent trading plans. The only downside, usually, was that there were a high number of trades indicated with a large tendency to get whipsawed right out of the trades.

Profitable, but with a lot of work unless a good set of rules were established to govern the trade management.

This is an example of a very simple trade entry plan using some basic trade management rules to provide a profitable, even if not a stellar, outcome.

I used the NYSE McClellan Oscillator (ratio adjusted version) and applied it to SPY to provide a very simple trade indication. The oscillator represents the rate at which stocks are becoming overbought or oversold. To be honest I am only interested in the easily seen correlation between the overbought value and the corresponding price moves in SPY, not the math behind the oscillator itself..

The green box on the oscillator chart below (3 years, daily) is the sweet spot where the more extreme oversold indication has some validity on placing high probability trades, values of -80 or lower.

Here is the SPY chart in the corresponding 3 year period.

As the oscillator line hits -80 I note the price candle of SPY for that day, green arrows. On the next day if the opening price falls within the range of the previous day's candle body or lower, buy at the open price or lower. Although using a lower price can easily be done it is a rather subjective decision and requires more rules to govern the trade entry. Therefore, in order to simplify the process there can be no exceptions to the simple entry rule and the opening price is always used.

I started out using a staged exit strategy but found that it was not only not necessary, it also hindered the profit potential by providing smaller, incremental profits. While these incremental profits serve to make me feel good that there are profits early on, they reduce the overall effectiveness and simplicity of the plan by 10% or more.

A brief outline of the management plan sounds something like this:

Each trade is opened and treated as a single position throughout.
An initial stop order is immediately established based on the opening trade price, this is a static order.
Particular staggered targets are established for the purposes of adjusting the trade exit.
As the first target is met, a VTSO is placed and set based on this target price.
As the second target is met, the VTSO is tightened based on this value.
As the third target is met, the VTSO is reset again but loosened by a small percentage, this is optional.
At this point the trade is running solely on the VTSO for exiting.
At any time that the price reaches the VTSO value the position is closed, profit or loss.

The advantages of the plan:

Using a VTSO allows for the stop to automatically be raised as the price climbs and allows the price to continue to climb dragging the trailing stop with it. Having multiple staged and fixed targets provides some intermediate adjustments of the trade to reduce the risk once the price starts to move in a favourable direction. This particular setup is simple as it allows a wider margin initially while tightening up the stop progressively without getting stopped out of a trade prematurely.


The draw back of this plan lies in the case where the price drops immediately following the initial entry position as this can produce the largest loss and is very disheartening if the plan is not adhered to thereafter.

I think that I would allow for further targets to provide for more adjustments of the VTSO along the way and perhaps a target, fairly large if hit, to close half of the position.

Having said that, a lot of time is spent sitting on cash between trades so I certainly don't suggest this as any core trading strategy, just a little moneymaker on the side.

Easy in and easy out.

Jeff.

ABB Stock Market Trading continued, Proper comparison

Rather than add to one of the previous posts, here is a note on comparing one trade size to another followed by a bit about account size and trade determination.

My initial simple trading plan included trading at least one lot (100 shares) of a stock. This produced a particular return, profit or loss.

Adding levels of complexity that introduces additional concurrent trades or splits up the initial trade make it a little bit more complicated to compare one against the other. At least on a dollar for dollar basis.

In the first plan I trade one lot, 100 shares bought, 100 shares sold at target or at stop loss. In the second plan it is the same entry but the first 50 shares get sold at target and the second get the VTSO treatment, or the whole lot stops out and is sold for my Maximum Loss Allowance (MLA) for that trade.

Easy enough.

In the subsequent alterations the entry trades go from the above guide to one entry at the initial target, perhaps a second and perhaps a third at subsequent targets. The farther along in the sequence the more shares traded due to the second and third possible trades. Cutting the altered trade sizing to 1/3 lots or tripling the initial plan isn't a fair comparison as many of the second entries do not set up and even fewer of the thirds. Then again, counting three trades with a combined size of 300 shares is not fair to the initial plan only using 100 shares.

It boils down to a subjective assessment of the win rates and returns that fit a particular account size and applying appropriate money management rules to determine which style fits both the account and the risk tolerance of the individual. This should be completed up front and in writing in order to have a guide to stick to. Making these up and the fly is not a great idea and can lead to problems later on, although not necessarily with a successful and profitable plan.

Here are two particular examples for an attempt at comparison, ABB at around $14 in the middle of 2009.

Simple trade plan, 100 shares in and all out at targets.Typical initial target is for $1.50 but how much of that is aimed for depends upon the price movement following the entry.

Buy at $14, sell at $15. $1 per share = $100 gain (7.1%)

VTSO applied with $1.50 trailing stop, 100 shares in, 50 shares out at target, 50 shares to trail.

Buy at $14, sell 50 at $15 and sell 50 at $17.50. $1 ps + $3.50 ps = $225 gain (16.1%)

Multiple entries and exits according to the final plan setup.

Buy at $14, sell 50 at $15 and sell 50 at $17.50. $1 ps + $3.50 ps = $225 gain (16.1%)
Buy at $13.50, sell 50 at $15 and sell 50 at $17.50. $1.50 ps + $4 ps = $275 gain (20.4%)
Buy at $13.00, sell 50 at $15 and sell 50 at $17.50. $2 ps + $4.50 ps = $325 gain (25%)
Total gain = $825 (20.3%)

Worst case loss for the respective plans:

Simple trade plan, 100 shares in and all out at stop loss.

Buy at $14, stop loss at $12.50. $1.50 per share = $150 loss (10.7%)

VTSO applied does not matter as the initial stop is always $1.50 on this priced stock, same loss.

Multiple entries and respective stops assuming the worst case according to the final plan setup.

Buy at $14, stop at $12.50. $1.50 per share = $150 loss (10.7%)
Buy at $13.50, stop at $12. $1.50 per share = $150 loss (11.1%)
Buy at $13.00, stop $11.5. $1.50 per share = $150 loss (11.5%)
Total loss = $450 (11.1%)

Keeping the worst case scenario in mind and using the typical account loss allowance of no more than 2% Maximum Loss Allowance on any single trade, this trade alone would require an account balance of $22,500 even though the trade only used $4050 in capital. Going with the smaller 100 share trades and keeping to the simpler single entry and VTSO half trade exit, the account could be $7,500.Of course these assume that this is the only trade on the map.

I'm breaking this into another post, again due to the length and this is a good place to break as the topic is shifting a bit.

Based on the numbers that I am looking at now, I think that the best comparison may just be no direct comparison and to consider the account and go from there. Starting with a small account may mean restriction to initial entries only and perhaps targeting lower priced stocks. Adding more stocks to the mix as the account grows then adding the second trade setups and thirds will allow the account and methods used to grow accordingly.

The win rate and overall returns will govern where I think the money is best applied which leads me into the more complex trades. Ideally taking every trade setup as it appears and making every trade at every level is the best overall action for this trading plan, it just may not work for everyone.

Jeff.