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All price charts are screen captures, by permission, from Prophet Charts. Prophet Charts are a
powerful and flexible analysis tool available from the Investors Tool
Box, and Think or Swim, as well as at the Prophet
home web site.
The purpose of having strategies with clear rules is to remove
emotion, particularly passion and fear, from the process if trading and
investing.
Beyond simply buying and selling stocks, there are strategies that
can be employed for security and for cash flow. The market trends
about 30% of the time (up or down) and is pretty flat the rest of the
time. About 75% of stocks move with the market in general, the
other 25% roughly split in the other 2 directions.
When the market is up it is relatively easy to make money.
When the market is flat there are still a few stocks going up, often
trading in cycles and ranges. When the market is down there are
few stocks going up, and they are usually pretty volatile.
So it is best to find a way to make money with the market, whatever the direction. That is where strategies come in. Following are the strategies that we are evaluating or using. The top of the page is strategies we are considering or testing, below are Specific Strategies We are Trading.
Options are a Zero-Sum Trade. That is to say there is always someone on the other side of each trade, someone who makes money and someone who loses money. The market maker always makes money. So when you lose money, someone on the other side of your trade made money. If you don't understand it, don't throw your money away.
I'll
assume you at least understand what CALL and PUT options are, and terms
like In the Money, Out of the Money, At the Money. If you don't
then I doubt you have a chance of understanding most of this page and
suggest you stick to the long and short stocks strategies. Plenty
of webistes out there will define how options work, and in order to
trade them your broker will require you to state that you understand
them in a notarized form. You can lose lots of money if you don't
understand options...
Most options trades lose money. Sometimes that is part of a
strategy to insure against loss, but often it is just bad trades...
Most options trades are closed before expiration. Either
rolled into another month or simply covered or sold to close the trade.
With options it is vital to know and understand the greeks and the
basics of price. I'll only summarize here, if you don't
understand it, find a resource to define and describe it in terms you
understand...
With options the price model uses historic volatility to estimate
the
theoretical value of the option. Normally the mark (midpoint
between
bid and ask) does not match this theoretical value. Since Price,
Time, and the cost of money are relatively constant, the volatility is
adjusted to achieve this theoretical price - the result is the Implied
Volatility (IV), or the volatility implied by the price people are
willing to pay for the option. The option price is strongly
affected by IV and a sudden inflation or deflation of IV will certainly
and significantly affect how profitable a trade is...
To estimate the fair value of volatility use the historic volatility
on the underlying security for the number of days remaining to
expiration. This should give a reasonable fair value. Now
solve the model equation for price to find the mark. Adjust the
volatility until the theoretical price matches the mark (or reorganize
the equation to solve for volatility). The result is the implied
volatility. The ratio of implied to historic volatility will tell
you how inflated the prices of the options are. If IV is too high
you might consider a strategy to sell options instead of buying them...
This is the basic investment method. It is good for large
amounts of money for short or long periods of time.
With the advent of short ETFs it is possible to invest IRA money in
funds that go up while the market goes down. There are leveraged
funds with 2x and even 3x leverage. We will use the 2x funds, but
in years they do well there are occasionally large distributions.
With all of these securities the same basic entry and exit rules
apply. What is critical is the selection of the correct kind of
security for the current market conditions. These trades are
directional and should be executed in the same direction as the market.
Long stock positions can be protected by put options and they can be
used to sell covered calls to generate income when a stock flags or
stalls...
Stocks: We select bullish momentum stocks
from the Watch List we maintain from the IBD-100. We occasionally
use stocks that result from other searches, but all must pass the
screening of the IBD combined score, MSN Stock Scouter and Analyst
Ratings. We also prefer a high financials score from the
Investors Tool Box. Most stocks that pass these factors are also
heavily traded.
Bullish ETFs: We select ETFs based on volatility
of the market and relative market strength. Most ETFs are price
based on underlying securities and are efficient if heavily
traded. When the market is particularly volatile the ultra ETFs
may be a bit risky.
Bearish ETFs: When the market is down this is
often the best way to go. We also select these funds based on
current relative performance. When the market is particularly
volatile the ultra ETFs may be a bit risky.
Bounce: This is our
preferred entry in most circumstances. We wait for a flag, a drop
in upward momentum, this may be just one day in a strongly moving
stock. We enter at 1% above the high of the low day.
