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This strategy can be quite rewarding for a steadily bullish stock. The construction of the trade begins with purchasing an ITM call 6-8 months out in time. The purpose of the ITM purchase is to create a stock substitution position with the long call. Because the call is so far ITM (Delta of at least .80 or better), the option moves almost in lock step with the stock at a fraction of the cost of the actual stock.
The trader then sells front month calls in order to reduce the cost basis of the long call and produce income. The strategy is in essence a covered call, but instead of using stock you use the deep ITM call. Remember that a large portion of the deep ITM call contains intrinsic value which is not susceptible to the ravages of time decay. A word of caution, Vega (the greek that measures sensitivity to implied volatility), is greater in long dated options, so LEAPS will be more vulnerable to IV.
Review the risk graph and you should gain more insight into the risk and reward of the position. Best, Robin
MONDAY 7/20
Leading Indicators
TUESDAY 7/21
None
WEDNESDAY 7/22
Crude Inventories
THURSDAY 7/23
Initial Claims, Existing Home Sales
FRIDAY 7/24
Michigan Sentiment-Rev
EARNINGS OF NOTE
MONDAY 7/20
BSX, BRO, CNI, HAL, HAS, JCI, LM, TXN, ZION
TUESDAY 7/21
AMD, AKS, AMLN, AAPL, BLK, CAT, CHIC, CAL, DEAR, DD, FCX, GILD, HCBK, LMT, MRK, BTU, QLCG, SGP, STX, LUV, SBUX, SYK, AMTD, KO, UTX, UNH, YHOO
WEDNESDAY 7/22
MO, BK, CMG, CTXS, DAL, DPZ, ETFC, LLY, GSK, ISRG, KEY, NITE, MS, NE, NTRS, OMTR, OSIP, OSTK, PFCB, PJC, SNDK, STJ, STLD, SU, BA, MOS, USB, USG, VMW, WLT, WFC, WHR
THURSDAY 7/23
MMM, ALK, AMSN, AXP, T, BLL, BMY, BRCM, BUCY, BG, BNI, COF, CELG, CME, CB, CIT, CS, DECK, DO, EMC, ECA, FITB, FLIR, F, GR, BLUD, IGT, ESI, JBLU, JNPR, KMB,KLAC, MAN, MCD, MSFT, NFLX, NEM, NUE, OXY, PM, POT, PFS, RMBS, RTN, RFMD, SWY, HOT, TRA, CAKE, HSY, TRAD, UNP, UPS, GRA, WYE, ZMH
FRIDAY 7/24
ACI, BIDU, FO, OXPS, SLB, TROW
The question was asked from last week’s commentary, “How can we maintain a constant risk factor when trading options?” Let’s once again assume that our constant risk factor is 2% of the capital invested of 16K per trade or $320.
We first determine the stop loss amount. I checked the Qs at about 8:30 MDT today (Friday) and the Qs were trading at $37.41. If we place our stop at the low of the prior day, the stop would be $36.72. Our stop margin is the difference between where the stock is currently trading and our stop loss. The resulting amount is $.69. If we are going long and decide to BTO the ATM August long call, we would first confirm the current delta (which was .57) That means that the theoretical change in the 37 strike August call for every $1 move in the stock would be $.57.
Whereas:
SP = Stock Price, SL= Stop Loss, RC= Risk Constant, SM = Stop Margin, D = Delta, ALPO = Allowed Loss Per Option, C = Contracts Purchased
The formula and math is as follows to keep our risk constant at $320:
(A) SP-SL = SM x D + ALPO
37.41 – 36.72 = .69 x .57 = .39
(B) RC / (ALPO x 100) = C
320 / (.39 x 100) = 8
The proof is as follows:
Cost of the 37 August call is 1.31. C x cost of the call = invested capital.
8 contracts x ALPO = RC
800 x .39 = 312- 320 (accounting for rounding factors)
We can now be assured that we can BTO 8 contracts on the Qs with the expectation of a bullish move in the ETF, but with the knowledge that if the stock doesn’t perform as anticipated, we will be stopped out at a stipulated loss of $320. You can set a contingency sell stop with your broker to close the option position when the stock trades at the stop loss level of $36.72. The stop triggers a sell order on the option and you are out with a $320 loss.
Remember that stops are not guaranteed. The market can blow through stops. However, you have a much better chance of being stopped out at your stop level when trading highly liquid, diversified ETFs like the Qs. Best, Robin
The DOW has broken through and stayed below the 50 and 200 sma. It has also broken below the neckline of a classic Head and Shoulders pattern. The break is not convincing, as the last three days have formed narrow range indecisive candles. From a fundamental perspective, I am looking for earnings season to give us definitive direction. This week GS reports as well as JPM. The CPI and PPI could also move the markets.
The SPX is bouncing along the 200 sma and has not yet broken the neckline of the Head and Shoulders. Should earnings act as a catalyst, we could see increased volume and follow through as the index decides upon its direction. The first downside target is 827 and the upside target is a retest of the swing low from 6/23 at 889 and then the top of the right shoulder of the Head and Shoulders pattern at 932.
