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Success With Options - Monthly Review, Issue #35 --November 2012 Edition
November 02, 2012
Hello,

Welcome to the November 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.

Turbulence Ahead! - November Newsletter

Welcome to the November newsletter. 

While October started out looking like it was off to the races, it was anything but. Are we in for more in November? Read on...

As usual, I'll be reviewing my trade this month, talking options strategies, answering your questions and more. As I write this, I'm on my way to Bolivia for just over a week. If you see a trade update in the next few days, it will likely be from an internet cafe or from my limited opportunities to get an internet connection.

Thank you to the many readers who have recently provided feedback to the newsletter. 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 Product

 

Trade Tutorial Summary

I had no trades going when I entered the month. I did put a new trade on that is partly closed and has an adjustment. Some of you may have noticed that the number of trade tutorials has decreased quite a lot over the last year or so. This is partly because I've had less time to analyze, set up, and write up the trades.

I 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. I'd like these to be more interactive that they have been historically.

In the mean time, I will continue to do trade tutorials but probably not as frequently as before. Here's the trade I was active on this month in a quick summary.

New/ Closed Trade Gain/Loss Comments
Open
DIA Iron Condor   Call spread is closed and the puts have been threatened. I added a calendar spread to the put side.

Win or lose, I find that I learn something from every trade. However, I haven't closed a trade this month so no real lesson to draw out.

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

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Options Strategy Focus: Evaluating Adjustments

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 newsletters I been discussing the topic of the psychology of a losing trade and how to calmly face a trade gone wrong. In this issue I want to cover a related topic: evaluating a potential adjustment

I've already talked about how psychology relates to making trade adjustments so I won't revisit that here. Instead I want to talk about considering the pros and cons of adjustments. In other words, what are the expected up sides to an adjustment and what could be the potential downsides to making an adjustment. Any time we are thinking about making an adjustment, we need to be able to objectively consider both sides.

Let's start with the advantages. What do we expect to achieve by making an adjustment? Of course the goal is to save a trade gone wrong. But to what degree? Here are a few of the potential objectives we may have.
  • Adjusting to make money from the change
    In this scenario, an adjustment is put in place because an outright change of expectation has taken place. In other words, you no longer believe the conditions that justified the original position are true. As an alternative to simply exiting the trade (a good alternative to consider), you put on an adjustment that will actually cause the combined trade to make as much or more money than originally expected.

    I've seen this happen for example when buying back a few contracts of the short strike in a short vertical spread, creating a back spread. If the underlying moves strongly enough against the original trade the increase in the uncovered options will more than offset the fixed loss experienced in the remaining spread. However, this kind of adjustment requires a pretty strong move of the underlying.

  • Adjusting to create a neutral effect of the change
    We often enter this kind of an adjustment because we are seeing the beginnings of a reversal that MIGHT negatively affect the original trade. I'll talk more in the disadvantages section about why this kind of adjustment might only result in a break even scenario. However, it's important to realize this kind of adjustment is more speculative in nature and is designed to protect the original trade.

    Many times my motivation, like that of minimizing loss (covered next) is that this is the best alternative. In other words, I've looked at exiting the trade and have a good idea of what the loss would be. Making an adjustment is aimed at a nullifying that loss by a resulting gain in the adjustment.

    A calendar spread is a good example of this kind of strategy. In this scenario, my expectation is that the underlying will violate both my long & short strike leaving me at a maximum loss. A well placed calendar spread will make money if the underlying is near the short strike in the last week of expiration. When this happens, the calendar can return 50-100% of the original investment.

  • Adjusting to minimize the loss in the trade
    The motivation in this scenario is simply to minimize the damage of a trade gone wrong. We know adjusting won't cause the trade to make money but it is better than the max loss we may be facing. The goal of the adjustment is to reduce the loss to somewhere between half the maximum loss and break even. There's nothing scientific about the target of half. However as we evaluate the potential down sides to adjustments, we'll see that the adjustment must have some reasonable benefit to justify the risk.

    A variation of this kind of adjustment is a roll on a vertical spread or iron condor. We are paying back a part of our original credit to roll a vertical spread up (in the case of calls) or down (in the case of puts). The goal is to give the trade a little more room for movement of the underlying.
Before beginning the discussion on the disadvantages of adjustments, it's important to point out that there is absolutely NO WAY to minimize the risk in all directions. All we do by adjusting is reduce the risk in one direction by increasing the risk in another direction.

