Daily Profit : options

High-Probability Strategy for Consistent and Easy Income

Ian Wyatt — Tue, 12 Jun 2012 16:43:00 GMT

Editor's note: Earlier this month options analyst Andy Crowder hosted a live chat to discuss "Create Your Own Odds: The High-Probability Strategy for Consistent and Easy Income" The response was overwhelming – more than 300 of you tuned in for the hour-long chat, and many of you came equipped with some excellent questions for Andy. While Andy was able to answer quite a few of those questions during the live chat, there were simply so many that he was not able to answer all of them. In today's Daily Profit, Andy addresses some of your most pressing options questions that went unanswered during our webinar.

If you missed the recent live chat, don't worry. You can click here to watch the recorded webinar in its entirety.

Andy, you speak about “probability of expiring” and the “probability of touching” often. Can you explain the difference? – Glen

Glen,

Let me start out with some obligatory technical mumbo jumbo and then I will get to an example that should hopefully help to clear things up.

Probability of expiring: The ‘probability of expiring’ reflects whether an underlying stock’s price is above or below a strike price at expiration.

An underlying stock will either finish out-of-the-money or in-the-money so there are two possible scenarios for ‘probability of expiring’: probability of expiring in-the-money or probability of expiring out-of-the-money (Prob.OTM).

Remember, we want to keep it simple so let’s focus on what matters – probability of expiring out-of-the-money.

Probability of expiring out-of-the-money is the chance that a strike price will close at expiration below an underlying stock price for calls and above an underlying stock price for puts.

As you can see my trading software offers this helpful tool, but for those of you who do not have a platform that offers Prob.ITM you can just use delta of an option as it is roughly the same percentage.

I will explain in a moment why knowing what the Prob.OTM is so valuable.

But before I get to the nitty gritty, let me explain ‘probability of touching’ (Prob.Touch).

Probability of touching: considers the possibility of the stock hitting (touching) the strike price at any time between now and expiration.

Again, I realize that some of you do not have access to trading software that gives you the probability of touching either, but any worthy trading software will provide you with the delta of any given option. And the Prob.Touch is simply double the delta.

So, the real question is, how can we use Prob.OTM and Prob.Touch to our advantage?

Look at the chart below.

The price of SPDR S&P 500 ETF (SPY) is currently trading at $131.50 and is currently in an overbought state. My assumption based on the current overbought state of SPY is that the S&P 500 will move lower over the next 39 days (July expiration).

This is where it gets interesting.

Because I think SPY will close below its current price of $131.50 I want to choose a strike that has a Prob.OTM that is AT LEAST above 50% and in almost all cases higher. I prefer 85%.

Look at the strikes below for SPY call options in July to see what qualifies – 132 and above. The strike immediately above the current price of SPY, 132, has a Prob.OTM of 50.87%.

That’s not high enough for me. It is essentially a coin flip. Again, I prefer something that has a higher Prob.OTM – say the Jul12 139 strike, for instance. It has a Prob.OTM of 87.26%.

That means that that if I sell a call vertical, otherwise known as a bear call spread, I might sell the 139 call strike and buy maybe the 141 strike. The trade would have a probability of success (also known as the Prob.OTM) of 87.27%. Extrapolate the 87% out 100 trades or 1000 trades and you begin to see the value of using options strategies with a high Prob.OTM.

But what about Prob.Touch? How does that factor into all of this probability madness. Prob. Touch should be viewed as the potential stress level of a particular trade.

In our case, if we sold the SPY Jul12 139/141 call spread, the underlying ETF or SPY would have a 26.28% chance of touching our short strike of 139. I like that percentage because there is still a low probability that SPY will ‘touch’ my short strike. This is invaluable information because it gives you a good idea of how stressful the trade will be.

Just think if we decided to choose to short a strike with a lower Prob.OTM, which inherently has a higher Prob.Touch, at say the 135. Again, we want to use a bear call spread so we would sell the 135/137. The 135 has a Prob.OTM or probability of success of over 70%, which is still fairly high, considering a stock trade only has a 50% chance of success.

But if you notice the Prob.Touch you will discover that the probability is over 62%. That just means that while you still have a good chance of the trade going in your favor, you should expect to experience some stress with the trade.

