Is market approaching a top?

The general market SPX has been going up since August 21 for about 2 months now. Although it had rested two times (in which each lasted only 1 week) since then, this 2 month period probably outlasted the average 1 month rising period this year. There is no major sign of a market top at this point, as the SPX price continues to grind up and market distribution days are rare. However, the MACD indicator is showing losing momentum.

Based on the behavior of small upward daily movement of the SPX prices since last week, the indicators and the higher than average number of rising uptrend days, I'm preparing for the end game for this market cycle for my positional trades. Basically, it means watching stock prices closely with relatively tight exit points to take profits and waiting for a market rest before fully entering new positions. According to Mark Douglas's book titled "Trading in the Zone", one of the seven principles of consistency in winning stock market is "I pay myself as the market makes money available to me". This is similar to my posting before on winning altitude. Therefore, I need to take profits gladly for this market cycle, as a number of stocks in my portfolio gained within or beyond my expectations.

In general, the last 4 weeks were probably very good time for most traders, since the market kept moving up. All of my positions are doing well except a couple of them that got stopped out. The only bearish trade (HOG) that I entered while market gave some bearish signals ended as a loser as market resumed uptrend within a few days after my entry. The Indian stock ETF EPI was a biggest percentage loser in over 1+ year's trading for me. It was the worse case scenario in my stop rule if the stock kept gapping down for more than 2 days. Looking it at the probability point of view, one big loss trading is still OK as my winning and losing distribution is quite normal up to now. I'll present more statistics later.

I also closed two positions which were big winners last Friday. NFLX was doing well up to one day before the earnings announcement. My exit rule requires me to exit before earnings day to keep my P&L smooth. So I was happy to take the good profit percentage. PYPL reached my target area as the high of the day and retreated from there. Considering its earnings announcement is coming soon, I decided to take profit off the table.  The PYPL chart was posted on StockTwits and is shown below.

My other stock positions include BIDU and EDU. Their earning announcement days are coming next week. So I need to take them off soon as well.

The only new position I entered after the last post was the XLV June, 2018 $79 call for a cost of $5.88 on 10-2. I felt health care could resume its recent uptrend after some rests, if the market rotates to sectors that made less progress this year. So I bought the call after XLV rebounded from a major support level around $81 as shown in the chart below. However, it hit the prior resistance at $83 and started to retreat. I could have sold a short call as a hedge yesterday after a two day declines in a roll. But it was actually trading higher when I was watching the stock price yesterday. Since XLV shot up to form a new ascending triangle breakout today, I don't need to short the call any more.

Trading Stocks in Turbulent Market Days

The market is a little bit turbulent in these two days, after a very rare (low probability event) 10-day consecutive rises of the DOW Industrial Average Index which is consisted of a small number of large companies. The major indices are presenting some weakening signals but not enough for me to consider a bearish market turn yet.

The Nasdaq is weaker than the SPX and its new highs – new lows accumulative index is turning down today. If the same index for NYSE also turns down for a couple of days as explained in my previous post, I would consider an intermediate bearish turn of the market and start trading with bearish positions. 

In the meantime, the volatility index VIX is jumping relatively high when compared to its high at early July. This is not a confirmative posture for a real down turn of the general market since it indicates a lot of people are already in fear even though the price has not dropped much.

Yesterday, I closed my EPI position by selling it at $26.66 as shown below and posted the trade in my StockTwit. The profit taking decision was based on my analysis of the target price of the stock chart mainly. 

I think the large and rapid drop of the US Dollar in the last month also played a role for me to consider exiting the emerging market for now. I felt the USD’s fall contributed to the dramatic rise of the emerging market ETF’s. These profitable rises for my EEM & EPI positions were nice in the past month. But USD, as an intermarket signal, seemed to start a turning process after the over-sell condition. Therefore, the USD price action and the rare consecutive rises of the DOW Industrial average make it easier for me to take profit when the emerging market ETF’s reached the price target.

