Trading Technical Analysis Signals With Option Spreads. By Steve Lentz Director of Education, DiscoverOptions Mentoring

Transcription

1 Trading Technical Analysis Signals With Option Spreads By Steve Lentz Director of Education, DiscoverOptions Mentoring

2 Disclaimer The views of third party speakers and their materials are their own and do not necessarily represent the views of Chicago Board Options Exchange, Incorporated (CBOE). Third party speakers are not affiliated with CBOE. This presentation should not be construed as an endorsement or an indication by CBOE of the value of any non-cboe product or service described in this presentation. Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois The information in this presentation is provided solely for general education and information purposes. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes. In order to simplify the computations, commissions and other transaction costs have not been included in the examples used in this presentation. Such costs will impact the outcome of the stock and options transactions and should be considered. No statement within the presentation should be construed as a recommendation to buy or sell a security or to provide investment advice. Investors should consult their tax advisor about any potential tax consequences. Past performance is not indicative of future results.

3 Technical Trading Systems Setups are easy. Exits constitute the devil in the details.

4 Exits: Must have a Game Plan Run the off-tackle play until the linebackers over adjust. Then, run the reverse play for big yardage. Later in the game, key the linebacker s weakness and exploit it thru another play series.

5 Exits with Option Spreads One Standard Deviation Challenge Using Out-of-the-Money (OTM) Credit Spreads Technical Stops

6 Technical Analysis Trading Premise: When a trend is about to end, sell option premium over one standard deviation out of the money and challenge the market to move that far. When is the trend about to end?

7 OUTLINE What is RSI Trading Signals Trading Plan Anatomy of Two Trades Testing Results

8 What is the RSI?

9 What is the RSI? RSI Relative Strength Index

10 RSI = [100 / (1+RS)] RSI = A smoothed average of the ratio of Average Gains (over x periods) to Average Losses (over x periods), i.e. RS, that is then normalized so it is scaled between 0 and 100.

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13 Day Average Gain = 8.58

14 Day Average Loss =

15 RSI = [100 / (1+RS)] RS = Average Gain / Average Loss Average Gain = [ (previous Average Gain) x 13 + current Gain] / 14 Initial Average Gain = Total of Gains during past 14 periods / 14 Average Loss = [ (previous Average Loss) x 13 + current Loss] / 14 Initial Average Loss = Total of Losses during past 14 periods / 14 Note: Losses are reported as positive values References: Wilder s New Concepts Book

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18 Trading Signals Overbought/Oversold Bullish RSI moves above 30 from oversold territory Bearish RSI moves below 70 from overbought territory Divergences Bullish Price makes new lows while RSI fails to make new lows Bearish Price makes new highs while RSI fails to make new highs

19 Overbought / Oversold Signals Do not occur very often each year

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21 Divergence Signals

22 Bullish Divergence

23 Bearish Divergence

24 Trading Premise: When a trend is about to end, sell option premium over one standard deviation out of the money and challenge the market to move that far.

25 How often will an underlying asset touch a strike price that lies just outside 1 standard deviation? Answer: approximately 1 time in 4

26 RSI (14) Divergence Credit Spread Trading Plan Bullish Trades Setup RSI (14) Divergence Condition The underlying index makes lower lows while the RSI fails to make lower lows. Trigger Once the Divergent Condition exists, an up close marks the entry point. Position Initiate a Bull Put Spread with the short strike located just over 1 (one) standard deviation out-of-the-money (OTM). Use a Probability Calculator to determine this point, and use the at-themoney call implied volatility as the volatility input. A. Which month? The first month that has over 21 days remaining. B. How much yield? One that brings-in at least a 5% yield or more. Skip the trade otherwise. Exits Remove the position if the underlying index touches the short strike OR otherwise, allow the position to expire worthless.