Most newbie traders don’t think about this important aspect. Always remember – you want to take emotions out of the equation. One way to do this is position-sizing, which should ALWAYS be considered with each and every trade. But the other way is to keep your Prob.Touch below 50% preferably below 30%.

I know this is a lot to grasp, but again these are the strategies that are revolutionizing how retail investors think about investing. The movement has already begun – so don’t be left behind. Again, I go over all of this and much more in my latest webinar. Give it a view and if you have any questions please do not hesitate to email me at optionsadvantage@wyattresearch.com.

Reduce Risk by 65% and Beat Buy and Hold

Ian Wyatt — Wed, 25 Apr 2012 19:34:00 GMT

With earnings season upon us and coming up on the "Sell in May" phenomenon I was recently chatting with one of our traders on how to protect our gains and even make a little money this summer. I'm largely a buy and hold investor so the summer seasonality really doesn't even factor into my strategy, however I get a lot of email from Daily Profit readers who are concerned about this. My head trader, Andy Crowder, recently addressed this very subject with readers of his service, Options Advantage. He was generous enough to allow me to share with you his strategy for protecting your portfolio with something he calls, "Stock Insurance". Read on for details...

Earnings season officially kicked off earlier this week and many self-directed investors are getting nervous about their holdings. Combine worries about earnings season with continued European debt woes and the upcoming “sell in May” phenomenon, and you can see why investors are concerned about the intermediate-term future of their investments.

So what’s the best strategy for a declining market?

For most self-directed investors, buying put options is the answer. Unfortunately, this strategy is one of the worst ways to protect the stocks in your portfolio right before an earnings announcement.

These misinformed self-directed investors yield to the assumption that when a stock or index is falling, volatility increases thus benefiting the long put position. This is certainly an added benefit to the long put strategy under normal market conditions.

However, post-earnings moves can actually be met with a decrease in volatility regardless of the direction of the stock following the earnings report. With that being said, always use caution when trading just ahead and through the earnings report of your stock of choice. This type of result is the reason why many newbie options traders are disappointed when they pick the direction correctly after an earnings report but still suffer a losing trade.

Implied volatility is pumped up before an earnings announcement, thereby inflating the price of an option. It makes perfect sense because the demand for puts are typically greater before earnings. And we all know that higher demand translates into higher prices, regardless of what is being sold.

However, coupling a long put with a covered call provides the ultimate protective strategy, especially when you’re concerned about your stock heading into earnings. This strategy is called a collar:

The Collar = (long stock + short call + long put [with different strikes])

A collar is the most popular method for protecting portfolio value against a market decline.

To build a collar, the owner of 100 stock shares buys one put option, which grants the right to sell those shares at the put’s strike price. At the same time, the stock holder sells a call option, which grants the buyer the right to buy those same shares at the call’s strike price.

Because the investor is paying and receiving premium, the collar can often be established for zero out-of-pocket cash, depending on the call and put strike prices. That means the investor is accepting a limit on potential profits in exchange for a floor on the value of their holdings. This is an ideal tradeoff for a truly conservative investor.

Moreover, the results of a new study examining the use of options in a collar strategy on the PowerShares QQQ (NASDAQ: QQQ) demonstrate that a collar strategy provides superior returns to the traditional buy-and-hold strategy while reducing risk by almost 65%.

The Options Industry Council (OIC) is pleased to note the study reaffirms the risk management potential of equity options, finding that during the entire 10-year study period, including the sub-periods around the tech bubble and credit crisis, collars significantly outperformed the QQQ, providing much needed capital protection.

“Loosening Your Collar: Alternative Implementations of QQQ Collars,” by Edward Szado and Thomas Schneeweis, looked at data from March 1999 to May 2009. The study concluded that over the entire 122-month period, the collar strategy returned almost 150%, while QQQ lost one-third of its value.

Additionally, the study simulated a collar strategy on a small-cap mutual fund. The return of the mutual fund collar was four times the return of the fund, while the standard deviation was about one-third lower. The study was conducted by the Isenberg School of Management’s Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts.

Options have become a necessity for the self-directed investor and the aforementioned studies prove the importance of integrating them into your portfolio. Don’t allow yourself to miss out on what IS the future of investing for the self-directed investor.

