HOW AND WHY WE USE ALERTS FOR OUR TRADING You may be more comfortable using a stop loss that is fine, however we use alerts. There may certainly be a place and time for a stop loss; going in for surgery, or traveling to China, and can't stay on top of the markets for a while just as examples. One of the main reasons we use alerts is because we are selling pretty far out of the money. If our position looks like it may be violated, that would mean the market had to move a lot in one direction to get that close. Not always, but normally when such a big move in one direction occurs, like we've discussed before, there is a correction or profit taking of some sort. That big directional move is often short lived and soon the market retreats in the other direction. During this time we are closely monitoring for signs of the market having gotten ahead of itself, in other words, being a bit oversold or overbought. We prefer to have an alert and watch more closely than to use the stop loss in this situation; just our personal preference. You will notice that our alerts are always set at 25, 20, and 15 points away from the sold strike. When you set an alert in your account you have the option of it going to your email, trading platform, or your cell phone, or to all of these. Let's say you have friends visiting from out of town, happens all the time here in Florida especially in the winter months. You told your friends you would take them out and show them the town, but the market is getting close to one of your positions. Your first alert goes off when it hits the price you entered which is 25 points away from you sold strike. If that is the only alert you put in, you will have no way of knowing whether the market is continuing in the same direction or if it has turned around and gone the other way. That's why you have a second and third alert in place to notify you. If that alert at 25 goes off, and that's it, then you know that it is somewhere more than 20 points away from your position. If you didn't have these other alerts you wouldn't know what was happening. You can also get basic internet through your cell phone where you can usually get a 20 minute delayed quote, just as a backup. I always worry too that maybe my alerts aren't working or weren't set properly, so I'm more comfortable having a backup as well. Technology is great, but only when it's working properly! Let me explain a little further. The alert at 25 goes off - this is simply a warning. Often you will notice intraday we can have some strong moves, but sometimes it will bounce back the other direction. If your alert at 25 goes off, you wait to see if the one at 20 goes off, if not you know it is somewhere above this level, preferably it has moved farther away. The alert at 20 is also a warning, but it is time to be prepared to exit your position. The last alert at 15 means it's time to get out. You have to have a set of rules in place. Rules are meant to be broken. There will be times when we will make an adjustment or close out a position before these alerts ever go off. The closer a position gets to the alerts, the more expensive it is to buy back and close out that position. If it is obvious that at some point you will have to buy it back; why not do this earlier when it is less expensive to do so. There also may be times when a bounce is long overdue. The 15 buy back point could be slightly altered. You have to be a little flexible depending on the market conditions. I wanted to have some basic rules in place, should something happen and for whatever reason I couldn't be reached or respond in time. HOW TO NEGOTIATE FOR MORE PREMIUM First I'm going to share from my own experience. Credit spread trading is a fairly relaxed style of trading, but there is one thing you have to figure out for yourself. What is your personality and patience level like? I have found that sometimes I just want to get into my trades and be done with it. Waiting for that opportune time to try and get an extra nickel, or to be patient and let the order sit open/unfilled for days or weeks can be frustrating or even stressful. As we discuss negotiating your premium, you need to learn a little bit about yourself and how you handle these situations. Are you happy if you only get filled on half of the iron condor, or are you going to force a trade to make sure you have completed the entire iron condor? I'm not trying to scare you, just trying to prepare your mindset, so you are ready when given the situation. The reason I mentioned the information above is for the following examples: Do you enter your order at the natural and get filled within minutes or seconds, or do you enter it at the mid price or higher and wait for the market to move in order to get your fill? Sometimes you can get .30 credit right now, but you put an order in for a limit of .40 credit. A couple of days go by, your order didn't get filled, and now the market has moved in the other direction and there is only .15 credit available for that same position. These are some of the situations that will come up. Maybe you don't know yet how you would react so you have to experience it and then you can learn for the next time. Let's first look at the position as a credit spread order. Depending on your broker you will choose sell vertical spread, or bear call spread. We are first looking at a combined position and then we'll discuss the legs individually. We have the 680/670 bull put spread. We are going to sell the 680 put and buy the 670 put. The spread is now 1.20 bid x 1.80 ask. These are both the natural prices 1.20 for a credit spread and 1.80 for a debit spread. We obviously are doing the credit spread, but if we were exiting our entire position we would be looking at the debit side. Everything we discuss also applies for exiting or closing out a position. 1.20 x 1.80 is the natural; on Think or Swim they will give you the mid price which is 1.50. At a quick glance you will see it; you don't have to calculate anything. There is no magic rule and it can vary on any given day, time of day, and index. The purpose of this discussion is to show you different ways of going about it and then you can figure out what works best for you. There are too many factors involved to just say this is what you do every single time. You can enter your order at the mid price. You probably won't get filled right away, so you will need the market to move. You can also try entering your order for .05 or .10 less than the mid price. Perhaps you start with the mid price and leave it for a while and then lower it by .05. If you are entering your order while the market is open, watch the price action of your spread order before doing anything to get a feel for where it is trading. If the market is calm the price may not change much at all, but if the market is on the move, you may want to sit back and watch the price action. If your broker doesn't show the mid price you can calculate it yourself. Just look at the natural bid 1.20 and the natural ask 1.80 and figure out what is the middle price of the two. The only guarantee of a fill is at the natural price 1.20 in our example, and even then the market needs to be stable enough for that price to last. If you enter an order for 1.20 and suddenly the bid/natural changes to 1.10, your order will just sit there. In our examples, we are not guaranteeing you will get filled, but if you don't need to be in the position right away, it is worth your while to squeeze a bit more premium out of the deal. It adds up, especially with our style of trading. We don't go for a home run every time. We hit singles every month. Sometimes getting an extra .05 or .10 can be an extra 1 - 2% or more in your return for the month! Next we will look at the spread as a whole again, but we want to get filled more quickly. Instead of the mid price we are only going to take 1/3 of the bid ask spread. 1.20 x 1.80 means there is .60 worth of fluff. If we take 1/3 of the fluff, that's .20. We add the .20 to the 1.20 natural and enter the order for 1.40. This is probably the quickest and easiest way to enter your order, if you want to get filled rather quickly. Now we're going to look at both put options separately. Again depending on your broker, you will select single, or option chain, or maybe you have to select just put options. The 680 put has a bid ask spread of 6.10 x 6.40 and the 670 put is 4.60 x 4.90. Again for the natural we sell the 680, sell at the bid for 6.10 and buy the 670, buy at the ask for 4.90. If we take 6.10 and subtract 4.90 that gives us the natural of 1.20. You can see there is .30 of fluff between both positions. 6.10 x 6.40 = .30 and 4.60 x 4.90 = .30. We are going to take 1/3 of the fluff from both sides. 1/3 of .30 is .10. We are going to add .10 to the bid of the 680 put, which is 6.10 to give us 6.20 and we are going to subtract .10 from the ask of the 670 put, which is 4.90 to give us 4.80. Our new math gives us sell the 680 put at 6.20 and buy the 670 put for 4.80 and a credit of 1.40. We went through both examples to try and cover the different scenarios of all the different trading platforms and brokers. This latter method is a little more old school and takes a little more time and effort. In both examples we came out with 1.40. It won't always work out this way, but they'll usually be within .05 or .10 of each other. If the math doesn't produce a nice round number, for example you have to divide .35 by 3. It is your choice whether you want to round up or down to the nearest .05. Again it has to do with your time frame on getting filled and how much you would like to squeeze out of the deal. Just a quick note on SPX; it can tend to have wacky bid ask prices. I'm looking at a position now. The spread looks like this bid of -.40 and an ask of 1.10. So there is no natural really to go by, but the mid is .35 on this one. If you have a negative bid, just subtract it from the ask. 1.10 minus .40 = .70. The mid between 0 and .70 is .35. The mid price is all you have to work with unfortunately. All other indexes that we mention are all traded electronically. The SPX is old school. Open outcry; meaning your order goes to the floor and someone shouts out your order and they see if there are any takers. Sometimes there will be a natural on the bid showing, but often you'll see zero or a negative bid price. Also remember that your broker is there to help you. Just because you use a discount or online broker, doesn't mean they aren't willing to help. Most if not all of the brokers we mention on our site, have former floor traders working there and answering the phone. If you are trying to figure something out, or have general questions, and aren't entering a live trade, they may ask you to call after the market closes. Don't be discouraged by this. They are simply busy taking care of orders and urgent matters. ANALYZING 9/11 AND HOW TO REACT TO A SIMILAR EVENT A lot was learned from the events of 9/11 and the financial community was not an exception. At the