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Success With Options - Monthly Review, Issue #76 -- May 2016 Edition
May 07, 2016

Welcome to the May 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.

Buy in May or Sell in May? - May Newsletter

First off, I apologize for getting this newsletter out a week late. I had good intentions but too many things distracted me.

After beginning the month with an apparent continuation to the rally we've seen since Feb, April ended pretty much where we started making two months in a row we've ended nearly flat. With just over a month of spring left, what will we see as we head into the summer months? Will this be a typical "Sell in May - Go Away" pattern?

In this edition we'll tackle that question, conclude our series on 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: Adjustments and Synthetics Continued

This section of the newsletter will focus more deeply on the details of some of the options strategies I use in the tutorials. In the last few issues I've been discussing the notion of synthetics. At this point, we'll focus on adjustment mechanics, but realize that the concept of synthetics is at play.

Quick Review
To begin, let's review some of the synthetic basics covered in past articles. I began by introducing the concept that synthetics is all about using one combination of options to simulate the risk profile of another. We talked about the fact that the combination of through the use of the synthetic triangle, you can essentially use the combination of any two of stock, calls and puts simulate the risk profile of the third.

One other concept I touched on briefly was that if you take away the concept of 'opening' and 'closing' trades, the effect of buying a call or put can have different effects depending on your starting point. Let's say I have an empty portfolio. Buying a SPY 210 call results in being long 1 contract of the SPY 210 call contract. But what if I already had a short SPY 210 call? I'm flat again in my portfolio. What happened though from a synthetic perspective? If you look at the risk profile of a long call and over lay it with a short call, you would see that the result is a neutral or flat risk profile - the same as if you had an empty portfolio.

Where all this is going is that the risk profile is what we're looking at. If you think of trades as overlaying a risk profile on top of another, that's the principle of adjusting. This becomes more apparent as you play around with the analyze tab on the thinkorswim platform.

Back to  Adjustments
In the last issue, I gave an example or two of synthetics for adjusting a calendar spread into a diagonal spread. We did this by combining two separate trades into a new position. Let's talk about a few more examples.

One of my first exposures to using synthetics in this way for adjustments was in a short vertical spread. I had a short call spread that was being overrun by the underlying. With just a few weeks to go before expiration, I knew that there was a high likelihood that the continued move could cause my spread to expire at least partially in the money. I also saw signs that the move was starting to run out of momentum. Let's say in today's market this was a $212/210 short call (the $210 strike is the short leg).

What if I could simply roll the 212/210 to a $214/212 spread? What I have accomplished is that there is an additional $2 on the SPY to move and that may just be enough to give me head room. Let's say I put the initial call spread on for $.50 credit. If I were to buy back the $212/210 spread and sell the same number of strikes of the $214/212 spread, I'll likely have to pay more that the initial $.50 to buy back the initial spread but I'll get some back by selling the new short position. Let's say I do this for $.35 debit. In this case, I've adjusted my position and reduced my maximum profit from $.50 to $.15. However, this may have made the difference between having as much as a $1.50 loss and being somewhat profitable. Note the risk remains the same so my reward/risk ratio got worse.

Let's analyze the above adjustment. I bought back the $212/210 spread - meaning I bought one contract of the $210 call and sold one contract of the $212 call. Next I sold a new spread - meaning I sold one contract of the $212 call and bought one contract of the $214 call to cover it. If you add up the buying and selling, you end up with buying one contract of the $210, selling two contracts of the $212 and buying one contract of the $214. This turns out to be the exact same pattern for a butterfly spread. I haven't talked about this on the web site because it's not a great money making strategy for me in most cases. However, by decomposing my adjustment, I now know that by overlaying a butterfly spread over a short vertical spread, I can adjust the position up or down as desired.

For one final example, let me talk about another adjustment strategy I've used based on the same above position. Let's say that my assessment tells me that my original position would expire out of the money (worthless) if only it had a little more time. Instead of rolling up, I want to roll out to the next month. What would that look like? It would mean buying the current short $210 and selling it in the next option cycle and selling the current long $212 and buying it in the next option cycle. The resulting trade cost me $.10 net debit, making my resulting credit $.40 if it works out.

Does that look like the pattern for a calendar spread? I'm selling one calendar spread and buying another calendar spread. The combination of the two, when overlaid on top of the short vertical spread result in rolling the spread out a month. 