Breakout: This is a place to add to a position,
or an alternate entry. We look for a chart pattern indicating
strong resistance and entry with a price 1% above the high of the high
of the established pattern.
At Support: This is an aggressive entry techniqe
that
results in more losses that are small and allows capture of greater
gains. The thesis is based on a price pattern, like a
double-bottom,
where one base is established and it is being retested. The entry
is
made at or slightly above the expected support level with a tight stop
below that level. This can result in more day trades.
Normally we exit with a stop order. Sometimes we take profit
at discretion, when other trades are breaking down and the market
posture is changing. We always consider re-entry on a subsequent
support bounce.
Initial Stop: 1% Below the low of the low day.
Bounce: Aggressive preservation of gains, exit
at 1% below the low of the high day. This is updated each day a
higher low is established.
Breakdown: This allows a small flag to happen
after entry. Once the flag is confirmed by a close with a higher
low the stop can be moved up to 1% below the low of the low day in the
flag.
Moving Support: If the stock has been on a run
then a moving average that is not seriously violated during the run is
a good standard. This is updated daily as the run
continues. In a long run without clear flags it is probably the
best. Exit below the threshold - the average and envelope may
vary from trade to trade.
As the 2008 year end rally faded we had several fakeouts which
resulted in trade entries. On an outside day reversal, like Dec 5
or Jan 9 this can result in day trades. There was a great deal of
volatility back in the market. For the moment we are accepting
this as cost of doing business. The only day trade could have
been avoided by holding off the order for the first hour of
trade. All of the trades could have been avoided by using 2% as
the trigger instead of as the limit.
In the late 2008 market with high volatility we have been trading breakouts on 15-minute candles. This results in few day trades and usually captures the late day runs which are frequent in the current market. We move the stops aggressively and capture any profit. Below is an example:
Using our day-candle rules we would not have entered until around 810. This allows us to see intra-day where the buyers and sellers have been in battle. Instead of waiting overnight and losing 30 points of movement, we caught the afternoon rally... Note that we didn't trade the bounce, but waited for the breakout above where the sellers had their last stand...
This market has been brutal, take profits and exit losing trades at the first sign of weakness. Feel free to re-enter on strength.
We generally try to be long the bearish ETFs in a down market.
This strategy is in paper trading at this time.
Theoretically a short position has infinite risk, in acutality
stocks don't generally gap higher any more than they gap lower.
Short stock positions can be protected by call options, and covered
puts can be sold if the security flags or pauses...
Any bearish watch list or results from bearish strategy
searches. These are not long term investments, they are pure
momentum trades. Fundamentals don't matter so much, just having a
stock that is in an established down trend.
ETFs are less volatile than stocks, and less likely to be subject to
large gaps. Being bullish on the inverse ETFs is probably best if
there is one for your target market.
Mostly just flip over the bullish entry rules for this:
Bounce: This is our preferred entry in most circumstances. We wait for a flag, a drop in downward momentum, this may be just one day in a strongly moving stock. We enter at 1% below the low of the high day.
Breakout: This is a place to add to a position, or an alternate entry. We look for a chart pattern indicating strong support and entry with a price 1% below the low of the established pattern.
At Support: This is an aggressive entry techniqe that results in more losses that are small and allows capture of greater gains. The thesis is based on a price pattern, like a double-top, where one base is established and it is being retested. The entry is made at or slightly below the expected resistance level with a tight stop above that level. This can result in more day trades.
Also just the long rules flipped over. Normally we exit with a stop order. Sometimes we take profit at discretion, when other trades are breaking out and the market posture is changing. We always consider re-entry on a subsequent resistance bounce.
Initial Stop: 1% Above the high of the high day.
Bounce: Aggressive preservation of gains, exit at 1% above the high of the high day. This is updated each day a lower high is established.
Breakdown: This allows a small flag to happen after entry. Once the flag is confirmed by a close with a higher low the stop can be moved up to 1% below the low of the low day in the flag.
Moving Resistance: If the stock has been on a
run then a
moving average that is not seriously violated during the run is a good
standard. This is updated daily as the run continues. In a
long run
without clear flags it is probably the best. Exit above the
threshold - the average and envelope may vary from trade to trade.
These are aggressive strategies when a strong price move is
expected. LEAPS can be used for very long term trades, and as a
substitute for a stock with a high share price. Deeply In the
Money LEAPS have mostly intrinsic value and can be suitable for this
approach. Many stocks offer options out on quarterly intervals
which can be used for intermediate term trades.
