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Wednesday Technical Review: Vertical Spreads

  • Written by Syndicated Publisher 1 Comment1 Comment Comments
    February 15, 2012

    I’m going to “hijack” the Market Recap today and talk about a trade strategy that I think many will enjoy to learn about. First a few notables on today’s market. With 30 minutes to go the markets put in quite the reversal off the lows and “stick saved” what could have been a very nasty close as downside momentum was building.

    Apparently the source of this “rally” was a report that Samaras one of the Greek leaders who had failed to sign a letter of intent regarding austerity had a change of heart and agreed to sign this document. But there is one minor detail. Actually one major detail.

    Without a PSI agreement (private sector involvement) where bondholders agree to voluntary forgive a majority of the debt owed to them the bailout of Greece will not happen. Greece can use the collective action clause (CAC) and force bondholders to write down debt but that triggers CDS (credit default swaps).

    Right now it appears in some form or fashion Greece will default and per Moody’s note on Monday it won’t be contained and will cause harm to Portugal’s ability to tap long term credit markets.

    The Vix

    I wrote the following in the Morning Brief  that I want to repeat “It is rather ironic and or telling that the SPX and VIX are both experiencing bullish breakouts. Certainly not something that should be happening.” While equities are still in a bullish pattern so is the VIX now confirmed by this week’s price action. Below is an updated six month daily chart. Speaks volumes to the change in investor sentiment and risk aversion.

    Currencies

    Big moves in the currencies today. The AUD (daily chart shown below) looks like it is finally ready to rollover. This could still be a head fake but it feels different here. Rather than intraday reversals to session highs it is doing more of a stair step climb lower.

    The “Samaras stick save” today came right at the session lows where AUD was about to fail at the multi-month down trend. Watch the overnight session to see if this key level holds.

    The USD and EUR/USD also took out some key levels today. The EUR/USD is now back below the 2005 uptrend while the USD has taken out prior February highs and sits above a key support level as shown below.

    Trade Strategy – Vertical Spreads

    In a few of the latest Morning Briefs  I have been discussing option strategies that involve the simultaneous buying and selling of options as a hedged strategy. This trade greatly reduces risk while offering a great risk reward ratio. I want to share more details of this trade and specifically use myself as an example.

    First let me explain how I trade. I have two accounts. One is purely for trading and generating income to pay the bills. The other is a longer term macro based trade. You have heard all about the latter but the former I seldom discuss. But now that the site is switching to a subscription service (Coming March 1) one of the services I want to offer is an income generating strategy while the longer term trade is given time to evolve.

    On Monday I purchased some 133 SPY March puts and paid $2.10 per contract. The trade went slightly against me into the close but I opted to hold it overnight and not hedge the trade just yet. Tuesday’s open was weaker and after an initial bounce moved lower where I was able to sell (write is another term or “collar” the trade) 132 SPY March puts for $1.93. This resulted in a total investment of $.18 ($18 per contract) with the potential of making $1 (or $100 per contract) if the SPY is at or below 132 by March expiration.

    This then freed me up to enter another trade. On Tuesday I bought the 126 SPY March puts and paid $.78 per contract. When the SPY pulled back into session lows I was then able to sell (collar up this position) the 125 SPY March puts for $.78. This resulted in a total investment of ZERO (excluding trade fees) with the potential to make $1 ($100 per contract) if the SPY is at or below 125 by March expiration.

    But this trade is not done yet and I don’t have to wait for March expiration to see how I do.

    The 125/126 spread is worth $.10 while the 132/133 is worth $.33 so I already have profit locked in.

    This trade moves slowly meaning with four weeks until expiration should markets rally hard right now the price of these spreads will move slowly and vice versa. So I’m able to get out of this trade and guarantee some profit if I so desire.

    I can trade around this position. For example if the SPY were to move up I could “buy back” the 132 or 125 short side of the trade and then sell again when the SPY moves lower.

    If I wanted to remove the hedged side of the trade (the short put) I could buy back and let the long side of the trade run freely for a few days if I felt the SPY was showing a lot of weakness and then either simply sell the long puts or short more puts against the position and further maximize profit.

    That’s probably enough for today. I’ll be redundant in the coming weeks discussing this strategy and also using myself as an example to show various “options” (pun intended) you have to manage the trade.

    But I can attest to the validity and beauty of this trade to generate income while you wait for your longer term trade to develop. On March 29, 2011 when BAC was trading at $15 and I said it was going to $5 (Short Bank Of America) I used a similar strategy every month to generate income.

    It can be very lucrative especially when trading a trend. I don’t write this stuff to gloat. I write it simply to show my readers how options when used correctly can be a very safe and rewarding strategy.

    Images: Flickr (licence attribution)

    About the Author

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