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Success With Options - Monthly Review, Issue #44 -- August 2013 Edition
August 03, 2013
Hello,

Welcome to the August 2013 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.

The Bulls of Summer - August Newsletter

Welcome to the August newsletter. 

Well, we had one bearish month this summer and we're back to more bullishness. If you count May, that's two bullish months this summer. Will August be another bullish month or will there finally be a decent round of bearishness?  Read on...

As usual, I'll be reviewing my trades this month, talking options strategies, answering your questions and more.

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) Trade Tutorial summary

2) Options Strategy Focus

3) Answers to your questions

4) Options Outlook

5) Featured Products
 

Trade Tutorial Summary

I have not entered any trades for a while but finally did so last Friday.  You may have noticed in general I'm not putting up as many tutorials as I have in the past due to time constraints. I'm willing do do more if folks are interested but I need to hear from subscribers to know if this is valuable.

New/ Closed Trade Gain/Loss Comments
Open SPY Put Vertical $74 This one made a nice little profit simply by following the rules I had in place.

Win or lose, I find that I learn something from every trade. I didn't close any trades this month so, no lessons learned. However, the lesson I'm focusing on this month is responding to changing market conditions. The trade I put on this month is an example of this.

From the SPY Put Calendar
... That fact is that as we are making decisions we don't know what will happen past the right edge of the chart. In this case, the market continued to rally and I could have done better. HOWEVER - the market could have just as easily sold off from here and my unrealized gains could easily have turned into a loss.

I do want to encourage you if you are a fan of the trade tutorials and have a Facebook account to participate in the tutorials by commenting, asking questions, or suggesting alternative strategies. Seriously, I think the tutorials would be much more valuable if folks weighed in on the trades.

Do folks find this section helpful? Let me know.

In the mean time, I will continue to do trade tutorials when I find time and the opportunity arises but not as frequently as before.

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

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Options Strategy Focus: Back Testing

This section of the newsletter will focus more deeply on the details of some of the options strategies I use in the tutorials. This month I want to focus on back testing. I may have covered this at some point in the past but it's a good idea to revisit this important topic.

First, what is back testing? I define back testing as a formalized process by which you can go back to a period in time and replay price action against a very specific set of trading rules. As you can see, I did not specify a particular tool. There are a lot of different ways to back test that range all the way from manual approaches to automated methods.

Before I go into more detail about different back testing methods, I want to talk about why back testing is important. The main reason is that it allows you to test your rules against a variety of different past circumstances. While past performance doesn't guarantee future results, robust testing over diverse past price behavior can give you a pretty good idea of how profitable your rules might be.

Another benefit of back testing is that it forces you to think through your rules to see if you are specific enough. I'll talk shortly about the process of back testing but as you work through that process you'll begin to see if you've been specific enough. It can help expose areas where you have left too many decisions open to subjective decision making.

Ok, let's take a look at some ways to back test.

The manual approach - The manual approach is just that. You really have little to no help in going through the steps of your trade. As a result, it can be quite time consuming. However, doing this at least a few times really helps you to appreciate the process.

In the manual approach you will begin with some kind of charting tool or way to walk through historic price action. I've found most trading platforms will allow you show chart with opening and closing prices over a range of dates you are interested in. I like to begin by looking at the large scale for a trend I want to test. It may be an up trend, down trend, choppy trading or whatever. Then, I'll zoom into a fairly tight  timeframe early in the date progression.

I'll use the scroll bar to move forward in time. The key is to make sure that you are simulating unknown aspect of real trading by not 'peaking' at future price action. Once I pick an area to start, I then use my rules to pick the entry trigger. Now, it's pretty difficult to calculate individual option prices let alone spread prices manually. As a result, I usually use this approach primarily to test entry & exit rules related to technical analysis.

Note: I should mention that there are tools that can be used to calculate option prices based on a number of factors that are part of the option pricing model. In addition, I added a quick ad-hoc pricing tool as part of the Introduction to Spreads video I released some time back. This tool allows you to arrive at an option price by adjusting a few quick factors like underlying price, days until expiration and volatility.

Assisted back testing - This refers to testing using tools that can help you both accelerate the testing process and perform a more thorough test. Here's what I mean. A few tools available on the thinkorswim include the thinkBack tool and the onDemand tool.

The thinkBack tool is a little more limited in what can be tested, only capturing closing price for each day. Here's how you can use it. First, pick a starting date (perhaps from the charting approach mentioned above). Select a spread according to your rules using the trade page on the onDemand tab. Enter it as you would on the actual trade page. Note that there is a date box called P/L Date that you can now use to spin forward. Use this in conjunction with your manual charting tool to advance day by day. Be sure to make sure no action is taken that isn't documented as a rule. Notice as you advance day by day the price of your position increases or decreases and your P&L is also displayed.

