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Success With Options - Monthly Review, Issue #26 -- February 2012 Edition
February 05, 2012

Welcome to the February 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.

Straight up and no looking back! - February Newsletter

Welcome to the February newsletter. Can you believe this January?  I expected some bullishness to start the hear but holy cow! Will the bullish run continue or stall? How did the trade tutorials fare for 2011? Read on...

Also in this newsletter, I'll be reviewing some of the updates on the site, trades for the month, talk options strategies and more.

I want to thank those who took time to provide feedback in response to my request in the last newsletter. I appreciate the time you took. 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

While the market has been rather active, its been rather quiet on the website front. Last month I added some Facebook features to the most recent trade tutorial pages.  If you have a Facebook account, I'd like to encourage you to jump in and comment. Participation from the community will make the tutorials even more informative.

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. By the way... thanks to those who have provided feedback already. You will start to see some of your requested topics (in fact, I did a option strategy focus a few months back on the Iron Condor strategy)

I entered January with one active trade, which is now closed. I added another trade early on that has been . Read on for details of the trades.

I mentioned last month that I've been working on the outline for the next video that will focus on mastering sort vertical spreads. I'm pretty excited about this and continue to work on details of the script and presentation material.

In the months ahead, I have plans to go through some of the pages and do some updates. In particular, there have been some changes with the brokers I've reviewed so it's probably time to revisit them.

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
Close SPY Put Spread $80  This is a trade that worked out better than expected despite the fact that I failed to put an exit order in.
DIA Put Spread

This trade is partially closed. At least the original put spread is closed. Prior to closing that side, I made an adjustment to turn it into an iron condor. Currently, this trade is being threatened by the strong bullish move. We'll have to see how the trade turns out.

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 SPY Put Credit Spread:
"...I suspect what happened was that I entered the closing trade to lock in my 80% but forgot to change the order type to 'Good Till canceled' instead of a Day order. As a result, it cleared out at the end of the trading day. The moral of this story? Be sure you pay close attention to the order before submitting. The thinkorswim platform gives you several chances to review the order before submitting."

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 Butterfly 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.

Over the past few months I've looked at the various options strategies covered on the website. This month, per request from a newsletter subscriber I'm going to look at a strategy I don't currently cover on the website. That strategy is the butterfly spread.

As it turns out, we've already covered the building blocks of a butterfly spread. A butterfly spread is essentially a combination of a long vertical spread overlaid with a short vertical spread. This ends up looking like the following.

Butterfly trade setup

If I were to enter a butterfly call spread centered around $133, this would mean purchasing a $131 call and selling a $133 call creating a long vertical spread (entered for a debit). At the same time, I'm buying a long $135 call and selling a $133 call creating a short vertical spread (entered for a credit). The long spread will realize maximum gain when if it expires anywhere at or above $133. At the same time, the short vertical spread will realize maximum gain if it expires anywhere at or below $133.

This leaves us with a bit of a dilemma. The only place where both spreads can simultaneously realize maximum gain is if the underlying expires exactly at $133. As the underlying moves either higher or lower, the losses of the one position eat away at the gains of the other. Fortunately, this trade will typically cost next to nothing as the credit from the short vertical spread mostly pays for the debit of the long vertical spread.

Below is a graph of the profit & loss for the the butterfly spread we've been discussing. Notice visually that the range of profit is very narrow but the return on risk is huge. A one contract butterfly costs abut $20 but has the potential to return $180 if we hit it right at $133 on expiration. To me, this is a bit like buying a lottery ticket. It doesn't cost much to buy one and the odds aren't great you'll win but if you do, you win big. In the trade below, the return on risk is 900%. That said, you won't do too badly by simply having the underlying remain between $131.20 and $134.80 or so.  That's still not a great range of profit but the cost is pretty small.

When entered, this is going to have a slight delta skew. The center strike of the call butterfly spread we've been looking at is slightly below the current price of the underlying. As a result, the delta is negative. If the SPY were to move below $133, the delta would become positive. Remember there are now 4 distinct options (2 of which occupy the same strike price) in this trade so each component will contribute either positive delta or negative delta depending on where it is relative to the underlying and whether it's a long or short option.

Let's look at Theta and Vega as well. Since the long vertical spread is In the Money (ITM), it will typically contribute positive theta. The short vertical spread will also contribute positive theta so it's no surprise then that the net theta is positive. Long vertical spreads are typically positive vega (benefits from an increase in volatility) while short vertical spreads are negative vega. As a result, the net vega will be the combination of the two. Depending on where the underlying is, the net vega could be either positive or negative.