This is the easiest way to lose money in option trading, and the most
common, but not nearly the most creative or complex.
OTM options can have huge gains, but at terrible risk of loss.
The deeper ITM your option is the lower the percent gains, but also the
easier it is to mitigate losses.
Strong upward move is expected.
Strong downward move is expected.
When you own a stock and buy a put to protect from the down side, the risk profile is the same as that of a call option at the strike of the put. This is a synthetic call option. An investor who has significant gains in a stock may buy an OTM put for protection from loss without taking profits directly, often they expect these to expire worthless.
When you are short of a stock and buy a call to protect from the up
side, the risk profile is the same as that of a put option at the
strike of the call. This is a synthetic put option. An
investor who has a short position may buy an OTM call for protection
from a short squeze, they want these options to expire worthless.
These strategies are responsible for a significant number of the
options that expire worthless each month. Just because someone is
buying OTM options by the bucket full does not mean that is the
direction they expect the underlying security to move...
If a stock has been on a run and stalls you might consider using a
collar - sell an OTM Call and use the proceeds to buy an OTM Put.
At a minimal cost this sets a floor against loss but also places a
ceiling for gains. If the run resumes then closing the collar
will keep you in the long trade.
Candidates for Long or Short simple equity positions are a great
start. Select from them the securities expected to move strongly
if you are going to include the leverage of long options.
In addition to expectation of a strong move, the underlying should
be heavily traded to create a liquid market.
There should be good open interest and/or volume on the options for
the candidate security, at least in the frong month, to create tight
bid-ask spreads in a liquid option market.
The stock entry rules are now tuned to very tight entries. Apply the bullish rules for call options and the bearish rules for put options.
The stock exit rules are now tuned to very tight exits. Apply the bullish rules for call options and the bearish rules for put options.
Note that if you sell options that get exercised the IRS may want to
to report the trade differently from a simple stock purchase or
sale... Check publications at the IRS
website.
These strategies essentially sell time, volatility, and fear.
It is a fact that most option positions lose money, and corolary to
that is that options are to be sold instead of bought.
Bear in mind that many losing option positions are strategic, OTM
calls to protect short positions from upside reversals, OTM puts to
protect long positions from downside reversals.
It is also said that if you buy OTM options you will, sooner or
later, end up out of money. Extend that thought to selling OTM
options...
Buying options gives you a right, selling options assumes an
obligation. You must deliver stock for short calls, you must buy
stock for short puts.
Except under certain circumstances, you usually only want to sell
options with 6-10 weeks of time left, usually the front month, often
the next month.
Unless your account is quite large by most standards, you cannot be
short of call options unless they are covered. They may be
covered by shares of stock (usually a Level 1 option strategy that can
be done within an IRA), or by other call option contracts
(spreads). When a stock has been on a run and pauses you can sell
a covered call for a while to profit from the time and depth of the
pull back. Cover the short calls on a support bounce unless you
want to have the stock called away.
Naked Puts, covered by cash or margin (a Level 1 strategy that can
be done within an IRA) can be sold, but it is often best to cover them
with another put option (spreads) or sell covered puts against a short
stock position - the reverse of covered calls... Cover short puts
on weakness unless you want to buy the stock.
These strategies succeed when the underlying security remains on the
safe side of the strike sold (low for calls and high for puts).
These use a short and long option of the same expiration month and
different strikes. Credit and Debit spreads have the same risk,
the difference is in paying the maximum loss up front, or taking the
maximum profit in advance. There are 4 basic vertical spreads:
Variations of these include additional long options (called a ratio spread) which allows you to profit from directional movement in the underlying price.
Another variation is to use a Bull Put Spread to finance a Call
option. This creates a risk profile that synthethises the gains
of a deeper ITM call.
Selling a Put and Buying a Call with the same strike and expiration
is a synthetic long stock position. You may not want to sell a
naked put, so you could use a Bull Put Spread.
Selling a Call and Buying a Put with the same strike and expiration
is a synthetic short stock position. Since you probably cannot
sell a naked call, you need to use a bear call spread.
In both of these strategies, bear in mind that you have a bid-ask
spread for each option, and you likely pay double the bid-ask spread of
a simple option trade when 2 legs are involved, and triple for 3 legs...
