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Success With Options - Monthly Review, Issue #003 -- March Edition
March 02, 2010
Hello,

Welcome to the March 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.

A Whole 'Lotta Nothin' - March  Newsletter

This month was up a little, down some more, up again and we're actually up a little from where January closed - actually about 32 points on the S&P 500.

Last month I said I was becoming a little more bearish and so  far, it has been a good thing. Given this move, will my bias change back to a bullish one? I think a few more days are required to be sure but read on for my March outlook.

Also this month I've been busy putting together some videos with more in the works. I've had a few good trades with more on the way I hope. I've also made a few updates on the website.

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. As promised, I did update the broker pages for both TD Ameritrade and Thinkorswim. I have also recently added a couple of new videos out on YouTube
I am in the process of putting together additional videos on the Iron Condor strategy. As I did with the initial vertical spread and calendar spread videos, I'll be going into more detail and showing an example trade that I'll follow to completion.

 

Trade of the Week Summary

February's trades have gone much better than my January trades. While most of the trades I put on this month are still open, they are well on their way to being profitable.

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

New/ Closed Trade Gain/Loss Comments
Closed Iron condor $192 gain This was the first trade I put on in February with my new neutral to bearish bias. It was a textbook trade.
Open Put Calendar spread   This is a one month calendar spread that is still open. As it stands, the position is still worth almost what I paid for it even though the DIA hasn't exactly gone as expected.
Open Short SPY put vertical   This trade is doing nicely. I sold 8 contracts of the put vertical and later sold just a few contracts of the 114/112 call vertical because the opportunity was there. I closed out 1/2 the put spread contracts for just over what I'd set for my target exit price. Monday morning the remainder of the put spread closed for the target price.
Open Short EWZ put vertical   This is my newest trade and is another bullish position. I put this trade on based on my assessment that EWZ was potentially forming a higher low, which is more bullish. I may be wrong but my stop is in place if that's the case.

The jury is still out on the trades I've put on. I believe the majority of them will close profitably, which will help make up for January's losses.

As I've stated before, I believe the longer term strategy of consistently trading the 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

In one of my recent trade tutorials, I used a trade management technique that I wanted to take some extra time to address in this month's trading tip.

When we first learn about trading strategies, we tend to think of entering a trade all at once and exiting the trade all at once. While that is often the case in my trades, I will occasionally break the trade up into multiple partial orders to either improve my entry or remove risk. Let me be more specific.

In my SPY put vertical spread, I entered the trade with 8 contracts sold. I had a limit order to close the position when I could do so for $.09, which locks in 80% of the initial credit. However, I chose to close 1/2 the position early by paying a little more than I initially planned.

Why is this a good strategy? Many times, we're faced with uncertainty in the market. While we may have a good outlook and a plan for profit on a trade, we simply can't know what the future holds. I often employ this technique when I am experiencing uncertainty as to the next market move. Sometimes I will have a plan regarding a particular trade or a trade adjustment but I'm not sure if it is right and I don't want to commit myself 100% to that plan.

In that case, I can choose to only commit a certain percentage to that decision. In the case of the trade last week, I was uncertain as to whether the SPY would continue the bounce and decided to close 1/2 the position early. Did I give up a few cents in profit to gain some peace of mind? Yes, but sometimes I feel it's worth it and is simply wise trade management.

How do you know when to use this technique and how much of the position to adjust? Let me tell you when NOT to use it. It's important to not be driven strictly by fear (either of losing your current gains in the trade or having a losing trade). This is a trade adjustment technique, not a fear management technique. The best time to consider this is when you are seeing technical indications that might make the case for an early exit but the case isn't strong enough to make an absolute exit. When you feel pulled between two actions, why not do both? Take one action with half the position and take another action with the other half. I also look at this as risk management. When I see the risk going up of either increasing loss or decreasing profit, I may employ this technique to remove risk.

As you begin to use this technique, I'd recommend starting by only adjusting a small percentage (say 25% to start). You may also consider doing this in a paper trading account first just to get comfortable with the process.  Over time, you'll become more comfortable with this technique and can increase the percentage as appropriate.

For an example trade where I used this technique, check out this put credit spread (2/9/2010)
 
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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 are a few good ones...
.
Q:  Which do you consider to be more risky: purchasing two one point vertical spreads or purchasing one two point vertical spread.

A:
The first question relating to a 2 contract $1 wide spread vs. a 1 contract $2 wide spread is an interesting one. On the surface it would seem the risk is the same. A $1 wide spread has $100 of risk so two contracts would have $200 in risk. A $2 wide contract has $200 in risk. Let's say you are paying $2/contract in commission. That means you'd pay $4 for the 1 contract $2 wide spread (making it a total risk of $204). However, you'd pay $8 for a $1 wide spread for a total risk of $208. This may be even worse if you take into consideration the commission for closing the trade.