My portfolio is on the light side as I sold most of my short near and intermediate term bullish positions. I’ll need to build up new bullish positions when the market gives bullish continuation signals. Yesterday, I entered a long term bullish position for REM with a purchase price of $46.83, a mortgage REIT ETF that provides good dividends (> 6%). I intend to hold this long position for a long time, unless it signals break-down of long term bullish trend. This ETF follows TLT trend in general, but outperform it with a large degree.

Closed EEM Long Calls to Take Profit as the Option Delta Reached Target

Yesterday, I closed the EEM long call (2018 January 19 $38 LEAPS) when EEM was dropping near its $44 resistance after I found out its Delta reached 0.86 which was over the target of 0.80 as described in the original post (Bought top performing emerging market ETF) when the position was entered over 3 months ago.

I did not roll out the long call to take profit and to remain in the position, because EEM had been rising in the up-trending channel in the last 5 months as shown in the chart below. I’d like to wait for the next EEM opportunity when it rests for a while.

Looking at my last trades on EEM, I had got out of a short call July 7 $41.5 on June 26 as it popped out of an ascending triangle as I described in a chart of a prior post and shown below. Since then, EEM pulled back to the triangle but did not trigger a new signal for selling another call. So, I was lucky to capture fast move of EEM in the last 4 weeks.

For EPI long stock position, I’ll continue to follow my plan to exit when it breaks 20+ day support that I identify along the way and the profit target exit will be the uptrend shows signs of ending or when the general market start to show weakness.

During my multi-week summer vacation, I had a few trades on the SPY & QQQ while I kept a minimal number of positions. I’ll document those trades later and look to expand my positions as market conditions allow since I’m back and able to handle the portfolios actively.

Closing Trades to Take Some Profits as Market Broke above Upper Boundaries

The stock market continued to show bullish strength today by crossing the 2 month long upper line of the up-trending channel by SPY & QQQ and above the upper Bollinger band, as shown in the charts below. The NYSE & NASDAQ trading volumes were lower than those in yesterday. It was a difficult time to take profits since there were no visible signs of market weakness based on price patterns.

 

However, the exit rule of my diagonal spread for my positional trades was met today for some of my positions. Basically, the rule specifies that when the Delta of the long option exceeds 0.80, the diagonal spread can be closed for profits for positional trades and rolled out for longer term trades.  The high Delta value and the crossing of the upper boundaries made me to decide to close some SPY & QQQ positions for profit. I’ll wait for a few weeks to see if there are new entry points on these ETF’s and manage remaining positions as market evolves.

The entry, rolling adjustments, and exits of the QQQ December 29, 2017 Call which was a position in a different account from the last post is shown in the chart above. The summary of the QQQ diagonal trades is listed in the table below. In reviewing the trades, it’s obvious that I had held the short calls for too long such that the overall profit was 28% only while the targeted profit could be 50% or more.

Date	Spread	Side	Exp	Strike	Price	Net Price	Total Cost
4/5/2017	SINGLE	BUY	29-Dec-17	127	10.63	10.63	10.63
4/12/2017	SINGLE	SELL	5-May-17	133	0.79	0.79	9.84
4/24/2017	DIAGONAL	SELL	19-May-17	136	0.58	-1.14	9.26
4/24/2017		BUY	5-May-17	133	1.72	DEBIT	10.98
5/1/2017	SINGLE	BUY	19-May-17	136	1.81	1.81	12.79
5/17/2017	SINGLE	SELL	9-Jun-17	139	0.83	0.83	11.96
5/25/2017	DIAGONAL	SELL	16-Jun-17	143	0.49	-1.92	11.47
5/25/2017		BUY	9-Jun-17	139	2.41	DEBIT	13.88
6/2/2017	DIAGONAL	SELL	29-Dec-17	127	18.03	16.86	-4.15
6/2/2017		BUY	16-Jun-17	143	1.17	CREDIT	-2.98

In the meantime, I decided to keep 1/3^rd of the QQQ diagonal spread for longer term trade. Since the December 29, 2017 $127 Call has its Delta about 0.82, I rolled out 3 more months to March 16, 2018 and raised strike price to $136 which had Delta around 0.65. As explained in the previous post, the rolling reduced the overall position Delta. I might need to adjust the short June16 $143 call if QQQ keeps rising.