very least, we are always hedged and protected on our positions. We know before we ever enter the position what the best case and worst case scenarios may be. If we sell a $5 credit spread and we take in .25 credit, and our trade size is 10 contracts; then we know the most we can lose is $4725. That's a significant amount, but at least it's capped. Many people still do not protect their positions or their portfolios. It's ironic that we have insurance for just about everything in life and wouldn't think of being without. For some reason it's different with the stock market. Sometimes it's just simply a lack of knowledge. If a person owned 1,000 shares of a $100 stock, they have $100,000 of their money at risk. As we have seen in the past, it doesn't matter how safe, large, or great a company it is. How are we to really know for sure if the books have been fixed or not? Pat yourself on the shoulder for finding out about Index credit spreads where we separate ourselves from all that mess. Even though we are hedged and we know what our maximum loss may be that doesn't mean we are going to just sit back and let that happen. Not if we can help it anyway. If you look back even before 9/11 the markets were already falling. To accurately analyze things you have to pick your dates carefully for a fair comparison. S&P500 9/10/01 closes @ 1092.54 9/17/01 closes @ 1038.77 down 53.77 points or 4.9% 9/21/01 closes @ 965.80 down 72.97 points or 7.0% 9/10 was a Monday, 9/11 was a Tuesday, 9/17 was a Monday, and 9/21 was a Friday. The last day you could have traded was 9/10 and then not again until 9/17 when the market opened again. In comparison, on 6/6/08 the S&P 500 closed down 43.37 points or 3.1%. The point being the market can be volatile at any given time. Since we are not directional traders and we sell far out of the money credit spreads, we are much more likely to able to survive and withstand these huge directional moves. We do have some additional rules in place, however, should a situation similar ever arise. At the first chance possible, we need to exit all of our bull put positions. There is no need to wait around and see if our positions will be violated. When it comes to the stock market, there are two prominent emotions we need to deal with: fear and greed. Fear is stronger than greed and thus the fear and panic can continue for quite some time. If we look back at our 9/11 example; when the market reopened on 9/17, it rapidly sold off all day. You could have gotten out as soon as possible on this day. It continued to sell off and reached a bottom on 9/21. Every situation is different, but often you need to be careful in the first 30 - 60 minutes of trading. In our example here, during the open the options will most likely be very overpriced. You may want to sit tight briefly just to see what is happening; briefly meaning "minutes" not hours. The stock market is designed to be orderly and most of the time it is. It's during these times when it is not orderly that we need to plan ahead and have a game plan in place. I don't have my own personal example of what I did on 9/11. I was fortunately in cash during this time. I had a business conference out of town and had gone to cash before I left. As they say, it's better to be lucky than good. AN EXPLANATION OF OUR MARKET SENTIMENT First off we don't care what the Dow is doing. Try to shift your focus onto the S&P 500, even if we weren't trading it that is your indication of what the overall market is doing on a given day. Also try to focus on the percentage up or down when possible rather than just the points up or down. The market sentiment that we post will be a summary of all the various indicators we use. When we do a live workshop we can show you what they all are and how to interpret them. It's too difficult to explain this through the website. We will interpret the data for you and give you a simple explanation of what we feel is going on. Don't use our market sentiment to bet the house on a single trade just because we stated something! Take our information as you would a hot tip on a horse race or a weather forecast. Keep it in the back of your mind, but know that it is not full proof. Also things can change in a heart beat due to current events, economic date, news releases, earnings, etc. What we are primarily looking for is an indication of the current trend, if there is one, continuing or possibly changing direction. If we have entered a bull put spread and the market is heading higher; we are waiting to see if we can safely put on a bear call spread. Our indicators can often tell us if there will be a pull back with the uptrend still in tact, or sometimes they can tell us if there will be a complete reversal and change of trend. We will use these not only to enter trades, but also to monitor if we need to exit a trade early or not. If one of our positions looks like it may be violated and are only days from expiration. We can try to gauge if there may be a pullback coming because the market is a bit overextended or maybe it is showing no signs of slowing any time soon and we may have to exit. It is by no means an exact science. The nice thing about our style of trading is we don't have to be 100% accurate all the time. We can still do very well even if we don't know which direction the market is going. However, there will be times when it's nice to have an indication of the possible direction, rather being totally clueless. When you monitor all of these indicators on a daily basis or even on a weekly basis, you can get a good feel of the overall market environment. It's certainly better than watching CNBC and hearing 15 different opinions every day from so called experts. Our indicators are specifically gauged for our style of trading and the timeframes in which we trade. We don't really care what things will look like in one or two years. We care about today, tomorrow, and the next month or two. We will update our sentiment outlook as often as is necessary. We also add this information sometimes to our emails for trade alerts. We try to stick our neck out and stay ahead of the curve as much as possible. ECONOMIC NEWS I'd like to touch on one way to try and stay on top of things. Go to www.briefing.com. There is also a live link to their website on the Getting Started page of our site toward the bottom. You can click free content, then calendars, and then economic calendars. I know for a fact that Optionsxpress has the information from Briefing inside their site; I'm not sure about the other brokers. I don't want to lull you into thinking that some are more important than others. This is true, but not always. Some times all the market needs is one tiny bit of news to set things in motion. Often this news comes from these various economic news releases. I will be watching all of these for you anyway, but it's always good to know about them especially for certain circumstances. They will play a key role mostly when we are getting ready to either enter or exit a position. Perhaps we are looking at a position we'd like to enter or exit, but we need the market to move a little bit in one direction before we do anything further. Some times these releases are helpful, but at the very least it's good to know about them ahead of time. There is one main reason I'm mentioning this whole topic. I realize most people are either working during the day or don't care to watch the market all day. Some of these news releases come out before the market opens and some come out while the market is open. Don't read too much into the numbers and try to predict what is going to happen. It doesn't even matter how much the actual number is compared to the estimate. It does matter, but not for purposes of this discussion. I just simply want you to be aware of when the news is going to be released. Before you enter an order especially if you are entering it at night or before the market opens; please check this economic calendar. It can some times make a big difference in whether your order gets filled at all, or at what price. HOW TO TIME THE ENTRY OF ORDERS Some of you may be wondering how long I keep my unfilled order open and sitting there. It's a personal preference really. My weakness is that I like to be in the deal and am not very patient when it comes to letting my order sit. I realize depending on you work situation during the day not all of you can do this, but here's what I do. I will monitor several positions in real time. I try to time my entry when I think I can get my price immediately or within 5 minutes or so. I will be looking ahead of time what I want to trade. I then wait for movement in the market. I don't care which direction just that it moves. When there is movement or a substantial change in direction particularly intraday that is normally when I trade. Except for the technical glitch the other day, my email is sent to you just before, as, or immediately after I have entered the trade. Normally the trades are not very time sensitive, but in this market they can be. First I would set up your email so that is checks for new incoming messages about every 5 minutes or so. I normally try to give you the heads up about when I may be trading, but some times opportunities present themselves in short order. One thing I'd like to point out is that if I do mention a particular strike level I am looking at it can change at any moment. It's just the way the market is now. This is why I normally will tell you after I've made my decision so I know for sure what trade I am entering. If I tell you ahead of time and then change my strikes, now I am managing my trade as well as the strike levels you have chosen as you may have entered a different set of strikes than I already. If your order is sitting unfilled do you wait or do you change your strikes or change your premium. On the ETF's I would not go below .04 in credit regardless of your commission structure unless it is the 2nd half of the trade completing the iron condor. If the market is calm and your order has not been filled yet, I would look for the next catalyst to move the market. Check the economic calendar at briefing.com, when is the President speaking next, what earnings are coming out in the next few days, oil and gas inventories on Wednesday morning. These are all items that tend to move the market. I am not a market maker, but let's try to figure out how they might prepare for their day. The futures are pointing to a higher open. The options on the call side are probably priced a little higher before the market opens and the bid ask spreads are most likely a little wider than normal. I would guess the bid ask spread on the put side is narrow. If the market continues higher and momentum picks up, the uncertainty of the move and how explosive it may be will probably keep the bid ask spread wide for a while on the call side until things calm down a bit. Most traders wait until the move is over and then they try to enter the bear call spread. I try to enter while the