Price Analysis vs. Insurance

Over the years I’ve developed my own methods of analyzing price action and that has helped me stay on the right side of the trade most of the time. Of course there are going to be failures along the way that aren’t necessarily due to a misreading of the chart but rather a news events that can have a big effect on price direction. Below are three of my tweets demonstrating how a nice setup on the /ES daily chart could fail spectacularly with seemingly no warning. The warning was actually there but it required an examination of the hourly chart to see it. What if I didn’t have the time or inclination to go beyond the daily chart analysis? Does that mean I just have to accept a big loss on that day and hope to recover that money on a future trade? No, it doesn’t. That’s where option trade structure enters the picture. More on that after you read the tweets below.

So the lesson from those tweets is that what doesn’t appear clear on one timeframe might be crystal clear on another timeframe. That still doesn’t protect me against a completely unexpected move that doesn’t show up on the chart. My portfolio has been hit by so many ‘out of the blue’ price events in the past that I don’t take that risk lightly. My key to trading longevity is utilizing trade structures that protects against the unexpected. In other words, an insurance policy. My current SPX position plus the potential adjustments to that position will serve as an explanation for exactly what I’m talking about.

My trading features an extensive use of the Delta Hedging (DH) strategy where, if I have a profitable directional trade, I don’t exit the position but rather take it to zero cost or a guaranteed profit and then leave it in the portfolio to potentially add additional future profits. Due to that strategy, this is my current SPX position.

The $15K open profit is not due to the trades I made last week but rather the trades made over the past few weeks that have been DH’d and haven’t expired yet. I held those bullish positions even as SPX was going down! The Call RS+ trades that I added on Friday have raised the profit ‘ceiling’ so you can see that if SPX goes up another 2% the position could add another $8K tomorrow. Unfortunately, a 2% drop in SPX and the position loses $11k tomorrow. Not a great reward/risk ratio! However, I want to know what the reward/risk is on a plus or minus 2% move for next week instead of just tomorrow. See that risk profile below.

That’s better! Risking $17K of my open profit to make about another $90K over the course of the entire week. However, I don’t love the possibility of losing $17K from my current position. What cheap protection could I buy to provide insurance against those downside losses? When I think cheap downside protection if a low VIX environment, I think Put Calendars! Below is the risk profile for tomorrow if I add some SPX Put Double-Calendars.

Well, that flattens the Delta risk some but I’ll still have a unfavorable reward/risk for tomorrow. Of course, the most important risk profile is for next Friday’s expiry. Lets see what that looks like.

Now that’s a definite improvement! The risk profile shows gains over my current $15K open profit by $2K if SPX is 2% lower this coming week to almost $90K if SPX is 2% higher. Now, before I wrap this up, below is another look at a key metric in this analysis of potential profits and losses this week. Risk profiles are estimations of profits and losses! You have to look at the Greeks to see the potential effects of a change of factors other than time and price direction. That leaves Vega or the implied volatility of the position’s options.

You can see from the above risk profile that the Vega is currently greater than 3,000. If the VIX, which is the measure of Implied Volatility for SPX, declines this week the entire position will contract. That means that some or potentially all of those profits are at risk of disappearing should the VIX drop by a substantial amount. That is something I can monitor through the week and make other adjustments if needed. In the meantime, I’m planning on adding these Calendars during Monday’s trading.

This post began with a discussion of price analysis and ended with an insurance plan in case the price analysis hits the proverbial stumbling block. As I’ve said many times, I’ve been doing this for many years and I’ve learned a lot of tough, painful lessons over that time. I’m using this blog to help other traders learn from those lessons without unnecessarily experiencing the pain. Trust me on this; price action analysis, no matter how good, cannot accurately predict future price. Use the analysis to point your trades in a certain direction but don’t ever assume that the analysis is a sure thing. My current price analysis anticipates higher SPX prices so clearly my position will profit much more if SPX advances by 2% this week than if it falls by 2% but I’m willing to give up some of those potential upside profits in order to buy insurance to protect against the unexpected price move lower.

Questions or comments? Post the below in the comment section.

This risk profile is to answer the first question below in the comments section about ‘defending’ the 4150 short Calls if SPX continues to move higher. SPX moving higher is my expectation and my current position with no adjustments added is long 140 Deltas so relatively bullish. A SPX move above 4150 without first pulling back to either Friday’s or last week’s HB seems unlikely to me but, of course, is certainly possible. A continued move higher without a pullback would cause me to play offense, not defense! I would simply add size to the Sep23/Sep26 Call RS+ that I bot on Friday. See what my position would look like if I doubled up on those RS+’s. (That potential transaction is labeled blue #1 and the yellow box shows my existing position)