That was quite the bullish reversal last week! Below is the SPX daily chart. The green, yellow and red lines represent last year’s high, HB (Half-Back or midpoint) and low. For weeks now I’ve been expecting SPX to reach 3662 because that was last year’s low and price had already dropped below the 61.8% retracement of last year’s range. Often, when the 61.8% retracement fails as support a full retest of the low is likely. The last chance for bulls to keep that from happening often occurs at the 78.6% retracement and, as you can see, buyers did step in near that level several times but, in the end, the full retracement was seen.
Below are SPX daily and weekly charts. Now that last year’s low was reached and price has seen a strong move higher (it’s a very bullish weekly candle) is the bear market over? I have no idea. Nobody else does either. Sure, lot’s of people will speculate about the direction of the market now but they’re just guessing and, in the end, that’s not a reliable method for profitable trading! I’ll continue to follow the price action and, as of Friday’s close, SPX is bullish on both daily and weekly charts since both have closed their current candle above the HB line. That line represents HB of the prior candle and is one of the basic methods of trend following that I rely on.
Below is the SPX weekly chart showing strong resistance in the 4225-4235 area. That area could well provide an upside target over the next few weeks and I would look for a good short (bearish) setup if price does rally up into that zone. In the meantime, I’m interested in playing the upside!
SPX has already rallied 300 points from the low so isn’t it too late to play for a continuation to the upside? It’s never too late to join a directional price move but obviously the best trade location was at last year’s low and I didn’t get long nearly enough Deltas there. ☹ Any bullish trade taken at the current SPX location (3911) has more downside risk if this rally does fail and price heads back to the low. The way I handle that risk is by utilizing a low probability bullish trade structure. There’s another name for a low probability trade and that name is a low cost trade! Lower cost means lower Delta (directional) risk in case price does reverse lower. That will reduce my loss if SPX has a bearish reversal this week. I’m sure many of you have heard from option ‘experts’ that high probability trades are the way to trade. That’s terrible advice for most traders since high probability means high cost! If price moves against the trade the immediate drawdown can be large causing many, if not most, traders to then exit the trade with a substantial loss. The reward/risk ratio on a high probability trade is also weak. Risking a lot to make a little is just not a good option strategy. The fact is that I have turned low probability trades into 100% guaranteed profitable trades, often within hours of initiating a position, literally hundreds, probably thousands, of times in my trading career! So they’re only low probability trades for a short time but I still have the advantage of the low initial cost. It’s hard to beat this strategy! 🤔 Below are the initial trades that I’m considering for tomorrow (Monday).
Both of those potential trades have a Delta of less then +8. That mean’s they have a less than 8% probability of being profitable. That sounds awful, doesn’t it? It’s almost a guaranteed loser! First, probability’s don’t reflect price action on a chart. They basically price risk based on the equal probability that price will either go up or down in the future. When I find a reliable trade entry chart setup I can tilt that probability in my favor and get a discount on a trade. Even if you doubt my ability, or more importantly your ability, to reliably find good trade location the math on a low probability still works! If I take a trade and price doesn’t do what I expect then I can exit the trade for a relatively small loss because it was a relatively cheap position due to it’s low probability! What if price moves in the direction that I expected? I can quickly move to Delta Hedge (DH) the position to reduce the initial cost or, in many cases, eliminate the entire initial cost or even lock-in a profit. That takes a low probability position and converts it to the highest probability possible!
Below is the risk profile of a current position that I’m holding in /ES (SPX futures). This position has a 100% probability of profit. It started out as a 40% probability of profit trade but was converted to a guaranteed profit within 12 hours! (See the trade fills below the risk profile). Now you might be thinking that a 40 Delta (40% probability of profit) option isn’t exactly a low probability trade and you’d be right. I needed higher Deltas on this trade because I was net short Deltas for my portfolio at the time and I needed to get longer Deltas fast to act as a hedge because /ES was rallying. Don’t let the higher Delta of this initial trade dissuade you from the low probability trade strategy because the exact same principal applies to any new position; low, medium or high Delta! Because this was a higher Delta initial position I was taking more risk on this trade if price moved lower but since my portfolio was net short Deltas that covered my downside risk. The more that you learn about trading the more that you’ll be able to manage your portfolio’s risk and you won’t view any one position as being more important than the entire position!
Here’s the trade fills:
Below is my current SPX position. I’m currently long about 90 Deltas and have a good amount of Theta but I won’t make much additional profit this coming week if SPX continues to rally. I’ll make a great deal more profit if price trades sideways to lower. Since my expectation is that SPX is likely to rally and since I have sideways to moderately lower SPX prices covered I’d like to add some additional long Deltas to the position.
Below is what my portfolio’s risk profile would look like if I added a 20-lot of the SPX Call spreads I discussed earlier in this post. If I place this trade Monday and price moves sideways through the week I’m good because of the positive Theta. A pullback of up to about 100 points would also make for a profitable week. And, with this adjustment to my current position, a rally would be profitable and I would then be able to turn those Call Spreads into Condors and lock-in some more profits. Mostly good outcomes for my portfolio this week regardless of what SPX does.
