Quote from Cache Landing:
Actually, I was talking about credit spreads. That is why I made a statement before that risk is all in how you look at it. If you are using software to get probability for profit then it likely will not give you a truly accurate number. The number it gives you will likely be the probability that the price of the underlying will be above or below a certain point at a given time. This is based on the volatility and price movement during a recent specified amount of time. That said, it should be obvious that this number isn't perfect. It needs to take into account a few other things that iT can't possibly account for, such as support and resistance.
Anyway, on these forums, as soon as someone starts promoting a certain strategy there are a bunch of people waiting to attack that strategy because it isn't their personal favorite. With that understood I will give a general example of a trade that might work out. To anyone who reads this....understand that I am going to use a couple ESTIMATIONS and give a SIMPLE analysis. I'm not trying to account for every possibility, nor perform a really thorough analysis. I would give you an example of a successful trade from the past, but I don't believe in that. As every disclaimer states, "past performance is in no way an indicator of future results."
Take SHLD right now. As we speak it's trading at about $118. If you look at the chart, it has been stuck in a range for some time now ($114 - $126). Anybody want to guess what will happen when it breaks out? Let's say that YOU think the support at $114 will hold. You could wait for the stock price to drop down toward $115 and get into a Feb. bull put spread.
Sell a 115put & buy a 110put. You'll likely get about a $2.35 credit depending on how close to $115 you let it get. Your risk is the diference between the strikes, minus the credit ($265), but that isn't the probable risk. If the underlying runs against you about $10, the spread will have increased from $2.35 to about $3.55, so if you buy it back then you'll have lost $120. Using that as a stop point your P/L would be almost 2/1. But are you really gonna let it run $10 against you? No, because you defined the support at $114. At $114 the spread will have increased to maybe $2.70, so if you buy it back then you'd have lost $35 (P/L=6.7/1).
Let's say you aren't excited about that loss. The underlying will likely break toward the downside after it passes through support at $114. So instead of closing the whole position you just buy back the short leg. You now have long put worth about $5.50. To break even you need to make up 0.35, so you put a stop in just in case it reverses on you again and wait for the more likely event that momentum carries it down to either break even, or a profit. At that point you could either sell to close or place a trailstop and try to ride the new trend down.
Anyway, because of the support, the probability of profit is actually much higher than it might appear, and the risk is much lower. If you factor in the reversal strategy then that is even more true. Obviously there is a little bit more to account for, like theta if you were forced to stay in the trade for a month without the underlying moving at all, but you get the idea. I'm not saying I would trade it like that because I would actually wait for it to break out before trading it, but the concept is the same.
For MAX profits you do have to hold them till expiration, but you can get very close to max profits much sooner if you are correct about the direction of the stock movement. In which case you wait until the short leg gets close to 0.05 and buy it back. The long leg is still open but essentially worthless at this point. Unless by chance the stock reversed big right after you bought the short leg back. I call that luck, but it happens. While you are in the position you can decide if you are just chasing pennies, and it would be better to free up the money in your account for another trade.
As far as ROE...you would be tying up $265 to make a maximum $235 if held to expiration. 88% in a month and a half. Not bad. Whoa...long response. Sorry
So you mostly trade credit spreads⦠I hadnât actually given them much consideration. To start with I tried a few debit call spreads, with very unexciting results, and resolved to leave spreads for a littler later in the game.
Your analysis is interesting and portrays them in a whole new light.
So while potentially more of your equity is at risk in any one situation, because of high probability setups (e.g. breakouts) and clearly defined S/R levels your
actual risk is much smaller.
And another factor that deterred me from using spreads was the seemingly poor risk/reward ratio. But, you paint them in a far more appealing colour. So because of the initially defined stop, which is by necessity close to the entry point for breakout plays, the small risk inflates the risk/reward ratio, giving you enviable figures like 1:7.
That compares
very favourably to my long ITM calls, and youâre also insulated from downside gaps.
Take my ITM calls on a 7K account. I can risk $70, meaning I can afford about 0.75 between entry and stop, taking slippage into account. If Iâm hoping the stock moves about $2 in my direction, then thatâs only gives a risk/reward of 1:3. Iâd have to expect a move of $5 to realize similar ratios to your spreads.
And I hadnât realized you can realize most profits well in advance of expiry if the underlying moves your way. So you donât
actually have to hold your spread for a whole month.
Iâd envisioned my long call strategy as a solitary ethereal surfer, hovering amidst an ocean of swells, flitting effortlessly from wave to wave. Riding momentum.
But it seems you can also maintain your mobility with spreads.
Also, it seems like youâre benefiting in 2/3 scenarios, substantial losses coming only by way of a sluggish underlying, which again, is unlikely at a breakout point. The stock will either burst through the S/R level or falter and fall back through the other way. Right? And if youâre wrong about the initial direction, because youâre using a credit spread you can easily adjust your position in the opposite direction.
It does make a lot of sense, and seems perfectly synergistic with a breakout strategy. So, in essence, while the right-hand side of your P/L diagram is a vertical spread, the left-hand side resembles a shallow version of the left-hand side of a straddle P/L. Is that correct?
Taking a real life applicationâ¦
I bout HXL 17.5 puts on 27th December. My rationale was: channeling, rising on faltering volume, a hammer at support then a long red candle with good volume. In retrospect, perhaps I should have been a little wary, given that resistance didnât hold on the last occasion and the aerospace industry has been in a steady uptrend since 2003.
Thank you, Osama.
Yesterday, a long green candle broke through resistance, after two days of strong accumulation.
So, I could adjust my position by selling a 22.5 put and metamorphosing into a bull put spread. My absolute max loss (5.0 â (credit â initial debit)) would be about 4% of my equity, and max profit would be 3%.
If the breakout failed, I could simply buy back the 22.5 put and ride my long put down.
Is that right?
Or (assuming the move continues) should I dissolve my position, incur my 0.8% loss and participate in the upside move with a long call?
