Rally finally stalls, some thoughts on option spreads

It’s been a while since my last post. I took a break from directional trading during the recent persitent uptrend. I’ve been spending time improving my skills trading option income spreads, which I’ll get to later in this post. First, a recap of recent action in the overall market, at least as represented by the S&P 500 etf. Several posts back I referred to a much advertised bearish head and shoulders pattern that never materialized. Instead, the larger time frame, or weekly S&P chart was building a much more powerful, and less advertised, bullish inverse head and shoulders. That did break out to the upside. Since then the stock indexes, defying all logic and fundamentals, proceeded on a very persistent uptrend over the last several weeks. It seemed that every attempt at a selloff was met with renewed buying. Volume was not impressive. It seemed like the buying was dominated by funds chasing momentum, not wanting to be left out of the party, and not knowing what else to do with idle cash. It seemed the bandwagon effect on this rally was classic. The beginning of the move was characterized by doubt and disbelief that the market could rally with such a bleak background. Then the doubters became belivers. When everyone was on the bandwagon a correction finally materialized, at least so far. It is amazing how the S&P went right up to the gap on the weekly chart. This could be nothing more than a statistical oddity. What is even more odd is that gap was left almost exactly one year ago. Not sure if a year old gap being filled is enough to turn this uptrend around, but it is interesting that the market pulled back right at that spot. Next line of support could be the rising neckline. But of course anything can happen, and the bull can resume whenever it wants.

The above chart illustrate the type of trade I’ve been doing lately. For those not familiar with option expiration graphs I’ll explain briefly. The green line is the distribution of profit at option expiration in dollars. You can see the zero line with profits and losses above and below. The horizontal axis is the price of the underlying security. In this case the stock is IBM. This is not a recommendation to do this type of spread on IBM. I am only providing it as an exampled. I do not personally have this trade on at the moment. It just shows the type of trade that is possible. The white line is the current profit or loss of the current trading day. As the current trading day approaches the option expiration date the white line will eventually merge with the green line. It will increment toward it each day until the two lines become one. If the price of the underlying is under the tent, that is between about 111 on the downside and 129 on the upside, there will be a profit on the trade. Maximum profit would occur around the 120 price. Of course a loss would occur if the price were to move outside these boundaries, and if no adjustments were to be made. However, there are many possibilities to adjust such a trade if the price were to move beyond the breakeven prices. This tent can be moved around to try to keep it over a moving price.

If the market were to sit still, this type of trade would be easy money month after month. In reality, markets move around, and those expiration break evens are often breached, and adjustments need to be made or the trade needs to be closed at a loss. Many of these trades would have a loss potential exceeding the maximum profit potential if defensive action is not taken. This is where the art of trading and experience comes in. Trade management is a far more critical element in trading than trade selection. Anyone can find a good trade to put on, especially without the pressure of being forced into a decision since no position is currently on. It takes more skill to manage a position once a trade has been established and the market has moved to a decision point. These spreads have another element to deal with other than price. That element is the direction of volatility. This particular trade happens to be a time spread, or calendar spread. Actually a triple calendar in this case. The calendar spread can also be hurt by a significant drop in volatility. If one expects volatility to drop, especially if the current volatility environment is high, then there are other types of spreads, such as butterfly spreads, than can be constructed to take advantage of falling volatility.

While away from this blog for some time, I have spent some time thinking about the direction of this blog. My initial reason for creating this blog was simply to have a place to put down my thoughts on the current market, as well as a place to write about indicators and technical analysis. I could have just gotten a big notbook and recorded my thoughts there. But it seemed to be a better idea at the time to put it out on a blog so other traders could have a resource based on my trading journey. I didn’t really care if there was anyone out there reading what I was writing. My goal was just to have a place to organize my thoughts. I got away from that in my updates. I’m not sure putting up a daily S&P chart with a couple of indicators and an opinion of possible market direction can really help anyone in an educational way. There are plenty of blogs that attempt to call market direction. That is not what I’m trying to do here. I would like to get back to having this blog be a space where I can just unload current thoughts about trading. I would like to discuss option spread ideas. Although I will be protective of much of the information I am learning in the Sheridan program. It wouldn’t be fair to Sheridan or anyone reading this blog to put out specifics. A little knowledge can be dangerous. The learning that goes on is a very long process, with many classes daily, and many private mentoring sessions doing live trades. This information couldn’t be presented easily in a blog even if I wanted to. However I can discuss broader concepts, as well as general market conditions, and of course politics, at least as far as they influence the financial markets.

2 thoughts on “Rally finally stalls, some thoughts on option spreads

  1. Hi Doug,
    I’m new to option spreads, can you please point me to a short description of the triple calendar spread you mentioned in your post? I only found the description for the simple calendar spread.

    Thanks.

  2. Adrian, the triple calendar is similar to a regular non-directional calender except the strikes are spread out rather than all at the money. This gives a little wider tent with the tradeoff of a little lower max profit potential. The only place I know of more in depth discussion on the triple variation is one of the guys in the Sheridan program who has been doing these on IBM for a long time. There are some archived WebEx files, but they can only be accessed by those in the program. I’d suggest just learning as much about calendars in general, and just thinking of the triple as splitting up the strikes. Dan Sheridan has some lessons open to the public on calendars on the CBOE website in the learning center. They are about an hour long. I’d start there. He gets into double calendars. Triples aren’t that much different.
    Doug

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