I’m not happy, Bob. Not happy.
Gilbert Huph– (Movie: The Incredibles)
Ask me why, Bob.
Entry Rules for Vertical Options Spreads
After nearly two years of pinging off the Options-Spreads walls, I find myself (again) “Not Happy” with my performance. However, 2020 has probably NOT been a good year for any Options Spread trader.
For the first six months of 2020, I naively believed I was protecting my account balance during volatile times by focusing on narrow-width Options Spreads. I would limit my new positions to spreads with a narrow strike-width of either 1 or 2.5 points. I thought I was limiting losses by limiting risk. This rooky thinking cost me dearly.
During the COVID-Crash and the following election crisis-mongering, the markets were thrown into a long-term volatility frenzy. During this time, most of my positions suffered max-loss.
“Not Happy!”
Commentary Contents
- Defining my Max Risk
- Follow a Trading Strategy
- Select a Short-Strike Price
- Select a long-strike Price
- Balancing Risk to Reward
- New Entry Rules Matrix
But sometimes it takes pain to gain wisdom. So now, ten months into the year, I’m discovering that most of my folly was in setting my Options Spreads strike-width to narrow.
This week’s journal post will allow me to re-reexamine my Entry Rules.
By no means do I (or anyone) have a foolproof gimmick to win. But my goal is to configure an Options Spread position that can best balances risk to reward for any new position I enter.
I have been using a rules matrix (as a bullet point list) in most of my past journal entries to record the criteria I selected. This yes/no list allows me to go back and see which settings made the most sense.
Below, I’m going to break the list down and try to explain what is most important. These are all questions I ask myself before I open any new Vertical Bull Put Credit Spread position.
Defining my Max Risk
The first thing a trader has to do is define a trading budget and fund a trading account to support the allotments. The account/budget sets the boundaries in which I can work. But setting up a budget is not the topic of this week’s commentary.
Based on the budget I set up back in January of this year, I forecasted these maximums for my trading activities. I consider these limits to be absolutes, so I don’t find myself short on funds later in the year.
Deemed to be the most important decisions to maintain, my max-risk for this year are:
- Current maximum dollars at risk < $3,000? (Yes/No)
- Max dollar at risk per position < $1,000? (Yes/No)
- Max time to have any dollars at risk < 4 weeks? (Yes/No)
Follow a Trading Strategy
During my first year, I did a lot of research on various trading strategies. The one system I chose to focus on was “Trend Trading.” (I thought it was reasonable to expect that if a stock is moving in one direction for over four months, it would likely continue that direction for another four weeks.)
- Is the long-term trend (four months) bullish? (Yes/No)
- Create a trend-channel that covers at least the past four months. Confirm that the channel is prominently moving in a bullish direction.
- Make sure the 9-Day Simple Moving Average (SMA) is above the 50-Day SMA.
- Is the short-term trajectory of the underlying bullish? (Yes/No)
- Draw a trend line that covers the past two weeks. Make sure that the current price momentum is bullish.
- Make sure the current underlying’s price is above the 9-Day SMA.
- Is the Put/Call Ratio < 1, (or falling if it is > 1)? (Yes/No)
- If the ratio is below “1” then the Marketeers are mainly buying Call Options as they assume the price will continue to rise.
- If the ratio is above “1” then the Marketeers are mainly buying Put Options as protection from the underlying falling.
- If the ratio was above “1” because of a market event but is steadily falling, the Marketeers are mainly buying Call Options.
Select a Short-Strike Price
The short-strike is the Put Option that I can sell.
It defines the maximum premiums I can collect. The further up the option-chain the Put short-strike is from the current price, the smaller the premiums I can collect, but at the same time, the higher the probability of a winning position.
To define a balance between the probability of winning the position versus the premiums I can sell it for, I will initially guess the short-strike as follows:
- Is the Short-strike > 1 SD below the current price? (Yes/No)
- When calculating 1-SD (one Standard Deviation) from the current value (CV) of the underlying, I will use this formula. Because this formula includes Implied Volatility (IV), it will adjust a short-strike according to its current volatility.
1-SD = CV – (CV * IV * SQRT( Days to Expiration / 365) )
- Is the short-strikes Prob-OTM > 70%? (Yes/No)
- As a minimum, I want the short-strikes probability for expiring out-of-the-money (Prob-OTM) greater than 70%. But during times of high market volatility, I would suggest > 75% or even > 80%.