momentum is still there. I have been early several times and I don't always hold out for the most premium I can get, but I am more concerned getting the strikes I want. If we take the same scenario and things are priced for the market to move higher, but suddenly some very bearish news comes out. If you trade a bull put spread ahead of or during the news and momentum you will most likely get filled right away. After the move has happened and things are calm again, the bid ask spread tends to tighten up and there you are sitting struggling to get your credit limit order filled. So the bottom line is when my email comes it's most likely because there is some news or momentum playing out. If you can't react to my email right away you can still enter your limit order. Just know that it may take some movement in the market to get your fill. It doesn't always have to move in the direction you want, just that it moves. It is also helpful if there is some uncertainty even for a brief moment which can lead to the premium levels being inflated. A good rule of thumb normally is to let your GTC limit order for entry sit there for a few days or so and then re-evaluate. When the market is more volatile, I would either enter a day order instead, or enter a GTC, but watch the open the next day very closely. The last thing you want is to get .07 credit on your current order when you could have gotten .05 on a further out of the money trade. I always try for the safer further out trade, but you may view things differently. WHAT SYMBOLS WE ARE CURRENTLY TRADING Currently in the Index world we trade RUT and SPX and in the ETF world their equivalents which are IWM and SPY. We used to always trade 3 to 4 different indices at one time. We felt the need for the diversification. What we found was 2 to 3 of our trades would be effortless and there always seemed to be one that we had to monitor much more closely. We'll use OIH for an example. You can trade this very successfully directionally. If you feel it is in a nice uptrend, you can successfully trade bull put spreads on it month after month. The problem is; it is not the largest basket of stocks. Should there be a downgrade on the sector for example, or a couple of the top companies in the trust report poor earnings, it can tank in a hurry. There is not enough premium to make up for these situations. Our focus shifted to larger baskets of stocks. On a big down day in the market just about every stock will trade lower along with the overall market. In the RUT which is the Russell 2000, there are roughly 2000 stocks. There's a greater chance that there will be some companies trading up. SPX which is the S&P 500, again same principal 500 stocks included in that index. The Dow Jones Industrial Average contains 30 stocks. On a big down day you will see 28, 29, or all 30 of these stocks trading lower. That's fine if you're a directional trader. With an iron condor the goal is to be overall non-directional. with it. Lately we've had some really big up days; sometimes even several days in a row. Next comes some rumor or profit taking to drive the market down and usually in a big way. After one, two, or three weeks of this action, the market could return right back to where it started. Instead of getting whipsawed and guessing when we should take profits, we can simply sit back and watch the market. As each day passes we become more profitable as time decay works in our favor. The smaller indexes or etf's can be much more resilient. The point being, it is often better to choose the smaller indexes and etf's for directional trading, but the larger ones seem much more effective for iron condor trading in our opinion. of them. In the beginning you may want to see what works best for you. The spread amounts on IWM and SPY can be as small as $1. You can widen this in $1 increments if you need to lower your commissions. We don't trade this way, but one option you have with the $1 strikes versus the larger ones, is you can buy back the sold strike and let the long one run. This allows you to switch directions. Let's say you sold the 70/71 bear call spread thinking the market would be bearish, or would not be bullish enough to get up to your 70 strike that you sold. If the market was very bullish all of a sudden you could simply buy back the 70 strike you sold and let the market keep moving up, thus adding value to your long 71 call. The reason this can work with the $1 spreads better than the larger spreads; is the delta of the 71 strike in this example would be a lot better because it is so close in strike distance. We don't recommend you trade this way as it can be much more risky and now you are back to being directional and sitting on pins and needles wondering when the market is going to turn on you. We just wanted to address this topic. With $1 strikes you can be very precise on where your strikes are. Sometimes when you go out into the future with the SPX; certain strikes aren't available, or sometimes you are stuck with a $25 spread as those are the only strikes available. With the $1 strikes you can also gain some experience with very little money at risk 1 contract=$100 and 10 contracts=$1000 for your margin requirement. The IWM and SPY are highly liquid so don't worry if you have a large account. They will easily be able to accommodate you. One newer development is with the broker Optionshouse currently offering the $9.95 per leg fixed price. They state the $9.95 price regardless of the number of options traded, but it is actually up to 3,000 contracts which should be plenty for most people. This is a huge deal for all types of spread trading, but obviously the commissions can really rack up if you have a standard commission structure and you're trying to trade thousands of contracts. I remember not too long ago being ecstatic to get my commissions down to $9.95 per 10 contracts traded. That was a big at the time. Now for the $5 and up spreads: you won't find many people trading a $5 spread, most will trade $10. Now the RUT is only available in $10 as the minimum, but with SPX most people like to do a $10 spread. The only reason I think this is; they feel they can negotiate more premium out of the deal that way. Partially true, however, I have found you get a better rate of return with the $5 spread. It gets a little worse at 10, worse at 15 and so on down the line. If you can get .20 on a $5 spread that is the same rate of return as getting .40 on a $10, but sometimes you can't get .40, you can only get .35 for example. If the rates of return are the same, then maybe you can save a little on commissions by doing the $10 depending on your commission structure. One thing you need to understand is in a worst case scenario, (you are in the hospital and unconscious). With the $5 spread that's all you can lose is the $5; with a $25 spread you can lose $25. Of course there are alerts and stop losses, but before you ever enter a trade you always need to be aware of the worst case scenario. You can negotiate your credit amount a bit more as the bid ask spreads will be much wider on the $5 and up spreads. The bid ask spread is very tight on the $1 strikes now as most of them are in penny increments. We have also found if the market is moving up and you have already sold a bear call spread. If you sold the $5 spread and collected .50 premium, if enough time has passed even though the market has actually moved closer to your spread than when you first put the position on, you can usually buy it back for less than the .50. This isn't always true as volatility could have changed dramatically etc., but generally speaking this is more true than with the $1 strikes as they would be about the same or even more expensive to buy back. CHANGES IN OPTION PRICING/ CHALLENGES OF LEGGING IN I was going to raise the credit limit this morning when I saw how strong the Futures were, but then I remembered how close we are to expiration and the fact that volatility would be lower today. We could have gotten about .06, but that's probably about it for today. In another account I decided to leg into the bear call spread. It worked out fairly well and I'm mentioning this not to brag, but to demonstrate a little bit about option volatility. Now you can leg into the short side first, but I very rarely do this. First off it takes up a lot of margin and second you are taking on a lot of risk. Yesterday I bought the SPY 118 calls and paid .08 for them. Legging in or out of a bear call spread is extremely difficult as we've talked about in the past. My intention was to sell the 117 calls against them by the close of yesterday, but I couldn't get enough and decided to hold overnight. As the day progressed yesterday I paid .08 and saw SPY rise about .50, a significant move, yet the 118 calls that I paid .08 for could now be bought for just .07. Naturally I was not a happy camper, but why did this happen? First off Monday's can be a little strange as they pump back in some of the volatility that they took out on Thursday and Friday heading into the weekend. Also when the market moves higher the VIX generally drops and that means the volatility and premium levels of options tend to fall. This is why it's hard to make money being long call options and legging in or out of bear call spreads as well. You can be right on the direction, but you bought the call option when premium was more expensive. Now even with the market moving in your direction you are fighting an uphill battle. On the put side normally just the opposite holds true. I held overnight which means I have taken on a lot of risk, but not really as the options are only .08 so even if the market opened lower the following day there wasn't a lot of money on the line. Yesterday around the close the 118 calls had an implied volatility of a little over 18%. I was watching very closely. Today with SPY opening up about 1.00 higher you would think wow this could be a very nice trade. Time decay was worth about .01 overnight so not a huge deal, but when SPY opened the 117 calls, which I was trying to sell, had an implied volatility of only 16%. Not to confuse you, but when two strikes are far enough out of the money they will tend to have about the same implied volatility. Even though we were talking about the 118 calls, the same goes for the 117 calls. At the open the 117 calls were showing .14 x .17. The high price on the 117's yesterday was also .17 with SPY trading much lower, but with the implied vol about 2% higher. With the market moving around a bit there was a point in which the 117's could only be sold for .11. I also had a chance to finally sell the 118's for .18, but at that point it felt like we could actually move above resistance so I waited. The end result I sold them for .17 and ended up with an overall credit of .09. Bought the 118's for .08 and sold the 117's for .17. This illustrates how hard it is to make money being long call options. You are fighting the fact that the market normally moves higher at a much slower rate. You are also fighting time decay and a decrease in option premium. There are a lot of factors involved in the pricing of options even intraday. When we simply sell a credit spread to enter a trade we can avoid most of the complications, although it can be frustrating at times when they aren't offering as much credit premium as we think there should be. EARLY CLOSING OF A CREDIT SPREAD In this tutorial we will talk about exiting a credit spread trade that has gone against you. This version of exiting early is specifically targeted at those of you who can't watch the market during the day. When exiting a credit spread early because it has gone against us we have four options. 