I want to begin by introducing myself. I currently write the Option Writer newsletter and provide the weekly contrarian information each Wednesday. I first began writing for OptionInvestor.com in 1998 about strategy money and risk management. It is my pleasure to contribute to the newsletter again after taking about five years off to manage the portfolio of a Multi-Strategy Hedge Fund. As you will learn, I prefer to sell premium versus buying. Over time I hope to teach and inform why selling is a preferable strategy.
The week turned out to be full of disappointments if you are a bull. Monday tricked a lot of us with a strong open and run above and beyond the S&P 500 ($SPX) 200 day simple moving average (SMA). The end result was that the $SPX ended slightly up on Monday but just shy of its 200 day SMA. The same test and failure occurred on the Dow Jones Industrials ($INDU). The $INDU ran up to 13130 +/- for the second time in two weeks (5/2/2008) only to fail to breakout again.
The NASDAQ 100 ($NDX) was a different story. The Index was already well above its 200 day SMA at the start of this week. The only resistance to note was from a gap down that occurred on January 3rd of this year. Price Gaps are often target support and resistance zones that represent price demand or supply, respectively. On Monday, the market decidedly moved up above the 2040 resistance and filled in the gap. Then news came out from Sandisk (SNDK) that the company was experiencing slower US April sales. The markets were looking for a reason, any reason at that, to sell off and take profits from the two month run off the March lows.
The advance decline line showed heavy distribution of equities. The NYSE had only 825 Advancing issues versus 2021 declining. The same was true on the NASDAQ Composite with 876 advancers and 1913 decliners. The TRIN (or ARMs index) closed at a high 2.28 while the TRINQ closed at 1.11. Long trade signals can be taken when the TRIN closes above 1.50. I like this trade on the S&P Futures contract. Normally, I set a profit target on part of the position with an equal stop loss for a one to one ratio. Then the remainder of the trade is closed at the open, assuming it wasnt stopped out first. This trade can be compared to trying to catch a falling knife. Using options I would sell premium on the SPY or SSO puts for an overnight trade to gap up. The risk is that you grab the knife by the blade and have to close the puts out for a substantial loss.
The CBOE 10 Year Treasury Yield ($TNX) dropped 0.90 or 9 basis points to a 3.831% yield. The 10 year has been consolidating for a few weeks and has substantial resistance at 4%.
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The big story all week has been the uptrend in commodity prices. Throughout the week the main commodity highlighted was Crude and Heating Oil. There is no doubt that the increases in food and energy have affected the cost of living (read the real CPI). Goldman Sachs pinned a very specific $141 crude oil target by this summer while Boone Pickens of BP Capital spoke out on CNBC and gave oil a $150 target. The result was that the speculators came in along with the commodity linked funds and ETFs to buy therefore pushing crude above $135 per barrel. However, at the time that crude oil was running toward new highs the DJ Oil Service Index began to decline. The headline on CNBC was Americas Oil Crisis on Thursday and Friday. As a contrarian, I took that as a signal similar to that of the Business Week headlines seen in 2000 regarding the new economy. DUG is the Ultra Short (2X) Oil and Gas ETF that tracks the inverse of the DJ Oil & Gas Index. That means that a 2% move down in the DJ Oil & Gas Index would result in an approximate 4% advance in DUG. For those of you that dont subscribe to Option Writer we sold the June 24 Puts on DUG. Selling Puts is bullish. I chose the 24s just in case Boone Pickens was right and oil went to 145 150 therefore pushing DUG to new lows. The value of the puts increases on DUG as the price of the ETF approaches the strike price. The opposite is true in that the value of the puts decrease as the price of the underlying increases. As Crude Oil futures and the high flying oil service stocks like RIG, HAL, CVX, APC, and SLB declined, DUG moved up to 28.47 from a low of 25.41. Oil closed the day at $131.60, up $0.79 on the day. We have the option to close the position early or wait for the puts to (hopefully) expire worthless. DUG has resistance at $28.75 from a gap that was established earlier this week.