On the SPY bullish positions, I sold diagonal call spread September 2017 $229/June 2017 244.50 Call for $15.31 as the long call had Delta over 0.80 as well. I’ll analyze the SPY diagonals in the future in a trade review.

My other diagonal call spread on MU was adjusted as well since the short call Delta reached over 0.65 and MU price action was strong. Thus, I bought back the June 9 $30.5 call and left the October 20 $27 call which was bought around May 11th naked. The MU stock chart is shown below.

How many premiums are fair for short options?

As an option seller, I've been interested to know if the premiums I received for selling options are fair or not. However, there are so many factors that impact the premiums of sold options. To obtain a reasonable feeling of the fairness, I studied the TLT option spreads that I dealt with in the last few months. I used TLT short options of similar probability of success, same amount of capital requirement with the same width ($5) for the vertical spreads, and day to expiration around 56+/-7 days. In this way, I was able to reduce the number of variables for this comparison.

My goal is to receive 10% to 13% return on capital (premium$/width$5) for all ETF's that I trade. For the TLT options that meet my criteria, it means the premium should be above $0.50. Based on the above table, it looks to me the following conclusions are true for the options of similar probability and risks.

• Put premiums are higher than call premiums under similar conditions
• Premiums are higher when the short option bid and ask prices are narrower
• Premiums are higher when open interests are larger
• Premiums are higher when Delta differences between short and long strikes are larger
• Premiums are higher when the IV differences (Skew) between short and long strikes are smaller
• Premiums may not be higher with longer DTE in the analyzed range
• Higher IV of the option does not guarantee higher premium

My biggest surprise is that the higher IV's do not always provide higher premium or ROC. In October  turbulent trading, I could obtain higher ROC as IV was much higher in those days. But now, the IV of TLT is still high and yet its option premiums offer less ROC. I found other more liquid options (i.e. IWM) offer reasonable ROC (>10%) at the same time. The only reason I could find so far was the lack of open interests in the options. So I would conclude the lack of option liquidity means lower ROC for option sellers and the middle option price of bid and ask may not be fair.

In general, I believe this is one way for option sellers to estimate the fairness of option premiums as they use options of similar parameters for the comparison.

Surviving a test of 3 SD event on TLT bear call spread trades

When I started to test my new premium selling strategy using TLT in middle to late September as described in my previous post on my positions on TLT & TBT, I had no idea that a 3 Standard Deviation test would soon appear. In fact, the 1st trades near middle of September were easy: 50% profit in 4 days as shown in the diagram below. At that time, FED announced end of QE. I thought TLT would start going down which was totally wrong as TLT continued to rise and shot up far beyond a 3 SD point at an intraday period.

Apparently, my short position of Nov$121/126c was in trouble as soon as it was opened. By Oct. 13, I began to realize that the uptrend of TLT was still intact as it firmly stayed above the $119 resistance level that I had in mind. So I began my adjustments and sold a larger number of bear calls of Nov$125/130c to make up possible deficits of existing losing position. The Delta of the short call strike Nov$121c reached my adjustment level of 0.65. So I rolled up and out the trade. On Oct 14 which was one day before the big 3 SD test, TLT broke up even further away from its upper Bollinger band. I had an opportunity to close the Original Nov$121/125c position and my sell order for Dec$127/132c was filled. I thought the price of TLT was pretty extended on that day. Then the big surprise came as market had a mini-crash and TLT sky-rocketed to test the 3 SD price. As usually, I watched market for less then one hour that day around Wall Street's lunch time. The Delta of my short strike Nov$125c were below 0.65, my adjustment level. Although shocked, I did not make any adjustments for TLT on that day. Well, the price started to move down which was what my positions favor since then. I think I was lucky to exit all the positions with 50% profits about 2 weeks later.

