enewsletter In This Issue... May 2010 > DiscoverOptions Letter > Option Strategy of the Month: Bull Put Spread Dear Readers,

Size: px

Start display at page:

Download "enewsletter In This Issue... May 2010 > DiscoverOptions Letter > Option Strategy of the Month: Bull Put Spread Dear Readers,"

Damon Malone
5 years ago
Views:

1 In This Issue... Dear Readers, Wow, what a month can bring! > DiscoverOptions Letter > Much Ado About Something By Steve Lentz > Option Strategy of the Month: Bull Put Spread > The Importance of Back Testing By Ken Dole Steve Lentz Director of Education First, we started broadcasting the Morning Market Huddle again. Every Monday and Wednesday morning at 8am Central Time, I meet in a WebEx room with traders and OptionVue 6 owners to review an options trading concept and even look at a trade or two. We have a lot of fun, and the best news is.you are invited. Please check your every Tuesday and Friday for an invitation. If you do not receive one, then please call us and ask to be put on the list. Second, have the markets gone nutso or what? In this issue, we address the May 6th Flash Crash and point out some lessons for options traders. What a day that was.and what lessons it taught! As always, I d love to hear from you. Please or call me with any questions or if you are interested in our DiscoverOptions Personal Mentoring Program. We are here to serve you. Best Regards, Steve Lentz Director of Education Page 1 May 2010

MUCH ADO ABOUT SOMETHING By Steve Lentz Director of Education Thursday, May 6th, 2010 saw the greatest financial earthquake since well.2008, which really is not that long ago in human years.

Most notably, though, much of the drop occurred over the span of just a few Figure 1: May 6th, 2010... Quite a Day Figure 2 minutes.

20% before kicking in. Therefore, these were never triggered. The two-minute chart in Figure 2 shows just how far and fast the S&P 500 index moved.

2 MUCH ADO ABOUT SOMETHING By Steve Lentz Director of Education Thursday, May 6th, 2010 saw the greatest financial earthquake since well.2008, which really is not that long ago in human years. That day, a "Flash Crash" occurred, whereby the Dow dropped over 1000 points before rebounding and the S&P 500 index dropped over 98 points before coming back. Most notably, though, much of the drop occurred over the span of just a few Figure 1: May 6th, Quite a Day Figure 2 minutes. Yes, it was already going to be a very bad day for the markets, but this heavy drop occurred later in the day, shortly after the exchange circuit breakers widened their threshold from a 10% drop to 20% before kicking in. Therefore, these were never triggered. The two-minute chart in Figure 2 shows just how far and fast the S&P 500 index moved. Notice that the scaling is off and the reporting company did not get it right. The true low was So what is an active options trader to do? Keep trading as if nothing happened? Let's address two items: First, there's the issue of risk for the neutral premium seller i.e. the trader using Condors, Butterfly and Calendar Spreads. These approaches constitute the core of the DiscoverOptions Mentoring strategy list, and all three (continued on page 3...) Page 2 May 2010

3 (continued from Page 2) May 2010 perform well when the underlying market moves less actively than options prices imply. Our Personal Mentoring Program shows students how to scan for markets that qualify for these strategies. Now, days like May 6th can cause large losses if a trader had resting conditional market orders for his adjustment trades to occur automatically. During ten very short minutes, the S&P 500 went from 1125 to and triggered countless stops all across the financial landscape. No doubt we'll never know the true financial debacle this really was, but suffice it to say that bid/ask spreads widened to extreme levels and numerous traders were taken to the cleaners big-time. For example, options on the SPY often trade with $0.01 wide spreads between the option's bid price and ask price. Now, take a look at Figure 3 below. In the OptionVue Matrix in Figure 3, you can see that the Bid/Ask Spreads are just a wee bit higher than $0.01. What to do? We suggest using alerts instead of resting conditional market orders. That way, in the event of another "Flash Crash", you can explore whether the crash is for real (there was no crash-worthy news on May 6th) and then use limit orders to greatly better the fill you otherwise would obtain. By the way, in our DiscoverOptions Personal Mentoring curriculum, we show students efficient approaches to implementing hedges to help protect against 9-11 and Flash Crash occurrences. Second, there's the issue of authentic price action. Many of our DiscoverOptions students use our non-directional strategies to supplement their directional trading. Most of these traders analyze price charts to make decisions. May 6th presents a problem in that much of the price action was caused by unknown market forces. In OptionVue and many other charting programs, you may edit the price levels for the open, high, low, and closing values for any given day. We suggest you do so for May 6th, 2010 in order to obtain a more accurate feel for support and resistance. Clearly, the Flash Crash was caused by parties yet undetermined who do not constitute the real market of buyers who overrode the sellers to establish a low value for that day. In evaluating price action, we need to know the accurate low value for the day. What should you change the May 6th low price to? Figure 2 reveals that the Flash Crash began and ended when the SPX was around 1112 or so. From there, the market drifted a bit higher to finish the day. It makes sense, then, to change the low to Figure 3: SPY Option Bid/Ask Spreads (continued on page 4...) Page 3 May 2010

