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Success With Options - Monthly Review, Issue #73 -- February 2016 Edition
January 31, 2016

Welcome to the January 2016 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 (nearly) 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.

Exciting Start to the Year - January Newsletter

Are things exciting enough for you yet? The year sure started out with a bang!

If you are wondering what happened to the newsletter from January, recall that I had mentioned I wouldn't be publishing a newsletter as I was taking the month off. As a result, we'll have two months of action to analyze. Is there more volatility to come or was Friday a signal of calmer markets heading into February?

In this edition we'll tackle that question, begin to explore option synthetics and answer a question that was recently submitted by a reader. Finally, we'll close as usual with a Market outlook for you. For more details, read on...

I'm always interested in receiving feedback on the newsletter. If you haven't done so recently, please consider taking a few minutes to visit the newsletter feedback page and let your voice be heard. This can be done anonymously so please consider how you can help make the newsletter better.

In This Issue

1) Options Strategy Focus

2) Answers to your questions

3) Options Outlook

4) Featured Products

Options Strategy Focus: Introducing Options Synthetics

This section of the newsletter will focus more deeply on the details of some of the options strategies I use in the tutorials. As we begin the new year, I want to open with a series of discussions on options synthetics. This is a fairly complex topic so I'll break the discussion down into more bite sized pieces.

Synthetics Explained
The basic idea of a synthetic position is that you use one type of market entry to simulate another. This can be done by using options to simulate the position of a long or short underlying position (stock or ETF). This is often because the simulated position can usually be entered for a much lower cost or margin impact. For example, if I were to buy 100 shares of SPY at $193.5, it would require at least $19,350 in my account. On the other hand, I can buy a $193.5 call and sell a $193.5 put and achieve the same potential profit or loss with a margin of only $4k or so.

What do I mean when I say a position can be simulated? I'm really talking about the risk profile. For example, given the above long stock position (100 shares of SPY) I mentioned, the risk profile would like like the following.

If I were to enter the synthetic position of a single contract $193.50 long call and $193.50 short put, the risk profile would look almost exactly the same. We'll get into this in more detail in future issues. I just wanted to provide a concrete example to start.

This is actually just one example of a synthetic position. A key point we'll explore in more detail in future issues is what is sometimes called the synthetic triangle. If you imagine a stock, a call and a put, the combination of any two can be used to synthetically simulate the third. It's important to point out though that options do NOT have the exact same characteristics. In the above example, a stock will have the same risk profile as long as you hold it. Options expire. There are a few other issues you may encounter where the behavior is not exactly the same. After all, you can't get something for nothing. If a synthetic long stock position were exactly the same as the stock itself, no one would trade the stock.

The Case for Understanding Synthetics
Synthetic trades or positions can be very helpful when you want a trade to have a certain risk profile but also have a certain price or entry characteristic. They'll often be less expensive or will respond a certain way to changes in market dynamics like volatility.

Another scenario where understanding synthetic positions is helpful is in creating adjustments to an existing position. This is probably where I find myself using the synthetics concept the most. I'll provide some examples of these in future issues as we explore some different synthetic positions and how they might be used. For now, I'll leave you with some examples of some nifty synthetic positions.
  • Synthetic long stock = long call + short put
  • Synthetic short stock = short call + long put
  • Synthetic long call = long stock + long put
  • Synthetic short call = short stock + short put
  • Synthetic long put = long call + short stock
  • Synthetic short put = short call + long stock
Stay tuned for future segments where we'll look at some of these in more detail.

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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!

l recently received a question regarding the strategies I've recommended for short vertical spreads.

Q: I read your post about trading spreads http://www.success-with- as I do trade them too and last year and part of the 2014 I was basically losing money only. I do not know if it was because the 2015 was really a tough year or my strategy was wrong. I applied almost everything you wrote about - I buy back the contract at 50% of the credit, I also liquidate it when delta reaches 30. At some point I was using the same strategy buying it back when the loss reached 2 times of the credit but many times I was kicked out of the trade early just because the volatility. Many times I had trades where the underlying went against me but still I was way above the market (put spread) but due to volatility the loss reached the limit and I would have to sell although it wasn't necessary at that point. So, my question is how do you deal with this so you do not get wiped out too early?

A: This is a really great question for which I want to respond to several different points.
  1. The Strategy
    What you've referred to is A strategy for trading short vertical spreads. It has been a strategy I've used in the past and has worked to some extent. I too have experienced some of your frustration with the whipsaw action of the market and the way it kicked me out prematurely many times. What I mean is that when I employed the 2x rule to stop me out of trades, I was frequently kicked out of the trade for the 2x loss, only to see the market reverse in such a way that the trade would often have worked out if I had stayed the course.

    This led me to look at the purpose for the 2x rule. It was largely to limit my loss in cases where the market made major reversals and not recover in time for my trade to work out. What I realized is that my 2x rule was a sort of money management strategy. However, short vertical spreads are a defined risk trade. That means I know exactly how much I'll lose on entry of the trade. I size my positions based on this max loss anyway.

    I decided to alter my trading plan rules slightly to eliminate this 2x rule. I'm now usually in the trade until it either exits for the 80% gain or sustains maximum loss. I found that while I do sometimes sustain the maximum loss, I can tolerate it occasionally (or even on a couple of trades in a given month) because of my money management rules (see the next point).

