This article is aimed at helping to choose which direction to take in a spread trade, along with the strategy, the timeframe and the trading vehicle.
These steps build upon my previous article, which looked at the Dow Jones Industrial Average (DJIA) chart for the last six months and found indicators point to a bullish trend. For simplicity, I chose to forego any neutral option spread trading strategy with a bullish tilt and stick with a basic bullish strategy.
Choosing directions
The chart analysis makes it very clear that the direction of the DJIA is bullish or upward. Though it might seem obvious to enter a bullish trade based on the analysis of the major trend, I separate the analysis from choosing the direction of the trade because they are not the same thing.
Even if the trend is bullish, I could choose a direction for a bearish trade because I am expecting a reversal. The trading direction you choose will generally follow your overall trading methodology.
I strongly recommend trend following for simplicity. That way, your analysis will almost automatically determine your trading direction and all you have to do is to trade accordingly.
A good example of when to choose an opposite direction trade or a reversal trade is in the gold and silver markets. Both gold and silver have frequent and severe reversals that become relatively easy to call, even in strong bull and upward-trending markets. Each security in each type of market you trade has its own characteristics that you can learn over time. Conversely, you can find somebody who is an expert on the seasonality and the linkages between the market in which you wish to trade and other leading indicators.
Getting back to our trade of the Dow Jones Industrial Average index, my trade direction is going to be bullish-oriented with the possibility of using a neutral strategy. This rules out bearish-oriented strategies or neutral-oriented strategies with a bearish tilt.
Choosing the option spread strategy
Going back to the list in a previous article, I select the bullish calendar spread as my strategy. While I could have selected almost any of the bullish, or even some of the neutral option strategies, I am choosing the bull calendar because it is a strategy that gives us unlimited profit if the trend continues and a limited downside if the trend reverses.
A bull calendar spread meets our conditions nicely for DJIA. It has unlimited upside profit if the DJIA continues the trend and it has a limited downside risk. My downside risk will only be what I invest to get into the trade.
A bull calendar spread involves selling an out-of-the-money (OTM) call that expires relatively soon and buying a longer-term OTM call.
My plan is that the OTM call I sell will expire worthless, while I get to ride the longer-term call for an unlimited profit to the upside.
Choosing Timeframes
I am choosing to sell an April OTM call and buy a May OTM call. The reason for choosing these months has to do with trading volumes and my analysis timeframe. A longer-term trade out to June or December expiration would require a longer timeframe for potential profit, and my analysis would not have been as reliable because I looked at only six months of trading and the trading volumes were significantly lower at the strike prices I wanted. For all of these reasons, I chose much earlier expiration months with sufficient volume for me to enter and exit trades easily.
Choosing Vehicles
Here is the list of relevant options:
Data Source: Chicago Board Options Exchange, Retrieved: March 8, 2017
The chart above shows the DJX options list for April 21 expiration and strike prices between $209 and $220. This equates to 20,900 and 22,000 on the DJIA. DJIA currently trades at 20,925. Based on the patterns I identified on the chart, I am choosing to sell the $215 strike price call that expires on April 21, 2017. While I could have cut things closer with a $212-214 strike price, the heavy bullish pattern I established during the analysis suggests that this would be asking for the calls to go in the money (ITM). I can run volatility and probability analysis on each price point, but $215 has the best combination of distance for the average to go before options expiry and a much higher premium for me to pocket than the $216 strike price.
I will buy a May call at the same strike price of $215. Here is the chart for that call:
Data Source: Chicago Board Options Exchange, Retrieved: March 8, 2017
Though the volume is low at $215, I am only entering one order, and it has some open interest. My net debit to enter this trade is ($1.95 – $0.95) = $1.00 x 100 = $1,000
In an upcoming article, I will summarize the steps I use to execute this strategy and I will touch briefly about few things you need to watch to avoid friction costs
Billy Williams is an author and a 25-year veteran trader. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.
