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Success With Options - Monthly Review, Issue #012 -- December Edition
December 01, 2010
Hello,

Welcome to the December 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.

Flat November, Up December? - December Newsletter

Welcome to the December newsletter! It's been a wild month with the SPX making highs not seen since 2008 only to give some of those gains back. We've seen two months of gains in September and October with a pause in November. What does December hold in store?

In this newsletter, I'll be reviewing the month in more detail and providing my outlook for December. Also, I'll update you on the video, review some trades, talk options strategies and more. Read on...

Thanks to those that have provided feedback on the newsletter. I do value and take into consideration feedback on the newsletter content and on ways I can make it more valuable for the readers.

Please feel free to voice your opinion. If you haven't done so already, 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
 

What's new at Success With Options

The big news with the site is the release of the video I've been talking about for several months. In last month's newsletter I announced the availability of the video, which is an early access version. While in in good condition already, I knew there was opportunity to improve the final product and wanted to provide a way for viewers to provide feedback.

I have already received some very good feedback and am in the planning stages of producing the final product with feedback incorporated. It's not too late to get your feedback in. If you have the video and haven't provided feedback, please do so in order to receive your 50% rebate.

If you haven't yet purchased the video, there's still time. Since I still have some copies left I decided to extend the evaluation period to 12/15 before this version of the video becomes unavailable. For more details about the video and to purchase it, please visit the video promotion page.
  • Since this is an initial release that I want to get feedback for, I'm only releasing 50 copies of the video of which there are still a few copies available. Once the feedback has been incorporated, I'll provide an unlimited release.
  • The video is just over 30 minutes long and is packed with information on buying and selling options and how to use the two concepts to construct spreads.
  • The video has several quizzes to test your understanding of what was covered
  • I've included an interactive tool to allow you to see dynamically the impact of price, time until expiration and volatility on the option price
  • The offer is first a low price - only $20. Second, I'll refund 1/2 of this price for those who provide feedback on the video. Third, for those who provide feedback, I'll also provide a free copy of the final product with feedback incorporated.
  • The final release will probably sell for about $25 so this is a good opportunity to not only get an early access copy but receive the final copy as well for only $10.
You can also check out the video promotion for this on YouTube. If you are newer to options spreads, you'll definitely want to check out this video.
 

Trade Tutorial Summary

I had a few trades going this month but so far, the results are mixed. Yet... every trade offers an opportunity to learn something.

Here are the trades I was active on this month in a quick summary. I only did a few since I was focused on other things.

New/ Closed Trade Gain/Loss Comments
Closed IWM Put Spread $266 This was a successful trade that benefited largely from the recent bullishness in early November.
Closed SPY put credit spread $266 This isn't a mistake. These two trades made exactly the same amount, again benefiting from the bullishness.
Open (sort of) EWZ diagonal spread -$334 This could have been a nice trade but the overall market was starting to weaken and EWZ seems a bit more susceptible to weakness than other indices.
Open GLD diagonal spread   I entered this trade just a few weeks ago. This is a nice inflation trade but more than that, I'm hoping to demonstrate some longer term management techniques with diagonal spreads.
Open SPY vertical spread   I couldn't help entering another bullish trade to take advantage of what I believe is short term weakness. Time will tell...

While I hate having losing trades, I find that I learn the most from them. I'm going to start including 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:
"...While it's often easier to draw lessons from the failed trades, I want to take a moment to look for some lessons learned in the midst of this successful trade. Every successful trade starts with a good trading plan regarding how and when to enter. However a successful trade is further assisted by having a set of clearly defined exit rules - both to limit loss and lock in profit. Furthermore, I consider this a successful trade because it was entered based on sound money management rules that helped ensure that I wouldn't suffer a severe loss if the trade went against me..."

From the EWZ call diagonal spread:
"...The turbulence of the last few days has shaken me out of this diagonal spread position. I'm kind of angry about this because my stop forced me out of the trade before it could turn around. Unfortunately that's the down side of having a stop loss order on a trade that may well run the gamut. In this case, my portfolio was small enough that the only way to enter even one contract of a diagonal spread was the stop loss..."