1- Do nothing 2- Leg out - this is very risky and you need the cash available and the ability to watch things in real time 3- Roll the spread up and or out - this can work successfully, but sometimes the trend is just too strong and this may not be the correct action to take 4- Simply closing the spread trade. The close of the spread trade is what we will discuss further. In the portfolio section you will see the far right column which is titled Alerts. These are provided as a rough gauge of when we need to close out a position early. The reason there are three alerts is in case of a sharp sell off one needs to know if the market is continuing to move in the same direction. If you only set one alert that's great, but then what? You would have no clue if you were away from your computer whether the market is continuing to move against you or if the market has bounced and is moving the other way. If you set three alerts you can wait to see if the second one goes off or not. It's hard to know sometimes whether to exit a trade early or not. We normally sell our spreads pretty far out of the money, so if one of our positions is about to be threatened there is always a chance that things are overextended and things will reverse shortly. It is difficult mentally to have to close out a position early especially when you feel the trend of the market is overdone. Never apply option number 1- Do nothing. When we enter a credit spread we are always risking more than we can make. Simply letting your trade go and hoping it will not end up in the money is very dangerous. If you let things go this far it can wipe out much of your profits even several months worth. It can be difficult to close your position out early only to find out a few days or weeks later that your position would have been fine if you left it alone. Get used to it as this can and will happen. It's hard to take a loss on a position, but when you close out a position early it will normally be a small loss. If you wait too long it could become a huge loss and this is what we want to avoid. One thing that many traders don't realize until after it's too late is that your thought process is not always correct. We can easily become paralyzed in a trade when it has gone against us and do nothing at all or end up doing the wrong thing. If this hasn't happened to you yet it will at some point. You will look back after the fact and say how could I have done that and been so stupid. The simple answer is you weren't thinking clearly. We, therefore, want to close out our position while we can still think clearly. There are many factors involved and it's difficult to summarize the situation, but most likely when our first alert goes off there will not be a huge cost to close the position. This first trigger gives us a warning and lets us evaluate our position and what the market is doing before things become too stressful. We may not act at all after this first alert, but it at least gives us a chance to look at the cost of closing the position while we still have a little cushion. Let's say we took in $1.00 on a $10 spread. We took in $1.00, but we are risking $9.00; never forget your maximum risk. We already know with this strategy the risk/reward ratio is completely different from other trading strategies. We took in .50 on a bull put spread and another .50 on a bear call spread. The bull put spread is going against us and at the time of the first alert going off it would cost .85 to close out the bull put spread. We took in .50 and it would cost .85 to close so that's a loss of .35 on this trade. Let's say we do nothing and wait for the second alert to go off. Now it would cost 1.20 to exit the bull put spread. Remember we still get to keep the profit from the bear call spread which is .50. On one side we would lose .70 and on the other side we would make .50 so the end result would be -.20 on this spread. Many of us can be very stubborn so let's look at this another way. You have the opportunity to control your loss to only .20 at this point and your loss will only increase if you wait while the trade continues to move against you. Don't forget the worst case scenario would be losing 9.00. When we exit early don't beat yourself up if it turns out that it was not necessary. Simply remind yourself that you were protecting your trading account. Remember the 3 rules of trading. 1- Never lose money 2- see number one 3- see number one and number two. You must focus on the big picture and understand that it's okay to take small losses, but if you can avoid it never take big losses. Summary - A simple rule is to try and not let your position go beyond a cost of 1 1/2 to 3 times to close out versus what you took in initially. In our example we took in .50 on the bull put spread so try to close out the position before it would cost more than 1.50 or even 2.00 since we also have the profit of .50 from the bear call spread. After closing your bull put spread we still have options. Maybe we can roll the bear call spread to take in more premium and we can go further out of the money on another bull put spread once the market calms down. Maybe it will even take a month or two to recoup the loss of this trade. You need to take your mind off the current moment and remember that we are in this for the long haul. If we take a small loss for the month or end up break even for the month so what, it's better than having a large loss and needing several profitable months to get back on track. Remember we never put all our money into one trade either. Even if we take a loss on one trade there's a good chance that we have other trades that will be profitable to offset this loss as well. This doesn't mean every time your spread goes up in value you simply close it out. We don't trade like robots and that's also a reason why we don't use stops to take us out of a spread trade. There are a lot of factors in the pricing of options. Since we mostly trade the S&P 500 we don't have to worry too much about a huge change in implied volatility. We do have to be aware of many other factors going on in the market. It's a personal preference, but I prefer to manual make the decision to exit a trade rather than having an automated one; at least for spread trading. Once we have made the decision the close out a position it is then certainly fine to enter an automated or contingent order to take you out of the trade. If you can't watch the market you have a couple options. You can exit your spread trade based on a price in the underlying. If SPX trades at 1035 or lower, exit the bull put spread as a market order. You can also use our example of exiting the spread for 1 1/2 to 3 times your entry price. If you do enter an order to take you out based on the pricing of the options be prepared to exit ASAP. Simply entering an order in advance could cause you to get tripped out prematurely. You'll notice we haven't talked about delta in terms of an exit strategy for this discussion. Delta can be affected as well with whatâ€™s going on in the pricing of options. It's very wise to know what the delta is, but it's not my style to simply say exit when the delta of your short strike hits x. We are our own Fund managers and while we need to know what is going on in all aspects of our trading; our first priority is to safely and successfully manage our Fund properly. The best Fund Managers out there are primarily successful because they allocate their capital properly; never putting too much into one single trade. They also minimize their losses and maximize their winners. With our strategy we always know ahead of time what return we will get on our winners. That alone is very important in one's trading plan. We must also be able to minimize our losers and keep the % of loss within the range of the % gain. Our winners will usually be from 5% to a high of maybe even 20% at times. We cannot successfully manage our Fund if we allow our losing trades to outpace what our winning trades will produce. EUROPEAN VS. AMERICAN EXERCISE STYLES SPX and RUT are both European and IWM and SPY are both American. Both allow you to hold until expiration or to buy back early if you want to. The European style means it can never be exercised early. This is really not an issue for us anyway as we don't let our positions ever get in the money. Let me explain: if we sold the 70/71 bear call we are short the 70 strike the only time anyone would normally exercise something is when the index was higher than 70 thus in the money. So yes this could technically happen with IWM and SPY, but like I said the way we trade, it will probably never be an issue. The main difference we are concerned with is how they are handled nearing expiration. Expiration date is technically the Friday before the 3rd Saturday of the month, but to simplify just call it the 3rd Friday of the month. Your broker should have a calendar built into their site showing the expiration dates as well. With SPY and IWM American style you can trade them right up until the close on Friday expiration. Sometimes on Thursday afternoon or even on Friday morning there will be a little bit of premium still available. As Friday moves on throughout the day it will quickly evaporate. ***** With RUT and SPX European style here's the deal. Please pay close attention! The last time you can trade them is at the close of the Thursday before expiration. Make a note of this or do what you have to so there isn't any panicking or lack of knowledge on this. I was in a trade on another index that was looking fine on Thursday. I thought if I needed to make any adjustments, I'd wait and do it on Friday. I learned very quickly, too late however; that it was a European style index. I couldn't do anything but wait for the settlement price to come in. Unfortunately for me, the market closed on Thursday perfectly fine, but on the open Friday there was a huge gap up. It never traded higher all day, only at the open and closed well below my sold strike. I didn't get totally wiped out, but enough to make sure it won't happen again. On Thursday you need to evaluate in a worst case scenario before the close, is there anyway my position could be violated on Friday. If there is any hesitation just buy back the sold leg or close out the position and be done with it. In my example I could have closed