Note that the Theta of the credit spread offsets some of the Theta
of the long option, and the Delta of both positions is in the same
direction, so the net effect (profit and buying power/margin effect) is
the same as buying a long option that is deeper ITM. It has the
same net risk of the deeper ITM option, which is usually reduced
risk, and a lower cost of entry... Bear in mind that you are
paying 3 bid-ask spreads on 3 separate options, though, increasing the
cost of the trade in less liquid securities.
In general you should sell options when you do not expect a stock to move quickly or you expect it to be range bound. Directional trades are much more profitable in general, and much more quickly.
In addition the underlying should
be heavily traded to create a liquid market.
There should be good open interest and/or volume on the options for
the candidate security, at least in the front month, to create tight
bid-ask spreads in a liquid option market.
Using the Bull Put/Call and Bear Call/Put synthetic positions described above may provide a lower cost entry for a directional trade. It will have the same risk profile of the deeply ITM option, though. Note that the Theta of the credit spread offsets some of the Theta of the long option, and augments Delta, hence synthesizing the effect of a more deeply ITM long option.
Sell covered calls if your stock position stops moving up. Not
necessarily on the first sign of a flag. If you want to keep the
stock then be ready to exit if the trend resumes, if you don't want to
sell the stock then don't sell a covered call.
If you are trading a synthetic position, use the same entry rules as the corresponding directional option trade.
If you are entering an ATM or OTM debit spread, which is a directional trade, use the same entry rules as the corresponding directional option trade.
If you are entering an ITM debit spread or a credit spread then you mainly want the underlying security in a price range, it is best to confirm a support bounce for a bullish spread or a resistance bounce for a bearish spread, and the cost/premium are related to the underlying price, but the conditions for entry are less sensitive to price than directional trades.
If you are entering an ITM credit spread, then you may not clearly
understand the principle, or you expect some price movement, or you
want to be exercised. Nontheless the short option can be
traded ITM or ATM in pretty much the same way you would manage a long
or short stock position. The only differences being that Theta
works in your favor for covering the short call, and the strike price
and Delta limit your gains. Use the stock entry and exit rules,
but you may not need to take profit if the underlying moves OTM - which
should be your target direction...
Option Expiration week can be quite volatile, if you have options
expiring then watch Gamma closely, cover short options that are near
worthless - it just isn't worth the risk of keeping them.
If you have a covered call that is ITM near expiration then consider
rolling up and/or out to the next month, or buy back the call option,
unless you want to take profits on the stock.
If you have a short put that is ITM near expiration then consider
rolling down and/or out to the next month, or buy back the option,
unless you want to buy the stock.
If you have any short OTM option near expiration, then consider
rolling out or closing the position to eliminate the risk - it's just
not worth riding it to zero, cover at a nickel...
If you are trading a synthetic position, use the same exit rules as
the corresponding directional option trade. You do not need to
close the long option - it can serve as a lottery ticket if there is a
strong reversal in the underlying price before expiration, and will
probably be next to worthless if you get the strong price move you
want...
If you are entering an ATM or OTM debit spread, which is a
directional trade, you can use the same exit rules as the corresponding
directional option trade. However, so long as the short option
remains OTM you don't need to exit if the underlying flags against
you. Theta is working in your favor. You might consider
covering the short option on an unacceptable loss (say 25% price rise)
or when you can cover it providing most (say 85%) of the gain from the
initial credit. If the price initially moves in your favor then
move the stop to breakeven...
Another rule of thumb is if you have made more than 50% of the
possible gain in less than 50% of the trade lifetime then take the
profit and find another trade. The reasoning here is you entered
a trade for $1 risking $4 with 4 weeks to go, now you are in a trade
worth $0.5 risking $4.5 with 2 weeks to go. If you would not
enter that trade in the first place why would you stay in it now?
If you are entering an ITM credit spread then you
mainly want the underlying security in a price range. You may
want to close the trade on an unacceptable loss (say 25% of the risk)
and also when you have reached most (say 85%) of the maximum profit
from the trade. This reduces risks when in expiration week, and
frees up funds for the next month to trade. Move the stops with
the stock price action.
If you are entering an OTM credit spread then you
mainly want the underlying security in a price range, however, so long
as the short option remains OTM you don't need to exit
if the underlying flags against you. Theta is working in your
favor.