The other thing to consider is the credit received (I'm talking strictly about credit spreads right now). The true risk in the trade is the width of the spread minus the credit received. I've found that sometimes I might get slightly more as a net credit for two $1 wide spreads than I could for one $2 wide spread, which can offset the additional cost of commission. In short, before making a decision, compare prices and don't forget to factor in the commission.

Q: Do you have a minimum credit you typically look for in a credit spread?

A: In regard to the second question, I don't usually have a minimum credit in a dollar amount but I do typically have a target ROI. However, since I often trade the same $2 wide spreads, I've found that ROI roughly equates to the same range of expected credit for the trade. Some other factors to take into consideration though are the current implied volatility and the time until expiration. Even when I regularly sell a short strike with a probability of expiring of 30-35%, these other two factors can have a large impact on my ROI. Just for quick reference, if I can get $.40 on a $2 wide spread, that's about 25% ROI. Sometimes, even when there are more than 20 days until expiration, volatility is low enough that I need to sell more time and I'm forced to look to the next month.

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

Since we're in the middle of tax season, I thought it would be a good time to review a book on taxes for traders.

The whole subject of trader taxation is a bit murky and intimidating, so any book that can help bring some clarity is worth reading. That's just what this book, The Tax Guide for Traders by Robert A. Green provides. There is a lot of good information found here that helped clear up many questions I had on the subject.

I want to point out that this book is not a substitute for a good CPA who is well versed in these issues. However it can help you become more informed so you even know the questions to ask when you talk with your CPA.

What I liked right off about this book was that its purpose was to teach the trader how to deal with the IRS and lower taxes legally. I'm not interested in trying to find sneaky ways to get out of paying taxes but I'm also not interested in paying more than I have to. This book provides an excellent balance.

Rather than doing a chapter by chapter review as I've done previously, I want to outline some of the key questions I had when first investigating the issue of taxes and trading and how this book helped answer them.
  • How are my trades taxed? - From previous experience I knew about short term and long term capital gains. I also knew that as an individual investor, the losses I could deduct in any given year were limited. What I learned from this book was that as a trader with trader tax status, I could potentially deduct all of my trading losses.
  • What is trader tax status and how does it help me? - I had heard about 'trader tax status' in some of the trading circles I participate in but didn't know what it took to join this 'elite' sounding group. It turns out this is one of those murky areas of taxation that requires some careful investigation, planning and navigation. This book spent several chapters discussing different aspects of trader tax status and how the IRS looks at it. This information alone was worth the price of the book to me.
  • What is Mark-to-Market accounting? - This was another intimidating term I knew nothing about prior to reading the book. My question was: "What is it and how does it help me?" This book more than answered the question. One of the things I learned was that Mark-to-Market accounting is one of the steps necessary to be able to fully deduct my trading losses. Of course that's only important if you have trading losses, right?
  • Should I form some kind of business entity for my trading business? - This was another question that I had wondered about. The idea of forming a business entity seemed time consuming and fraught with potential pitfalls.  Not only did the book talk about when an entity was necessary but also which one might be appropriate given my circumstances. 
  • What are Section 1256 contracts and how does that benefit me? - I had heard about the 60/40 rule for long term/short term capital gains in trading but didn't know how to take advantage of it. From the book I was able to understand why I might want to consider trading options on some of the broad market indices.
As you can see, there is a lot of great information crammed into this book and it deserves to be on the shelf of every trader who is trading as a business or considering trading as a business. I'm glad I bought it and have it to refer to from time to time.

More on this book or to purchase...

Other books in my library

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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.

"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."


"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."

Shortly after last month's newsletter went out, a round of selling took the SPX all the way down to a low of $1044 before a hammer formed followed by a nice little short term rally. As of Friday, the last trading day of February, it was unclear if the rally would continue or fail. Since this newsletter is going out a day late, I'm going to include Monday in the analysis. So what do you think?

SPX Market outlook

Monday morning, the markets opened up fairly strongly and remained near the highs throughout the day. The evidence is beginning to point to a resumption of the bullish trend.
  1. We saw support hold in the area where I had outlined some months back
  2. We then saw a higher high form with another one just a week later
  3. We also had a higher low formed
I am now cautiously bullish. Notice that there is still resistance at the higher highs around $1150. We could see another re-test of that resistance with a failure. A failure to break through this high area would leave me a bit more neutral.

How will this affect my trades going forward? Unless I see indications to the contrary, I'm going to be putting more bullish positions on. Expect to see some bullish credit spreads, maybe a diagonal and a skewed iron condor in up coming trade tutorials. It should be a fun month!
 
More on technical analysis.

Options strategies I use.

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