The other commodity story this week was Gold. As the re-emergence of inflationary pressures became more evident Gold was this weeks inflation hedge of choice. After basing near the 860 865 area Gold Futures rallied to a high of 935.5 before settling at $925.80. This has been a very volatile commodity. The chart below shows a variety of moving averages. The most relevant being the 50 (Blue) and 89 (Gray) day SMAs show that the price has broken and closed above the two moving averages for three days in a row. A little consolidation is due and a retest to the 50 day SMA at 914.49 would be healthy. There are a few options for option traders to play Gold. GLD doesnt trade options. The Power Shares DB Precious Metals Fund (DBP) trades options and represents about an 80/20 Gold and Silver split, respectively. The only problem is that the options have very little volume. The Gold Bugs Index ($HUI) trades options too but like the DBP has little volume and open interest. Then there is the CBOE Gold Index ($GOX). The $GOX is a decent index to write options on because it is priced at $194.88 versus the $HUIs $441.20. That means it costs half the margin to write options on the $GOX.
As mentioned earlier the $SPX attempted to close above the coveted 200 day SMA on Monday but was unable to hold onto the morning gains. The market traded flat on Tuesday until the Federal Reserve minutes were released. The easy explanation of the minutes is that a couple of the governors had dissenting votes which indicated that the inflationary pressures may potentially create the need to increase interest rates sooner rather than later. Wednesday the market broke the two month uptrend line and continued to close just above the 50 day SMA. With the recent decline, the 89 day (Grey line) may be the next line of support (at 1358.65).
The above chart is a depiction of the daily $SPX chart with exponential Bollinger bands and RSI. The close is near the lower Bollinger band. However, the lower Bollinger band is declining. This suggests that the amount of volatility is increasing and thus the downside potential is also increasing. The midline or the 21 day Exponential Moving Average is represented by the Dark Green line. I began using the Exponential Bollinger band study about four years ago when I discovered the Bollinger band lines were much more responsive to price and the range of price. Bollinger Bands can be a good indicator of the price range but can also provide an early indication of the stocks tendencies. For instance, the $SPX charts upper Bollinger band is flatter than the lower Bollinger band. The lower band is curling sharply lower too almost as if the indicator was taking a cue of the fast moving averages decline (8 day EMA in Magenta)
The above grid represents the $SPX June Open Interest at each strike price. The put open interest represents possible peak support at the 1350 price level. The Call Open Interest shows resistance at the 1400 level. There is a little more Call open interest than the Put open interest which is interesting in that the total Put Open Interest is greater for these strikes than the Call strikes.
The Nasdaq 100 ($NDX) began the week above the 200 day SMA and about down 3.27% Year to Date. By the end of the week the $NDX was down 6.42% YTD. As mentioned earlier the index filled in an important gap at 2040 on Monday and declined precipitously to end the week down 72 points at 1958.
The $NDX chart shows the gap (in yellow) from January being filled on Monday. Another important point with this chart is that the $NDX broke the 200 day SMA (red line) but managed to close above it by the end of the day. The technology weighted index managed to close down 5.96 or 15 points above the intraday lows (1943.85) while the $SPX closed near its lows on Friday. If the $NDX cant hold above the 200 day SMA, there is a gap that could need to filled at 1846. 1846 is just above the 89 day SMA but below the 50 day SMA. The support for the $NDX is that the Slow Stochastic is oversold.
However, the Bollinger Band chart doesnt convey the same story of support. The price resembles a cliff hanger holding of for dear life at the 21 day EMA (Green Line). In addition, the RSI isnt at extreme lows either. The Lower Bollinger Band is still advancing. This shows that the lower band is still providing support. The problem with the lower band being support is that it is 60 points lower. The Open Interest grid (see below) shows a similar fate. Peak Put Open Interest doesnt exist until 1900. Peak Call Open Interest is close at 1975. That shows that option investors are placing a lot of resistance at 1975.
The CBOE Volatility Index ($VIX)
The VIX reached a short term peak low on Monday and trudged higher all week. The weekly low of 15.89 broke the prior October low of 16.08. Had the VIX closed below 16.08, the sentiment indicator would have continued to signal a bullish signal. Since it bounced on Monday, the trade signal was to neutralize long positions and/or begin positioning into bearish trades. When writing The Contrarian I look for the signal to be confirmed by the slower to react 10 day SMA of the $VIX (shown below).
As you can see the Moving average has only flattened out its decent and not confirmed a bearish trade signal. A good example of the confirmation was the moving average crossover on 3/27/08 which signaled the bullish trade signal that is just now being removed. There were multiple short term signals provided from the sentiment indicator but the patient trader waits for the confirmation and positions their portfolios with an overall bias. When running a Multi-Strategy portfolio one can weigh the portfolio according to the signals bias and then take opportunistic positions on the short term signals we get from the actual $VIX. In summary, there isnt a new bearish signal yet.