You might consider covering the short option on an unacceptable loss
(say 25% price rise) or when you have most (say 85%)
of the gain from the initial credit. Consider using a trailing
stop or just moving the stop order with the price of the underlying.
At expiration Delta must be either 1 or 0, this means that Gamma can
move dramatically near the money. Because of the obligation of a
short option, even if it seems far out of the money, it is worth
covering or rolling when you get into the week of expiration, unless
you want to be exercised. TOS does not charge commissions for
covering short options under $0.05 per share. The lesson for this
is a position in 1987 that was over $20 OTM and completely worthless,
but the next day things fell apart and not spending a nickel or even a
penny cost them $90K...
These strategies are generally slow strategies for securities in holding patterns.
A calendar spread includes holding a front month short option and a long option at the same strike price expiring in a later month.
A diagonal spread includes holding a front month short option at one strike price, and a long option at a different strike price and expiration month.
These strategies tend to neutralize Delta near the short option,
reducing price sensitivity. If the underlying moves out of the
profitable price range of the spread you may need to adjust by rolling
the short option up or down - therefore if there is a bias to the
direction you expect the underlying to move you should select an option
type that provides credit for those roll actions.
Perhaps you want to exercise the long option if it moves your way -
then you can roll the short option for a debit to adjust the Delta.
A security has made a significant correction and has been forming a
base. You expect the stock to move up, but maybe not right
away... Buy a long call option with a strike below the base, and
sell a front month call option above the current price. Until the
stock breaks out and starts running you will profit from Theta and,
probably Delta. At some point, though, if the stock runs up far
and fast you might make more money from the long call and decide to
cover the short call, even at a loss, to gain from the directional
trade. When the run pauses you can take profits or sell another
short call to get value from Theta while the stock decides to pull back
or keep going...
You can buy more than one long call and cover it at different strike
prices to increase the profitable range of the spread and reduce
sensitivity to price in a volatile underlying security in favor of
Theta.
You can also use these to subsidize the cost of a simple long call
option, benefiting from both time decay and directional volatility...
Up to the month before the expiration of the long option you can
roll the short options in time and in price to adjust the trade...
Note that this is tantamount to calling a bottom, one might throw on
a put calendar and cover the short put if the stock breaks down and
continues.
This strategy can also be played with puts if you expect a security
to go down, but don't know when - cover the short put when the move
begins...
If the stock starts to go down you can buy a long put or two which
sets delta absolutely flat or slightly negative. This can allow
you to wait for a few days to see if support holds or the stock
breaks...
A security has been in a horizontal channel for some time, it has
volatility within that range making it hard to profit from simple price
movement....
You can buy long put options at strike prices spanning the price
range of the stock, typically 6 months out - remember the stock should
have been in a range for at least a year or so...
Then sell front month put options at strike prices to adjust the
risk profile for maximum of Theta and minimum of Delta...
No matter what the price of the stock does within the range you are
making money in either the long puts or the short puts. Each
month until the month before the long puts expire you roll the short
puts out to the next month, profiting from the higher volatility
typical of the front month.
If the stock is put to you then you may sell the stock and then sell
another put for the next month, or you can keep the stock, able to
exercise the long put you have for protection, and sell covered calls -
this depends on the profitability of the covered calls and the
probability of the stock entering an uptrend - a directional trade will
be more profitable...
If the stock moves down out of your range then you may roll down the
put options. This incurs an additional debit but allows you to
take the price change back out of the long puts later, normally at a
good profit compared to the debit...
If the stock moves down strongly then cover the lower short puts and
let it run... You can then either exit the trade with directional
profit, or sell new puts to flatten delta around the new price base...
If the stock moves up then you can exit the trade, or you can roll
the short puts up. Note that this creates a credit spread,
however, which can significantly increase the risk of loss in the trade.
Since this strategy is relatively insensitive to price movement the entry rules are a bit more loose.
If you are trading a Call strategy they you may want to wait for proven support to buy the long call, and sell the short calls later if the price stalls after the bounce...
For the more neutral strategies you are not concerned with price
movement, you can set entry rules if you like, but our experience is
that it doesn't matter so much.
Each month you will need to roll the short options, this may require
an additional debit or provide an additional credit if you roll
vertically as well.
Within the month you may need to adjust the position by adding
vertical spreads too roll vertically within the month. This may
involve additional debit or credit depending on the direction.
Exit if the trade cannot be adjusted by rolling the strike prices in
play. Exit at the expiration of the long options, or at the
expiration of the last short options.