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

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Options Strategy Focus

Based on feedback, I have modified this section a little bit to focus more deeply on the details of some of the options strategies I use in the tutorials. As you've perhaps followed some of the tutorials, you might wonder why I chose one strategy vs. another. Last month I began this section by talking about how to decide what strategy to use when thinking about entering a trade. I talked about how it's important to understand the characteristics of the different strategies so that the correct one can be selected based on your objectives.

This month I'll talk in more detail about the characteristics I talked about last month, including timeframe, bullishness or bearishness, impact of the greeks, and cost. In the various strategy pages, I've talked about the resulting greeks. It is worth the time to take a look at the construction of the various strategies and understand better how the combination influences the resulting greek values. I've summarized the key ones like delta, theta and vega below so I won't spend any more time talking about them here.

I want to first talk a little bit about timeframe. As you've probably already noticed with the various trades I employ, each strategy has a slightly different timeframe that is required to fully play out. Typically vertical spreads are the shortest term and can complete in 2-4 weeks, depending on market conditions. Calendar spreads are usually a little longer term and diagonal spreads even more so. Iron condor trades are simply a combination of two short vertical spreads so their timeframe is pretty much the same as the vertical spread. Because of the way long vertical spreads work, they will often require a little more time to develop - or they require a very strong bullish or bearish move.

Another factor to consider is degree of bullishness or bearishness of the strategy. Short vertical spreads tend to be either mildly bullish or mildly bearish. Combining a short call and short put spread creates an iron condor that is generally neutral (within a range). Depending on how they are constructed, long vertical spreads will typically be more bullish or bearish than their short vertical counterparts. The less in the money they are to begin with, the more bullish or bearish they will be.

Calendar spreads, while longer term in nature, tend to be only mildly bullish or bearish as the selected strike will be only a few strikes above or below the current underlying price. A diagonal spread, which is a combination of a vertical spread and a calendar spread, can be both longer term in trade duration but more bullish or bearish. They can be more bullish or bearish because there is more flexibility to roll up or down to create a wider spread.

One final characteristic to consider is cost. Different trades have a different initial cost or margin requirement that may be a limiting factor in selecting a strategy. The cheapest trade to enter overall is the iron condor. A $2 wide iron condor with an approximate probability of success of 50% will cost about $1 in margin, which is also the risk in the trade. Vertical spreads will cost slightly more and calendar spreads even more. Usually diagonal spreads are the most expensive and can cost anywhere from $500 - $800 to enter depending on the width of the spread and the duration.

As you can see, there are many different factors to consider for each strategy. To simplify the process of evaluating these characteristics, I've provided a table that summarizes the characteristics for each strategy.

Strategy Delta Theta Vega Timeframe Bullishness/ Bearishness Avg Cost
Short put vertical Positive Positive Negative 2-4 weeks Mildly bullish $150/contract
Short call vertical Negative Positive Negative 2-4 weeks Mildly bearish $150/contract
Long put vertical Negative Negative Positive 3-4 weeks Mildly - strongly bearish $150/contract
Long call vertical Positive Negative Positive 3-4 weeks Mildly - strongly bullish $150/contract
Iron condor Neutral Positive Negative 3-4 weeks Largely neutral $100/contract
Put calendar Negative Positive Positive 4-8 weeks Mildly bearish $200/contract
Call calendar Positive Positive Positive 4-8 weeks Mildly bullish $200/contract
Call diagonal spread Positive Positive Positive 6-10 weeks Mildly - strongly bullish $500/contract
Put diagonal spread Negative Positive Positive 6-10 weeks Mildly - strongly bearish $500/contract

Note: the above table provides some generalizations about the various strategies. Depending on how they are constructed  and how the underlying moves, the characteristics may change. For example, a typical long vertical spread will start out having positive  vega and negative theta. However when the spread is fully in the money, it becomes negative vega and positive theta.

You may be realizing that strategy selection can be somewhat complicated. It can seem that way at first but the more you become familiar with the characteristics, the more instinctive the selection process becomes. You decide you want a bearish strategy that offers positive theta, positive vega and a 6 week timeframe and you automatically think of the put calendar spread.