CBOE Put/Call Ratio Update
Normally, the Put Call ratio signal updates are on Wednesdays. But I wanted to take this opportunity to cover the recent signal change. We got a sharp bounce up in the CBOE Equity Put/Call ratios 10 day SMA this week which created a neutral signal. However, the 10 day SMA wasnt able to break above the 20 day SMA to signal a confirmation of a bearish signal.
Since we are an option trading website I want to discuss options and strategies that utilize options. With the popularity of ETFs there have been many new concepts delivered to the market place. The Ultra Shares have begun to trade options thus providing a leveraged product on a leveraged ETF. Disclaimer: This isnt for the faint hearted. However, lets assume it is 3:50 PM and that we think that the market will bounce at the beginning of trading on Tuesday. Furthermore, our assumption is based upon historical high probability signals including technical analysis and sentiment indicators. Thus we take a position on the Ultra S&P 500 Proshare (SSO). SSO closed at $71.39 on Friday. The most aggressive option writer can sell and in the money put at the June 73 Strike for $3.70 per contract. For this example, we feel the best coarse is to sell the June 71 Put for $2.65 per contract. Selling 10 contracts there is an approximate $14,000 margin requirement. Therefore, one contract requires $1,400. Since we are receiving $2.60 per contract, we have to have at least $11,400 in the account to initiate this trade ($14,000 less $2,600 initial premium). I will be doing the Wednesday Market Wrap and reviewing how the trade resulted. Have a nice long weekend.
Robert J. Ogilvie
Play Editor's note: This past week's failure in the major market indices does not bode well for the summer. I suspect we will see a bounce soon but it may end up being a new entry point to establish bearish positions. I haven't had the chance to read this week's market commentary so I don't know how my own hypothesis lines up with this weekend's wrap. FYI: A few stocks that I am watching as potential put candidates on a bounce are ISRG, FDX and UTX. I also think that MT might be a strangle candidate right here near $100. Another candidate readers might want to consider is buying calls on the VIX. Yup, the Volatility index. A dip near 18.00 or a breakout over 20.00 could be used as a new entry point to buy calls. Target 22.50-24.00.
Mechel OAO - MTL - close: 49.19 change: -1.91 stop: 47.69
Why We Like It:
BUY CALL JUN 50.00 MTL-FJ open interest=600 current ask $2.70
BUY CALL JUL 50.00 MTL-GJ open interest= 28 current ask $4.60
Picked on May 25 at $ 49.19
Carbo Ceramics - CRR - close: 48.00 change: -0.81 stop: 46.90 *new*
After a tough week it's not looking good for the bulls. CRR has produced a failed rally pattern with the intraday spike above $50.00 on Wednesday. Now we're seeing multiple bearish divergences in the technical indicators. CRR's bullish trend is in short-term jeopardy. We're not suggesting new positions at this time. Instead we're raising our stop loss to $46.90. More conservative traders may want to just exit early. Our target has been the $52.00-52.50 zone.
Picked on May 11 at $ 47.45
Harsco - HSC - close: 61.09 change: -1.27 stop: 59.95 *new*
Danger! HSC's 2% decline isn't so alarming. We were expecting another dip on Friday. Our concern is the breakdown under one of HSC's trendlines of support. There is still a decent chance that HSC will rebound from here but given the tone of the market we would hesitate to open new bullish positions. We're inching up our stop loss to $59.95. Our target is the $64.50-65.00 range but more aggressive traders may want to aim higher.
Picked on May 01 at $ 60.38
IHOP Corp. - IHP - close: 47.71 change: +0.52 stop: 49.49
On Thursday we gave IHP an ultimatum. Either bounce from technical support at the 100-dma or we're dropping it as a potential bullish candidate. Well, the stock delivered a bounce on Friday but that doesn't mean buy calls yet. What we really want to see is a breakout over resistance near $53 and its 200-dma. Our suggested entry point to buy calls is at $53.75. Friday's bounce means we're willing to be patient for another day or two as we wait and see if there is any follow through on the rebound. If triggered at 53.75 our target is the $59.50-60.00 zone. The P&F chart is bullish with a $68 target. Note: More aggressive traders might want to consider buying this bounce with a very tight stop under Thursday's low as an alternative strategy. Our concern is the overall market tone and overhead resistance. FYI: The most recent data listed short interest at more than 26% of the very small 14.8 million-share float. That's about two weeks worth of short interest so if IHP breaks out it could see a huge squeeze. Note: we have to label this a more aggressive play because the option spreads are so wide.