As a final point, let's talk about when you would trade this kind of strategy. Given that the butterfly spread is more or less a neutral strategy, it will have a higher likelihood of success in less volatile markets. However, the cost to enter will typically be higher when volatility is lower. I'm not a huge fan of this strategy but if you are willing to toss out an occasional trade, this is an ok trade to add to a larger set of trades. I should mention that the butterfly spread can be a decent adjustment approach when laid over one side or the other of an iron condor. However, this is beyond the scope of this article.

I don't currently have a strategy page for the butterfly spread. However, I may manage to put one up in the future and maybe even toss out a sample trade just for the fun of it.

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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!

This month I didn't receive any questions so it seems like good opportunity to manufacture one as an excuse to review last year's trades.

Q: In 2010, the trades you posted in the tutorials didn't do so well (in fact the lost several hundred dollars). How did your trades fare in 2011?

A: First of all, thank you for this excellent question! Let me start by directing you to look at the trade tutorial page near the bottom where I continually tally the results. Notice that the net results of all my trades was a whopping $1 gain. In other words, I just broke even.

At the risk of sounding a bit defensive, I want to start this discussion by reminding folks that the primary objective of the tutorials is to demonstrate execution of the strategies. However, a losing portfolio isn't a good advertisement for a set of strategies let alone a good endorsement of my ability to demonstrate said strategies. I did make it my goal this year to practice better trade management and trade selection. Whereas in 2010 I randomly chose strategies simply to illustrate them, in 2011 I attempted to also make correct strategy selections in response to my market outlook. With that in mind, let's see how the trades fared overall.

As I said at the beginning, all I managed to do was break even. However, let's take a look a little more closely. I executed 18 trades last year in total. Of those trades I had 14 winners and 4 losers. Obviously then I had more winners than losers so why did I only break even? Let's look at my average winning and losing amounts. My average gain on a successful trade was $65 while my average loss on a losing trade was $281. Clearly, my average loss was much larger than my average gain. This shouldn't be surprising since most of my trade strategies have nearly a 3:1 risk to reward ratio.

What lesson can we draw from this? There are actually a number of lessons.
  1. First of all, my results this year are noticeably better than last year, which I believe is a result of both a more focused approach to strategy selection and to my change in trading rules for the short vertical spread strategy, which made up the bulk of the trades last year.
  2. I also believe the results could have been better had I managed them more closely. If any of you have done much paper trading, I'm sure you've experienced this phenomenon. You will generally always pay closer attention to trades that have real money on the line than ones that don't. This is definitely the case for me. My personal trades got more of my attention and I often didn't give the virtual trades the tutorials are based on as much attention. I will attempt to do a better job of this in 2012.
  3. The fact that losses weren't greater I think is still a result of good money management when it comes to position sizing. Results could have been definitely worse had I not employed strict money management rules.
Overall, I'm pretty pleased with the results from this year. While a nice increase in the portfolio would have been nice, breaking even isn't too bad either as I get to stay in the game longer.

  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, it may change if the charts indicate something different.

As I mentioned at the beginning of the newsletter, I had expected some bullishness but not to the degree we saw. With that said, I did talk about a triangle technical pattern last month that was building. These tend to have some pretty powerful moves once they break out of the triangle. Last month I summarized my outlook as follows.

"...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. "

Here's how the month played out.

As the chart above shows, it's been pretty much straight up since the beginning of the year. In fact, there have been several major jumps. There are several ways to look at this run. First of all, notice that we're now approaching a new resistance area around $1350 or so. Second, in a triangle pattern, there is a projected possible movement that is roughly equal to the width of the wide side of the triangle.

In this case, that width is about $130 ($1170 to $1290). Theoretically, that would make the target $1420. Let's weigh that against the fact that the underlying has already moved quite a ways away from the moving average. While there's no guarantee that the underlying will snap back to the moving average, it often happens. While the $1420 price target may still be realistic, I'm not sure we'll get there without a few pauses.

How does this affect my trades? I currently have one short call spread in place that is left over from a put spread turned into an iron condor. That spread is currently being threatened but hasn't been overrun yet. If we see some more strength, I'll need to adjust. In the meantime, it may make sense to begin thinking about another bullish trade? Any suggestions?

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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