Finally, below is what my portfolio would look like if I added a 40-lot Call Vertical spread to my current position. It’s easy to adjust my portfolio’s Deltas by simply changing the size of this order.
This was a lot of content for one post and I don’t expect it all to make sense if you’re new to these strategies. The question you have to ask yourself is would you like to be able to have option portfolio’s that look similar to what mine does. If the answer is no then you can move on knowing you at least considered my strategy. If the answer is yes then you have your work cut out for you! Read the blog posts (including this one) over and over and over again! Simulate these trades on your platform. Experiment with them using very small size trades! Trading 1-lot SPY positions can be done for less than $100 of initial risk and you’ll never really understand the strategy until you try it! Don’t add a new position until you’ve either exited the first position for a small loss (if price doesn’t follow thru) or you’ve gotten to zero cost or better. Once you’ve recovered your initial risk capital add a new position when a good chart setup materializes! Below is a link to two other posts that I’ve made in the past. Read, Learn, Practice!!!
Link: Low Probability Trades
Link: Another Low Probability Setup
Gretar asked a great question in the comments below so I’m adding this update to the post. The question refers to when I close out positions. As you’ve all seen from my tweets and posts that I tend to use one position as a hedge against a new position which is then used as a hedge against an even newer position and so on and so on… Of course, at some point my positions could become to large and complicated to effectively manage so I use two basic methods to control that ‘risk’. One, I use various expirations for my positions to minimize expiry (time) risk and so that some of the positions are rolling-off (expiring) every week. The other method I use is to evaluate the current reward/risk ratio of each of my open positions. Below is the risk profile of the /ES position discussed earlier in this post. My current reward/risk ratio is now less than 1:1 in the position. That’s still acceptable to me but if /ES continues to rally as the week progresses (this position expires in 5 days) then the reward/risk ratio will continue to drop to 1:2 (risking $2 to make an additional $1) and then 1:3 and then 1:4 and, well, you get the idea.
There is a way to continue harvesting profits as price moves higher. My current /ES position is a $50 wide spread (3875/3925). That $50-wide spread can also be viewed as ten $5-wide spreads or five $10-wide spreads. Each one of those $5 wide spreads can be worth up to $5. If I could collect say, $4 by selling that $5 wide spread then, in my book, that’s a pretty good deal. If I continue to hold a $5 wide spread instead of selling it for $4 then I’m risking that open $4 profit to make another $1. That’s not a great reward/risk, is it? So, in my current position above I can rest orders to sell Credit Spreads so that I’m harvesting gains as the price rises. I wouldn’t personally sell $5 wide spreads because the commissions really add up that way but I would sell $10 wide spreads for Credits in the range of $7.50 to $8.50 each. That effectively locks-in ever larger profits on the position. Right now I could lock-in another $1,562 in minimum profits by selling a $10-wide spread but I’ll hold out for a Credit of more than $6.25.
Hi Paul.
I want to thank you for your posts. I have been reading them for some time now and am starting to try your method out for myself. At first your content went a little over my head. But I am slowly gaining a better understanding (hopefully).
As I understand your method you enter based on a certain set up on a chart and exit with loss (if price moves against you without you being able to DH) if a price level fails. Also as I understand if you have DH a position you tend to keep it even if price moves away from the center of it and use it as a hedge for other positions?
When do you however decide to close out a position and take profits? Do you just let you position expire?
Congratulations Gretar, you have a very good understanding of my methods! As far as closing out positions I do tend to hold them longer that it would appear advisable if the price action turns against them because I use them as hedges to allow me to build ever larger positions without taking additional initial capital risks. However, when the future reward/risk ratio of a position declines to a point where I risk giving back a relatively large amount of the current open profit to make a relatively smaller amount of additional gains then I consider closing the position. I’ll add an example soon to update the post.
Thank you Paul for your answer. Really appreciate you taking the time.
Do you then think about your portfolio in groups. That is short term, medium and long term positions and those groups as separate. And each position individually, that is even though you have positions that hedge a new position your goal is still to DH it and take out the risk?
Because I’m constantly Delta Hedging (DH’ing) my positions I’m basically forced into either initiating new trades or I have to exit existing positions to keep the Delta risk from getting too large. I do not mind taking large Delta risk during regular trading hours but I generally reduce that risk prior to the close. You may have noticed that some of my positions can get quite large and that’s a natural progression of the DH strategy. I’d rather build size than reduce it as long as Delta risk is being managed however, for most traders that are new to the strategy, they may benefit from just the opposite approach, exiting trades instead of building, at least until they are more experienced. The biggest exception to my personal ‘building’ strategy is when positions are within a few days of expiry. Then I’m more likely to reduce size by exiting positions if the Gamma risk is becoming larger. I generally have at least 2-3 different expiry’s in my portfolio to contain the Gamma risk. As far as grouping positions by short, medium and long term I’d recommend that you do whatever helps *you* organize your portfolio.