(continued from Page 3) May 2010 See how the next day, May 7th, had a lower low and established a support level for future reference?

This edit is easy to do in OptionVue 6 and we hope you consider doing it in other analysis programs as well. We remain alert to changing market conditions and events.

com at our booth at the Los Angeles Traders Expo!

4 (continued from Page 3) May 2010 See how the next day, May 7th, had a lower low and established a support level for future reference? Without this edit, then traders would look to the May 6th low instead (Figure 1) and possibly be deceived. This edit is easy to do in OptionVue 6 and we hope you consider doing it in other analysis programs as well. We remain alert to changing market conditions and events. Please call or me should you have any questions or comments. Figure 4: Edited Bar $SPX Bar Chart Visit OptionVue Systems and DiscoverOptions.com at our booth at the Los Angeles Traders Expo! Trading Technical Analysis Signals with Option Spreads Option spreads can give you a tremendous edge when trading technical analysis entry signals. Join Steve Lentz LIVE as he explores how to exploit technical analysis signals using option spreads. Backtested results will be presented. Live Seminar with Steve Lentz - Saturday June 12 at 8-9 AM LOS ANGELES TRADERS EXPO JUNE 9-12, 2010 REGISTER NOW! Page 4 May 2010

5 DiscoverOptions Personal Mentoring Program Page 5 May 2010

Option Strategy of the Month - Bull Put Spread Establishing a bull put spread involves the purchase of a put option on a particular underlying stock, while simultaneously writing a put option on the

6 Option Strategy of the Month - Bull Put Spread Establishing a bull put spread involves the purchase of a put option on a particular underlying stock, while simultaneously writing a put option on the same underlying stock with the same expiration month, at a lower strike price. Both the buy and the sell sides of this spread are opening transactions for the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, with the same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bull put spread, as any spread, can be executed as a single position in one transaction. For this bullish vertical spread, a net bid and offer for the whole package can be received through your brokerage firm from an exchange where the options are listed and traded. As the name suggests, this is a trade you would put on when your outlook is neutral to moderately bullish. A trader often employs the bull put spread when he is sure the underlying stock will not fall in price. If the investor's opinion is very bullish on a stock, it will generally prove more profitable to make a simple call purchase. However, a trader may also choose this spread when they are not comfortable with either Figure 1 (continued on page 7...) Page 6 May 2010

7 (continued from Page 6) the cost of purchasing and holding the long call alone, or with the conviction of his bullish market opinion. A bull put spread tends to be profitable when the underlying stock increases in price. It can be established in one transaction at a credit (net cash inflow). The put with the higher strike price will always be sold at a premium greater than the offsetting cost of purchasing the put with the lower strike price. Maximum loss for this spread will occur as the underlying stock price declines below the lower strike price, and is equal to the difference between the strikes minus the credit received. The maximum profit for this spread is equal to the credit received from placing the trade, and occurs when the underlying stock price is above the higher strike price with both options expiring out-of-the-money. If the underlying stock price is between the strike prices when the puts expire, the short put will be inthe-money, thus worth its intrinsic value. The long put will be out-ofthe-money and have no value. The performance graph for a Bull Put Spread is like a backwards "Z" over the strike price of both options. The risk graph of a Bull Put Spread is shown in Figure 1. To view 75+ other FREE options articles, visit DiscoverOptions.com. The DiscoverOptions Education Center offers a broad range of instructional material for all levels of options traders, from the beginner to the professional. You can easily search through more than 70 articles to find the topic you re looking for... Start Searching Now Page 7 May 2010

THE IMPORTANCE OF BACK TESTING By Ken Dole DiscoverOptions Mentor I've been a long time user of the OptionVue program and a Discover Options Mentoring coach for over 2 years.