out my position for just a commission fee and a very small dollar amount; instead I lost a much larger dollar amount. Here's how the settlement works: when the market opens on Friday morning; once every single stock in the index has opened they come up with a settlement price. I'm not sure about their exact formula, but it can have a mind of its own. I have often seen the settlement price come in out of the range of what my charting software even shows. This past expiration on RUT, my software shows a high on RUT of 764.38, yet the settlement price was 765.07. Bottom line is you need to proceed with caution. If we are talking a day or two before expiration, there won't be much premium left in the position, so it wouldn't cost much to just close it out and be done with it. However, we are human beings and we tend to get a little greedy at times. Prepare yourself ahead of time and again always calculate worst case scenario vs. being safe, controlling risk, and being able to sleep well at night. Trust your gut feeling. The settlement price can be found at cboe.com. We have a link to their site on our "Getting Started" page, or your broker should have it. The price comes out on RUT usually not until mid afternoon or after the close, and on SPX usually around late morning or early afternoon. Depending on your broker as soon as that settlement price comes out, they may free your margin up right away or they may wait until Monday to do so. IMPORTANT TRADING INFORMATION SPX and RUT are European style options. IWM and SPY are American style options. SPX, RUT, SPY, IWM all trade until 4:15pm EST. However that does not mean your broker will let you trade up until 4:15pm; some cut you off at 4:00pm; so please verify and confirm. Since we are dealing with options, you will not be able to begin trading until 9:30am EST or later. Some days they may not open the options for trading at exactly 9:30am. It may be a couple minutes later or as much as 15 minutes later. Here are our preferences for collecting option premium. This is not cut and dry, but rather generally speaking. There are certain minimums we try to attain per trade. The reason is simply risk versus reward. If you sell closer to the money you can get more premium, but you will be buying back positions that go against you more frequently. If you sell very far out of the money; you will take in less premium and have a higher winning streak, but when you do have to close out a position it will cost a lot to do so. Here are three examples. We sell close to the money and take in $1.00, we go further out of the money and collect $.50, and finally we go very far out of the money and collect $.25. In each scenario it will cost the same roughly to close out the position. Let's say it costs $1.80 to buy back the position. In the first example we are now at -.80, not bad, but you could have to do this every other month or so. The second example we are now at -1.30, but will probably only have this happen 1 - 3 times a year. The last example we are now at -1.55 and this will probably also happen about 1 - 3 times a year. The first method is more stressful and involves having to watch the market much more closely. The last method is less stressful, but when you do lose it could wipe out 3 or 4 months of profits very easily, because you weren't taking in much premium to begin with. We choose the second option. We're not saying it's perfect, but it has proven to be the best in our opinion. We also feel it is easily duplicable. If we chose the first option; not everyone can sit in front of their computer all day long, or respond to the email alerts quickly enough to successfully follow along. Of course you can always tweak things to your liking. If you see one of our trades and you want to try and go closer or further out of the money; you can certainly do so. We may have an order open waiting for a certain minimum price and you may prefer to take .05 or .10 less and get filled right away rather than waiting. It makes life a lot easier on both of us if you choose the same trades we do. If you choose something different, we aren't going to leave you on your own. Just know that we may not be able to respond as quickly as is needed. With all of our trades you are given the alert prices and immediate email alerts if any action needs to be taken. Here are our normal minimums we like to collect: $1.00 spread .05, $2.50 spread .10, $5.00 spread .20, $10.00 spread .40, and $25.00 spread 1.00. The only difference here is on the $1.00 spread we try to collect a little more to offset the commission costs. Not everyone trades with the fixed price on options regardless of the quantity. We will always enter a position with a limit order. If we need to exit a position early, we may or may not exit with a limit order. This depends on the circumstances and each situation can be a little different. Whether you choose to enter your order as an all or none is up to you. This probably depends mostly on your commission structure whether you're paying a flat fee or a per contract fee to trade. DIFFERENT SCENARIOS AND HOW WE TRADE The market is always changing and we try to tweak our trading to keep up with these changes. Any changes we make are always tested in our own accounts thoroughly before being introduced to our trading service. If we make a significant change in our trading style, we will certainly bring it to everyone's attention and update this section as well. In a perfect world we would simply put on the entire iron condor all at once. The market would trade sideways until expiration. We would get to keep all of our premium and that would be the extent of it. Sometimes it is like this, but unfortunately it's not that simple and easy all the time. Another way to trade, in a perfect world, is to wait until the market has put in a bottom and enter a bull put spread. Then let the market run up and when you see it has run out of steam, enter a bear call spread. This gives you a huge cushion. You were able to enter the bull put spread and the market took off to the upside. By the time you enter the bear call spread, the bull put position could already be 100% profitable. Believe me we do try to keep things simple and easy, but things aren't always as simple as they appear. We do everything possible to get a good indication of the current market conditions and what the upcoming market conditions may be. We currently use 13 different technical indicators and 30 different economic and fundamental indicators. We do everything possible on our end, but we can't control world events, the economy, or what the Fed does. One other big factor is volatility. There are 3 different volatility indicators we can easily look at. VIX, VXN, and VXO. The first one commonly called the VIX is what most people gauge the volatility of the market by. It can also be a contrarian indicator. The lower the VIX is, the less volatility there is in the market. This means options will be priced less expensive. This normally happens during a flat or calm market. It can also happen when the market is in a nice uptrend. The VIX is also an indicator of how much fear is in the market. When the market is going up, there isn't much fear. People are generally happy when the market is going up. What goes up does not always stay up. When the VIX gets too low and people are too complacent, that is the time to be concerned. This figure changes from time to time. Generally it is when the VIX gets below 20 or below 15. Here is how this all ties together. The market is calm and the VIX is low. We put on our iron condor and everything is fine. A couple weeks go by and we are already profitable on our positions because time decay has worked nicely in our favor and the market has not moved. All of the sudden we get a huge spike in volatility for whatever reason. The credit spreads we are already in have suddenly gotten very expensive because the increase in volatility has caused an increase in the option premium. The problem is when we first sold them, they were very cheap. Since we are already in an iron condor at this point; we can't lose on both sides of the trade. If the market makes a big move in this scenario to the downside, we can be in for some trouble on our bull put spread. The put options are almost always priced more expensive than the call options, during times of panic, even more so. One other note of caution; sometimes we will have more than one credit spread or iron condor on a given index with the same expiration. Normally this is due to a significant move in the market in a particular direction. Our bear call spread was looking safe while the market was in a downtrend or moving sideways. All of a sudden some positive news comes out and the market makes a strong move to the upside. We may close out our current bear call and add another one further out of the money. We may also keep the existing position and add another in addition to. We sold the 1450 calls and bought the 1500 calls originally on SPX. We now want to add another bear call spread. If you only have one trading account, you are now limited for adding an additional position. Here is why: If you wanted to now sell the 1500 and buy the 1525, both positions are now uneven. You originally were long the 1500 calls now you're looking to sell the 1500 calls to open. This would leave you with short the 1450 calls and long the 1525 calls. Our margin was $25, but has not just jumped to $75. If you wanted to do both of these trades in this example, you would just need to have a second trading account. It can be with your same broker. You would have account A and account B. Otherwise, in this example, your only choice for adding another position would be selling the 1525 and buying the 1550. Being that much further out of the money, there may not be enough premium to put on the position. We try to avoid this situation. We try to always choose 2 strike prices that won't affect the original position. You may want to open a second account to have available, but can leave it unfunded until you need to use it. One of the reasons we sometimes have more than one position on the same Index in the same options cycle, is for added safety. There are several variables involved. Often when buying back a position that may become violated, it is going to cost more to buy it back then the original premium we took in. If we can add a second or even a third position, it allows us to take in additional premium. It makes the process of closing out a potentially losing position a little easier to deal with. For example, we took in .50 on a position. It looks like it may be violated, so we have to buy it back for 1.20 to close it out. We are now at - .70 for this particular position. This is our bear call. We already took in another .50 on our bull put and that position is safe. We are now at -.20. If we can find another safe bear call for .50, we are now profitable. Since the market has moved, we may even be able to find another safe bull put spread and take