The COMPQ has been consistently more bullish than the DOW or the SPX but has recently succumbed to bearish sentiment retracing to test support at 1754. The index is forming a Bear Flag. The trigger point to the downside is the low from 7/8 at 1727. If the COMPQ breaks that level on volume, we could trade back down to 1675. If the bearish move does not materialize, we could climb back to the bottom of the gaps at 1793 and 1824. If upside momentum prevails we could move beyond those gaps to the swing high at 1862
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This strategy entails selling to open ITM short Calls and Puts in the front month. This is a premium collection strategy and to be successful, the stock must remain stagnant. This is a credit trade and as such it has a limited reward and an unlimited risk on the upside as well as the downside. Review the risk graph and it will reveal the risk and reward profile of this trade. Best, Robin
ECONOMIC REPORTS
MONDAY 7/13
Treasury Budget
TUESDAY 7/14
Core PPI, PPI, Retail Sales, Retail Sales ex-auto, Business Inventories,
WEDNESDAY 7/15
Core CPI, CPI, Empire Manufacturing, Capacity Utilization, Industrial Production, Business Inventories, Crude Inventories
THURSDAY 7/16
Initial Claims, Net Long-Term TIC Flows, Philadelphia Fed
FRIDAY 7/17
Building Permits, Housing Starts
EARNINGS OF NOTE
MONDAY 7/13
OZRK, FAST, NVLS
TUESDAY 7/14
GS, INTC, JNJ, YUM
WEDNESDAY 7/15
ABT, CTAS, GCI, KMR
THURSDAY 7/16
CY, GOOG, HOG, IBM, JPM, MAR, NOK, NVS
FRIDAY 7/17
BAC, C, GE, MAT
If you use stop losses, make sure that you use them wisely and size your positions so that your amount at risk is constant. Most traders trade a binary system that yields either winners or losers. When trading that type of system, it is crucial to have a methodology that produces a slight edge. That edge should result in more wins than losses. However, even with a slight edge, the trader can lose overall if he/she has a poor or nonexistent money management system. The lack of trading success occurs because the losers can lose more than the winners. On the other hand, the trader can still be an overall winner if he/she has more losers than winners but cuts the losers short and lets the winners run.
The following is a simple position sizing procedure that can bring money management discipline to your trading. It can yield successful results over time if implemented with a reasonably effective trading system. Your expected loss should be defined as a net percentage of your portfolio per trade. Let us assume that you choose to lose no more than 2% of your trading capital in any given trade. With that information and a well defined stop loss, we can solve for the number of shares that should be traded.
EXAMPLE
Entry - $35.54
Stop - $34.80
Stop Margin = $.74
$2000 (max risk per trade) / $.74 = 2702 shares
If the trader feels confident that the stop will execute as planned, it would result in a loss of $.74 per share or $2000 ($.74 x 2702). After the initial stop is placed and the stock moves in a profitable direction, the trader may want to initiate a trailing stop in order to capture more gains.
However, we must consider that 2702 shares x $35.54 equals $96,029 which represents 96% of the trading account on one trade, which is totally unacceptable. Diversification of the account would suggest no fewer than five positions in differing Sectors and Industries. One should also keep an amount in cash in reserve for contingencies.
A suggested allocation could be five stock positions utilizing 80k of capital with 20k set aside in cash. That would translate to 16K per stock position.
Recalculation of the risk and stop criteria:
$320 (risk per trade)/ $.74 = 432 shares. If the trader initiates a position on 432 shares of XYZ stock and is stopped out for a $.74 loss per share, his/her resulting loss would be $.74 x 432 shares = $319.68, which is 2% of invested capital on XYZ.
The amount of planned loss never changes. Should the stop loss be wider than the aforementioned $.74, it merely reduces the number of shares traded resulting in the same 2% planned loss.
The second scenario is much more acceptable that the first example. We are now reasonably diversified in five stock positions with a well defined stop and cash in reserve for contingencies. An effective trailing stop procedure can also allow the winners to run and outpace the small strictly defined losses. Best, Robin
The SPX is flirting with a crucial level of support at 875. If it breaks this level on increased volume, we can expect the index to trade down to 825.
If you have been long delta, it may be prudent to consider getting more delta neutal and even a little short delta in anticipation of a bearish move. Make sure that any adjustments you make are within your risk tolerance and that you do your own due diligence. Best, Mark
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Buy ITM calls and puts 6-8 months out in the same expiration month. This is a limited risk strategy that can produce profits if the underlying moves significantly. The spread will always be worth the difference between the long ITM call and put strikes. The small amount of extrinsic value that exists in the position is exposed to implied volatility and time decay.
It is suggested that the position be given enough time to achieve a substantial move one way or the other which is the reason for buying long dated options. One may even consider LEAPS. It is also suggested that one consider selling front month OTM puts and calls against the position in order to reduce the cost basis.
