Sometimes experienced traders need to be reminded of the flexibility of options. New traders need help finding the trade that will fit their personalities, time availability, and trading account sizes.
Last week, we imagined the case of a trader studying trades back in mid- to late-July, when this and last week's articles were first roughed out. All the entry prices for the trade examples were from July 25, so you can check results against chart examples shown and I'll update some of the results, too. However, this article wasn't intended as a trade suggestion but rather as an example of how to choose a trade that fits all your parameters. A simple scan from OptionsXpress was chosen to begin the search.
We imagined the case of a trader mildly bullish on DELL and willing to risk about $500 on that directional bet, someone who felt that a trade that unfolded over two or more weeks was a good fit, personality wise. Inputting that information into OptionsXpress's Strategy Scan returned three trade suggestions for the active trader with all trading permissions. Most of us know the pros and cons of a straight call purchase, so we examined the other two cases, the bullish call spread purchased for a debit and a call back spread, sold for a credit. If you haven't read last week's article, I urge you to do so, but I will include the Strategy Scan overviews and charts again in this article.
Overview of the Two Strategies (Bullish Call Spread on top and Call Back Spread below it):
Expiration Charts of the Two Suggested Positions:
Last week's article ended with these comments about these two expiration charts. It's easy to make a decision, then, that article read. If you feel almost certain that Dell is going to head higher, but probably won't get above all that possibly strong resistance at $14.00, the bull call spread is the preferable trade among these two. If you feel that Dell is due to either roll over and cascade lower or mount a massive rally over the next month, the second trade is your trade. You're covered if it rolls over.
But was that all there was to consider? the article asked. We had imagined a trader who wanted to be in a trade about two weeks, not one who wanted to carry the trade through to expiration. Of course, in retrospect we can look back and see how each of those trades performed. The trader looking at the scans that day couldn't look into the future. What else would have gone into the decision?
Let's transport back to July 25, when this article was first roughed out and these charts snapped. Let's say that it was your view that Dell would have risen to 12.25 in a week or two, and that implied volatilities would drop while the price rises. We know that the T+0 line sometimes looks different than the expiration line. For example, in my preferred trade, the T+0 line can sometimes be positive and the trade profitable while prices are over the expiration chart's sea of death. DELL's call back spread's expiration chart has a sea of death from $11.67-16.33.
Let's look at how that call back spread trade will appear with those 12.25-in-a-week-with-lower-volatility parameters set. Remember that this was snapped on July 25, not after the fact. We're looking at the information that would have been available on that day. I used think-or-swim for this view so I don't appear to be favoring one brokerage over another.
Sea of Death with Time and Price Rolled Forward:
One of those vertical lines is marked at the downside expiration breakeven and the other is our test $12.25-in-a-week-or-two level. As we can see from studying this chart, which captures the expiration sea of death, the lowered implied volatilities have dropped the T+0 line right to the expiration line. That's what happens when implied volatilities drop. Lowered implied volatilities move the T+0 line closer to the expiration line, as the CBOE's Jim Bittman and fund manager Jim Riggio both often note. In fact, this T+0 line predicts that the trade will be down a little over $100 under those conditions.
Looking at this chart, I might quibble with the characterization of that trade as mildly bullish. It seems "bearish unless wildly bullish" to me. However, the exercise has been a useful and instructive one for the trader looking for a new preferred trade. I don't often think of ratio spreads when thinking about trade possibilities, so it's brought up a possibility that I would not have even considered.
Is it the right trade for this hypothetical trader? I don't think it is for that trader, and I know it isn't for me. Maybe if the time frame were longer and I had an extremely bullish view of Dell . . . .
As an update, DELL indeed climbed into early August. My Word file tells me that the original article was roughed out on Wednesday, July 25, and the accompanying charts all snapped that day, too. By Friday, July 27, DELL had already risen above $12.00. For the bullish call debit spread, a potential profit of $142.50 after $1.25/contract commissions would have been theoretically possible. I always caution that slippage occurs in live trading and that back-tested theoretical results don't always reflect live ones. That profit represented a 29.69 percent gain based on the max margin or buying power of the trade. On that same day, the call back spread showed a theoretical loss of $111.00, a 23.22 percent loss on the max margin or buying power in the trade.