Be sure to check out the detailed descriptions of the various options strategies I employ for an in depth discussion of many of these characteristics. Remember, practice makes perfect so get out there and try the strategies.

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!

This past month, I received a question that relates to a topic I haven't discussed much on the website.

Q: How much capital is actually required to trade options effectively?

A:
This is a great question, and one that may have crossed many newer traders' minds as they've considered trading options. 

There are actually various schools of thought on this. Some will argue that you can trade options with only a few hundred dollars. Others suggest that you shouldn't trade options unless you have an account of $20,000 - $50,000. Which answer is right? Both? Neither? Let's take some time to think this question through.

On the surface, I could say that you can enter a trade like an iron condor on the DIA or SPY for roughly $100 in margin. In this kind of a trade you might risk roughly $100 to make roughly $100 for a 1 contract $2 iron condor spread. However, you wouldn't want to enter this kind of trade if your portfolio balance is only $500. Why?

The main reason is that if the trade is a loser, you lose 20% of your portfolio in one trade. Another reason is that you may not be allowing enough free capital to make necessary adjustments if that is part of your strategy. Furthermore, other trades such as vertical spreads and calendar spreads may actually cost more than $100 in debit cost or margin. A few losses of this kind would obliterate your account and you'd be on the sidelines watching all the good opportunities pass by.

Here's another perspective. In my trade tutorials I talk about limiting my trade risk to just 2% of my portfolio. If we take the above trade as an example, that means I need at least $5,000 to risk $100, which would be 2%. Consider also that in any portfolio I'm trading, I may want to have the flexibility to trade 5 or more different trades. Let's say that each trade carries on average $200 of risk (on a $10,000 portfolio). That's a 2 contract iron condor or a 1 contract vertical or a 1 contract calendar spread perhaps. If I trade 5 of these different trades each carrying a risk of $200, I'd be risking $1,000 total. How much of your portfolio are you willing to risk if every trade went bad?

Let's step back and talk about the larger perspective. Knowing that trading options carries risk, how much of your total investment capital do you want to tie up in this kind of trading? The answer better not be "all of it." I can tell you from bitter experience, that this is a bad idea.  Remember, you never want to risk more than you can stand to lose and this includes options trading.

In the larger scheme of things, you want to consider this kind of trading as maybe 20-30% of your overall investment strategy. Ideally, you might want to have the majority of your investment capital spread out among other longer term investments such as stocks, ETFs or even real estate.

Back to your original question then. How much should you have to trade options? You might want to start with a $10,000 account and only trade single contract positions until you get comfortable. You can start with a smaller account like $2,000 - $5,000 but you will be forced to take fewer trades and may also be limited in types of trades you can enter. In addition, with an account this small, you will likely be risking more than 2% on each trade. If you can live with this, fine. However, it runs the risk of blowing up your account in a few trades if you're not careful.

If you would like to submit  a question, comment or feedback on the website, please visit 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.
 

November has shown almost no net gain as we end the month nearly where we started. I hinted that this might be the case in last month's newsletter. In it I summarized my outlook as follows:

"Here's what I suspect may happen. We may see some short term selling in the next week or so followed by another attempt to push to higher highs - maybe up to $1200. In the end though we may see November end up pretty much where it started (emphasis added)."

While I was correct in my final statement, the way it played out was slightly different than I expected.



For the last two weeks or so, we've seen just a sideways range. How this will resolve is still yet to be determined. The market is acting like it's afraid of its own shadow. There is a fair amount of good news but it's tainted by the economic situation in Europe. I believe the market wants to rally but needs a respite from all the bad news.

The thing to watch out for is the support level right at $1173. There have several attempts to touch that level but each time has resulted in buying. As we've seen in the past few months, we could see the month begin with another rally. However, we could also see a failure of this support level and that would probably lead to a lot more selling.

How will that affect my trades? I am monitoring the market daily. If we see a break of support at $1173, I'll probably close all my bullish positions and sell some call spreads right away. If we see a rally from this level, I will become more bullish (cautiously). However I will be holding off on adding any bullish positions for the moment until we clear the overhead congestion area above $1200.

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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