If you have diagonal spreads then you might get one additional month
by ending with a vertical spread, if that makes sense in the context of
the specific trade.
Above we have described the basic rules are are testing and experimenting with as an overview. We'll add a few from time to time, but those basic rules provide strategies for manking money in any market condition.
We each have a ROTH IRA and a Rollover IRA, so that is 5 accounts we have to manage, and 2 savings trade accounts, so 6 accounts in all... Our retirement funds are divided into roughly equal chunks. Eight of those chunks (all 8 in the smallest account) are currently allocated for market ETF investment. The remaining chunks are for single stock or option investments. We have far more money for retirement than we do for savings, and this becomes a problem in generating meaningful amounts of cash to live on today...
We use Think or Swim (TOS) and we use TD Ameritrade (TDA). TD
Ameritrade we use for stock and ETF trades only. We have had
issues with option orders executing at Ameritrade, I guess it is just
too complicated for them, besides their commissions are very high
compared to TOS. But that makes 6 accounts to manage...
We do trade option strategies in our IRA accounts, TOS allows you to
trade any strategy with defined risk and cash to cover it. Don't
play with fire unless you really know the chemistry...
So why are we still at TDA at all? The lure of automated
trading. Strategy desk is a powerful tool for automated trading,
but our testing indicates some rudimentary flaws with the whole idea as
implemented for now. Your technical strategies are easily encoded
with a simple language (well, I am a software engineer) to trigger buy
and sell conditions. The same language can be used to create
chart studies and alert conditions. Back testing these strategies
on whole populations of stocks is easy to do and fun to do, because the
back testing works so well...
Therein lies the rub - there are subtle differences between the
market in real life and the market in historic 1-minute bars.
There are also differences between what the code returns for historic
prices and what it returns in the live market. Just one example
is when you mix day and week bar studies, in the live market the bar
week close study returns the current stock price, but in back testing
it returns the closing price at the end of the week -- I assure you
that if I knew the price a stock closed at on the end of the week, we
would be embarrasingly rich, anyone would, but the fact is you don't
know that...
Oh, yes, I had an interesting experience entering an order ticket
through Strategy Desk. The stock was between my buy and limit
prices, so I just set a market order. I stepped into another room
for under a minute and returned to find no position in place. I
logged into the website and saw no position, I checked the order
history and saw no order. I went back to Strategy Desk and it
looked like the order had been entered, but not executed. I went
back to the website and saw the stock was there, and now the order was
there, and now the position appeared in Strategy Desk... I
checked the time carefully and found that, indeed, the order I entered
in Strategy Desk was not recorded until almost a minute later, now that
is really timely for automated trading, isn't it.
So, being an engineer, I waited for a stock I wanted to indicate a
buy signal, it moved up and started to pull back a little, so I entered
a limit order and an alert, and I waited... Now in the TOS
platform I watch the price of the stock in real time as it drifts down
and passes my limit (the alert triggers) by about a dime and then
bounces back up never to look back... The limit order from
strategy desk was then registered and never executed because the price
had already been there and gone in the almost a minute it took to get
into the system... About an hour later the stock begins to drift
down towards my upper limit to enter this trade, so I create an alert
on Strategy Desk, and I enter a limit order through the website, just
pennies before the stock got there... I see the TOS platform
display the price as the Strategy Desk alert sounds, and refresh the
web order status page - bang, it was there and had executed...
Lesson Learned: If you really want an order executed NOW at
TDA, then use the website. Strategy Desk is great for complex
alerts language, and it is a fun toy for back testing and fine-tuning
strategies that simply won't work the same way in the live market.
Now this is just our experience, well some of our experience, and
Your Mileage May Vary... TDA has that actor who played a really
honest and devoted lawyer on TV, so trustworthy, go ahead...
You can use any brokerage you want. This is just what we have
observed, and that was in 2008, so it may be completely different now...
We use the TDA Strategy Desk for alerts so we do not have to be
watching the computer every moment. Then we make our own trade
decisions and trade the moment on TOS.
We trade the rules described above, with long positions in Stocks
and ETFs. Our IRA accounts get 8 blocks devoted to ETFs
selected for current performance based on which markets, which sectors,
in broad baskets, are doing best at the time. If there is a
better trade forming, we'll pull out of a weak investment on weakness -
the slightest weakness, and move it. We don't do this lightly, we
allow trends to form and become clear before we break out the cutlery.