Picked on May xx at $ xx.xx <-- see TRIGGER
iShares Russ.2000 - IWM - cls: 72.21 chg: -0.96 stop: 71.45
The bulls might be in trouble here. The small cap Russell 2000 index has produced a failed rally under 750 and its 200-dma. Momentum indicators are waning. On the other hand the RUT and the IWM have spent a week consolidating lower but have not yet broken their bullish trend of higher lows. We are very cautiously bullish here. A bounce on Monday might be used as a new bullish entry point but honestly you may want to exit early at $74.50 and just scalp a couple of points. If the IWM does bounce we will seriously consider exiting in the $74.50-75.00 zone instead of waiting for a rally higher. Currently our target is the $77.50-80.00 range. The P&F chart is bullish with an $87 target.
Picked on April 28 at $ 72.55 *triggered
Priceline.com - PCLN - close: 131.65 chg: +1.26 stop: 126.99
As expected shares of PCLN bounced on Friday but not enough to hit our trigger to buy calls. More aggressive traders might want to consider jumping in early right here. We do not see any changes from our Thursday night play description so we're reposting it here:
"PCLN exploded to new highs a couple of weeks ago on its earnings news. Now the stock has pulled back to fill the gap. Traders are buying PCLN near its trendline of higher lows (see chart). The stock can be very volatile so we consider this an aggressive, higher-risk play, but the bounce looks like a potential entry point. Just to be sure we want to see more follow through so we're suggesting a trigger to buy calls at $132.75. If triggered our target is the $139.50-140.00 zone. FYI: We do want to point out that the consolidation over the past two weeks has turned the P&F chart bearish."
BUY CALL JUN 130 PUZ-FW open interest= 911 current ask $7.00
Picked on May xx at $ xx.xx <-- see TRIGGER
Molson-Coors Brewing - TAP - cls: 58.32 chg: +0.27 stop: 55.49
Shares of rival BUD soared 7.6% on Friday following news that it might be a takeover target by InBev. This strength bled over into shares of TAP and TAP hit our suggested trigger to buy calls at $58.51. Now that the play is open our target is the $64.00-65.00 range. Failure to hold most of its gains on Friday is somewhat concerning so readers may want to wait for TAP to trade over $58.50 again before initiating new positions. FYI: The P&F chart is bullish with a $69 target.
BUY CALL JUN 60.00 TAP-FL open interest=1612 current ask $1.15
BUY CALL JUL 60.00 TAP-GL open interest= 460 current ask $2.00
Picked on May 23 at $ 58.51 *triggered
Apollo Group - APOL - close: 43.43 chg: -0.56 stop: 48.01 *new*
APOL lost another 1.2% on Friday. Shares look poised to continue lower but nothing goes down in a straight line for very long. Readers need to be expecting a bounce eventually. We're adjusting our stop loss to $48.01. More conservative traders may want to use a tighter stop or consider taking some profits off the table now. We're not suggesting new positions at this time. Our target is the $40.50-40.00 zone.
Picked on May 18 at $ 46.71
3M Co. - MMM - close: 75.81 chg: -0.83 stop: 77.01
MMM continues to inch toward support in the $75.50-75.00 zone. We do not see any changes from our Thursday night play description so we're reposting it here:
"MMM has been consolidating sideways for four months. The stock's bullish breakout from its bearish channel back in March never saw any follow through. Now shares of MMM are nearing support around $75.00. A breakdown can be used as a new entry point to buy puts. Our suggested trigger to buy puts is at $74.95. If triggered our first target is the $70.25-70.00 zone. Our secondary target is the $66.00-65.00 range. The P&F chart is bearish with a $69 target."
BUY PUT JUN 75.00 MMM-RO open interest=4400 current ask $1.30
BUY PUT JUL 75.00 MMM-SO open interest=5179 current ask $2.15
Picked on May xx at $ xx.xx <-- see TRIGGER
(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)
Amgen Inc. - AMGN - close: 42.38 chg: -0.39 stop: n/a
We do not see any changes from our Thursday night play description on this AMGN strangle. The stock continues to trade sideways providing an opportunity for us to open positions. A breakout one way or the other is imminent. The question is whether or not AMGN is going to move before, during or after the upcoming ASCO conference, which lasts from May 30th through June 3rd. We are suggesting entry points in the $42.00-43.00 zone. We have suggested a July strangle and a slightly more aggressive June strangle. The options in the July strangle are the July $45 calls (AMQ-GI) and the July $40 puts (AMQ-SH). Our estimated cost for the July strangle was $1.65. We want to sell if either option hits $3.50. The options in the June strangle are the June $45.00 calls (AMQ-FI) and the June $40.00 puts (AMQ-RH). Our estimated cost on the June strangle was $0.56. We want to sell if either option hits $1.10 or more. June options expire in four weeks.
