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Success With Options - Monthly Review, Issue #25 -- January 2012 Edition
January 02, 2012

Welcome to the January 2012 edition of this newsletter!

This is a monthly newsletter packed full of tidbits not found on the website. This is my attempt to stay connected with those who find value on the the website and want more.

Since this newsletter is published every month, you are always up to date and empowered to be a better trader. That's because I'll be sharing lessons I've learned over the prior month, answering questions from other viewers and providing a spotlight on useful websites and trading tips. If you find this newsletter valuable, pay it forward and send it to your options trading friends.

To access previous issues of the newsletter, click here.

Flat year, What's Next? - January Newsletter

Welcome to the January newsletter. I can hardly believe it's been 2 years since this newsletter first started. Some of you have been subscribed the beginning. Thank you for your patience and loyalty as the newsletter has evolved.

As we finish out the year, it seems like we're right were we were at the beginning of the year. How did your portfolios fare? With the style of options trading we discuss, you should theoretically have a gain. What's next for the market? Will we see any bullishness, or will the bears rule in 2012? Read on.

Also in this newsletter, I'll be reviewing the month in more detail, review my trades, talk options strategies and more. As I write this newsletter, I'm traveling back from visiting family over the holidays. I pray your holidays were blessed with good family, good food and good rest.

As we head into 2012, it seems like a good time to ask again for any feedback you might have on the  newsletter. What would you like to see in future newsletters? Thanks again to those who have provided feedback on the newsletter in the past. I do value and take into consideration feedback on the newsletter content and ways I can make it more valuable for the readers.

Please feel free to voice your opinion. If you haven't done so already (or recently), please consider taking a few minutes to visit the newsletter feedback page and let your voice be heard. I don't require an email address to submit the feedback so you can do this anonymously.


In This Issue

1) New on the site

2) Trade Tutorial summary

3) Options Strategy Focus

4) Answers to your questions

5) Options Outlook

6) Featured Product

What's new at Success With Options

There's been a lot going on recently, mostly with small changes to the website. Last month I added a Facebook 'like' button immediately below the left navigation menu. If you have a Facebook account and find the website helpful, I encourage you to take the opportunity to 'like' the site. This month I added a couple of comment areas to the newer trade tutorial pages. The intent here is to allow you to weigh in on some of these trades yourself. If you have a Facebook account, feel free to jump in and comment.

I also continue to look for new topics to expand the information on the website. Perhaps you have some topics you'd like to see covered. You can let me know using the newsletter feedback page.

I entered December with one active trade, which is now closed. I added another trade right as the month was coming to a close. Read on for details of the trades.

Finally, I've been working on the outline and plan for the 'Mastering Short Vertical Spreads' video, which is the next one I plan to release. Honestly, the more I work on this the more excited I get at the potential. This video will include three key components. First, I'll teach a concept. Second, I'll demonstrate the concept. Finally, I'll give you a chance to practice the concept through either simulated steps or directly on your paper trading account. I'm sure you'll agree these three ingredients will help make sure you get the most from the material. Look for this video in coming months.

As to the trades I opened and closed, see the trade tutorial summary below for additional details.

Trade Tutorial Summary

I had a few more trades going this month. The one trade I closed was a winner. Here's the complete list of trades I was active on this month in a quick summary.

New/ Closed Trade Gain/Loss Comments
Closed DIA Put spread $68 This trade was another successful trade. I set a smaller profit target on this trade due to the choppy market. Check out my commentary on this in the tutorial closing comments.
Open SPY Put Spread    

Win or lose, I find that I learn something from every trade. I want to include some key thoughts/lessons learned from the past month's trade tutorials here. Here are the nuggets from last month's closed trades.

From the DIA Put Credit Spread:
"...What I'm considering more and more these days is the phrase "there's nothing wrong with taking profits". The more turbulent the market, the more willing we need to be to simply take profit and get out. In other words, we need to be willing to adapt our strategies to the times we're trading in. As long as the market remains turbulent, it may be better to settle for less profit if more trades are successful."

