Investoid

Today the Fed did the (slightly) unexpected and dropped their target rate by a half percent. The market has subsequently rallied a couple percent off this news.

I was listening to BNN and watching the DIA options closely. Once the news broke, DIA went up about one dollar and hit resistance around 136. Meanwhile the 136 Sept call option was only up to an 0.80 ask price, so I thought that was a good exit point for this option given the potential upside on the Dow. I decided to hold onto the 138 option to see if DIA would break the resistance and if I could use my defensive measure to reduce the loss. A short time later the stock began to increase above 136. I looked at using my stated defense, but found that it was best to exit the trade entirely since the gains from the 138 option were greater than selling a 139 or 140 option, given that I’m not sold that this rally will last beyond the close. The 138 option could have been sold for 0.30-0.35 cents, depending on whether one took the bid price or went in the middle of the spread. The net exit for this trade was a 0.45 to 0.50 debit.

In the worst case this trade would have lost 0.10 per contract (before commissions, which are an important factor the smaller your lots are), which isn’t that bad given that the underlying went in the wrong direction. It was a good learning opportunity and made me reconsider whether I should stop looking at speculative trades and start focusing on more ‘income’ style plays that other option traders look for. The journey continues…

I’ve been looking at this trade for the past couple of days, based on my belief that the Federal Reserve will not cut their rates more than 25 basis points next Tuesday. As a result, I expect the markets to be disappointed, or at the very least muted based on the Fed’s decision. Even if the Fed gives the market a half percent cut, this has already been priced into futures prices, and thus I doubt there is much upside regardless.

As a result I am looking to take out a bear call spread on the Dow Jones Industrials ETF, DIA. I want to open a 136/138 bear call spread for a 0.40 cent credit per contract or better. I plan on holding until after the Fed decision, but not until expiration. Based on current option prices, I want to fill this at 55 cents and 15 cents respectively for each option.

If the Dow does start to go up and gets close to or goes through my short option strike, and the market looks like it will continue to climb, then I have a defensive adjustment planned. I’ll be looking to buy back that option at a loss and sell some 140 or higher options, turning the trade into a bull call spread. My thinking is that if the market continues to go up I can partake in the upside a bit and eke out a profit, but if it goes back down I’ll capture the additional funds from the higher options that I short, thus limiting my losses.

Note: I will only be paper trading this strategy, since my current broker forces you to go long first and then short on option spread trades. Since the short contract has a dime spread on it, I don’t want to risk that the market will move down while I’m holding the long position while waiting for the short position to be filled. This is really frustrating and as a result I’ll be moving brokers right away. I am thinking about OptionsXpress, but if anyone has comments on it, Interactive Brokers or others who are good for option trading, please let me know.

I will update this trade next week once we’ve seen what the market does.

Note 2: This is not a recommendation for anyone to perform this trade. Please see my full disclaimer.

As I am becoming immersed in the option trading world, I have come across some pretty good blogs dedicated to option trading. Here are my favourites:

• Option Pundit: is dedicated to providing consistent income through option trading. Earlier this year Option Pundit (OP) started a paid newsletter that details his portfolio trades, which have demonstrated extremely strong returns. He now has a goal of achieving 100% annual returns, and is well on his way. OP uses a variety of option strategies, although he seems to favour credit trades (ie. initial trade causes him to receive money, instead of outlay money). While the English suffers at times, the quality of the content is unsurpassed.
• Option Addict: a blog run by Jeff Kohler, an instructor for InvesTools. He is mainly a directional trader, meaning he looks for strong 3-6 month trends or other technical indicators in individual stocks and then waits for pullbacks/bounces to enter options trades. I haven’t read through his blog archives in depth, so I’m not sure if he favours buying calls/puts or using credit trades like pull put and bear call spreads. He offers several companies to watch on a regular basis, although he rarely (if ever) provides specific trade information.
• My Traders Journal: is written by a person who works full time at AT&T while finding option strategies to augment his income. He mainly focuses on writing naked puts, which can be a risky strategy if you don’t want to own the underlying. Since this strategy is synthetically the same as a covered call strategy, he uses it as a way to lower his entry cost to a stock he likes in the worst case while getting a steady income in the best case.
• Option Strategies In Action is written by Canadian John Manley, who runs a research firm. He talks about specific trades and setups in stocks and indices, and goes through trade adjustments in detail. He also focuses on credit trades for the most part.
• Condor Options: is a blog that discusses market happenings, and details the trades post completion that they do for their paid advisory service. They focus on iron condor trades on index ETFs, and have a pretty good track records over the past year. Even during this turbulent time, they were able to be essentially neutral this past month, which is pretty good for a strategy that is market neutral and depends on little movement either way. Their service currently has a waiting list.

If anyone has others that they like, feel free to comment below. I’m always looking for more information and opinions.

