After explaining the basics of a trading plan using the Dow Jones Industrial Average (DJIA) index in a previous article, I will repeat the process one more time but use equity options in the following example.
First, we must determine the market trend. Is the market bullish, bearish or neutral? We will use the basic 20-day and the 200-day exponential moving averages (EMA).
Next, we need to determine some technical factors before deciding to enter into a particular option spread.
- What is the current trend for the underlying security?
Based on the recent positive crossover above the 20-day exponential moving average and the extended time above the 200 EMA, the trend is definitely bullish. This suggests that, for the near term, call options or selling puts have a higher probability of profit. I used exponential moving average because some traders prefer it and I want to show that both forms of moving averages work.
- Are we near a possible reversal?
A variety of factors, including tapering volume trends, parabolic price spikes and several other indicators can suggest a near-term reversal. In this case, both the 20-day exponential moving average and the 200-day EMA indicate continued upward movement. The bullish trend is probably not near a reversal
In which direction should I trade?
Our direction for the trend is bullish for the underlying security — GOOG. I used the same principles for determining a bullish trend as in the previous example. This means we can choose any of the several bullish-oriented credit spread strategies.
Choosing a strategy
I will use the bull put credit spread in this case. I will sell an in-the-money (ITM) put option with a higher strike price and buy a lower strike price out-of-the-money (OTM) put option with the same expiration date.
Choosing timeframes: Our timeframes will be relatively short in most spread trading. The short time frames minimize long-term risk and time decay, if the time decay works against us. In this case, we are using time decay to our advantage. We chose an expiration date as close as possible while achieving a sufficient premium credit.
Choosing the strike price: Depending on the chart volatility and volume of options available, we could go as high as we want to assure a low-risk trade. GOOG shows that bouncing 50 points in a single day is not unusual. That shows high volatility. We need to consider that band of volatility for our strike price selection.
We will choose $831 as a strike price for Alphabet, Inc. (Nasdaq: GOOG), since it is near its current price and provides a fair margin to work with because of the volatility.
Based on our volatility analysis, we will sell an in-the-money (ITM) March 17 put at $840 for $10.19. We then buy an out-of-the money (OTM) put below our sold put at $820 for $2.50.
Watching options mechanics to avoid friction costs
Once you choose the least expensive broker for your style of trading, there are a few other ways to minimize your friction or execution costs when trading multiple options.
1) We need sufficient trading volume to avoid bumping the premium with our purchase and to be able to execute in or out of the trade without delay.
2) Some options covering the same underlying security have a higher premium than others with nearby strike prices. We generally want to minimize our premiums unless we are selling the option.
These two criteria pushed the trade to the $840 and $820 puts because each of them had sufficient volume to execute our transaction.
I will calculate potential profit for our bull put spread as:
Maximum Profit = Net Premium Received – Commissions Paid
For us to receive the maximum profit, we need the underlying price of GOOG to remain below or equal to the strike price of the long put.
Our breakeven point for our bull put spread can be calculated as follows:
Breakeven Point = Strike Price of Short Put – Net Premium Received
In this example, for each option pair we would receive $10.19 – $2.50 or $7.69 in credit.
Our hope is that GOOG continues rising at least moderately and exceeds the $840 level. In that case, both options will expire worthless by the expiration date. This produces the maximum profit.
Our worst-case scenario will unfold, if we missed the trend and the Alphabet’s share price drops below the lower strike price.
For example, GOOG could decline to $800 before the options expire. In that case, both options will be in the money. The $820 option is going to be worth at least $20 on an intrinsic basis, while the $840 option will be worth $40. The spread is now $20. Having received $7.69 in credit when we entered the trade, the loss will be $20 – $7.69 or $12.31.
Note that all calculations are based on one option, while a real trade will be based on a contract of 100 options. This means that the profit could be $769 or the loss could be $1,231.
I will put all this information into my trading plan sheet.
Sector: Tech / Media sector. Large Cap
Sector Major Trend: Bullish
Underlying Security: Alphabet, Inc. (Nasdaq:GOOG)
Option(s) Traded: Sell: an ITM March 2017 put at $840 for $10.19.
Buy: an OTM March 2017 put at $820 for $2.50.
Strategies Applied: Bull Put Credit Spread
Expected Trade Duration: Before March 17 expiration.
Max Loss Allowed: $1,231 based on GOOG falling to $800
Triggers for Quick Close: Earnings announcement disappoints.
Potential Upside: Credit for entering the trade less commissions.
Potential Downside: Difference between the sold ITM put and the bought OTM put plus commissions.
This example and the DJIA example from previous articles show how to apply trading basics to two different trades. The same principles apply to both bullish and bearish trends. All you need is to follow the trading plan checklist and your trades will be heavily tilted toward profitability. The simpler you can keep your techniques, the higher the chance that you will not make any errors.
You can set up trading alerts with your brokers that look for trend changes, new highs, new lows and similar signals, but you easily can become overwhelmed with too many signals to watch and too much information to analyze.
Focusing on the few indicators that have worked for traders over the years, such as the Turtle Trend Traders, is the way to improve your odds.
In the next article, I will discuss risk control and money management.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com