27 RSI (14) Divergence Credit Spread Trading Plan Bearish Trades Setup RSI (14) Divergence Condition The underlying index makes higher highs while the RSI fails to make higher highs. Trigger Once the Divergent Condition exists, an up close marks the entry point. Position Initiate a Bear Call Spread with the short strike located just over 1 (one) standard deviation out-of-the-money (OTM). Other details are same as above. Exits Remove the position if the underlying index touches the short strike OR otherwise, allow the position to expire worthless. Bullish Entry Triggers are ignored when a bullish credit spread is already in play. Bearish Entry Triggers are ignored when a bearish credit spread is already in play.

28 Anatomy of Two Trades 7/15/08 Sold Aug 600/590 Put Credit Spread Expired 8/15/08 Result -- Winner 6/2/08 Sold July 800/810 Call Credit Spread Expired 7/18/08 Result -- Winner

29 Testing Results

30 HYPOTHETICAL PERFORMANCE DISCLAIMER HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. FUTURES AND FUTURES OPTIONS TRADING INVOVLES SUBSTANTIAL RISK, AND THIS RISK SHOULD BE FULLY UNDERSTOOD BEFORE TRADING.

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34 Exits with Option Spreads One Standard Deviation Challenge Using Out-of-the-Money (OTM) Credit Spreads Technical Stops

35 Directional Option Spreads Using STOPS 1) Determine the likely direction for an underlying asset 2) Determine a stop level that makes sense 3) Benchmark Credit Spread As a baseline trade, propose an out-of-the-money credit spread with the short strike set at or just beyond the stop level. A. Note the Reward to Risk Ratio 4) Potential Improvements Propose additional trades in an effort to improve upon the Benchmark Credit Spread. A. For bullish trades, propose bullish butterfly spreads B. For bearish trades, propose bearish calendar spreads C. Use the Reward to Risk Ratios to determine which trade is better.

36 Directional Option Spreads 1) Determine the likely direction for an underlying asset Fundamental Analysis Technical Analysis Indicators Price Patterns Indicator and Price Pattern Combinations i.e. Oscillator Divergence plus a Candlestick Reversal Pattern Trend Line Breaks Point and Figure Breakouts

37 Directional Option Spreads 1) Determine the likely direction for an underlying asset 2) Determine a stop level that makes sense Prior Swing Points (isolated highs and lows) Support and Resistance Levels Average True Range to give the market some breathing room Trend Lines

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39 Stop at 86

40 Directional Option Spreads 1) Determine the likely direction for an underlying asset 2) Determine a stop level that makes sense 3) Benchmark Credit Spread As a baseline trade, propose an out-of-the-money credit spread with the short strike set at or just beyond the stop level. A. Note the Reward to Risk Ratio

41 $1060 $450 = $610 Credit Benchmark Credit Spread $ $610 = $4390 Requ. $610 / $4390 = 13.9% Yield

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43 Today s Reward to Risk Ratio is Approx. 1:1

44 Reward to Risk Ratio Gets Better with Time.

45 Directional Option Spreads 1) Determine the likely direction for an underlying asset 2) Determine a stop level that makes sense 3) Benchmark Credit Spread As a baseline trade, propose an out-of-the-money credit spread with the short strike set at or just beyond the stop level. A. Note the Reward to Risk Ratio 4) Potential Improvements Propose additional trades in an effort to improve upon the Benchmark Credit Spread. A. For bullish trades, propose bullish butterfly spreads B. For bearish trades, propose bearish calendar spreads C. Use the Reward to Risk Ratios to determine which trade is better.

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48 Bullish Butterflies Benefit from Declining IV Bearish Calendars Benefit from Rising IV

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50 Reward to Risk Ratio could be better, depending on time and price points. A strong and quick downside move could still mean a poor R/R ratio.

51 Credit Spread Calendar Spread Modeling both positions at various dates could help you determine which position is best. At 5 days in the future, the Credit Spread clearly has the advantage.

52 Credit Spread Calendar Spread At 21 days in the future, the Calendar Spread may make more yield only within a certain price range. Otherwise, it underperforms. All in all, the Credit Spread would be chosen in this particular case.

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