I think the most useful way to look at the disadvantages of adjusting is to consider different adjustments and look at what happens to them if things don't go as planned.
  • Buying back part of the short options
    The goal of buying back some of the short options on a short vertical spread is to create a back spread. A back spread results in some of the long options not being covered by the short options. For example, if I had a 4 contract short put vertical spread and bought back two of the short options, I really now have a 2 contract short put spread and 2 long puts. Heavy selling will result in the 2 contract put spread being overrun to realize maximum loss. However the long puts will make money and theoretically have unlimited gain potential.

    What happens though if the selling doesn't happen as expected? Let's consider two cases. The first is that the underlying falls but ends up somewhere above the short strike. In this case the original short vertical spread would have worked out but since we paid potentially a hefty price to buy back the short puts, the overall trade loses money. However it likely will not be as much as might have originally have been lost if the trade had gone completely wrong.

    A second scenario would be that the selling does result but not to the degree expected. It may fall to a level near the long option. Depending on when you close the trade, the result could be anything from breaking even on the trade to losing as much or more than the original trade would have lost.

  • Closing part of the trade
    The goal of closing part of the trade is to reduce the risk exposure in the trade. This adjustment works best when performed well before any major reversal takes place. Let's consider the same trade as above where we have a 4 contract $2 wide short vertical spread. I entered the trade for a credit of $.45 so my risk per contract is $1.55 or $620. By buying back 2 of the spread contracts, my risk is reduced by half but to do so I will probably pay more than my initial credit. That loss on the 2 contracts needs to be added to the risk. Let's say we paid $.70 to buy back the 2 contracts. The resulting $50 loss will exist no matter what happens.

    What happens if the selling only falls to just above the short strike by the time we close? If we let the remaining 2 contracts expire, we make $90 on the remaining contracts but have to subtract the $50 loss of the two contracts we closed. So, we barely break even. However there is an opportunity cost here because had we left the original two contracts on, we would have realized a $180 gain instead of a $40 gain. The opportunity cost of the adjustment would be $140 (the final amount we gave up to adjust the risk).

    If the underlying falls somewhere below the short strike, then the trade that is left on is going to experience loss no matter what. Let's we experience maximum loss on the remaining contracts. That would be a loss of $310 (plus the $50 on the original part we closed) for a total of $360. Had we left the entire trade on, we would have lost nearly twice as much. The key point here is that while we minimized the loss we couldn't completely erase the loss.

  • Buying a calendar spread
    The purpose of buying a calendar spread is to use the gains of that calendar spread to offset the loss of the short vertical spread. As an example with our short vertical spread, if we were to buy a 2 contract calendar spread at a strike between the short and long strikes of the vertical spread, cost might be something like $1.20 per contract for a total cost of $240. In the best possible scenario, the underlying falls to within $1 above or below the short strike of the calendar. The value of the calendar could widen out to twice it's value or $480. This gain will partially offset the $620 potential loss of the original vertical spread.

    While not a perfect solution, the calendar has the benefit of being somewhat tolerant of being wrong. So what happens if if the underlying sells off even harder than originally expected? The original spread can only lose the max loss of $620. However, as the underlying gets deeper in the money on the calendar spread, the spread will become more and more worthless. That means not only have we realized max loss on the original trade but now we won't even get all of the $240 investment back on the calendar spread. That causes our risk to grow to the combined $620 plus the $240 cost of the calendar.

    What happens though if we were wrong on our assessment and the underlying sells off partially, only to resume it's upward climb? That means the original trade will realize max gain of $180. However, we will likely not be able to sell the calendar spread for what we paid. That means the loss on the calendar spread has to be subtracted from the gain on the vertical spread.

    As a bonus, if we were agile enough and recognized a legitimate resumption of the upward trend, then we might have been able to make money on the calendar AND on the vertical spread. It's happened for me a time or two but it's difficult to reproduce this.