    I want to stress that you should consider your trading plan somewhat flexible. I don't mean you should keep changing it every month when it doesn't yield what you want. Rather, you should evaluate it every 6 months to a year and consider if changes are necessary. You would use your trade logs and trade journals for the year to look for opportunities to adjust your strategy. I want to also emphasize that you should back test any adjustments to see  if they will indeed improve your outcomes (more in a moment).

  2. Money Management
    Let me take just a brief moment to stress that money management is key to staying the course in a trade that's gone bad. What that means for you is somewhat unique to your situation and risk tolerance. I use a 2% rule, meaning that the maximum loss for any trade cannot be more than 2% of my overall portfolio value.

    Let's use the example of a $20,000 account. Two percent would be $400. On a $2 wide short vertical spread with a $.45 credit, my max risk per contract is $155. How many contracts can I sell and remain within my max risk per trade? In this case, just two. In this case, my trade could lose $310. Can I live with that? Yes. Can you? That's a question you have to answer for yourself. If that feels like too much, change your rule to 1% or 1.5%.

    I've found that a rule like this gives me the courage to stare a bad trade in the face and let it run. Of course it sometimes works against me. However, more often than not, the trade actually works out.
  3. Back Testing
    Let me state again this principle: the key to successfully adjusting your strategy is back testing. That means taking the new rules and running through a set of trades for a given timeframe. One thing I like to do is adjust my strategy and re-run the year's trades to see if I may have gotten a better outcome.

    Is this time consuming? Yes, but it's worth it. An investment of a couple of hours to painstakingly run through the trades will give you the courage to let your new strategy to run for 6 months or more without feeling the need to fiddle with it.

It's important to realize that your trade plan is not set in stone. You can adjust it periodically. The keys I've given you above should be the guideline you use to do so. At the risk of turning this into a commercial, I do cover this in some amount of detail in the Short Vertical Spread video available on the website.

Help me ensure we have an interesting question or two to respond to next month. Submit your questions at 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, expectations may change if the charts indicate something different during the month.

We certainly saw a lot of volatility through December and into January. It's actually quite a bit more than I had anticipated.

In the December newsletter, I summarized my outlook as follows:

"...At this point, the market is likely to swing either way. We have a range established between recent highs and recent lows that form support and resistance levels. Given that this is written several days into December, we already can see that the first move was down with a sharp rally on Friday. As we head into the last few trading weeks of the year, the market will likely be more bullishly biased as is typical for this time of year. However, this year feels a little different, so we may not see the typical strong finish we've been used to seeing at year end. ..."

Here's how December and January played out.

I had suggested that things were feeling a bit different and I was right on that count. I really had no idea though that we'd see the kind of selling we experienced, especially in January. Of course there are always fundamental issues that are behind this but it's always interesting to see the technical analysis line up as well. Notice how the initial support lines up with the 61.8% fibonacci retracement around $2,000. Expect that to act as resistance on the way back up. About a week ago we saw a strong selling point that ended in a hammer forming that was subsequently confirmed by the next few days.

I think it's always good to step back at the end of a year and get the big picture. For that reason, I included an inset showing the 2 year monthly chart. You can see that where we found a bottom recently around $1800 is pretty close to the October 2014 low. In the longer term, we are still in bullish territory. However, in the medium term (6 month timeframe), things look a lot more neutral. Of course near term (4-6 weeks), things are much more bearish.

We saw a bit of a rally on Friday that may signal more bullishness. However, given the climate, I'd approach any rally with a bit of skepticism. There are still a number of head winds, both technically and fundamentally in the market.

I'm actually looking for a good entry for a bearish trade, assuming that there may be either a reversal or at least a sideways trend for a while. I'm considering overhead resistance of the 30 day moving average, which is currently coincident with the 50% retracement level. Even if this is a turn in the market, there is the chance for some churn while the market adjusts.

As always, do your own analysis and whatever trades you enter, use good money management and have exit strategies in place in case you are wrong in your analysis. It's a good practice to be prepared with trades in either direction but not to act without confirmation.

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 Products

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

One of the more recent additions to the portfolio of services and products is the Live Web sessions. These sessions are recorded and and available for a very reasonable price of $12 per session. I've created a Newsletter Special. If you add all 4 sessions to your shopping cart, you can get 4 sessions for the price of 3 by using the discount code: WebEx4Pack

Some time back, I released the second for sale video. The title of this video is "Mastering Short Vertical Spreads". I now have a total of two strategy training videos for sale . Here is a quick summary of each.

An Introduction to Options Spreads
This 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.

For more information or to purchase the video.

Mastering Short Vertical Spreads
The focus of the video is on one specific strategy, including all aspects of of the process. This includes:
  • Understanding the construction and how the trade progresses over time
  • Selecting the long & short strikes
  • Planning entry & exits
  • Managing the trade once entered
  • Back testing
  • Creating a trading system with the strategy
I'm excited about this project. Many know this is my go-to strategy for options trading. After watching the video, I'm certain you will understand why.

For more information or to purchase this video

Special Discount offer:
If you'd like to own both videos, you can do so for a bulk discount. Simply add both videos to your shopping cart and then enter the discount code 'combo10' to receive $10 off your shopping cart total.

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