Next week I will be going over several examples of how to use collars for stocks with upcoming earnings reports.

Stay tuned!

Editor’s note: If you’re interested in learning more about how to protect yourself from a declining market and the “Sell in May” phenomenon then you might want to check out my live presentation on “Stock Insurance” next Thursday, May 3^rd.

During this one hour live discussion I’ll show you how you can use a simple options strategy that can protect and grow your portfolio during the summer doldrums. Plus, I’ll be taking your questions live and giving you concrete, actionable investment ideas. The event is free, but we’re limited to only 1,000 spots. Last time we did this spaces filled quickly. So if you’re interested, click here to get the details and to reserve your spot before they’re all gone.

When Greece Runs Out of Money

Ian Wyatt — Wed, 14 Sep 2011 20:24:00 GMT

I hate to embarrass my friend and colleague Andy, but he's easy to pick on. The fact is, while most people in my company regularly buy stocks, he hasn't done so for over a decade. He's an anomaly, and we give him a hard time.

That is until we saw how much money he makes in the markets. Last week, he made over 47% gains - which turned his $3,000 investment into over $4,400.

So, I'm excited to announce that I've asked Andy to show Daily Profit subscribers how he does what he does. This weekend is your chance to find out. Just click here to sign up (for free) for an event Andy's hosting. That's when he'll reveal his methods to me and everyone else.

European leaders have a meeting scheduled today to discuss Greek debt. What a novel idea.

It's becoming increasingly likely that Greece will default on its current debt obligations. Germany just doesn't seem to have the will to continue with bailouts. Without new funds, from bailout loans or a higher taxes (which Greek citizens are protesting) Greece may run out of cash in October.

So, if there is going to be a default, it's coming up quickly.

I'll reiterate my thoughts from yesterday. Greek default should be expected to push stocks lower. This should be a good buying opportunity. And there's no real reason to buy ahead of this event, especially as it becomes more likely.

But once it occurs, we should be poised for decent year end rally.

Retail sales were flat in August, after a 0.3% rise in July. That's clearly not being interpreted as a negative by the investors. It could have been worse.

While high unemployment isn't helping, consumer confidence is taking a major hit these days. A Bloomberg poll shows that 72% of Americans think the country is in the wrong course. And given the utter stagnation in government, it's not surprising.

Here's one ironic note: 57% of those polled believe that the best way to create jobs is to cut taxes and government spending.

Taxes, maybe. But government spending? There should be absolutely no doubt that cutting spending will raise the unemployment rate, not lower it.

I want to be clear that I'm not advocating more government spending. It's clear that spending levels are out of touch with fiscal reality. And it's unfortunate that much of the stimulus spending we've seen that's contributed to current deficits has been misguided. It's hard not to be skeptical of Obama's jobs bill.

At the same time, now would be a good time for a little kickstart to the economy. Low growth rates are also not helping confidence, nor are they helping the unemployed.

Technology and financials were your market leaders yesterday. This is as it should be. Conventional wisdom says the financials lead in the early stages of a rally. But as I've stated, I'm not too excited about a rally until we get clarity about Greece, one way or another.

I asked TradeMaster's Jason Cimpl for his thoughts on the where the market is headed next. Here's what he had to say:

Over the past three weeks I have spoken about how important the 1175 area is for traders. Which ever group, bears or bulls, that successfully controls 1175 will be able to dictate the short term trading trend.

Last week the bulls lost the 1175 support area, and SPX quickly fell to 1135. Now bulls need to fight hard to get it back. And should they take it out, SPX could be on its way back above 1200. On the other hand, the bears must show some defense of that 1175 zone today if they are to take the market lower this month.

I favor the bulls, and another trip back to 1197. But I've increased all of our stop losses in case the bears show-up in force today and prevent a break out past 1175. If the bears are able to protect 1175, SPX is headed for 1115 - and our portfolio, with five open long trades, would be negatively impacted by such an event.

Like Retail Sales, the Producer Price Index (PPI) also came in flat for August. Inflation is basically non-existent right now. There's no doubt that will worry the Fed, but I doubt it will act with more stimulus anytime soon, at least not until we get clarity on the jobs bill.