  • Rolling a vertical spread
    The objective in rolling a vertical spread is to give yourself a little more room. For example, let's say our put spread we've been talking about is a $140/138 spread. We may feel the underlying may fall down to the short strike ($140) sometime before expiration. We can gain a little more 'head room' by moving the spread down $1 or $2. This rolling comes at a cost as the debit to buy the original spread will be more than the credit received to sell the new spread. You may take in a credit of $.45 on the original spread and pay back $.25 net on the roll.

    In the best case scenario, rolling allows the needed room and the final trade ends as expected. However, consider that if the selling continues, there is a risk that rolling the puts down won't be enough to save the trade and you've just paid half your initial credit to try to salvage the trade. As a result, your max loss is now width of spread - credit + debit for roll.

Why do I spend time talking about what could go wrong with adjustments? First, many of these have happened to me and I've found that adjustments aren't always worth the benefit they may offer. I'm not saying you should never consider adjustments. Rather, I would suggest that you simply take time to consider the benefits and risks associated and evaluate that compared to the risk of either closing the trade outright or letting the trade run.

Be sure to review the Trade Adjustment page to get familiar with the various adjustment techniques. In addition, have a look at the Options Trading Systems page for more information on good trading habits and tools.

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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 received a question about protecting trades. I'm going to paraphrase it a little.

Q: I am trading a strategy that has been going pretty well for me... until recently. Is there a good way to protect a trade or prepare for an unexpected turn?

A: This is a really good question. In past newsletters I have been talking about adjustments and the psychology of dealing with a losing trade. I want to address this particular question in two ways.

First, realize that there is no way to protect in all directions at once. If you haven't already done so, read through the discussion in the Options Strategy Focus about the downside of adjustments. Making an adjustment CAN improve a trade gone bad, but it can also turn bad itself. I think realizing there is no perfect adjustment puts you in a position to make better informed decisions about if and how you want to perform adjustments.

Second, the best way to prepare for unexpected events is to anticipate them. In other words, instead of focusing all your analysis on how the trade might go right. Spend some time considering what might go wrong and how that might affect your trade. In reality, there are only a few potential market behaviors. The market can go up a little, up a lot, sideways, down a little or down a lot. Of course, it can also go up a lot, then down a lot and end up about where it started as well.

Any time you are considering a trade, you should take some time to consider the various scenarios. This is true of adjustments as well. If we are able to anticipate the events AND have a plan, then any move the market makes isn't much of a surprise to us.

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.
 

I was partly right in my outlook for this last month. I said there would be volatility, and there was. I even said there might be some selling, and there was. However, I wasn't anticipating completely failing the 30 day and 50 day moving averages. Last month, I summarized my outlook as follows.

"... Looking ahead to the next month, I wouldn't be surprised to see volatility return to the market. The SPX has pulled back approximately half way between the highs and lows of the month and is sitting both on the 30 moving average and the midway point on the upward channel. I suspect the next move may be up but there is also room to come down and test the bottom end of the channel. "

Here's how the month played out.



We did see a little bit of a push to the highs but that resulted in a complete failure, all the way down to the 38.2% retracement level (I have my fibonacci drawn backwards). It's a little to early to tell if this will hold but this does look like a fairly strong level of support.

For the next month, I'm expecting two things. I'm looking for a bounce at the current 38.2 fibonacci level and I still anticipate some volatility so we may see a lot of choppiness for the next week until we get past elections. Then, we'll probably be driven mostly by earnings announcements. We're heading into a season that is traditionally called the 'Santa Clause Rally'. We'll see if that holds this year. If on the other hand the fibonacci level fails to hold, I think we'll see some pretty strong selling all the way down to at least the 61.8% level. Be prepared and and have plans in place for all eventualities.

How does this affect my trades? I currently have the remainder of the iron condor on (the put spread) with a put calendar as an adjustment. I'm going to be looking to maybe close the calendar if the market bounces from here. I may also look for another bullish trade. However, I will be wanting some fairly short term trades given the current potential volatility. Hey readers, what trade would you enter? Send me a trade suggestion with some details about entry, exits, etc and I'll post it.

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 released the first 'for sale' video about a year ago. 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.

For more information or to purchase the video.

New Video Coming
I am also in the final stages of the next video, which I'm very excited about. It features my favorite strategy - the credit spread, or short vertical spread. This video will cover everything from how the spread is constructed to how to create a trading system around it. Be watching for this video in the coming months.

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