A composite implied volatility for Dell's options showed that vols had indeed dropped, by 7.61 percent, dropping that T+0 line right into that sea of death, as the rolled-forward theoretical chart had shown would happen. At the same time as the lower vols were dropping the T+0 line for the call back spread trade into that sea of death, it was sending the bull call spread's T+0 line up to climb toward the ceiling of the expiration chart. In both cases, the drop in vols moved the T+0 line closer to the expiration line than might otherwise have been expected that far out from expiration.
There's another important consideration we haven't considered, however, one that absolutely impacts the type of trade that will turn out to be our trade. We have not yet discussed adjustments and the ability or willingness of traders to employ them. Some traders want or need a set-and-go trade. They may not be able to monitor a trade on a regular basis. They may be unwilling to devote more time or funds to a trade once they've opened it. They may be trading in a small account, so that they're allowed only three round-trip options trades in a week. Others do want to adjust, have time to monitor that trade, and have left extra funds for adjustment.
Remember the call back spread? Let's imagine another scenario. Let's imagine that Dell started higher and met some benchmark that told this trader that it was going to keep going. What if, on the day that the trader was comparing and contrasting those two trades, that trader considered the theoretical possibility that the $12.25 mark was hit a week after the trade entry and that was the benchmark? If our trader were the adjusting kind of trader, the trader could adjust by selling two of those four AUG12 14 calls and buying two AUG12 8 calls.
New Theoretical Chart after Adjustment:
That adjustment is going to cost money, as the trader has to pay a debit for that vertical trade that swings two of those long 14 calls down to long 8's. Think-or-swim estimates that the new maximum loss on the position is $570 plus commissions. If the trader had planned to keep to that $500 maximum loss provision, this adjustment would not be available to that trader, so the trader must know before the trade is initiated if adjustments will be attempted. The trader needs some experience figuring out what those adjustments will be and what they will cost, what the new risks will be and other such concerns.
This chart tells us that the change has converted the sea of death into a plateau above the horizon, but it's a low plateau. Think-or-swim estimates that under the conditions set forth, that plateau portion sits at a potential profit of about $30.00 minus commissions. With just a little slippage, a stubborn market or a trader who waits a little too late or acts a little too soon, the meager profit could be a small loss. It could be a sandbar under the water rather than a plateau rising above it. Still, maybe the hypothetical trader feels a strong conviction that if Dell were to get past $12.25 that it's going to burst higher. Even a sandbar is better than a sea of death . . . as long as the trader now felt fairly certain that Dell will continue to climb and to likely be above $14.00 by August expiration. I don't know that I'd like to take the chance that I could effectively make this adjustment in the future since $30.00 doesn't allow enough for slippage and commissions. In other cases, we might test for an adjustment and find that it offers more promise, but this kind of test would have helped our hyptothetical trader to make a decision before even entering the trade.
As an addition to my original article, I went back and looked at what would have happened if I had swung two of those 14 calls down to the 8 strike on Friday, July 27, the date that Dell was obviously closing above $12.00 but not at $12.25. That would have indeed have created a sandbar under the water rather than a plateau on solid ground. Moreover, it would have bumped the max margin or buying-power effect up to $674.00, well above the initial $500 allotment. As had been feared, that minimal $30.00 possible plateau profit turned into a approximately $82 sandbar loss.
None of these back-and-forth decisions would be possible, however, if the trader didn't allow for extra funds for adjustments. That doesn't mean that only those who adjust can make money in the markets, but it does mean that this decision is an important aspect of deciding which trade is the right trade for you, your temperament, your outlook, your account size, and your ability to monitor a trade.
We traders have many choices because options are so flexible. That flexibility shouldn't be utilized by jumping from one trade to another, however. I am a firm believer in the importance of knowing your strategy and your underlying.
But then, that's my personality. What's yours and which trade best fits it? You owe it to yourself to go through this kind of testing.