in some additional premium. This is simply reacting to whatever the market is doing. One of the hardest things to do sometimes is sit on the sidelines and wait; especially if you're sitting in all cash. You want to put that money to work. Very seldom, if ever, will we be in all cash. However, sometimes we need to be cautious and patient while adding additional positions. It is better to have only entered one side of the trade safely, then to have entered both sides just to be in it and be facing a loss. Here is one thing I have found very useful when I get impatient or feel the need to trade unnecessarily. I use my virtual account for these situations to get that desire to trade out of my system. Try it the next time you're unsure of a trade, or maybe you feel like you're forcing a trade just to be in something. It may help. MONEY MANAGEMENT | ASSET ALLOCATION Please note we are not giving advice on this topic, but rather sharing what we do in our own accounts. It's your money and you are certainly free to do as you please. We have strongly recommended throughout our website that you first get comfortable with this strategy in a virtual account. Just writing trades on a piece of paper is pretty much useless. In the virtual account you must be accurate and you can also mimic a funded account. Take it seriously. If you plan on trading with $10,000, start your virtual account with $10,000, or only use $10,000 to trade with. Practice and allocate the same percentage per trade as you will in your funded account. The best part is to see the account balance grow and gain confidence and experience as you go along. When you are ready to begin trading with real funds, always start out small. If you are new to trading, you will experience more emotions now that you have real money on the line, even if it is a small amount. This is the next step in gaining experience and getting comfortable with our trading strategy. Then you can step it up a bit, but watch and monitor yourself and your emotions very closely. Our trading style is pretty laid back and designed to take as much emotion out of trading as possible. Many people trade just fine until the dollar amount per trade or amount of money at risk gets to a certain level. Then, they lose it. They start exiting trades when they should have stayed in and vice versa. Always remember the most important part of trading is properly managing your money. As Warren Buffett has said "Rule No.1: Never lose money. Rule No.2: Never forget rule No.1." Normally people will fall into one of two categories when they trade. Some people are in the phase of growing their account size so they have more capital to work with. Other people have already built up their capital and simply want to preserve it. Use the calculator on our website on the Performance page and calculate what size account you think you need to achieve your goals. We built another calculator, but weren't able to implement it into the site. Perhaps we can email it to you. With this other calculator you can enter all of the same information, but you can also tell it how much money you want to withdraw each month. It's pretty cool to play around with; especially when you see the difference in compounding when taking out $0 per month versus taking out just $2,000 per month. At some point your account will be big enough where you can take out enough to pay the bills and still have some left over to put back in and compound. Or, as we've mentioned before, some people keep the balance the same and take out the profits each month. You'll have to decide what you want to do and what works best for you. You've probably heard this before, but it's worth repeating. If you lose 50% of your account value, you then have to make 100% just to get back to where you started. When you want to load up on that sure trade, do the math and figure out what would happen if you lost it all. Let's first discuss what the traditional rules are. Never allocate more than 1% or 2% per trade, never ever go over 5% per trade. That's great if you have a huge account, but most people don't and it will take quite a while to get anywhere with that approach. When you hear those figures, it's usually coming from a professional trader, floor trader, mutual fund, or a hedge fund. They don't want the exposure to be too great in any one position. They trade individual stocks, so it makes sense. If they are trading Enron and they only have 1 - 2% in that trade, even with Enron going bankrupt, they still live to trade another day. They also play by a different set of rules. Forget the fact that may have more money to work with. The private trader usually has 2 to 1 margin, with a maximum usually of 4 to 1 for intraday trading. The big boys may have 100 to 1 margin. Go ahead and do the math and you'll quickly see how they can still make a great living only allocating 1 or 2% of their account per trade. If you have a large account, or even as your account size grows, it is always a good idea to cut back and allocate less per trade. Again we need to address how does the person with the smaller account get going. Never put more than 20% into a trade. So everyone is on the same page, we need to define this a little more clearly. The 20% figure is the margin requirement for putting on the trade. $100,000 account, 20% of that is $20,000. If you're trading RUT which has $10 spreads, that means you can put on a trade of 20 contracts. If the first 20 contract trade was a bear call spread on RUT, you can still add a bull put spread on RUT with another 20 contract trade. Remember the margin remains the same for an iron condor. You may not be comfortable at first or ever putting 20% into one position and that's fine. Understand that this is a different style of trading. We trade very broad indexes and we are profitable on a minimum of 85% - 90% of our trades. In comparison, most other forms of trading, people are normally very happy with 30% - 50% profitability. We're just using this as an example of the maximum ever allowed. If you're on the higher end % of the allocation like 10% - 20% always round up. Here's what we mean if they require $20,000 in margin requirement, but you took in $1,000 in credit premium, with many brokers, they will only require $19,000 in margin requirement. For the allocation purposes do not use $19,000, use $20,000. If you are using a lower % for allocation then you can choose which figure you want to use. Always try to keep at least 10% - 25% of your account in cash. There may be brief times when you are fully allocated and that is ok, but it's always nice to have some money on the sideline. You may need to make an adjustment, or an opportunity may pop up and it's nice to know you can act on it. We normally trade 2 indices or 2 ETF's at a given time. Even at the maximum allocation of 20% that only adds up to 40%. We may be in more than one expiration cycle at a time. We may be in as many as 3 expiration cycles at one time, but only for a short time, normally it is 2 expiration cycles at a time. If you look at our current portfolio it will be easier to see what I am talking about than to explain it here. Lately we have been in 2 - 5 trades per Index. The most recent example was 2 Aug, 2 Sep, and 1 Oct. The Oct was added as Aug expiration was approaching. At this point we were allocated at around 100%. We had these 5 trades on 2 different indexes for a total of 10 trades. If that sounds like too much, you could have done 1 Aug, 1 Sep, and 1 Oct. If you were allocating 20% per trade, notice you would not have had enough capital to put on the Oct trade until the Aug one expired. In the example above of 10 trades, we allocated right around 7% or 8% per trade, maybe even as much as 10%. If we ever become fully allocated it is normally only for a matter of days, or a maximum of 2 - 3 weeks. Options are always decaying. However, the most rapid time decay of the option premium is in the last 30 days. We have found if you simply try to sell front month credit spreads only, you cannot always position yourself safely enough. By selling a little further out, we can usually gain a little more cushion. If we go too far out we can run into a couple of problems. The time decay is not rapid enough. We tie up our capital without becoming more profitable. Also the available option strikes can be very limited. This is another example of how we try to change when the market changes. If the market is vey volatile, we may need to shorten up our time frame and vice versa. There's a fine line that we are always trying to find. DELTA AND THE REST OF THE GREEK FAMILY You will hear some talk about the Greeks. Some people monitor the gamma, theta, vega, and rho. Don't worry about any of these. All we really care about is Delta. Delta is the relationship of the movement of the option in relation to the underlying stock, or in our case the underlying Index or ETF. The higher the delta the more it will move. This is much more important if you were buying an option because you want to know how far and how quickly your option will move. If the delta is 50; that means for every 1 point move in the underlying, your option will move .50 or half. When you go deep in the money you can get a delta of 1.00, so it will move at the same rate as the underlying. There is delta for puts and for calls. The call would have a delta of .50 and the put would be -.50. When we put on a position, we are first looking at what amount of credit can we get. Next we look at the distance out of the money to see how safe it looks. Finally we look at delta. Sometimes we don't look at delta when entering a position at all. When entering, however, the delta will usually be in the single digits; usually always less than 10. This means if the market stays where it is, the only thing that needs to happen is for the time value to erode out of our options. What we use delta mostly for is to monitor the safety of the positions we are already in. The delta we are referring to by the way is the delta of the individual strike prices, not the delta of the spread itself. If we entered with a delta of .08, we want to monitor this as time goes on. There is no set value as far as exiting when it comes to delta. We don't automatically get out of a position when the delta reaches a certain figure. We also monitor the volatility figure of primarily the VIX. We look at where the VIX is now compared to where it was when we entered our position. We could also do this by checking the Greeks as well. Rather than learning and knowing about all the different Greeks and what they mean, it is easier to learn delta and to stick with the VIX for purposes of checking on volatility. We try to keep things simple. We are sharing exactly what we do. We don't pay much attention to the other Greeks either. One other thing we look at; is the cost to close out our position. If a trade is moving against us we will see it in a few ways. First visually on a chart, second the cost of closing out our position early, and