Picked on May 22 at $ 42.77
McDonald's - MCD - close: 57.73 chg: -0.80 stop: n/a
Five cents! The June $57.50 put almost hit our target at $1.65. All we needed was another five cents. MCD declined again on Friday losing 1.3%. The stock is down several days in a row. While the new trend is bearish we should expect an oversold bounce. . We are not suggesting new strangle plays at this time. The options we suggested were the June $62.50 calls (MCD-FZ) and the June $57.50 puts (MCD-RY). Our estimated cost was $1.10. We want to sell if either option hits $1.65 or higher. More aggressive traders may want to raise their target. Keep in mind that June options expire in four weeks and will see their premium erode more quickly.
Picked on May 18 at $ 60.53
Fortune Brands - FO - close: 69.02 change: -1.38 stop: 69.45
The retail index's attempt at a bounce on Thursday failed when the sector sank to new relative lows on Friday. Shares of FO suffered a 1.9% decline on Friday and broke down under short-term support and its 50-dma. The stock hit our stop loss at $69.45 and its MACD on the daily chart has rolled over into a new sell signal. Our play is closed and I suspect that FO is headed for the $67.50 or $65.00 levels soon.
Picked on May 07 at $ 70.05 *triggered
Lufkin Industries - LUFK - cls: 77.07 chg: -3.80 stop: 77.85
Crude oil and natural gas continued higher on Friday and yet the energy sector stocks were unable to avoid the market sell-off. Shares of LUFK were hit harder than most for no particular reason. It seems that as the market's correction ran headlong into the weekend that traders decided lock in gains and LUFK, trading near its highs, was a big target. The stock hit our stop loss at $77.85 closing the play. The breakdown under $78.00, which should have been new support, is a big negative for LUFK.
Picked on May 18 at $ 80.59 /stopped 77.85
Reliance Steel - RS - close: 66.30 chg: -0.67 stop: 59.99
We are giving up on RS at least temporarily. Traders bought the dip near $65.00 again on Friday. The trend is still bullish but we're not going to wait for a dip into our suggested entry range of $64.75-64.00. Instead we're going to go for a more aggressive, buy the dip play in another steel stock MTL. See details on MTL in the new play section. We will keep RS on our watch list for another entry point. This play has been dropped unopened.
Picked on May xx at $ xx.xx <-- see TRIGGER
As many of you know, I'm all about setting trading goals. My trading goal for this year is to experiment with trades that will vary my income-producing trades. Since I was originally hired to represent the self-taught trader, I thought some might want to follow along with some of my attempts to meet my goals.
This year, I want to experiment with varying my delta, theta and vega risks (price, time and volatility risks). I've decided to focus on four types of trades in addition to the condors or credit spreads that make up the bulk of my trading: ATM condors rather than the high-probability ones I've been trading; butterflies, both ATM and even more speculative OTM ones; calendars; and double diagonals.
So, that's the first step in my trading plan: deciding what needs to be changed and how to go about changing it. Almost all investors understand the need to diversify their portfolios. Traders need to diversify their repertoires, too, as well as the securities they trade. Market conditions change. The trades that worked great for trending markets aren't necessarily so great for channeling ones and vice versa. The trades that worked great for bullish environments--environments in which volatility tends to be decreasing--can be disastrous in environments in which prices are dropping and volatility is expanding.
However, experimenting with new trades can incur unexpected risks. I thought I'd devote this Trader's Corner to some ideas about how I approach new types of trades or familiar trades on new securities. I'm not approaching this article as an expert telling you what to do: I'm a self-taught options trader who is still learning. I'll even let you in on some of the mistakes I've made, too, in hopes that you won't repeat them.
First, set a goal for how much money you'll risk each option expiration cycle on experimentation. Most people pay a tuition fee as they're learning new trades. The market collects that tuition in losses when some unexpected wrinkle occurs or just when you're doing your best deer-in-the-headlights impression.
Experimenting collects a fee in another way, too: when you're experimenting, trade size is smaller and commission costs eat up an exorbitant proportion of the potential profits. Sometimes a trade that would be profitable if one were trading 20-25 contracts and taking home $0.25 profit per contract, for example, is only break-even or results in a small loss when trading only 1-2 contracts and paying commissions out of that smaller profit.