For more information on all of the trades I've posted as option trading tutorials, click here

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Options Strategy Focus: Anatomy of a Diagonal Spread

This section of the newsletter will focus more deeply on the details of some of the options strategies I use in the tutorials. In past issues, I've talked about how to select a strategy and using technical analysis to improve timing of entries and exits. In recent issues, I've returned to topics more directly related to the trading systems. Lately I've begun exploring the anatomy of various spread strategies.

Last month I looked at the the calendar spread strategy. This month, we'll look a a related strategy, which is the diagonal spread.

The diagonal spread is interesting because it really has characteristics of both a calendar spread and a vertical spread. Whereas a calendar spread is made up of a long and a short option with different months BUT the same strike price, a diagonal spread has a long and a short option in different months AND different strike prices. Like a calendar, the long strike is bought several months out and a short option is sold closer in. There are actually two different versions of this spread. One where the short strike is more in the money than the long strike and one where the short strike is less in the money than the long strike.

I want to focus on the type of diagonal spread where the short strike is less in the money than the long strike. This is very similar to a long vertical spread. It also has many similar characteristics to a covered call. In this version, you want to select a long option in an option cycle several months out in time a fair amount in the money (ITM). How far ITM is a matter of the rules of your trading plan. A good rule of thumb is to locate a short strike having a delta of around .7. The short strike should be in the closest option month having at least 20 days until expiration. You want to sell a strike price that is currently out of the money (OTM).

Like the calendar spread, this kind of spread is entered for a debit. The interesting part of this strategy is that as you roll the short strike from the current month to a farther out month, you will eventually end up with a long vertical spread. The trade makes money both from the credits received from the roll and the width of the spread (assuming it expires fully ITM). A diagonal spread will almost always cost less to enter than the actual width of the spread. As a result, if you are fairly bullish this trade has a high probability of making money even without the credits for the roll.

The majority of the work in trade management is in managing the roll of the short strike. Like the calendar spread, the ideal rolling point is when the underlying is right at the short strike and there are somewhere around 4-5 days until expiration. This will offer the best credit for the roll. A variation of the calendar style roll is to roll both out to the next month and up a strike or two, which results in a wider spread.

As the portfolio summary shows below, there are a lot of similarities in the greek interactions to the calendar spread. For example, notice the positive vega. Like the calendar spread, ITM diagonal spreads benefit from the increase in volatility. This is a unique characteristic - in contrast to vertical spreads and iron condors. Notice also that the diagonal spread has similarities to the vertical spread in its net delta. This is a bullish trade that will benefit from a move up in the underlying (DIA).

Notice also the unique shape of the ideal P&L graph below. There is a slight bump in the profitability of the trade right at the short strike. This comes from the calendar spread component. Other than that, this P&L graph looks very similar to the vertical spread P&L graph. Like the calendar spread, it's rare to realize the absolute maximum gain without taking the trade to the absolute last trading day and landing right at the short strike on the roll(s). The best you can hope for is to get a decent credit on the roll and have the underlying be completely through both strikes near expiration.

As a final point, I wanted to talk about when this strategy makes sense. As a rule, I prefer to use the call diagonal spread. However, a put diagonal spread would make sense in a strongly bearish market. I tend to prefer using a diagonal spread when the outlook (bullish or bearish) is a little longer term or the underlying is in a bit longer trend. This is a trade that takes roughly 4-6 weeks to develop so this strategy doesn't work well in a choppier market. 

For more information on this strategy, visit the diagonal spread strategy page.

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Answers to Your Questions

I frequently receive email from visitors to the site with questions that aren't answered directly from content on the site. Many of these are great questions and I think the answers would be valuable to all readers. Each month I'll be posting one or two questions, so stay tuned!

Here's a question I received actually related to a service provided by thinkorswim, now TD Ameritrade.

Q: I was using the trading log I received from you as part of the newsletter sign-up. In using this spreadsheet, I'm wondering how you would record adjustments (for example rolling one leg of an iron condor)?

A: This is actually an issue I've wrestled with a few different times myself.  The trouble is that the spreadsheet takes a fairly simplistic view of a trade; one entry and one exit. In reality, trades are often a little more complicated than that. As a result, I've actually come up with a couple of solutions that have worked for me in the past.