third with the change in delta. If the cost to close out our position is becoming greater, we want to know why. We simply confirm this with what we've already discussed. LEGGING OUT FOR EMERGENCY SITUATIONS You can do this with either a bear call spread or a bull put spread. You have a bull put spread already intact because you think the market is either bullish, flat, or not going to go down far enough to violate your position, but you were wrong. The market is selling off sharply and you're potentially in a lot of trouble. What do you do now? Remember with a credit spread you are completely hedged. You know what your worst case scenario will be. Let's say you have a $5 spread. You sold the 875 puts and bought the 870 puts on SPX. That's a $5 dollar spread and the maximum you can lose is $5 minus whatever premium you took in let's say .30. In this example the max you can lose is $4.70 if the market falls apart and you can't react quickly enough. That's the worst case scenario. You can also close out the entire position all at once before SPX gets close to the 875 sold strike. In this example you were able to close this position out when SPX was trading around 890. You closed out the entire bull put spread and between the cost of closing and the credit you originally received, you lost $2.35 on this position. This was half as much as just letting it go and not doing anything at all. Our third and probably most risky choice is to leg out of this position. We buy back the 875 put that we originally sold and we are now long the 870 put. We are suddenly directional traders now and are no longer hedged. We could in fact lose more money this way than the previous worst case scenario of losing $4.70. It cost us money to buy back the 875 put and if the market now decides to rally, we could lose most or even all of the value of our long 870 put. This is why this scenario is used only as a last resort and for emergency situations. The goal is to try and break even. We can easily look up what we sold the 875 for and bought the 870 for. If we decide to buy back the 875, we can then calculate at what price we need to sell the 875 put to break even. The goal is to get out intraday by setting a limit price to sell the 870 put. In a fast and furious market, you might even be able to make a profit on this trade. If you're able to actually profit, great, but don't get too carried away. Be happy to simply walk away at even and be glad you didn't lose $4.70 on this trade. Legging out was more necessary in October of 2008. The market was rapidly falling setting all kinds of records to the downside. When the positions were originally entered the VIX was trading in the 30's and 40's. As the market fell, the VIX rose to as high as the mid 70's. This made simply closing out the positions a very expensive option. Since the market had some fast and furious moves down, it made it easier to leg out of several positions successfully. One other note is that it will be easiest to break even or profit the smaller the spread is. A $1 spread is the easiest spread to leg out of and a $25 or higher spread is the most difficult. Just look at any option chain and you will see the price of SPY 87 and 86 compared to SPX 875 and 850. The 87 and 86 are much closer in price compared to the 875 and 850. This means not as much move in the price is required to get you to break even. We discussed legging out was necessary in October 2008 because of the rapidly falling market and huge rise in the VIX. What about in a bull market? Unless there is a large gap up, most likely it will be easier to just close the position early. Every scenario is a little bit different of course. As the market is rapidly rising the VIX is actually dropping. Again the VIX is a measure of fear in the market and unless we're near a market top, there isn't much fear in the market. As the market is rising our cost to close the position is increasing as the market rallies closer to our sold strike, but at the same time the VIX is dropping. Normally the market rallies much slower than it sells off. If we bought back our sold call and were now left with a long call, our odds are not as good at breaking even on the trade. Not saying we won't ever have to do this, but the odds are much less likely than in a falling market. HOW TO BEAT THE MARKET MAKERS I learned something the other day that I'd like to pass on. It doesn't necessarily pertain so much to our trading strategy as it does with trading options in general. Please note this topic is for situations when you have a bit of time to get in or out of a position. The market makers are very good at what they do. They've been around a long time and they know all the tricks that exist. Many times it is you versus a computer, not a human being on the other side of the deal. I want to focus on human emotions for a moment. After all that is what the stock market is comprised of; several millions or billions of people with their hard earned money at work. As time goes on they battle with fear and greed depending on what is going on. Unfortunately we aren't all meant to be traders. In fact very, very few people are cut out to be a good trader. The main reason is that we let the wrong emotion get in our way at the wrong time. Let's look at a recent trade of mine and hopefully you can relate. I was looking to get long a call option while the market was falling a bit. It doesn't matter what the ticker symbol or strike price was for this example, but I was going after a strike price that had the most volume for that day. It's always good to choose a strike that has a lot of action. One reason is the bid ask spread is usually tighter, and I will explain the other reason. While we can't always pick a top or a bottom, sometimes it's just nice to know that you did the absolute best you could under the current set of circumstances. One way of doing this is to make sure you don't overpay for an option. Nobody likes the feel of entering a position to only be instantly rewarded by being in the red right away. If you are buying to open, getting long, and the option has a bid ask spread of 2.70 x 3.00. That's a bit wide, but I've seen a lot worse. First off, you never want to just pay the full ask price if you can help it, and remember our example here is when you have some time to enter in a slower moving market. First thing you can try is to put in an order at the middle price, or 2.85. As long as your order is not an all or none, your order will most likely get posted to the bid side. To try and insure getting posted to the bid side you should also have your routing preference set to best exchange and not a particular exchange. Instead of a bid ask of 2.70 x 3.00, once your order is placed to buy for 2.85, it will look like 2.85 x 3.00. Occasionally they will just fill you at the middle price, but that didn't happen in my trade. Now you can keep playing games and trying for 2.90 or 2.95 to try and get filled. Most likely all this will do is move your order once again to the bid side and you still won't be filled. Let me explain first what they are doing on the other side. They don't want to fill you for less than the ask, so by posting your order to buy on the bid side, they are simply trying to match you up with a seller. If we're still trying to buy at 2.85, they are simply posting it on the bid side waiting for a seller at 2.85 to come along. They match our trade up and never have to get involved. What I am about to explain doesn't necessarily involve any movement in the underlying, but it does involve the right conditions of what the underlying, or stock is doing. Once again we have a fairly active strike price, let's say the volume of our particular strike price is 1,200 so far on the day. It's not overly active to where we are getting our middle price filled, but enough that we know there are other people trading it as well. Now for the human emotion part of the deal. Remember the bid ask was originally 2.70 x 3.00 and once we entered our order to buy of 2.85, the bid moved from 2.70 to 2.85. We are trying to buy and get long this call option, let's put ourselves in the shoes of the seller. The seller is trying to get out of this option. He or she has been seeing a bid of 2.70 and is waiting to try and get a little more out of the deal, but at the same rate they really want to get out. When the order to buy comes in at 2.85 that moves the bid price to 2.85. Since we are all mostly stupid when it comes to trading because we let our emotions get in the way, does the seller immediately enter an order to sell at 2.85? Heck no! The seller now says wow this thing is finally moving in my direction let me wait and see if maybe I can sell at 3.00. Right? We've all been there. First we were looking to sell at 2.70 now we can get 2.85, but we get a little greedy and hold out for more. We've all been there before. So my order is still sitting there on the bid side at 2.85 and no sellers are biting. I move my order to 2.90, it gets posted to the bid side and nothing happens. The time frame by the way is leaving the order sit there for about 10 minutes or so. Again I'm just trying to make sure I don't overpay at the current moment so I'm not willing to let the order sit there very long. During this time the stock is barely moving so the option pricing is remaining the same. I am basically playing the role of the market maker temporarily as I am controlling the bid price by what I enter as my buy price. As long as my buy price is less the ask price this little game continues. After a while I want to get on with my day and just be in the deal, but I still don't want to pay too much. Here's what I did - the seller was looking at 2.70, then 2.85, then 2.90 as I was changing my buy price and the ask had remained at 3.00. Nothing was happening so I put myself in the other personâ€™s shoes for a moment. That's when I cancelled my order completely. By me cancelling the order the bid price immediately went back to 2.70. If you are the seller what are you telling yourself now? You're going to get out the next time you see that sell price move higher right? You got greedy and should have gotten out at 2.85 or 2.90, but you waited thinking it would go even higher. Now you see its back at 2.70 and you're getting fearful it's moving the other direction, the next uptick and you're going to sell no matter what. I played one more hand before I got filled and it was this. I let that 2.70 bid price sit there for a while, I didn't have a buy order in. I then entered a buy order of 2.80, but immediately cancelled it. I just wanted it to flash on the screen on the bid side for a short time. Once I cancelled the buy at 2.80 the bid was back to 2.70. I then entered a buy order at 2.75 and bingo was filled immediately. I didn't know for sure that there was a seller out there, I was just hoping. The only way this worked was for me to think like I was the seller and what I would do. We're all programmed just about the same. Given certain situations