Very important concept tweeted by Steve Burns and validated by the ‘Horse’. They both know what they’re talking about. Sounds good in theory but how do you do that? That’s what this post is about. Read it, understand it, trade it. Ask questions if you don’t get it!
Step 1: Wait for a setup that offers a good potential reward/risk! A failed breakout above prior month’s high is a good setup for a short (bearish) trade. The target then becomes the HB zone of the prior month’s price range. The stop on this trade becomes a close above the high of the daily candle that triggered the short. In order to keep the potential loss on a failed trade as small as possible I’d need to initiate a short position with a relatively small amount of short (negative) Deltas.
Step 2: Structure a trade to have low initial Delta (directional) risk so that if the position is stopped out I’ll have a relatively small loss. When structuring bearish positions, Put Condors are very effective, cost efficient, and easy to trade! Below is from TOS ThinkBack showing what it would’ve cost to buy a Broken Wing Condor (BWC). Broken wing just refers to the fact that the two ‘wings’ of the Condor are different widths. I wanted the debit side of the spread to be $5 wider than the credit side to open up a profit to the downside in case price doesn’t stop at the target area. On Sep2, the day that triggered the short setup, I could’ve bought the BWC for $2.60 ($260).
Step 3: Manage the position. This is where everything I’ve shown you in the past about getting to zero cost on a position comes in handy! However, just for arguments sake, let’s say that I don’t ‘manage’ this position, I just let it run. What does that scenario look like? As of 09/19/2021 the current Greeks of the position are: -2.98 Delta, -.03 Gamma, 19.48 Theta, -26.66 Vega. That means right now the biggest exposure is to Vega (volatility). The volatility measurement for SPX is the VIX. The VIX has been rising as SPX has been falling. That’s typical. That effect is suppressing the profits in this position. So wouldn’t another structure, such as a Calendar or Diagonal, have been a better choice? I don’t mind that the profits have been suppressed on the way down because I know that when price reverses and moves higher or if it just consolidates sideways that the VIX will drop rapidly accentuating the profits in the position. On the other hand Calendars and Diagonal lose much of their value in that environment. Also, consider that the Theta is $19.48/day and rising! The initial investment was $260 so at $19.48 in Theta that is a 7.5% per day return on investment just from the passage of time! And, that number will continue to increase as long as price remains in 4425-4450 range.
This post has shown you one simple way to find a good trade location, structure a trade and then manage it (or don’t). They are many other ways to find a setup as we discuss daily on the twitter feed such as the declining upper band or rising lower band of the 8 SMA. Find a setup that you like to trade, wait for it to happen and then use a low Delta risk strategy to trade it. Also, mind your stops!
09/20/2021 Update: The SPX futures (/ES) is down by 1.3% prior to today’s regular hours trading and the open profit on the Put Condor in this post has increased. As I contemplate reducing risk in the position I’d consider the reward/risk of any adjustment that I might make. If you view the 4480/4450/4425/4400 Broken Wing Condor as having 11 embedded $5 wide spreads (6 debit spreads and 5 credit spreads) it’s easier to understand how to evaluate a potential adjustment. If I wanted to sell one of the $5-wide debit spreads (4480/4475) I could collect a $3.60 credit. The maximum potential value of a $5-wide spread is $5 and the minimum value is $0. So, if I don’t sell that spread at it’s current value of $3.60 I could lose all of that $3.60 value or I could hold it to expiry and, if SPX is at or below 4475, I could sell if for $5.00. So I’m currently risking $3.60 to make an additional $1.40. That’s a reward/risk of .39:1 or, if you prefer it stated as risk/reward, then it’s 2.57:1. There’s no hard and fast rule for reducing risk. Each trader has to determine their only levels of risk tolerance. In my case, that’s affected by my price action analysis. If price makes a bullish reversal on the chart I’ll be much more likely to reduce risk than if price is trending lower.
Comments or question? Give them to me below.
Great post. I would add to this discussion the importance of selecting options with liquidity, spreads, and volatility behavior that will realistically accommodate your risk parameters. A stop is only as good as the price you can market out for when price hits your stop, NOT whatever the risk graph predicts the mid-price will be if that move were to occur.
If your rules say your max risk is $100, for example, you simply cannot trade options with $1+-wide spreads. It took me an embarrassingly long time to internalize this lesson. I’d see a great setup in $AMZN, say, and I’d open a position with a nice tight stop and low delta that looked safe on the risk graph. But then I’d realize that the bid was further away than the max loss my rules would permit. In effect, according to my rules, I was stopped out of the position from the moment I opened it! And that was the best case! If I got even a tiny quick move against me, things got even worse–vol would move, spreads would expand, market makers would pull their heads in. By the time I actually got stopped out of my “tight stop,” I’d sometimes lost multiples of my max risk. Or worse, I’d tell myself that I “couldn’t afford” to market out, so I’d take my stop off and just stare at the stock then try to limit out when my stop got hit. Recipes for disaster.
We’ve been talking a lot lately about the need to keep your trading simple. Asset selection is an important part of that equation. Particularly when you’re starting out–when your account is perched on the knife edge of success and failure–it’s vital that you only trade options that offer the highest odds of performing to your expectations.