I've set a specific goal of risking no more than $500 per option expiration cycle on new trades. That will go up as I experiment. That's a very small portion of the two accounts in which I trade, far less than 1 percent. While I'm experimenting, I consider all such trades speculative trades and appropriate only for the speculative portion of my trading accounts. That's true even though most of the trades with which I'm experimenting will eventually move into the income-producing part of my trading account when I feel comfortable with them again and bulk up the number of contracts I trade.
For those of you experimenting with new types of trades or familiar trades on unfamiliar vehicles, move such trades to the speculative part of your trading account where they properly belong. To summarize where we are so far, then, set a trading goal, decide what needs to be done to accomplish that goal, and determine a maximum amount that will be risked in meeting that goal.
Then it's time to educate yourself. Read as much as you can about the new tactics you intend to employ. Talk to other traders who have traded that type of trade or that vehicle. Listen to webinars presented by CBOE or your brokerage.
Paper trade an opex cycle or two before you attempt a trade with real money, but there's really nothing that approximates the real give-and-take of trading except real trading. Only testing your skills with real money will elicit the kinds of emotions that sometimes cause problems in trades. Just make sure you do it with small numbers of contracts and that you're vigilant about your stops.
Before escalating higher in size, traders need to know that they can handle the emotions wrought by a particular kind of trade. Although I love condors, I've heard traders confess that they can't sleep at night with condors in their portfolios. Me? I don't do long straddles. Something about this rather sedate trade doesn't fit my personality or, apparently, my trading skills. Give me a condor, and I can let it play out; give me a straddle, and I'll keep trying to leg in and out and end up with a mess. An unprofitable mess. My normally patient personality turns into something else irked by that straddle sitting there in my account.
I would even go so far as to warn that you shouldn't escalate the size of trades too much until you've had a bad month and handled it well, both in terms of the losses you incurred and the emotions engendered. It's only then that you know that you can trust yourself to honor stops, to act when appropriate and stay steady when appropriate. Woe to the trader who collects profits for the first month of trading a new strategy and immediately ramps up the size of the trade. A number of would-be condor traders, not having faced a losing month, don't understand what it feels like to have a condor that goes bad when prices start zooming toward a sold strike.
Those of you trading with a $2,000-25,000 account, particularly those under $10,000, might have more difficulty experimenting in live trades. They may represent too high a percentage of your trading account. That's okay. Although not a perfect solution, there's a way around that difficulty: continue paper trading.
Paper trading is more sophisticated these days than in the early days of online trading, when most traders were restricted to a spreadsheet in which they noted the parameters of a paper trade. If life got busy, it was all too easy just let it go without updating or "forget" to tend to a paper trade gone sour. Most trading platforms enable paper trading these days that mimics the actual trading platform so closely that it can even engender some of those emotions that trading does. I remember testing a simulator for trading currencies, grumbling under my breath about how they kept coming up and deliberately hitting my stop during thin trading . . . until I realized that no one was seeing my stop. It wasn't a real stop on a real trade.
If your online brokerage doesn't provide for paper trading or a simulator, the CBOE does. Let's look at an example of a trade on a CBOE simulator. I gave myself a $5,000 account and a high level trading clearance so I could sell options and enter combination trades. Then I looked for an example trade.
Lately, I've been researching calendar spreads. I haven't been a fan of calendar spreads in past times, but I'm forcing myself to try a few now and then. I have been studying a recommended practice of trading calendars on the MNX each month, placing them a couple of percentage points above the ATM level about 30-40 days before option expiration. So, on May 14, with the JUN options within that 30-40 day window, I set up an example order. The page is difficult to read due publication parameters, but it involves the sale of a JUN 205 call and the purchase of a JUL 205 call. My main goal here is to show you how closely the CBOE's virtual trading platform mimics an actual trading platform.
CBOE Virtual Trade Spread Order Preview:
The difficulty reading that chart might also make it impossible to read the cost for the order. It's $254.90, so it fits my parameters of risking $500 or less a month. I'm sticking to that even though this is a paper trade. Since it fits that parameter as well as my goal of varying risks, it's time to punch the "Place Order" tab, right?
Not so fast! What are the risks of calendars? We're told that the only risk in this type is the original debit that's paid, but is that true in all cases? (Hint: no, it isn't.) What do we know about the MNX or its options? Are they American or European settled? How is profit taken and when are losses taken? I would never enter a real trade without knowing those things, so shouldn't I know them before initiating a paper trade, too? What do I expect to happen if the MNX moves up or down?