The largest chunks of our money are spread in broad baskets and
strong stocks.
Since volatility strongly affects option prices, it should make
sense that all strategies are damaged when volatility changes.
If you expect volatility to increase then use strategies that are
long of volatility and profit from its increasing. If you expect
volatility to reduce then use strategies that are short of volatility
and profit from its deflation. For example, say it was September
2008 and you expected the market to go down, but did not know how much
it would go down, so you employed a Bear Call (Credit) Spread with
strike prices in October. You got more than you bargained for,
but as the market dropped into the abyss you find the short call
options are holding their value, and your spread is not improving in
value much. This is because volatility is going up as the market
falls and a vertical credit spread is short of volatility. If you
were long of a put option, which is long of volatility, the value went
up as the market went down, and went up further as volatility increased
dramatically. On the other hand, if you had bought a call option
on November 21, 2008 its value went up as the market went up, but not
as much as you expected because volatility was falling. If you
had sold a Bull Put (Credit Spread), on the other hand, your profit
increased as the market went up, and moreso as volatility fell.
Short options benefit you from decreasing volatility, their value
goes down so it costs less to cover them. Vertical Spreads,
particularly credit spreads, benefit from this. Debit Vertical
Spreads also benefit somewhat - while the long option loses value, the
short option is cheaper to cover.
Long options benefit you from increasing volatility, their value
goes up so you profit more selling to close. Calendar Spreads are
good for this, as are Diagonal Spreads, and simple Long option
positions.
If volatility is steady in general, then options are typically
perfectly priced, so timing is everything with long options and you are
faced with the statistic that most option trades lose money...
A Bundle of
Strategies Played Together... The idea is to keep a long call for
directional trades, but always be making money from theta decay and
provide protection from downward price movement.
Say the market has pulled back significantly. Say the market
is no longer plunging, but is not in a jaw dropping rally,
either. Say the market is just flailing about. A few stocks
are holding value, waiting for an excuse to rally, but nothing is
moving strongly...
You have a list of stocks you know should recover value as the
market finally begins to recover, and they have established some
strength by setting higher lows and higher highs, they may run or they
may flail with the market...
After a significant correction, like late 2008, things really do
eventually turn up, but they might no move far or quickly...
Wait until you see a higher low and a higher high (on daily candles)
and then start the trade:
(1) Use a Bull Put Spread to
subsidize a longer term call option, probably at least 2-3
contracts... Then the dance begins...
Over time you expect to profit from price action on the long calls,
but there may be a winding path along the way...
Follow your basic rules for each leg of this trade.
(*) If the call is quarterly
or LEAP, then if the trade runs long enough you may roll it out (or up
and take profits) to continue the trade.
(*) If the price action
continues as you like then roll the Bull Put spreads out and up to
continue to benefit from Theta Decay... Those long puts may come
in handy later on, if things go sideways (or even down...).
Let's say the stock stalls... Your Bull Put Spread is doing OK, but
your long call is bleeding away (Theta Decay)...
(2) So after a few days,
sell a covered call. A few more days, sell another, make Theta
positive... You may choose to cover all the long calls, but that
also puts a hard lid on long term profits if the stock runs quickly...
(3) Say the stock starts to
flag a little bit, probably you do nothing, but if it is far enough,
maybe roll down one of the short calls for instant credit and to move
the profitable range for Theta down...
At this point the stock may fail(5), rally(4), or hold value.
If it holds they you are set... Roll the short calls and the
bull put spread if they expire, and let Theta decay work in your
favor...
(4) If it rallies than you
should cover the lowest call quickly, to benefit from the price rise.
If it continues to run up then cover the higher calls quickly for
profit, and allow the directional trade to run while you profit from
Delta...
When the stock pauses again then go back to step (2)...
(5) If the stock begins to
fail, don't panic. First Cover the short puts from the Bull Put
Spread. You should find that the short calls and remaining long
puts effectively neutralize price sensitivity.
Note: If you don't have a bull put spread supporting the call,
then buy a long NTM put or two to neutralize Delta...
This gives you several days to watch the price action. At this
point the stock can find strength (6) or continue to fail (7)...
(6) If the stock bounces
above the strike of your long call then you are doing great...
Either sell the puts for profit, or create a new Bull Put Spread and
cover any short calls, all of which should be profitable trades
now... Back to step (2).
