Just a reminder that this, or any post on this blog, is based on trades that I have either placed or considered placing and should not be taken as a recommendation for anyone else to trade!
Below is the Daily chart of RUT (Russell 2000 Index). Previously I viewed this chart as a very bearish setup targeting 1250 or lower likely in 2024 however the current price action has thrown that analysis into question as price has broken out above the 2000 area which had been strong resistance over the past year or so. Since that breakout above 2000 could be just a bearish overthrow I’ll watch that level closely as a breakdown back below it should, at the very least, target the Fib retracement zone of the current rally from the 10/27 low at 1633. Ultimately I’d expect a return to the bottom of the prior range near 1650 and, if that breaks down, the 1100-1200 area. If price did reach the bottom of the channel near 1650 I’d also expect a strong rally before any likely breakdown but I’m getting ahead of myself at this point in the analysis since I only need to trade for a decline back to a typical Fib retracement target of 1800-1900 within the next 60 days.
Price history doesn’t necessarily repeat but it often rhymes so it pays to be aware of not only Fibonacci retracement zones but what price has actually done in the past. Check out the 3 previous declines in RUT on the daily chart below. Would it be unreasonable to expect a similar decline in the near future? I don’t think so.
Setting price targets is the first step in the process. The second step is designing a option strategy for a trade. Since I have covered many long Vega trades such as Calendars and Diagonals in this blog but I don’t think I’ve discussed a bearish Put Condor I’ll be using that strategy to trade the RUT here. A Condor is a short (negative) Vega trade and, generally, if price is dropping, then Vega (volatility) rises so why utilize a Condor strategy? 2 reasons: (1) since a Condor is made up of 2 Vertical spreads and Vertical spreads do not depend on volatility to reach a maximum value at expiry I can know exactly what the reward/risk in the trade is and (2) OTM (out-of-the-money) Put Condors are really, really cheap to buy! It’s like getting your favorite product on sale. Who doesn’t like a good sale?
Below is the risk profile of the 1900/1800 Put Vertical spread with Mar15 expiry. That expiry is 74 days from today and if you refer back up to the previous chart you’ll see why that duration seems like a logical choice. I could go further out in time but buying time costs money and I’m trying to maximize the reward/risk ratio in this trade.
But wait, earlier I mentioned buying a Condor and that risk profile above is just a Vertical debit spread. Another case of false advertising? Alright, below is the risk profile of the Put Condor.
Hmmm, something doesn’t look quite right with that Condor! I can’t quite put my finger on it. š¤ Oh, I see what I’ve done, I’m showing buying the 1700/1600 Put Vertical spread instead of selling it to make a Condor. What an embarrassing mistake! š Or was it? š If you’ve read some of my other blog posts or follow me on Twitter (X) you’ve come to expect me to not use conventional strategies in the conventional way. I’m all about putting myself in a position to reduce or eliminate the initial cost of a trade in the early stages of the trade allowing me to maximize the current reward/risk. So how does that risk profile above help me achieve that goal?
Just because the Fib retracement zone of the current rally indicates potential support in the 1800-1850 area that doesn’t preclude the index from dropping further to be more in line with the prior 3 declines of 15%+. Having 2 separate Put Vertical Debit spreads opens up more potential profit to the downside. But wait, why not just buy the 1900/1600 Vertical spread if I think price could move down that much?
The risk profile above shows the cost of the 1900/1600 spread. At a cost of $22.55 that is 70% more than the 1900/1800 spread and 40% more than the combination of the 1900/1800 and 1700/1600 spreads. Cost matters when you’re trying to make a profit on your trades! This has all been very interesting but when am I going to get to the initial cost reduction strategy? See next risk profile below!
A little confused? All that risk profile shows is a Condor. First buying a 1 lot of the 1700/1600 Put Vertical spread and then selling 2 of the same is just the same as selling 1 to start with. š¤Ŗ What are we missing here? I wouldn’t be selling that 1700/1600 Vertical spread now, I’d be selling it later after RUT moves lower in price. What if RUT doesn’t move lower? That’s where trade size comes in. I don’t trade any bigger size than I can afford to lose!!! This is a defined risk trade so the cost of the trade is the most I can lose under any circumstance. Given that, I still want to reduce that maximum loss IF price moves in the expected direction! How many times have you had a trade on and making a profit only to have price reverse and turn your profitable trade into a loser? Learn to manage risk of a profitable trade without rushing to exit it while there is still more potential profit in that trade. IF RUT would decline to around 1900 before the end of January with a likely increase in implied volatility I’d expect to be able to sell the 1700/1600 spread for a $9 Credit. Since I’d be selling 2 of them that would bring in a $1,800 Credit. The initial cost of the 2 separate Put Vertical spreads was $1,620 which would mean that I would own the 1900/1800/1700/1600 Put Condor spread for a net Credit of $180!
Now that you’re in the cost reduction mode I’ll show one additional way to eliminate all initial cost but not drastically reduce potential downside profitability just in case RUT does experience a larger than expected decline. This is based on expected option prices if RUT declined to near 1900 by Jan26 and implied volatility increased by about 5%. I could then sell the 1700/1600 Put spread for a $900 Credit and sell the 1900/1880 Put spread for a $800 Credit. That would then leave me long the 1880/1800 Put Vertical spread for a net Credit of $80.
There are typically many ways to reduce or eliminate the initial cost of a trade and I encourage you to spend some time understanding the strategy and techniques!
Questions or comments? Leave them down below. I especially appreciate any comments so I can know whether or not these posts are helpful or not. Don’t forget to follow me on Twitter @VegaOptions.
hello,
any reason why you chose to use fibs and not to use the sma bands for analysis here?
The bands and the Fibs work together or separately. The RUT charts in this post are based on very long time frames and so I’m focusing on target zones where price is likely headed. In that type of analysis the bands aren’t needed. When it comes down to finding spots to add risk and then reduce risk I’d use the 8 SMA bands.