The MNX is the Mini-NDX index, "based on 1/10th the value of the Nasdaq-100 Index (R)," another portion of the CBOE site tells me. It is a European-style index, meaning that it's cash-settled, and it normally stops trading the Thursday before option expiration. For June, that option expiration would be Saturday, June 21, so the MNX would stop trading Thursday, June 19. The settlement value would be shown as XMS and would be 1/10th of the NDX's settlement value. The fact that it is cash settled would be reassuring to some traders since some freak unnecessarily about a sold strike (the June call in this case) being exercised.
Get in the habit of checking such essentials, even before placing a paper trade and especially if trading live, even if the number of contracts is small. We all are going to make dumb mistakes in our trading, as I did recently when I thought I was entering a June bear call spread and instead found myself the proud owner of a July one, 65 days before July's expiration. We're human and we're going to occasionally make those mistakes, but that doesn't mean we should be deliberately cavalier about placing any trade, even a paper one.
It's still not time to click on that "Place Order" tab. Before you place a trade that involves a sold option, investigate whether the underlying delivers dividends. If so, when does it go ex-dividend? You don't want to discover when in the midst of a trade that your underlying pays a dividend, and that your sold call has been exercised, but only after you've collected the obligation to pay the holder of that sold call a dividend.
Does that have the ring of something that may have happened to me? It did, with SPY options. Fortunately, the cost wasn't a large one, but it was an unexpected one, and it taught me a lesson. Subscribers have had harsher ones. Through the years, I've heard from some who wrote a few minutes before Thursday afternoon's close on opex week, asking if I knew when their SPX options expired. By the time their emails arrived in my mail and I could answer, they might have had little or no time to make decisions as to whether they would close out their positions or risk the sometimes crazy settlement action on Friday morning. Verify whether the options in your vehicle stop trading when the cash market stops trading or if, as happens with most indices, it continues trading fifteen minutes after the close. That difference can sometimes mean the difference between a profit and a loss.
I've heard from subscribers who turned on CBNC, noticed that gold or some other commodity was up "too much" and jumped into a bearish trade on some security related to the commodity or into a futures trade. One futures trader didn't know how much was being lost or gained in that trader's trading account with each jit or jot of the gold futures; another didn't know the differences in the ways that some of the crude-related indices behaved in relationship to the movement of crude. Crude rising doesn't always mean that the refiners will rise, for example. I've heard from a trader who wasn't aware whether an expiring crude-related security was cash settled or settled by delivery of crude.
In summary, after deciding on a trading goal, the method for meeting that goal and the amount to be risked on testing, traders must meet other parameters, too, when experimenting. Even when paper trading options, traders should check on the type of expiration of the options (European or American), type of settlement (Friday morning or Friday afternoon), and whether the underlying pays dividends as well as the date it goes ex-dividend. If your underlying is an equity, traders should determine whether the company has earnings or any other price-moving event scheduled during the period the trade will be in effect.
What about profit or losses? How does a trade work? Where, in practice, would traders cut losses or take profit? An example might be shown using the MNX calendar trade profiled earlier. Although the CBOE site doesn't offer a profit/loss chart for the MNX trade shown above, my brokerage, BrokersXpress, does and so would most others.
Profit/Loss Chart at Expiration:
The chart and figures indicate that the calendar trade's breakeven points are $197.95 on the bottom side and $212.89 on the top, with the greatest profit accrued if the MNX ended the JUN expiration at the 205 strike. Of course, this chart ignores the commissions. In practice, traders can't do that, of course, but traders who are experimenting with small trades have a bit of a quandary. As mentioned earlier, with some brokerages, commissions exhort a greater proportionate toll on trades of one or two contracts than on a greater number of contracts. Depending on the trade I'm experimenting with, I may consider the commission cost a donation for educational purposes. While experimenting, I may prefer setting my stops and profit targets without reference to the commission costs so I can better watch how the trade unfolds. Again, this might not be possible with a smaller account.
The P/L chart and figures display information about what happens with changes in price, but experimenting traders also need to ask themselves what happens if volatility changes or if time goes by. Without going into too much detail because explanations would require at least several other articles, this calendar trade is positive vega and slightly positive theta, so that it would benefit both from a passage of time and a rise in volatility. That part about benefiting from a rise in volatility prompted my reluctant exploration of calendars again. The condors I prefer are hurt when volatility expands.