8 THE IMPORTANCE OF BACK TESTING By Ken Dole DiscoverOptions Mentor I've been a long time user of the OptionVue program and a Discover Options Mentoring coach for over 2 years. In my opinion, back testing your trading systems is one of the most critical steps in becoming a successful trader. And with the BackTrader module in OptionVue 6, our students have access to one of the most powerful tools available for back testing option strategies. Why Back Test a Strategy? It's not too hard to understand the concept of back testing. It is simply a way of running a trading system through a set of previous trading data. With back testing you go through the process of trading without actual money involved, allowing you to find out how profitable a system may potentially be by looking at how it would have performed in the past. The most obvious reason for back testing is to create and/or test various strategies in order to trade more profitably in the future. If you're using a strategy that a course or other service is promoting, it may seem redundant to back test it - after all, they should have done considerable back testing already to prove it works. But I would argue that even in this situation you should back test it to better understand the strategy. The next most important reason to back test a strategy is to gain experience. It is one thing to read the rules of engagement, but quite another to actually practice executing the trades without the stress of risking real dollars. You can observe how to enter and exit the trade in the most efficient way, as well as see how well it works over time and in many different market environments. During this time you will see how comfortable you are, making sure it is something that suits your trading style and risk preferences. The last point I will make is that back testing helps you develop discipline. Discipline is vital to successful options trading and any benefit in this area is well worth the time. You will see how the strategy reacts in different environments, enabling you to be confident in your entry and exit rules. It is during this time that you also establish your money management rules. Now you will be better prepared for real trading and much less likely to alter the strategy on the fly or based on emotion. Seeing how a strategy would have performed over many years means that you are much less likely to abandon the strategy because it loses money for a month or two. This ability (continued on page 9...) Page 8 May 2010

9 (continued from page 8...) May 2010 to follow a strategy, without being deterred by the occasional inevitable loss, is a key component of discipline. If you have tested a trading system over a long period of time you will know in your heart that it will work 8 out of 10 times. You will also know that there were times in the past when a string of consecutive losses occurred. This ability to stick to a strategy over the long term, combined with disciplined risk management, is what allows a professional option trader to stay in the game for years. As a Mentor who has worked with many different kinds of students, I know that using back testing will help you solidify your trading education into a disciplined trading system. It will also help you overcome one of the main problems many would-be traders face, the psychology of trading. Your knowledge of the systems being traded is only part of your trading success. How you implement it is vitally important. Fear and greed can play a huge role in upsetting your progress as a trader, and anything you can do to ensure that your actions are not guided by emotions is worthwhile. Back testing can also help you gain practical experience. Execution of trades is an important skill for any strategy. It is good to know before you need to trade how slippage will vary at different times of the day and in different market conditions. In general, the more liquid assets will have less slippage, but each asset, whether a stock, index, ETF, or future, has its own unique market. Seeing how this market works will enable you to maximize profits as you implement your trading systems. The BackTrader Module in OptionVue The DiscoverOptions Personal Mentoring course includes the use of the OptionVue 6 software and all our data services, including the BackTrader module. For those that don't own OptionVue 6, a free 14-day trial that includes all data services is available at While in BackTrader mode, OptionVue 6 will automatically download historical prices, volatility information and charts going back to January 2, You can look for new trades, conduct analysis and track your progress in the Portfolio Manager. You can then step forward in time by 1/2 hour or daily increments and watch how your position(s) changes along with historical volatilities, Greeks and profit/loss. Using BackTrader can be a rewarding adventure, but can also be a little frustrating for those still learning how to use it properly. By knowing a few key things, you can greatly improve your effectiveness and efficiency in your time spent using BackTrader. Optimal Use of BackTrader (continued on page 10...) Page 9 May 2010