Select a long-strike Price
The long-strike is the Put Option that I have to buy to limit my total risk. (I made a comparison between various strike-width in my “Wide Strike Widths for Options Spread” post between 1, 5, 10, and 15 strike widths positions.)
The further the long-strike is from the short-strike, the higher the dollar risk I will have to accept when opening this position. The increase in risk is calculated at $100 times the difference between the short and Long-Strike. (i.e., a spread with a short-strike of 250 and a long-strike of 260 will require 260 – 250 = 10 * $100 = $1,000 placed at risk.)
Also consider, the further the long-strike is away from the short, the cheaper the premium I have to pay to complete my spread, meaning more of the premium that I collected when selling the Short-Strike I get to keep.
Selecting the long-strike also influences how to define the Exit-Strategy.
How the long-strike defines the position’s risk
The narrower the strike width in an Options Spread, the more likely I will suffer a max loss if the underlying goes south. Consider a theoretical spread where the strike width is only 1. If the Short-Strike has an 83.7% probability of expiring OTM, the long-strike may only be 84.4% Prob-OTM. The 0.7% difference will not provide much additional protection.
Conversely, a wider the strike-width will less likely suffer max loss. Again, consider a theoretical spread where the strike width is 10. If the Short-Strike has an 83.5% Prob-OTM and the long-strike has 90.5% Prob-OTM, then the 7% difference is considered sizable protection against max loss. In this scenario, having a stop-loss strategy to mute the loss further might be a good idea.
How the long-strike defines the position’s premium
The narrower the strike width in an Option Spread, the smaller the amount of premiums I can collect. If the short Put Option strike is 315 and pays $1.81 and the long Put Option strike is 314 and cost $1.70 then the premium I can collect is $1.81 – $1.70 = $0.11 * (315 – 314) * 100 shares = $11.00.
Conversely, a wider strike width will yield a higher premium. If the short strike of 315 pays $1.81 and the long strike of 305 costs $.95 then the premium I can collect is $1.81 – $0.95 = $0.86 * (315 – 305) * 100 shares = $86.00.
Balancing Risk to Reward
Consider comparing two theoretical Vertical Bull Put Options Spreads. One spread is only one strike-width and the second is ten strike width.
Current price of QQQ = 281.15
QQQ:256p/255p – 1 Strike Width – Expires 10/30/20 – Max Gain = $11.00
QQQ:256p/246p – 10 Strike Width – Expires 10/30/20 – Max Gain = $86.00
I will then either open:
- (10) QQQ:256p/255p collecting 10 * $11.00 = $110 and risking ($1,000 – $110 =) $890.
- (1) QQQ:256p/245p collecting 1 * $86.00 = $86.00 and risking ($1,000 – $86 =) $914
Although not equal, both are near enough to the maximum trade dollars per week and near equal in premiums received. But if the markets went badly south, then the losses are much different between these two positions.
As an illustration, assume after I open this theoretical position, and the markets go south…
| % Change From Open | Premiums Collected/Paid | Premiums Collected/Paid | |
| 10 * 1 Spread Width | 1 * 10 Spread Width | ||
| At open | +8.9% | $110.00 | $86.00 |
| Expires worthless | — | $110.00 | $86.00 |
| Expires 1 Strike ITM | -9.3% | -$890.00 | -$14.00 |
| Expires 2 Strikes ITM | -9.7% | -$890.00 | -$114.00 |
| Expires 3 Strikes ITM | -10.0% | -$890.00 | -$314.00 |
| Expires 4 Strikes ITM | -10.4% | -$890.00 | -$414.00 |
| Expires 9 Strikes ITM | -12.1% | -$890.00 | -$814.00 |
| Expires 10 Strikes ITM | -12.5% | -$890.00 | -914.00 |
Therefore, one 10-Strike-width Vertical Bull Put Credit Spread will have a significant loss-buffer built into the position. The position can fall into a 10% market correction and only lose @35% of the max loss.
New Entry Rules Matrix:
- Current maximum dollars at risk < $3,000? (Yes/No)
- Max dollar at risk this position < $1,000? (Yes/No)
- Max time to have any dollars at risk < 4 weeks? (Yes/No)
- Is the long-term trend (four months) of the underlying bullish? (Yes/No)
- Is the short-term trajectory of the underlying bullish? (Yes/No)
- Is the Put/Call Ratio < 1, (or falling if it is > 1)? (Yes/No)
- The current price above 9-Day SMA?:
- 9-Day SMA above 50-Day SMA?:
- Is the Short-strike > 1 SD below the current price? (Yes/No)
- Is the short-strikes Prob-OTM > 70%? (Yes/No)
- Short-Strike price below the trend channel at expiration?:
- The current price within the bottom 1/2 of Bull Trend Channel?:
- Is the long-strike at maximum width? (Yes/No)
Previous Post from OptionsTradesByDamocles
This Week’s Market Sentiment
(As of 10/05/2020)
This Market Sentiment is as of the start of my trading week. This analysis is typically completed by midday Monday morning, and I will use it to help guide my trading decisions for this week. By the time this journal is published, it will be a week old.
