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Success With Options - Monthly Review, Issue #002 -- February Edition
February 01, 2010
Hello

Welcome to the February 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 books, websites and 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.

"As January goes..." - February Newsletter

You've maybe heard the saying "As goes January, so goes the year". January didn't start off too well.The SPX is down almost 4% from December's closing price and down over 6% from the high established the first week of January.

Last January wasn't a very good indicator of how 2009 turned out. In fact, there are many instances where January's performance was not a good indicator for the rest of the year.

Whether you believe the saying or not, it is true that these last few weeks have been quite different than the last few months. As an options trader, I am looking at the 20-40 day window to trade in. Regardless of how 2010 will turn out overall, I've changed my outlook somewhat.

For more on this, read on...
 

In This Issue

1) New on the site

2) Trade of the week summary

3) Options Trading Tip

4) Answers to your questions

5) Book review of the month

6) Options Outlook
 

What's new at Success With Options

Other than adding trade pages, I haven't made any major additions or changes to the website. I will be making some updates this next month on the broker review pages since it's about time to update some of those. 
  • Ezine Articles - I have been busy writing a number of articles that are related to topics posted on the website but in some ways, add to or provide more focused discussion. Have a look!
 

Trade of the Week Summary

This has been an interesting month. In the last newsletter, I announced that my new resolution was to trade the trend I was seeing, which at the time was bullish. Well, this month the trend may be changing (more later) and the result was that many of my trades stopped out with a loss.

Here are the trades I put on this month in a quick summary.

New/ Closed Trade Gain/Loss Comments
Closed Short SPY put vertical $288 gain This was a trade I put on in late December and was the only profitable bullish trade I had.
Closed Short EWZ put vertical $136 loss Fortunately the stop order triggered early and I was out of this trade with a relatively minor loss 
Closed Short SPY put vertical $459 loss I attempted another bullish trade on the SPY, which ended up costing me - but only by roughly my 2% of the portfolio
Closed Short DIA put vertical $408 loss Another bullish trade I put on that stopped out when the market change occurred
Closed Short SPY put vertical $81 loss This last trade was a bit of a risk trade where I tested that the sell off was over with an early stop on a close below $109. This could have been a nice trade if I was right but only cost me a little ($9/contract) to find out I was wrong.

So, I end the month flat (i.e. no trades open). It's tempting to jump to the conclusion I was wrong to trade the trend, however, my total loss this month was only $796 or about 4% of my portfolio. I believe the longer term strategy of consistently trading trend and following my trading plan will prove out.

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

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Options Trading Tip of the Month

This month, I want to add something new to the newsletter. Options trading can be complex and many of the nuances of trading can often get missed.

The first tip I want to cover is related to the price at which you buy or sell an option or option spread. Newer options traders will often simply take the ask price when buying or the bid price for selling, however it is possible to get a better price than that.

Depending on how liquid the market is for the options being traded, it is often possible to get a price midway between the bid and the ask.

Why is this important? If you are trading just a few contracts it may seem unimportant to try to save a few cents on the trade price. However these pennies add up. Think of it another way. Let's say you pay $2 per contract in broker commission. If you can get a few cents better price, you've paid for your commission.

Why are you able to get a better fill price than the bid or ask? Because many times the options market maker is willing to give up some of their edge to add to or remove from their inventory. This is often true with smaller quantities of orders.

Most trading platforms will tell you what the mid price is between the mid and ask and will allow you to set this price as a limit order. If you are unsure if you have this capability, check with your broker.

For more information on broker platforms, check here.

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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!
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Q: I have recently been trading credit spreads for 90% of my trades but I'm wondering if there's any reason not to use Debit spreads at the same strikes to create a bullish or bearish trade setup?
A: I've been asked this question a few times and it's one I've pondered myself in the past. It may be tempting to think credit spreads are superior because you get a credit up front. However, there isn't a whole lot of difference between a credit spread (short vertical spread) and its debit spread (long vertical spread) equivalent. To consider the two trades equally, you'd need to select the same set of strikes for the put spread (i.e. short 111/long 109 put) and the call spread (long 109/short 111 call).

If you look at the P&L graph for each of these, you'll see that they are pretty much the same. You'll find the greeks will be fairly similar as well. For the most part, the only real difference is the way they are managed.

Except... that when you have a debit spread, while you are in profit (i.e. fully ITM), there is a risk of early assignment on the short strike.This isn't too likely unless you are deep ITM on the debit spread but the risk still exists. When this happens, you will need to exercise your long strike to close the trade out completely.

When deciding on which strategy to use, there are several factors to consider.
  1. For the same position, which one has the best ROI? Usually one or the other will have a slightly better potential profit.
  2. Do you find it easier to work with a trade that offers an initial credit with a margin requirement vs paying a debit up front with a potential profit to be locked in when the trade is closed?
  3. What are the trading rules for each strategy?
Credit spreads do pose a risk in that it is tempting to focus on the gain and not the risk. With a debit spread, I find this to not be the case.