in the stock market at least 90% of the population would behave the same way. This probably won't always work for you as it did here, but if you have the time and patience give it a try. It's nice to feel like you won the battle for a change because we always seem to get screwed when trading options or at least it often feels that way. MORE ON ALLOCATION PER TRADE Let's take a look at a $100,000 trading account and give some examples on how to properly allocate this for our trading style. We may be in as many as 3 different options cycles at any one time, but this is usually for only a brief period. Let's say we are already in the November and December options cycles. We also want to leave some money available for a couple of other spreads outside of trading the S&P 500. This helps us to further diversify our trading, but we only do this when opportunities arise. It is not something that we force every month to happen. If we are trading only the S&P 500 you then have the choice to further allocate your trading for non S&P 500 trades or to have more cash on hand. When things are very volatile you will want to have more cash and when things are more calm you will probably want to be more fully allocated and be in less cash. In the above example we are already in November and December. If we want to add January we will normally only do this as November expiration is almost upon us. By adding this third option cycle it may very well use up all or most of our cash on hand. We only do this when the November positions are very safe and won't require any adjustments. If for some reason you don't have enough funds to add the January position you can either put on a smaller trade and add to it later, or simply wait until after November expiration. At that point you will have freed up your margin to allow for the January position. Many people that are new or simply inquiring about our service often ask how many trades we do every month. It's not a simple question to answer really as we don't have a set amount and we rather trade when opportunities present themselves. If we have two spreads on for the November cycle and two spreads on for the December cycle; we consider that to be 4 trades. If all four of these spreads are mated up and are Iron Condors you can call that 4 trades or 8 trades it doesn't really matter. What matters is the use of your margin. You will be using the same amount of margin whether you have a directional credit spread on or a full Iron Condor spread. We will have 2 to 3 spreads on the S&P 500 for any given option cycle. It depends on what the market is doing and how much the market is moving around. We may add to the existing strikes or we may add a new set of strikes. This also depends on what the market is doing. The key is to try to allocate the same amount of capital to each trade. This helps you to stay on track in terms of your allocation and also helps you to trade better. As the market moves around if you have put all your money on one or two trades you could easily get faked out or do something very wrong. If you over-allocate it will affect your ability to think rationally. We recommend you be in at least 2 S&P 500 trades per options cycle. You might find a third to be too much to manage or perhaps your schedule doesn't permit you to trade that often. We understand that, but only trading one is too much capital to be allocated to a trade. If the second trade is simply an add to the same set of strikes isn't that the same as putting on one larger trade you might ask? Normally when we add the second trade it is later in the cycle and or the market has moved. This means the risk characteristics of the trade are now different. If the S&P 500 is trading at 1100 and you sell a 950/940 credit spread with 45 days to expiration, versus the S&P 500 trading at 980 and you are selling the 950/940 credit spread, but now there are only 12 days until expiration. The risk/reward of these two trades is quite different. Let's use some real figures now with a $100,000 trading account. The allocation per trade should be from a low of around 5% to a high of around 12%. If you have a very large account you can allocate less than this and if you have a very small account you may choose to allocate more due to the impact of commissions. Let's we use 5% to 12% as our example. 5% might be during more highly volatile times and a willingness to be in more cash. 12% might be during less volatile times or maybe you only want to trade the S&P 500 trades and thus don't need to set aside margin for any other trades. We'll use 10% per trade for easy math. If you are already in 3 trades for the November cycle and 3 trades for the December cycle you are now using 60%, or $60,000 of your $100,000 towards margin. You have $40,000 in cash. To keep things simple we will assume the full amount for the trade and its margin use. If you took in .50 on a $10 spread, technically your broker will only require $9500 be put aside for margin. For this discussion we will put aside the full $10,000. It is wise to always have at least $20,000 to $25,000 or more set aside in cash. If we are getting ready to add a January cycle trade we normally will only do that when there are about 2 weeks or less in the November cycle. As we add the January trades we may violate the rule of the amount of cash on hand, but we realize that in a very short amount of time the November expiration will come and go and free up a lot of margin as a result. The reason we need to keep cash on hand is for any adjustments that may arise. If you were looking to regularly leg out of a position you would want to have a lot more cash on hand to make sure you would have the funds to do so. Probably something like 50% cash on hand at all times. Keeping at least a little cash on hand will enable you to close out a position that is going against you and to be able to roll a position if you need to. In other words having plenty of cash on hand gives you more options. If we have a $10,000 Iron Condor position. One side is going against us and we need to close it by buying it back early. When we do this we are still obligated to have $10k in margin set aside for the other half of the trade unless we close that out early as well. Since the trade has gone against us it is probably going to cost more money to close this position than we originally took in. This is an example of why we need some cash on hand. If we only had a bull put spread on and not a full Iron Condor and we were closing out the bull put spread early that would free up our margin. In that scenario we wouldn't need to have as much cash to do this. SPY VERSUS SPX I think the majority of the subscribers trade SPX. Aside from Optionshouse and now eOption, all the other brokers have pretty similar fees for options. Some subscribers tell me what they were filled for on SPX. Sometimes it's the same, sometimes a little more than SPY, sometimes a little less. In the long run it evens out, but of course you have less commissions involved. Here is the comparison, or pros and cons of both - SPY: Pros - If you have the ability to see in depth option quotes you can see all exchanges, the prices and the size. There are 7 exchanges competing for your business. You have the option to leg in and buy from one exchange and sell on another exchange in order to get a better fill. You can see a real quote, a bid price that will fill instantly if you like. Also a natural ask price that will fill instantly for a quick exit. You don't have to worry about getting beat up badly with a wide bid ask spread. It seems to be much easier to successfully leg out of a $1 spread should you need to. This is due to the more narrow bid ask spread and it is usually a quicker process to start making money on your long option, or less movement is required in the underlying. Cons - It can be more commission intensive depending on your structure, but there's nothing wrong with taking the time to compare both trades before entering. Maybe you will have more commissions on SPY, but if you can get more premium it might be worth it. Most brokers let you preview your order before sending and it should show the money received less commissions so you can do a comparison. Most of the time your SPY trade will only fill when the natural is hit or when your order is matched up with a debit spread trade. There isn't much room for negotiation only price movement will help you get filled. SPX: Pros - You will be trading less contracts so it will result in less commissions. Always compare the end amount of premium in the $10 vs. the $5 spread. Personally I prefer the $5 spreads when given the choice and would avoid going wider than $10. It can be fun to try and negotiate and battle for your premium as you try to get filled at the mid price or maybe a little less than the mid. Cons - You are dealing with only one exchange, the CBOE. You are also dealing with humans trading in the pits and you are reliant on their desire to trade. I was frustrated one day on getting filled and had someone contact the SPX pit to find out what the story was, don't go asking your broker to do this for you because they probably won't, and the feedback was they were more focused on trading the front month contract and I was trying for a fill on the next month out. You most likely will not see a natural bid price, so you have to be more patient in sending an order and waiting and maybe tweaking your price a little. Even if you are not trying to be real aggressive on your fill price, it will take a bit longer to get filled due to the process. SPY is an electronic order to all or at least most exchanges, and SPX your order will be yelled out to the traders in the pits. You also have to worry about the wide bid ask spread when trying to exit a trade. You are looking to buy back your spread to close it out and the market is moving against you. You don't want to pay the full ask price, so you try for a limit order and you wait to see if they will fill you. No fill yet and SPX continues to move against you so you adjust your order and wait again. By the time this is all over you finally get filled and are out, but you ended up paying more than if you have just entered your order at the full ask price the first time around. I've been there and done that a few too many times. Both products are very liquid and you will probably never outgrow either one. If you look at the open interest it is normally very similar. You will see the most open interest at the more round numbers, 1100, 110, 1150, 115, etc. It boils down to personal preference and I always recommend people try both to see what they like, or stick with what you are most familiar with. Commissions have become quite cheap over the years, but some brokers haven't kept with the times and thus you might be forced to trade SPX. Don't just take my word for it test it out for yourselves and send some feedback once you do.
Pages to are hidden for
"SpreadTheTrend Tutorials"Please download to view full document