VIX: Broad Market Volatility
9-Day SMA slipped to 27.6 from 26.9 last week.
The VIX is an emotion-gauge for the general investing population. It is thought to be driven by the Marketeers’ current level of greed or fear. As a one-month forward-looking volatility matrix, it is not designed to tell us which direction the market will be going, but more of how fast it can get there.
A VIX of 15% is assumed to be a market at rest. But since the intrinsic nature of the Stock Market is to move up, a VIX closer to 15% or below will have an innate tendency to rise.
I adjusted the trend-channel to 1) extend beyond the Nov. 3rd election, and 2) to move mostly sideways. Since there is a lot of unknowns as to what the country’s economic policies will be next year, it seems most Marketeers are looking to start picking sides.
The VIX continues to scream “THRASHING” for the next several weeks.
The Marketeers remains high strung and ready to bolt over anything during the next several weeks. Any new positions I consider entering should the at an ultra-high Prob-OTM.
Put/Call Ratio:
9-day SMA (all OCC options): ended most flat 0.69 from 0.67 last week.
Put Options are frequently used as protections against existing investments falling. When the ratio between Put Options bought versus Call Options bought is above 1, then this is an indicator that the Marketeers are buying insurance to what they may see as declining Markets. Conversely, when the Put/Call Ratio falls below 1, then there is a general sense that the broader Markets will increase, and more investors are buying more than selling.
The Put/Call Ratio continues to be out of sync with the other four indicators. Although the S&P 500 continues to thrash and the VIX is shouting uncertainty. Marketeers seem to have a curious lack of interest in protecting their current portfolio. Therefore, I will assume that the majority of the Market’s activity is with realigning assets.
Consumer Sentiment Index (CSI):
The Consumer Sentiment index hopes to take a broad snapshot of what we all feel to be the direction of the U.S. economy. It measures how consumers feel about their personal financial situation and compares that to what they believe is happening to others throughout the country. The survey contains 50 questions and is conducted to more than 500 people each month.
A low rating is a general dissatisfaction with our current management of U.S. economic policies. This dissatisfaction will imply that something has to change.
A high satisfaction rating suggests approval of the current policy management and implies market stability.
The U-M consumer sentiment was revised higher to 80.4 for September as expected. It shows a more optimistic outlook for the national economy and the prospects of a continuing recovery – despite what the faux-journalists are claiming.
Market Indexes:
DOW = 27,683 – Up 1.9% from 27,174 last week.
S&P 500 = 3,348 – Up 1.5% from 3,298 last week.
The S&P 500 is a stock market index that tracks the 500 largest companies in the U.S. This index represents about 80% of all the capitalization for the country. The S&P is widely considered the best indicator of how all the U.S. markets are performing.
The new trend-channel that I have drawn suggests that I expect the selloff will continue, at least through the election. The 9-Day SMA is well below the 50-day SMA, which reinforces the selloff assumption.
Looking at last week’s S&P chart, even though the value rose slightly for the week (1.5%), the daily volatility sent the average daily price fluctuating over 1%.
Geopolitical Tree-Shakers (GTS):
- White House / Trump testing positive for COVID-19
- Upcoming Supreme Court confirmation battle
- Playing tags with the Stimulus bill
- Stoked civil unrest across the country is petering out
- Election year politics exacerbating the economy and COVID fears
- Polls for the presidential election seems to be moving Biden’s way
- (Vice) Presidential debates
My sentiment for this coming week:
Of my five indicators above, the CSI and S&P 500 suggests that, “in the long-term” we are, and will remain in a bull market trajectory – thus, I have post-election hope. But the VIX and the short-term S&P 500 indicators signify that they are lock-and-loaded to bust any position I open this week at the drop-of-a-hat.
But the lack of synchronization between these four indicators (CSI, S&P, VIX, GTS) and the Put/Call Ratio suggests that the Marketeers believe the Biden/Harris will win the election and significant fiscal policy changes are expected.