10 (continued from page 9...) May 2010 BackTrader is designed to be used while moving forward in time and will work best while doing so. One key reason for this is the need to get the full three days of data used by the variable volatility model. Three days of volatility data are needed to get the most accurate theoretical option prices and Greeks. If you have just started BackTrader and moved directly to January 2, 2008, for example, there is only one day of volatility data available. If you analyze a position immediately you will not get the most accurate graph possible. By advancing forward a day to the 3rd, and then the 4th, so that BackTrader brings in two more days of data, the program now has three days of data and the graph will look much better. Starting two days at the close before your actual intended date and then advancing forward a day at a time will set up your modeling information properly. Once underway, moving forward smoothly a day at a time will give you better results. Jumping around to random dates or moving backward will work, but you will not get the best possible results. An occasional backward move, if necessary, should be ok, but repeated backward moves will increase the probability of errors occurring. Closing all open Matrixes other than the one(s) you're using for the back test, and even closing the Quotes Display itself, will cut down on the amount of data needed to download with each change and Figure 1 dramatically lessen the time for your testing. To close the Quotes Display, just click the small black x just below the main program red X. If you keep the Quotes display open, then every asset listed will be updated by BackTrader every time you advance, which of course takes a bit longer. Tracking your Performance The main goal of back testing a strategy, of course, is to see if it would have been profitable in the past. To do this you will need to set up a new account (by clicking the Info button in OptionVue 6) and making your initial deposit. You can also use BackTrader with an existing account to go back and see what it looked like on a specific day. The Transaction Log (accessed by the T.Log button) records every trade. Now you are ready to trade. Go back to the starting date you want to start (continued on page 11...) Page 10 May 2010

(continued from page 10...) your test on. You enter the initial trade(s) in the Matrix using the Convert Trades button, which automatically enters these trades into the T.Log.

11 (continued from page 10...) your test on. You enter the initial trade(s) in the Matrix using the Convert Trades button, which automatically enters these trades into the T.Log. They will now be recorded and also move from being a prospective Trade to the Existing Positions parameter in your Matrix. Now you simply move forward a day at a time, making any adjustments, closing transactions, and opening new trades as required by the rules you are following. Each day you should make sure to open the Account Status (or just leave it open at all times). This is particularly important for making sure you get an accurate Performance Graph (Figure 1). Being able to see a graph of your account performance over time is a valuable feature that many users overlook when back testing. The account value shown in the Account Status window on the last time of each specific date is the number that is written into your account history and used to draw the performance graph. Making sure there is a (correct) account value is essential to getting a performance graph filled in with accurate yields, draw downs, and profit. If you do not open the Status during the test you will end up with a straight line graph from beginning to end or no graph at all. The other important report to look at is the Performance Analysis report (Figure 2). It is this report that gives you all the statistics you need to determine if this is in fact a tradable strategy, and one that you would be willing to trade. Just because it is profitable does not mean it actually has a trading edge. Each option strategy has a probability of profit. For example, just randomly buying any at-the-money option is going to have a probability between 30-40%. You need a significantly higher percentage of winners to show that the trading system you are following does better than that. You should also look at things like the maximum drawdown, the average winning and losing amounts per trade, and how many consecutive winners and losers you have. A strategy where you win 4 out of 5 times, but average a 10% gain on winners and 100% loss on losers, will be unprofitable. And be honest with yourself. Will you really have the discipline to keep trading this system after hitting that period of 10 months of consecutive losses, even though you know that over a five-year period it will likely be very profitable? Figure 2 (continued on page 12...) Page 11 May 2010

12 (continued from page 11...) Conclusion May 2010 Once you are familiar with how BackTrader works, you can greatly improve efficiency by testing a couple different strategies on the same asset, or several different assets with the same strategy, to quickly compare performance. There is a tradeoff between how long the testing takes and the number of assets or strategies you are doing, but I've tested 3 or 4 at the same time and it worked well. Creating a different account for each test will make it much easier to record results and compare different strategies. There is no limit to how many accounts you can create, so if you want to save the test results for later review, I recommend setting up accounts for each test. You can always use a super account to combine multiple accounts and see how you would have fared if you were doing them all simultaneously. Recording snapshots and taking notes during the test can be very helpful. Create a document with the initial test parameters clearly stated and then take snapshots of the Matrix with the original positions and adjustments at key intervals. The Transaction Log will record all of your trades and results, but the file will make it easy to see what all the trading rules and adjustments were, and what you were thinking at that time. You can then easily share test results with friends, a trading group and/or create a PowerPoint for presentations. Given some practice and persistence, BackTrader can increase your arsenal of strategies and push your trading skills to the next level. Spend the time to become proficient with it and I think you'll be pleasantly surprised with the results. Page 12 May 2010

Letter To Our Clients INF RMER. A Forum for Options Trading Ideas

Letter To Our Clients INF RMER. A Forum for Options Trading Ideas In this issue - Letter To Our Clients - Len Yates - True Delta: Your Competitive Advantage - Steve Lentz - Butterfly Balancing with True Delta - Steve Lentz - Customer Support - Jim Graham INF RMER A Forum