As I’ve mentioned before, when you trade options you are working with a product whose value will change in a non-linear manner with respect to the underlying. When you are working with out of the money options, this means that you will experience very high percentage changes to the option value for every dollar change in the underlying asset. However, the farther along the option chain you go into the in the money options, the closer the change resembles the movement in the underlying asset.

Take for instance a ‘deep in the money’ (DITM) option. Let’s say you have a stock worth $50 and you buy a call option with a strike price of $40. That means that right now, the option is worth $10 + some time value (which depends on its expiry date). If the stock declined to $49 in one day, in theory the option value would decrease to $9 + time value. If the option has a far away expiry (at least 4 months, preferably 8-12), then it is likely the option value would only go down $1 since the daily time decay on such options is very small. Similarly, if the stock rose to $51 then the option is now worth $11 + time value. In option terms, the option’s delta is very close to 1.0.

Since these options behave very closely to the underlying, if you hold a DITM option you essentially have a long (or short) position in the underlying, until such a point that the stock has moved closer to the strike price (ie. against your position). When you’re buying a long term DITM option, you are making a leveraged buy or short decision against the stock. This leverage ratio can be greater than what your broker would provide you on margin, and does not have any interest to pay. It is an interesting strategy to use if you are bullish or bearish on a stock with liquid options.

Lenny Dykstra uses this strategy and chronicles his trades in his thestreet.com column. He has a pretty good track record when using this strategy, although as of yet it isn’t that long.

There are a couple of things you need to watch out for when using this strategy:

• Don’t buy these options at the ask price. Longer term options are relatively illiquid and will have bid/ask spreads of at least 20 cents. Place a limit order at a price you like and make sure you adjust it if the underlying moves significantly.
• Determine your stop loss and profit limits for these trades. Since you are highly leveraged, a small move in the underlying can make a big difference in your return. I haven’t used this strategy yet, but I’d be looking for a max risk of about 15% with similar upside (ie. risk reward ratio of 1).
• Look for options whose time value seems reasonable, meaning that implied volatility isn’t too high. Compare prices across expiry dates as well as strikes, to find a reasonable entry point.

I am thinking about using this play on a short basis against the US Real Estate Industry, via Dec 07 or Jan 08 put options on the iShares ETF IYR. Today the index was higher but gave up its gains. If another rally occurs without any material change in the fundamentals of the space, I’ll be looking to make an entry.

One of the most important concepts in options trading is that of adjusting a position. Since you’re dealing with derivative instruments they behave in a non-linear fashion with respect to the underlying security. As a result, you can have great percentage changes in your position based on movement in the underlying. Since we’ve had so much volatility recently, your position can go very quickly for or against you. But it doesn’t always make sense to simply exit a winning or losing position. Instead, you may want to make some adjustments to your trade and lock in some gains or to counter the losses.

For instance, I purchased a 27.5/30 Aug strangle on Cisco (CSCO: Nasdaq) to capitalize on an expected move due to its earnings announcement. I purchased the options well in advance, since the implied volatility of such options historically increase greatly as the earnings date approached (and subsequently crashes after the announcement). I was planning on holding the straddle until only before the earnings date, and take advantage of the increase in the implied volatility (which increases the value of the options). I was hoping that the stock would move a bit as well to put one of the options in the money.

In the end, the stock approached 30 before the earnings date but still hadn’t crossed it. My position was slightly positive (I was up about 5%), and so I was faced with taking a small profit or gambling that the stock would move greatly after the earnings and make up for the loss in value that was sure to occur by the reduction in implied volatility. I decided to take my profit, but I needed to have at least one of the options sold at the ask price (as opposed to the bid) to make it worthwhile. I placed two limit orders and was going to cancel one and make it a market order once the other hit.

Unfortunately, I got distracted at work and didn’t get back to the trade until right after the markets closed. One of the orders hit, but the other didn’t, meaning I now had a directional position that I didn’t want. Cisco rocketed up after hours and instead of a mildly profitable trade I had a losing position (mental note: look for a broker that has special order software for multi-option positions).

Instead of exiting my position, I should have been looking at an alternative that would have reduced my risk in exchange for more limited upside. As I thought about the trade last night, I realized I could have sold some 32.5 calls (and possibly some 25 puts) for a credit (cash to me), meaning that I would have increased the current profit on my trade. This would have converted my position into a short (the wings) iron condor. If the stock hadn’t moved that much and stayed between 27.5 and 30 after the earnings announcement, I would have only lost a limited amount of money compared to what I would have lost with only having the strangle. If the stock moved up even a little, or down substantially (over 10%), then I would have made some pretty decent money but less than if I had kept my existing position. The reduced profit would have been well worth the peace of mind that would have come from me not having the proper trades in place (or time to monitor them) to exit my position.

Adjusting positions over time to account for changes in your opinion, strategy, or the movement in the underlying is an important lesson to learn. This one was an expensive one for me, but hopefully I’ve figured out when the realize it’s better to modify that exit entirely.