There are plenty of GTS items to trigger a market reaction.
There still remains no consensus on an Options Strategy.
This week, I will focus on:
- Limit the max risk per trade to < $1,000.00
- Short Stike Price to be > 8% below the current underlining’s price
- Keep the week’s total dollar risk < $1,000.00
- Keep the overall dollar risk to be below $3,000
- Will focus on mid-term trades: 4-5 weeks
- Credit spreads only (need positive cash flow for psychological reasons)
- Will consider only Bull Spreads
- Set Conditional-Trailing-Stop-Limits
Profit and Loss Statement
(As of 10/09/2020)
| Year 2020 | Month Oct | Week #41 | |
|---|---|---|---|
| Beginning Account Balance | $9,000.00 | $2,418.99 | $2,418.99 |
| Deposits (Div. & Int.) | $38.52 | $0.00 | $0.00 |
| Withdraws (paycheck) | -$2,375.24 | $-0.00 | $-0.00 |
| Premiums on Open | $5,553.00 | $97.00 | $97.00 |
| Premiums on Close | -$9,556.00 | -$18.00 | -$18.00 |
| Fees Paid (total) | -$164.41 | -$2.10 | -$2.10 |
| Ending Account Balance | $2,495.89 | $2,495.89 | $2,495.89 |
| Total Gain/Loss | -$6,504.11 | $76.90 | $76.90 |
| ROR | 3.2% | 3.2% | |
| ROC | -46.3% |
Realized Profit by Strategy
| Year 2020 | Month Oct | Week #41 | |
|---|---|---|---|
| Vertical Bull Put Credit Spread | -$4,013.74 | $158.90 | $158.90 |
| Vertical Bear Call Credit Spread | -$182.79 | $0.00 | $0.00 |
| Vertical Bull Put Debit Spread | $0. | $0.00 | $0.00 |
| Vertical Bull Call Debit Spread | -$66.83 | $0.00 | $0.00 |
| Icon Condors | $0. | $0.00 | $0.00 |
| Cover Calls | – | – | – |
| Total | -$4,263.36 | $158.90 | $158.90 |
Schedule for this Week
Goals for this week: (10/05/20 – 10/09/20) (Week 41)
- Document lessons learned or new thoughts
- Open new positions
- Update Trading Log as trades occurs
Entry Rules for Vertical Bull Put Credit Spreads:
- Current maximum dollars at risk < $3,000? (Yes/No)
- Max dollar at risk this position < $1,000? (Yes/No)
- Max time to have any dollars at risk < 4 weeks? (Yes/No)
- Is the long-term trend (four months) of the underlying bullish? (Yes/No)
- Is the short-term trajectory of the underlying bullish? (Yes/No)
- Is the Put/Call Ratio < 1, (or falling if it is > 1)? (Yes/No)
- The current price above 9-Day SMA?:
- 9-Day SMA above 50-Day SMA?:
- Is the Short-strike > 1 SD below the current price? (Yes/No)
- Is the short-strikes Prob-OTM > 70%? (Yes/No)
- Short-Strike price below the trend channel at expiration?:
- The current price within the bottom 1/2 of Bull Trend Channel?:
- Is the long-strike at maximum width? (Yes/No)
Monday:
- Determine/update this week’s market sentiment section
- Calculate/record Put/Call Ratios for all stocks on the watch list
- Review/tweak Trend-Channels for all stocks in the watch list
- Set target expiration dates for all options as follows:
- Bull Credit Spreads: Oct 30 (<4 weeks)
- Look up Ex-Dividend dates for positions in/approaching ITM (MarketWatch/Calendar)
- Stage possible trades for all watch list stocks by 10:00 AM
- NO TRADING BEFORE 10 AM. (Let the Market find its direction after the weekend.)
- Watch one Webcast or take one online mini-course to be completed by Friday.
Tuesday – Thursday:
- Review how yesterday’s staged trades moved. Adjust premiums to take advantage of movements.
- Submit a couple of Spreads, but keep a close watch. If one is accepted, cancel the others (we want only one new active trade per day).
- Be mindful of Entry Rules.
Friday:
- Review the total technical dollars at risk for this week. If significantly below $500, then submit additional spreads if prudent.
- Update and post weekly journal (this blog) with any lessons learned or strategy changes.