Study the risk graph and you will gain understanding of the risk and reward of the strategy. Best, Robin
ECONOMIC REPORTS
MONDAY 7/6
ISM Services
TUESDAY 7/7
None
WEDNESDAY 7/8
Consumer Credit
THURSDAY 7/9
Initial Claims, Wholesale Inventories
FRIDAY 7/10
Export Prices ex-ag, Import prices ex-oil, Trade Balance, Michigan Sentiment-Prel
EARNINGS OF NOTE
MONDAY 7/6
None
TUESDAY 7/7
RT
WEDNESDAY 7/8
AA, FDO, PBG
THURSDAY 7/9
CVX, FC, HELE, SGR, VALU
FRIDAY 7/10
INFY
ETFs (Exchange Traded Funds) provide instant diversification in your trading. Trading an ETF can result in a basket of stocks that allows the trader to capture the movement of a specific sector or index with one click of the mouse. Many ETFs are highly liquid with literally millions of shares exchanged daily and with $1 strikes and narrow bid/ask spreads. The ETF allows the trader to also escape specific company risk which is appealing in this unstable environment.
A survey 840 investment professionals conducted by State Street Global Advisors and Knowledge@Wharton, the online business journal of The Wharton School at the University of Pennsylvania revealed that “67% of the advisors identified ETFs as the most innovative investment vehicle of the last two decades and 60% reported that ETFs have fundamentally changed the way they construct investment portfolios.” The survey went on to say that “The top five most appealing characteristics of ETFs as ranked by the financial advisors include:
1) Low Cost
2) Liquidity
3) Intraday Trading
4) Tax Efficiency
5) Investment Style Purity *
It may be worth the effort to explore the world of ETFs. There are more ETFs being added every year. You have the ability of investing in the major indexes, emerging markets, specific economies, sectors as well as inverse plays on the indexes. ETFs have certainly come of age. Best, Robin
*Source, Business Wire, a Berkshire – Hathaway Company June 10, 2008.
As indicated in last week’s post, a break of the swing low of 8461 on the DOW would likely set up a retest of the bottom side of the consolidation pattern from May, which is exactly what happened. We are now challenging the backside of the 200 sma and we are sandwiched between the 50 and 200 sma. The index could break either way out of this current consolidation. We are coming into earnings season soon and that could be the catalyst needed to move the market. The first target to the upside will be 8587 and then 8878. A break of the May lows of 8221 will portend a bearish move down to 8191 and then 7750.
The SPX successfully retested the 200 sma for the second time since breaking through to the upside on 6/1. We also got a bullish 50 sma crossover of the 200sma this past week. At 918, we currently reside at the double top from 12/8 and 12/17, 2008. Our first target is 930 from 5/18/2009 then 944 from 1/6/2009 and finally the recent high at 956. If the index breaks the Tuesday’s low of 889, we could go to the swing low of 879 from 5/15 and then the swing low of 827 from 4/21. I feel that 875 is stout support and it will be significant it breaks that level. I am still bullish.
The COMPQ is really the shining star!! I have maintained that the Tech sector will lead the way and it has. The index is bullishly above both the 50 and 200 sma. Immediate upside targets are 1880, 1897 and 1905. Downside levels to watch are 1793, 1773 and 1754. We are going higher!!
Week over week, the DOW is down 102, the SPX is off by 2 and the COMPQ posted an 11 point gain.
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A strap is a non directional bullish bias long option play. It is comprised of two calls and one put with the same strike and expiration. One may actually structure the trade with a greater ratio of calls to puts depending upon how bullish the trader wishes to design the trade. The risk is the debit in the trade and the reward is theoretically unlimited. Study the risk graph and you will gain insight into the risk and reward of this position. Best Robin
ECONOMIC REPORTS
MONDAY 6/29
None
TUESDAY 6/30
Consumer Confidence, S&P/Case-Shiller Home Price Index, Chicago PMI
WEDNESDAY 7/1
ADP Employment Change, Construction Spending, ISM Index, Pending Home Sales, Crude Inventories, Auto Sales, Truck Sales
THURSDAY 7/2
Average Workweek, Hourly Earnings, Initial Claims, Nonfarm Payrolls, Unemployment Rate, Factory Orders
FRIDAY 7/3
None
EARNINGS OF NOTE
MONDAY 6/29
APOL, HRB
TUESDAY 6/30
SCHN, ZZ
WEDNESDAY 7/1
STZ, GIS
THURSDAY 7/2
None
FRIDAY 7/3
None
There are not too many things in this life that are absolute. None of us are going to get out of this life alive, taxes are here to stay, especially now with record government spending and time will pass.
In the trading game, there are no certainties with the exception of theta. Theta is the greek that indicates the daily decay rate of options. If you are a holder of options, theta is your enemy because as each day passes, your option is worth less as time decay eats away at the value.
Because of the certainty associated with time decay as measured by theta, I prefer to be a seller of options. The certainty of decay is now working in my favor. I don’t need the stock to move and in fact, I would prefer it didn’t move at all. I can make money in all three market conditions, bullish, bearish or stagnant. I don’t need to hover over the trade and I can sleep at night. I can structure a program that will generate monthly income with a high degree of probability of working with a minimal need for adjustments.
If you are a seasoned trader, you may know of these strategies, but are they working for you on a consistent basis? Best, Robin
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