Wrapping Up
It's amazing how this can affect your trading when you begin to look more holistically at your portfolio and analyze it in terms of what you want to add or remove in terms of risk profile. You'll begin to look at all your trades a bit differently.

I want to wrap this series up with one note of caution. Actually... maybe several notes of caution. First, always, always paper trade before applying to a real portfolio. When you are placing real money at risk, you want to be especially comfortable with the mechanics or you could make matters worse. Second, any adjustment will have it's own associated risk. In both the above examples, we gained either overhead room to move in the current month or added additional time for the trade to work out. In both cases, we gave back some of the credit, reducing the profit but also creating a worse reward/risk profile.

Sometimes the simple answer is to close the trade and be done. However, armed with the knowledge you gained from these last few articles, you now have a few additional tools in your trading toolbox.

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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'm using part of a question I recently received on trade logs

Q: I really enjoyed reading your blog post about keeping your trade log. I am currently only unsure how do you maintain your trading log (which tools do you use)? Is there anything in particular that frustrates you in that process?

A: This is a great question and one I have addressed recently. On the web site, I have covered a little bit about some of the components of an option trading system, such as money management, trading rules, trading plans and so forth. In addition, I've talked about trade journals and trade logs but I haven't really talked in detail about what I use specifically.

Part of the reason I haven't covered much detail on this is that there are so many different ways to manage trades. Let me first talk quickly about the difference between a trade journal and trade log. I use a trade journal as a way to capture the events, decisions and factors that go into a particular trade from start to finish. It's purpose is to allow me to go back and analyze how well I'm following my rules, evaluate decisions to see if there are trends that may indicate a possible adjustment to rules and so forth.

By contrast, the trade log is more about capturing the trade itself in the context of a collection of trades. The main purpose is to determine your overall wins and losses, gains or losses and general progress on growing your portfolio. In this case, the only items I tend to keep are the barest details of the trade (ex Short Call Vertical SPY 120/118), the number of contracts, debit/credit on entry, debit/credit on exit and commission. From there, I can calculate the gain on the trade as well as monthly gains by adding up the individual gains for  a month. From there, I can calculate all sorts of additional metrics like average gain, average loss, win/loss ratio, and more.

Currently, I do all of this using an Excel spreadsheet. There are in fact many ways this can be done. For me personally, the spreadsheet works well because I have the ability to do calculations that are sometimes fairly complex and it allows me to enter and review trades fairly easily. There are of course many alternative ways this could be done. Each will come with advantages and disadvantages. My focus is to have a tool that serves me, not the other way around. I want entry and maintenance of trades to be as easy as possible and this largely does the trick.

For more information on trade logs, check out the trade log page on the web site as well as the overall options trading systems topic that covers many other aspects of options trading..

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.

What did we actually see accomplished in terms of market change from beginning of month to end of month? Not much. In between a whole lot happened though.

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

"...The SPX and the market as a whole are definitely becoming much more bullish. We can see several indications of this, including recovery of nearly all of the fibonacci retracement, breaching a down trending resistance line I'd drawn some time back from prior highs and the $50 or so points remaining to fully recover all that was lost in late 2015 and January of this year. The one risk is that we are currently at the highs near the end of last year and early January. That seems to be to act a s a bit of a head wind.

I think it's possible to see some sideways movement as the market digests the current strong up trend before making a further push to the past highs. I'd treat pullbacks as a buying opportunity (or an opportunity to enter bullish trades)...

Here's how April played out.

Granted, this newsletter is coming out a week late so we have a preview of the month. However, let's take a look at the month. Notice that after a quick rise to the highs established back in early November, there was a bit of a pull back. The question now is which way we'll see the coming weeks go.

What we saw last week (the first week of May) was additional selling to a low and consolidation area established in the early part of  April. This itself could act as support as Friday's action suggests. If that fails, there are two additional levels of support. It's possible the 200 day moving average might act as support around $2012. It's also possible that the first fibonacci level might also act as support closer to $2000. On the upper side, there are pretty much no real areas of resistance until we get back to the November high around $2115. Given the recent selling the odds may favor at least a short term rally. The next logical movement is to attempt to break through the upper resistance area. I'd expect that to be the move in May.

A few months back, I mentioned GLD. Last month I got a nice diagonal spread in place toward the middle of the month. While I missed out on the big move in the last week, it did offer a nice little return for a 2 week trade. Keep your eyes on some of the different index tracking ETFs like SPY, IWM, DIA and GLD. They all offer some potential opportunities to trade in either direction using your favorite options strategies.

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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