Cycle Trading

[Duma]

This is a long post about option spreads that if you have an interest, I think you will find informative.

Back on 2/11 I wrote a post that had a link to a video by Don Kaufman about trading option spreads. I have done a lot of reading on this subject and have actually moved one of my accounts to trading spreads. If you watch Options Action they use spread almost exclusively, but they are not the type of spreads that I am going to talk about. Mine are much more conservative. Options Action is not alone in this type of trading spreads. Several major players trade this way. So why trade spreads? 1. Limited risk 2. Great returns.

What I want to do with this post is to explain how spreads can be traded and compare that type of trading to other types of trading. Spreads that I am trading are bull credit spreads which involve buying a call ITM (in the money) and then selling a call somewhere around ATM (at the money). I put up a post (18792) last week that showed that TV (time value) is the highest ATM. So the idea is to sell the option with the most TV and let that decay for profit. A spread will make money fast if the stock takes off and moves much higher than the sold call, because this type of action kills TV. If the price action is slow the price of the spreads will only increase slowly as time decays. But decay it will. All one needs to happen to be successful with a spread trade is for the stock price to stay above the sold call. So one can actually make a profit and price not go up at all for certain types of spreads, Class 2 and 3 talked about below.

So I classify my spreads as 1, 2 or 3.

Class 1 sell the call higher than price. This will make the most money but it is the most risky because the price has to move up beyond the sold call.

Class 2. sell the call at the price. This will make less money, because price does not have to move at all.

Class 3. sell the call ITM. This will make the least money, but is very conservative. Price can even decline a bit to the where the call was sold and the trade will still reach max profit.

But make no mistake about it, it doesn't matter if you trade 1 share of stock or 10 contracts of futures, both still require price to go up to be successful. So picking the right time to trade is important. To do this I am using my 60min chart. I am going to discuss one of my spread trades on Visa that I bought on 2/13, 10 days ago. If you look at the chart below of Visa, you can see that I bought at a very favorable point in the M65 [MACD(65,90,10)] curve. At the time of purchase the curve was in Mark Down but was at my favorite buy point with M65 flat, M12H positive, and price above 20ema.

So to put on the trade I bought 3 Mar16 115 calls for 5.47 each and I sold 3 Mar 120 calls for 2.42. The price of V was 118.60, so this is a Class 1 spread which is the more risky but has a good payout. This spread cost me $915. If I hold to expiration, the spread will be worth $1500 (buy 300 shares at 115 and sell at 120) as long as price is at 120 or above.

This means my max profit is $585 for a gain on 64% on my investment. Repeat this on several more spreads and keep repeating several times a year as the options expire and returns can be very good.

Since I bought the spread, prices moved quickly higher through Accumulation into Mark Up from the 118.60 to 123. It pulled back a bit to 120 and then moved higher again Fri to 123. As of Fri this spread had a value of $1300 and a profit of $385. The number I like to watch is trade profit to max profit. In this case it is $385/$585 or 66%. I would be very happy if I had to end the trade with this number over 70%. No matter what, when Distribution is reached (or other situations), this trade will end instantly. If V does not go into Distribution before expiration, Mar 16, and price stays above 120, I will receive max profit of $585.

So how will this trade compare to just buying stock. To achieve the same profit to Fri it would have required a purchase of 90 shares that would have cost $10,674. I am not really sure how to compare the risks, but I know my spread will not move down as fast as the stock if prices were to decline. Also consider that fact that I could have tripled my gains by doing 2 other stock spreads and still have only used $3k of my capital, not $10k. Professional traders know that to really beat the market, leverage of capital is necessary. My spread was less risky and leveraged my capital well.

Next let's compare what would have happened if I had bought an option. In my original spread buy, I bought a 115 call for 5.47. Forget about selling the higher call. With the price at 118.60, I think this would have been about a 70% delta. So that would be an exposure of 70 shares which is pretty close to just buying 90 shares outright. Friday that option closed at 8.40, so we would have a profit of $293. This is pretty close to what the spread did, but the risk was much higher. Of the positive, the cost was only half of the spread, but if prices moved down, the stand alone option would decrease at least twice as fast as the spread. I think spreads win the risk factor again.

I am now convinced that spreads are how most professional trade. The key to any trading is to manage risk, but still make a good profit. The kind of spreads that I have described I think do this very well.

When I started to configure my account, I really had no idea how to do it. I am pretty comfortable with my current allocation. For my spreads I have used 40% of my capital. I also have a 100% exposure to the market via SSO and TQQQ, but since these are 2x and 3x funds, my total capital used is only 100%.

Here is some personal data from my account for last week. I am only showing these numbers to show a real time example of how a spread account might work. My account marked time for the first 4 days of last week. Mon-Thur SPY was down 1% and my account was just above 0%. So my spread gains over came the loss from the market. How sweet it that? And then Fri hit, my market holding of SSO/TQQQ were up 1.8%, the spreads were up 3.3% for a total gain of 5.1%. So for the week, I was up 5.1% vs SPY of .6%. The key take away here for me is that even when the market was down a bit, my spreads were still making money and when the market did well, I did really well.

There are many more things I could discuss about spreads that I would happy to discuss if someone wants, but this is a good start. This is only one way to make money which I like because I have the ability to go away for a day as I did Fri and not worry. If the market had cratered as I posted was my fear Fri morning, I would just start to unwind and lock in my profits Monday. Time decay over the weekend would have been a big help to whatever loss I might have had Fri if any. As it turned out the market is still fine for another day.

My goal for the year is 100% gain for this account. I think it is very doable but it remains to be proven by me. But there is no end of promotions claiming to be doing this and more. I am starting to believe them. But make no mistake about it, timing of trades is always key.