As in any trade, it is important to have a clear trading plan with a set of rules for entry and exit. I personally trade debit spreads differently. My debit spread strategy involves buying an ITM option and selling an OTM option and is often used when I'm a little more bullish or bearish.

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

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Book Review of the Month

Last month, I reviewed a book I really found helpful in my early trading called Fundamentals of the Options Markets by Amy Hoffman and Michael S. Williams.

This month, I want to review another book I found extremely helpful in understanding options. This one falls into the category of 'must own' for any serious option trader. The book is Option Volatility & Pricing by Sheldon Natenberg.

By comparison, this book is much more of a reference book. This is the kind of book you buy and read, and then re-read fairly often. If you're into marking up and writing in your books, this is the kind of book that will have many highlights and notes in the margin after years of reading. Every time I read it, I pick up something new or gain a deeper insight into some particular concept.

Why is this? I think Mr. Natenberg puts it well when he writes in Chapter 6, "... the risks with which an option trader must deal are not one-dimensional. A wide variety of forces can affect an option's value." I find that I learn more and more about these forces each time I read his book.

Given that options are complicated instruments, I've found it critical to have several books like this on my shelf that I can refer back to time and again.

Here's a quick insight into the book and some of my favorite chapters:
  • Introduction to Theoretical Pricing Models (Chapter 3) - This chapter lays the groundwork for the various complexities of options and the factors that influence an option's price including exercise price, time until expiration, current price of the underlying, interest rate and volatility. In this chapter, he lays out basics of the Black-Scholes formula as one of the more popular pricing models.
  • Volatility (Chapter 4) - Mr. Natenberg goes into a great amount of detail on the hardest aspect of option pricing. He begins with a short lesson on probability, distributions and statistics. All of this lays the groundwork for understanding how volatility affects the theoretical and actual price of an option. This chapter also provides a nice explanation of the differences between future volatility, historical volatility, forecast volatility, and theoretical volatility.
  • Option Values and Changing Market Conditions (Chapter 6) - This chapter uses the potential changes in market conditions and their effect on options values as a backdrop to explain the various option greeks. As such, it is a fairly standard treatment of the topic. However, per the style of the book, Natenberg provides many charts and examples to explain the topic. One I particularly liked is the explanation of gamma. His chart 6-9 helps explain why I no longer hold my options until expiration.
  • Introduction to Spreading (Chapter 7) - This chapter lays the groundwork for the remainder of the book, which goes into various spread strategies. There are several good quotes in this section including the following. "Spreading is simply a way of enabling the option trader to take advantage of theoretically mis-priced options..." While I don't believe there are too many cases today where options are mis-priced, I believe they are priced according to prevailing expectations, which may present opportunities to take opposing viewpoints. For example, low volatility in a bullish market may lend itself well to buying a put calendar spread with the expectation that a correction will result in both a rise in volatility and a move downward to the short strike. 
There is much more to be found in this gem of a book. If you are serious about trading as a business, then this book is a 'must own' book. More than that, it must be a book that is read often.

For more on this book or to purchase, click here.

To see other books in my library, click here.

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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.
 

Last month I summarized my outlook as follows.

"I also wouldn't be surprised to see a nice correction after the first of the year. If it happens soon, then we may see a nice fat correction down to the 1000 level. That may seem wishy washy, so let me be more precise.


Given the above two possibilities, I believe right now it is more likely for the S&P to continue up to 1200 before retracing."

It turns out I was close. January began with resumption of the strong bullish movement and broke above the previous high of $1130 formed at the end of December. However, after a week of buying and running the SPX up to $1150, sellers suddenly showed up and the remainder of the month has resulted in selling. We now have a lower high and a lower low in place, which means for the short term, I'm more bearish.

It still remains to be seen how much of a correction this will be. As of now, we are off 6% from the high of $1150. Despite a number of decent and better than expected earnings announcements, uncertainty around possible legislation of banks and health care and continued economic recovery has caused sellers to show up each time a rally begins.

 SPX market outlook for Feb 2010

Given the two instances where support has been broken, I wouldn't be surprised to see continued selling all the way down to the $1030 level, which would represent about a 10% correction from the recent high. Interestingly enough, this is roughly the horizontal support area I've outlined. It may turn out that the 200 day MA will intersect in this area soon and could pose a good argument for the up trend to resume.

This month, I'm going to be more inclined to buy a put calendar spread or two, sell some call credit spreads and maybe sell an iron condor. The first two strategies are outright bearish trades, while the iron condor is more neutral. I would put this trade on with the expectation that selling may continue down to $1030 and then a bounce will occur.

What else could happen? If the $1030 level fails to act as support, then we could see selling all the way down to $875-900. Also, buying could resume this month and a resumption (at least temporarily) of the up-trend would be signified by a close above the $1100 area.
 
For more on technical analysis, click here.

For more on options strategies I use, .

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