Part 1
This post will outline a step by step process where I’ll show you when a trade setup would have been triggered and how it could have been traded. Even though I use this strategy literally hundreds of times in a year with my own trading, this is not one of my actual trades. This is a simulation using the ‘on demand’ feature from ThinkorSwim (TOS). However, this is actual trade data so the prices are quite accurate. The reason for using on demand is that I can show you, to the second, when a chart setup is triggered and at what price option trades could have been placed. The on demand feature allows me to stop time and grab screenshots to walk you through the process. I can’t do that with real-time trading. I hope you’ll find this exercise worthwhile and use it as a reference guide.
First, let’s look at the current FB daily chart. You can see where Monday’s price broke down and closed below the previous week’s low. Breaking below the previous week’s low is a legitimate bearish trade setup although perhaps not the best way to trade that price condition. I’ll discuss passing up this trade setup for a potentially better one in part 2 of this post. For now, I’ll take the bearish setup and run with it.
Below is the FB chart from about 55 minutes into the trading day on Monday 10/19. First thing I want you to notice is where the morning low was. Soon after the open sellers took price to with $.01 of the previous week’s low. We know that there are always buyers at the previous week’s low. We just don’t know how strong they are are relative to the sellers. So price bounced off the low and rallied weakly higher. One nuance to watch here is that if price continues to trade near that previous week’s low and can’t rally very much then buyers aren’t very strong and it’s likely that price will fall further. At this point I’m simply ready to initiate a bearish trade but I haven’t done so yet.
Below is the chart from 65 minutes into the trading day. Price has now broken the previous week’s low and triggered the bearish trade. I have 2 typical choices for my stop price; price acceptance above today’s high or today’s opening price. So, what is price acceptance? That refers to price trading at a price level for a period of time where some real volume is transacted. In other words, if price moved above one of the stop levels mentioned, traded a very short time with little volume being transacted and then dropped back below that price again, that is not acceptance! I’m not easily stopped out of trades because I demand acceptance to trigger a stop. Sometimes my drawdown on a failed trade is greater because of that but, in general, I have many fewer failed trades!
So now it’s time to initiate the bearish trade. I’ve selected to buy the Dec18 FB 250 Put. Why? Why not? Here is one of the great things about trading options utilizing the strategies that I show you with this service. In a trade setup like this, I can choose any number of strikes and/or expiration cycles and still have the ability to reduce or eliminate cost, often within a matter of hours! In this example I’ve just decided that I need some duration in my portfolio so I picked the Dec expiry. I paid a few cents over the mark price to get a fill so I now own the Put for $12.95
Before I move on to the adjustment phase of the position, let’s estimate what my loss might be if price were to find acceptance above my stop level and I had to exit the position. First, I own the 250 Put for $12.95. Now look at the mark price of the 245 Put in the option chain. Around $11.00. Why is that relevant? If the stock price were to move higher by around $5 then the current price of the 250 Put will be worth approximately the same as the 245 strike Put is currently. So, depending on which of the 2 stop levels I chose, I’d expect my loss to be between $1-$2 if I’m stopped out.
See the chart below. Fast forward in time and now FB price has dropped below 261. I’ve got a little profit going but nothing spectacular. Price certainly looks like it could keep going lower here so what is significant about this price? Nothing other than at this point I could already eliminate all cost from the position and actually lock in a small profit. How would I do that? Now we’re getting to the secret sauce of the Vega Options style of trading. I believe it’s what sets this educational service apart from all of the others. But you can be the judge of that. Read on!
The first thing I’d do is sell the 245 Put in the Dec18 expiry. That turns the long 250 Put into a 250/245 Put Vertical debit spread. I’d have received an $11.50 Credit for doing that. Ok, right now you’re probably questioning my math skills. The 250 Put cost $12.95 and if I’m selling the 245 Put for $11.50 that doesn’t eliminate all of the cost much less lock in a small profit. Before you ask for a refund for this service let me say that I’m not done with the adjustments yet. Keep reading!
Below you’ll see the risk profile of the original Put I purchased plus 2 additional trades. #1 is selling the 245 Put creating the Vertical Debit spread that I’ve already mentioned and #2 is selling a $5 wide further OTM Put Vertical Credit spread for $1.60 Credit. By making that second adjustment I’ve now created a Condor spread. Now what is my net cost in this position? $12.95-$11.50-$1.60 equals -$.15. That’s a $15 Credit. See, my math skills aren’t that bad after all.
So the significance of the stock price falling below 261 is that was the stock price where I was able to lock in a small profit and still hold a position that has the potential to make a much larger profit between now and Dec18 expiry. Earlier we estimated that my likely loss if I was stopped out would be between $1-$2. With this new position my maximum profit is $5.15. That means the reward/risk ratio on this position is between 2:1 and 5:1. Of course that reward/risk ratio was calculated on the original cost which I was exposed to for literally just a few hours. I didn’t even have to carry that risk overnight! I could’ve finished the trading day on Monday with an asset worth up to $515 that had a less than a $0 cost.
Now I want you to envision a portfolio that has many of these types of low cost or no cost positions. The setups that failed along the way were stopped out for relatively small losses and are no longer a part of the portfolio. The portfolio is then made up of almost all winning positions! I know that sounds impossible but I can honestly say that I often have extended periods of time where I don’t have any net losses. In other words, the small losses from failed setups are more than covered by the relatively larger number of no cost positions that typically comprise my portfolio. Carrying losing positions in a portfolio not only drains financial capital but it’s also a drag on emotional capital. Quickly moving on from losing positions and, almost as quickly, Delta hedging positions to limit losses or locking in gains is a much more enjoyable way to trade.
This post was an example of just one setup (selling a breakdown below the previous week’s low). As I mentioned at the top of the post, it’s not even the best setup that I can come up with here. In part 2 of this post I’ll examine the opposite trade. That would be going long on Tuesday after Monday became a failed breakdown. That’s going to have to wait for another day. In the meantime, as always, questions and comments are welcome!