With the onDemand tool, you can approach an automated back testing approach. It's almost like entering a time machine to go back and test your strategy against a specific timeframe. If only you could do it with real dollars. Entering onDemand converts your thinkorswim platform into a virtual trading platform where you can pick a starting date and then enter your trades as if it were live. I should mention that the entry of orders is still a manual process. However, the beauty of this tool is that you can catch inter-day price action and enter limit & stop orders that can be triggered as price action plays back. In addition, you can set a trade up with exit orders and then just let the price action play at normal speed or accelerated speed.

Automated back testing - In this category of tools you can pretty much automate all aspects of the trade process once you've entered in your trading rules. This obviously is a more complex style of tool and will usually require purchase or subscription in order to use. One such tool I'm aware of that can be used to test options strategies is AmiBroker. I'm sure there are others out there as well that I haven't looked into.

In the recently released video, Mastering Short Vertical Spreads I have a section on back testing covering some of these techniques. There is also a nice demo of using the onDemand tool from thinkorswim. Additionally, you can visit the website at the Options Trading Systems page where you will find useful but more general information about trading rules, trading plans, journaling, etc.

Stay tuned for the next options strategy focus as we return to more strategy related topics. I'm always looking for additional topics that are helpful to readers. Send them in via the newsletter feedback page or the Contact Me link.

Back to the table of contents.

 

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!

Q: What would you recommend as a good starting portfolio size for trading strategies like you recommend on your website?

A: This is a really good question but one I can't easily answer with a simple dollar amount. Instead, let's walk through the thought process for how you would come up with this amount.
  1. Money management - As followers of the website and this newsletter are aware, I am a strong proponent of consistent position sizing. I think you have to start there. What risk percentage can you live with per trade? Let's start with an assumption of 1% risk per trade. Keep in mind that newer traders should start with a smaller risk amount until you prove you have a decent track record.
  2. Risk per trade - Next, you need to look at the risk you are taking in a trade. For vertical spreads, this will be dictated by the width of the spread. As a minimum, you might have a $1 wide spread with an average credit of $.25 leaving a risk of $.75 per contract ($75 actually). With a 1% risk, you must have at least $7500 just to sell one contract of this spread. Other strategies will have more risk. For example, a typical calendar spread might have an initial debit of between $100 and 200, which represents the maximum risk. In this case, you'd need $20,000 minimum to start.
  3. Number of active trades - This may not directly impact your portfolio amount, but you should consider how many trades you have going simultaneously and how having several of them go bad might affect your portfolio.
  4. Draw down tolerance - What will be the impact to your trading if you have a draw down? If you start with the bare minimum, it might be that one failed trade means you can't trade and still remain within your risk tolerance. As a result, any amount you arrive at above should take into consideration a buffer of some sort to allow you to sustain trading even with a few failed trades.

These are important considerations to think through before ever getting started with a real account. Another key aspect is that whatever portfolio you allocate to these kinds of strategies should be a fairly small percentage of your overall trading capital. In other words, if you allocate $20,000 to this kind of trading, you should have much more than that set aside for other, types of trades like stocks, indexes, bonds, etc. Different people have different rules of thumb, but one I can live with is that my option trading capital is no more than 20% of my overall investment capital I allocate.

Obviously, I didn't provide a fixed dollar amount because I think it's pretty hard to provide a number that would suit everyone's circumstances. Use your own judgment and if possible, err on the side of being more conservative to begin with. For more detail on some of the points I've mentioned above, check out the money management page 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.
 

If you blinked, you may have missed the selling in June. July saw a rally back to the highs set in May and then go even higher. Did any buyers go away for vacation in the summer or was June's selling it for bearishness?

Last month, I summarized my outlook as follows.

"... It still remains to be seen whether this will act as ultimate support or not. I see this as a fairly thick line in the sand. To break the level around $1560 means we could see even more selling down to the $1520-25 level. We could also expect more erratic buying and selling days over the next few months as the summer plays itself out. That will contribute to additional volatility and volatility is good for premium sellers..."

Here's how the month played out.



Interestingly, the low that was set in June did indeed act as a bottom. In fact, we had three straight weeks of nearly non-stop buying before we saw any kind of pause and then we have started seeing more buying. However, we are now getting to a little bit of an overextended state as the current price moves away from the moving average. The current distance is just over $50 S&P points (sorry, I just noticed I used the SPY chart this month).

I'm expecting one of two things to happen in the next month. We will either see a quick push higher followed by some bearishness down to re-test the support at $167.50 on the SPY chart or we'll see some sideways consolidation that will give the moving average time to catch up to the price.

How will this affect my trading? I currently don't have any trades on but I am looking for an opportunity to sell a call spread above the market somewhere in the  $173-174 range for the short strike. That should give some room for continued buying without overrunning the position. I'm actually hoping for a fairly strong round of selling so I can find some good bullish entries. I missed my chance a week ago with that little pause. Now, we'll have to wait a little to see the market tip its hand for the Fall timeframe.

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 sales type information.

As I announced earlier,  I just released the second for sale' video last week. The title of this video is "Mastering Short Vertical Spreads". I now have at total of two 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 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. While a long time coming, it's been a labor of love. 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 Newsletter Subscriber 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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