A fairly straightforward way to handle this situation is to treat the adjustment as a separate trade with its own entry. For example in the case of the iron condor adjustment, you would enter the closing cost to buy back the existing leg. Then, you would add a new trade that represents the new vertical spread. It makes the original trade look kind of bad, but it is actually a fairly accurate way to look at the adjustment. If you placed the order as one rolling trade, you may have to guess to some extent. You might simply price out the cost of buying that same spread and use that as the closing cost of the original spread. Then, you would use a little math to calculate the theoretical credit for the adjustment.

Another approach you can use, especially if you are comfortable cell math is to create a mathematical operation that includes all the debits and credits related to the trade. You would formulate a cell entry that looks similar to this: '=(+credit-debit+credit)'. The key to making this work is that all debits must be preceded by a '-' and all credits must be preceded by a '+'.

In general, I've found the first approach to be a better solution for most adjustments. The main reason is the simplicity of entries but the other benefit is what I mentioned earlier - separate entries better represent what actually happens. I do like to use the second approach when tracking calendar spreads and diagonal spreads.

If you would like to submit  a question, comment or feedback on the website, please visit this page.

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Options Outlook

In concluding this newsletter, I want to provide a brief outlook for what I'm expecting for the next 20-40 days. Before I do, I need to insert the following disclaimer.

This is not a recommendation to buy or sell stock, ETFs or options. It is simply my opinion of what I expect and how I plan to trade. As such, it may change if the charts indicate something different.

It looked for a while like we were going to see that Santa Clause rally. However, the month showed a whole lot of nothing. Last month I summarized my outlook as follows:

"...So, will we see the continuance of the strong move over the last few days? It actually wouldn't surprise me to see the $1300 level tested, with a pause before breaking completely trough. As a result, it may be near the end of December before we see the SPX break completely through the $1300 level. A final point to consider is that if the SPX fails to reach above $1250, this could signal perhaps another round of selling. "

Here's how the month played out.

The month started out looking like it would break out to new highs. However, the combination of mediocre economic news here in the U.S. and more bad news from Europe served to trigger a bit of selling. Interestingly, the selling stopped right at the 38.1% (I removed the fibonacci retracement lines I had on last month) before bouncing strongly. We ended the month near the recent highs and the year pretty much unchanged.

I mentioned in the last trade tutorial that we are forming what looks like a triangle pattern. Some chart technicians might call it an ascending triangle but that would disregard the highs formed back at the end of October. Regardless, what this kind of pattern often indicates is that the market is preparing for a strong move either to the up side or to to the down side. I'm leaning a little more toward a bullish breakout. HOWEVER, with all the news driving the market, we could see a failure of this recent upward trend. If we see lows back down below $1200, we may see a lot more bearishness in the coming months.

How does this affect my trades? I currently have one short term bullish trade in place. I'm going to be watching what happens in the first week or so of January. We may seen an opportunity for a longer term bullish trade (any suggestions?). I'm also tempted to sell a call spread near these highs that would be closed out if we break above $1275 or so. Be watching for new trades to show up in the next week or so.

Remember to stay nimble and alert. Make a point of doing market analysis every day, especially if you have open trades. If you choose to enter any trades, be sure to do your own analysis and follow your rules for entry and exit.

More on technical analysis.

Options strategies I use

Be sure to take time to provide feedback on the newsletter.

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Featured Product

I'm adding a new section to the newsletter. Feel free to disregard if you aren't interested in sales type information.

For those that aren't aware, I recently released the first 'for sale' video. The title of this first video is appropriately "An Introduction to Options Spreads". I say it's appropriate because this will be the first of several videos I'm working on that really are a labor of love. My goal is to provide a more in-depth and comprehensive coverage of options spreads.

To that end, this first video provides a good coverage of the basics of options spreads, including why they are preferable to other options strategies like buying options and selling naked positions. What I believe makes this video valuable is that it combines presentation with interaction. Once you have the basics down, you will be well prepared to start digging deeper into some of the options strategies employed on this website.

For a relatively small cost of $29, you can own this video, which offers over 40 minutes of material. This package is very easy to install and use.

Expect more videos to be released in the months to come.

For more information or to purchase the video.

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