This Week’s Trade Activity
(As of 10/09/2020)
Spread Count Summary:
| Year 2020 | Month Oct | Week #41 | |
|---|---|---|---|
| Vertical Bull Put Credit Spread | 67 | 1 | 1 |
| Vertical Bear Call Credit Spread | 12 | 0 | 0 |
| Vertical Bull Put Debit Spread | 0 | 0 | 0 |
| Vertical Bull Call Debit Spread | 7 | 0 | 0 |
| Iron Condor | 0 | 0 | 0 |
| Total | 86 | 1 | 1 |
Current Dollars at Risk:
| Year 2020 | Month Oct | Week #41 | |
|---|---|---|---|
| Vertical Bull Put Credit Spread | $903.00 | $903.00 | $903.00 |
| Vertical Bear Call Credit Spread | $0.00 | $0.00 | $0.00 |
| Vertical Bull Put Debit Spread | $0.00 | $0.00 | $0.00 |
| Vertical Bull Call Debit Spread | $0.00 | $0.00 | $0.00 |
| Iron Condor | $0.00 | $0.00 | $0.00 |
| Total Dollar Risk | $903.00 | $903.00 | $903.00 |
| Max Risk Allowed | $3.000.00 | $1,000.00 |
New Trades Opened This Week
(10/05/2020 – 10/09/2020)
QQQ: 253p/243p – Open 10/06/20 – Expires 10/30/20 – Max Gain = $97.00
(Vertical Bull Put Credit Spread)
At Open: Prob. OTM=83.7%, Head Room=-9.5%, Max Loss=$901.00, IV%=33%
Entry Rules for Vertical Bull Put Credit Spreads:
- Expiration date set at <= 4 weeks?: Yes (24 days)
- Probability of OTM > 70%?: Yes (83.7%)
- Short-Strike price < 1-SD below current price?: Yes (1SD=$253.54)
- Dollar risk per trade <= $1,000.00?: Yes ($901.00)
- Total dollar risk <= $3,000: Yes ($901.00)
- Put/Call ratio below 1.5, or flat, or falling over that last 2-3 weeks?: Yes (1.3 falling from 2.3)
- The Trend-Channel is Bullish?: Yes (See chart)
- Short-Strike price below the trend channel at expiration?: Yes (See chart)
- The current price within the bottom 1/2 of Bull Trend Channel?: No (mid channel)
- The current 1-week or 2-week trajectory bullish?: Yes (see chart)
- 9-Day SMA above 50-Day SMA?: No, put almost
- The current price above 9-Day SMA?: Yes (see chart)
- Set a GTC Conditional Trailing Stop Limit (CTSL): (No, see comment below)
This position was opened after two solid looking days of a positive market. But because of the nearness to the election, the Prob-OTM for the Short-Strike is above 80% and the headroom (gap between current underlying price and the short-strike is > 9% (QQQ would have to exprience a “correction” for this position to go ITM).
I did not set a CTSL because of the possibility of exiting early due to a momentary gap. So instead of setting any kind of Stop-Loss order, I set an alarm to trigger if the price of QQQ falls to one strike above the short. The thinking here is that I can make a judgement call if QQQ falls to 254 (@9% below the open price).
Trades Currently Cooking
(As of 10/09/2020)
Trades Closed This Week
(As of 10/09/2020)
QQQ: 260p/250p – Open 09/14/20 – Expires 10/09/20 – Max Gain = $179.00
(Vertical Bull Put Credit Spread)
At Open: Prob. OTM=73.3%, Head Room=-6.0%, Max Loss=$820.00, IV%=21.7%
At Close: Prob. OTM< 95.3%, Head Room=-6.4%, IV%=34%, ROR= 19.6%
Cost to open: $1.79 premium collected * 100 shares = $179.00
Cost to close: -$0.18 paid * 100 shares = -$18.00
Net Profit= $179.00 to open – $18.00 to close = $161.00 – fees
Actual ROR = $161.00 / $820.00= 19.6%
Glad to see October starting off with a winner, after September being such a big loser.
This position was closed five days early (10/5) when the gross profit hit 90% of max gain. The current value to QQQ is nearly flat to when this position was open, but the has been declining over the past four trading days. Given how irrational the current market swings are, I thought it best to close before the next wave of trashing.
Conclusion
Disclaimer
Even though I have tried to make it clear that this blog is my journal, documenting my trek into Options Trading, it has been suggested by others that I, nevertheless, include a general disclaimer. So here goes…
“This blog and the information contained herein is not intended to be a source of advice or analysis concerning the material presented. The information and/or documents contained in the blog do not constitute investment advice.”
Contact Me
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