What does all that mean? If price movement isn't too large, so that prices either stabilize or move slightly higher, both the passage of time and the likely decrease in volatility that comes along with such price action would benefit the calendar trade. The spread would hopefully widen and the trader would be able to collect more credit when the trade was exited than the debit paid to open the trade.
That's how it worked when I tried an actual AMX May/June calendar in real trading. The weekend of April 26-27, I'd done some work with various screens, looking at securities with unusual volume the Friday that had ended the previous week. I'd discovered that after announcing earnings on 4/25, AMX had dropped precipitously. My study with volume/price-spread analysis had convinced me that AMX was likely to steady or maybe climb.
Note: this chart does not feature current prices, but AMX has continued to trend sideways.
Annotated Daily Chart of AMX:
Although the timing wasn't quite right, I could initiate (and did initiate on April 28) the trade for $1.10 per calendar contract. I sold two May 55 calls and bought two June 55 calls for a debit of $2.20 plus commissions. The $220 cost and total risk fit my parameters for how much I would risk testing the trade. Because it was closer than I'd like to expiration and not as much extrinsic value in that sold $55 call as was optimum for a new calendar spread, I knew I'd have to watch it carefully. If the calls got too close to par as they went into the money and closer to expiration, they could be exercised.
I would remove the trade if the spread narrowed so that I was losing 25 percent of my initial debit, I decided. That would mean that since I'd paid $1.10 per calendar contract, I would exit if the spread narrowed so that I could get only $0.825 credit when I sold it. I was looking for 20 percent profit, so I wanted to exit for $1.32 or more. In actuality, if commissions were factored in, I would have needed to collect about $1.70 credit to collect that 20 percent profit, but since commissions exact a higher toll on small one- or two-contract trades than they do on larger ones, as discussed earlier, I set my profit stop at $1.45, which would be a little above breakeven once commissions were paid. It was a compromise between totally ignoring commission costs and requiring 20 percent profit with them.
AMX cooperated with my original viewpoint of what it would do. After the trade was initiated April 28, AMX traded sideways to sideways/higher, moving up toward the level that I thought would be resistance on daily closes. It bounced back down from it.
I exited on 5/12 for $1.45 credit. I reaped just a little over a whopping $10.00 profit after commissions for my efforts, but I did begin the process of reacquainting myself with how a calendar unfolds. I gained confidence about trying it again, even in this market climate, and moved a step closer toward my goal of participating in a trade that's on my list of repertoire-expanding trades but is the only one that's completely new to me: those double-diagonals. Because a double diagonal is a sort of a combination of a short strangle and double calendars, easing back into the more familiar calendars seemed a good start for me.
This week, I initiated my first double diagonal, and I lost $169.64. Before I initiated it, I went through all those steps listed above. I identified the amount I would put at risk, the vehicle I would use, the expiration type of that vehicle, the way it's settled, whether or not it awards dividends or has earnings. I'll knew as much as I could about how the trade unfolds. I've already studied P/L charts for double diagonals, but I did it again for the specific trade I entered. I knew, before I initiated the trade, where I would put my stop and where I would place my limit order for my intended profit. I expected to pay a tuition for the learning experience, hoping I wouldn't, hoping I would instead be able to pull off one of those like-magic adjustments with double diagonals. In fact, I had the first one saved and ready to go, turning the put side of the diagonal into a double calendar when markets headed down, but the trade forced me to kick in another rule I'd set. If the sold strike was too closely approached within a week of entering the trade, just take your losses and go because it's just a bad trade.
What did I learn? I learned that it made me jittery and I had to think many times, checking options chains over and over to make sure that I was saving the right order to convert a put diagonal into double calendars. I also learned that I still can take a loss when needed and not do the deer-in-the-headlights thing. I learned I have the go-ahead to keep trying.
It sounds daunting, doesn't it? It should. It's your money that's eventually going to be put at risk, your real money. More than that, it's your confidence in yourself as a trader and that can be more vulnerable than your trading account.
Oh, and that MNX calendar I set up as a paper trade? MNX on Friday, May 23 had
dropped below the breakeven point, so that it would have been time to adjust or
roll down the calendar. With MNX at 195.90 that afternoon, the bid/ask was still
2.07 x 2.27, so a trader who elected to exit and not adjust wouldn't have lost
much. Time to go back to the drawing board and think about that one before the
Today's Newsletter Notes: Market Wrap by Robert Ogilvie, Trader's Corner by
Linda Piazza, and all other plays and content by the Option Investor staff.
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