(7) If the stock continues to fail then you may reach a point where the loss on the long call is too great. Sell the calls trades and keep the long puts until there is strength.
When the stock bounces then you should take any profit from the long
puts immediately.
If you sold the call side of the trade, then you may consider
starting a new trade here, go to step (1)...
If you didn't then you should cover the short calls which should be
profitable. You may also consider rolling down the strike to
below the new support level, putting on a new bull put spread, and
going back to step (2).
Below is a chart of Q4-2008 for Jacobs Engineering...
On 21 November it found a solid bounce with the rest of the market,
and started into a bull flag on 1 December. The broad market
rally on 5 December along with a bounce up off a moving average
provided the entry point:
At this point we just wait to see where the stock goes, So far we
have profited from a short put and 3 short calls. Volatility has
deflated, and we are about even on the Apr Call...
In the sections below we document the specific rules for strategies
we are trading now with paper and/or real money.
Based on Vertical Spreads above we have done some extensive backtesting on this specific strategy and are running with live money in the right circumstance.
These rules include discretionary exits which can limit
gains though they are intended to mitigate losses.
We show the study set we use and a handful of entry/exit
points.
These are the rules we back-tested. The live rules running on the
Strategies page may have changed...
Below is the study set we generally use for this strategy. We
have
1% and 2% above the high and below the low included as helpers, the 10,
30, 50, and 200 SMA, and an SMA envelope shown on the 30-DMA with a 3%
offset, but we'll commonly change that, using different averages as
needed adjusting to trends on particular securities.
You will also see an EMA Bollinger Band light in the background and
also the $SPX index light in the background. We use candles and
the
averages more than these, but have them for reference.
We use the Investools standard MACD and Stochastic studies, but also
use Slow Stochastic (80,20) which has served us well.
We also use Accumulation/Distribution, On Balance Volume, and Wilder
RSI as supporting indicators, but rely more strongly on candles and
averages - everything else is just supporting evidence.
In the chart I have identified some potential entry/exit signals:
Stock or ETF that are range bound or reversing are best. For
stocks
an Implied Volatility of at least 35% seems to be needed.
Backtesting
of DIA suggested that only about 16% Implied Volatility was needed to
find the desired range in premiums for risk.
If the stock is strongly trending then apply a more directional
strategy.
Backtesting was with trades having a maximum risk of $1000 to $1500,
typically 3 contracts. We prefer not to risk more than 2-3% of
the
total portfolio or 5% of the specific account.
We are looking for a gain of no less than $0.66, typically $1 to $2
on a strike spread of $5 - Minimum Max Gain of 15%, typically 25% to
67%.
Evaluate trade daily, reconsider normal exit or adjustment points.
Also consider discretionary exits; if there is no compelling reason to exit, let it run, compelling reasons include:
Set up orders or alerts for the following day. Backtesting
generally suggested use of alerts - triggers would often be tripped at
bad exit points, but waiting often produced a better exit point.
Evaluate the recent population of trades (say last 3-6
months).
From the backtest population of 200 trades we have the following
expectations:
Allowing 2 Standard Deviations the average gain may be from (6.3%) to 29.5% (Average +- 2
Standard Deviations). The larger the population the less volatile
the result will. be.
If the win/loss, or the normal/modified exits, change more than
about 5%, or the return on risk changes by more than about 10%, then
re-examining the strategy may be in order...
Smaller populations will be more volatile and more likely to deviate
from the normal population.
Bear Call on bounce from resistance. Bull Put on bounce from
support. Avoid Counter-Trend trades. Avoid Earnings and
Splits.
Use the "preponderance of the evidence" from technicals, but act on
candles when supported. If no specific candle
pattern then use flag price patterns for entry.
Prefer entry to NTM/ATM spreads on bounce triggers. Bounce triggers include:
Also breakouts with caution:
Create a GTC order to cover the short option at $0.05 (no commission at TOS). Back testing suggests this will be the exit around 1/4 of the time.
If not using a stop order, then set an alert at a price to allow evaluating an exit order before hitting the stop.
If using a stop order then make it an OCO order with the other
order. Back testing was generally done covering the short option
at
the stop and holding the long option until another reversal signal.
Instead of stop, consider adjustment, typically by applying a butterfly to roll the strike up/down.
Also consider rolling out in time if the trade is moving slightly
bad.