In retrospect, I think there are a few lessons learned from the adverse test for the high probability option selling strategies:

• Don't panic in the market extreme events and use trading rules to guide the reaction
• Trade a strategy only if you feel confident about it
• Keep sufficient capital to fight the adverse events (I'm still working on it)
• The high probability strategy can have large temporary losses (3 x potential profit this time)
• Profits can be earned even if price projections are wrong at times
• Refrain from over-adjustments

I had the thought of making adjustments if TLT reached and stayed above resistance level of $119. Had I done it, I would have sold TLT calls with lower strikes which would gave me larger temporary losses. It would be a bit more difficult to reach the 50% profit with the lower short call strikes. After reviewing my trades here, I think I should stick to the adjustment rule based on the Delta of short strikes, rather than support/resistance levels obtained from technical analysis.

A review of my rolling adjustments on TBT

I sold option premiums on TBT in the last couple of months as TBT fell fast. Initially, I sold naked puts (P1S) of Delta 30 as TBT broke down its support line around $60. I planned to get assigned if TBT would drop below the sold strike as I had the view that interest rate would not continue to fall for too long. On the 2nd day after the opening short, I watched TBT failing to rebound and decided to sell bear call spreads to collect some premium on the down side. For about 4 weeks after that, TBT maintained a slightly downward trend and got a relative large increase of its implied volatility. Thus, there was not many premiums that could be materialized as shown in the chart below.

In the meantime, I developed a new general trading plan for selling premiums using some principles from Karen and some paper trades. It had enough rules for me to test it with the real money using TBT. So I started to trade it for the following occurrences. I also realized that rates may take 10 to 15 years to bottom historically. This puts the rising date to 2020 since we had a record low rate period.

Around 8-15, TBT broke down another level of support and fell hard. On that day, my short put had its Delta reached over 0.65 (which was my adjustment Delta). So I decided to roll it down to the next 30 Delta in the next cycle (October). I bought back the original short put and sold more bull put spread with 20 to 30 short Delta to cover the deficit. In this process, I made an mistake in selling less contracts, because I failed to consider my profit target was 50% of max potential. The proper formula for the new contract size should be the following:

Adjustment size = original size + 2 x (Deficit / new credit).

TBT started to bounce back immediately after my adjustment. After the 3rd and 4th day of the re-bounce, it became apparent to me that TBT was resuming its fall. So I sold more bear call spreads on the 5th day which TBT tried a weak pull-up. Luckily, the 50% profit target of the bear call spreads were reached in about 4 days. Thus, I closed it according to my rule. On the next day, I felt TBT dropping too low and too fast. I was able to find a lower put strike which was beyond my projected downward target. So, I sold some other bull put spreads (P3S & P3B). Since then, TBT started to pull up again. I followed it up closely and was trying to close the new bull put spread around 50% profit target. But I found this time, the re-bounce was more powerful especially the pull down on the 2nd day of the re-bounce was overcame on the 3rd day. Thus, I decided to let the profit accumulate. I may let it expire worthless if the market does not create a big ripple to shake me out. I plan to let the 1st bear call spread (C1Short/Bought) to expire as its short strike at $62 appears to be safe for me.

In retrospect, if I did not adjust around 8-15, my profit today would have been double that of the actual profit as shown in the bottom sub-graph. It also showed the P&L would have lager swing had I not adjust. This is a typical example of adjustment at the worse time. But I believe it's an uncertainty that we have to take. There are a couple of actions I could take that would make it better for the adjustment. First, I could have exited the P1S trade after 3 weeks when TBT kept testing lower side and did not show any sign of rises as the overall down trend was prevalent and persistent. Second, I should have sold more contracts when calculating the adjustment size. Overall, these trades were experimental and thus not consistent. I should be able to firm up my rules and apply them consistently in the coming weeks.

TBT: Profit from higher interest rates

Interest rate sensitive ETF's reacted on Government job numbers strongly today. TBT jumped above the recent 2 month long down trending channel with strong volume. My naked put Dec$70p sold about 10 days ago reached most of its profit with current Delta 0.09 in a surprising period of short time. So I bought them back for $0.25 each to nail down the profits and initiated some June$73c contracts for a longer term trade at the cost of $8.5 each. My stop loss will be around the recent low of $71. If TBT pulls back without heavy volume, I'll look for an opportunity to double my contracts. I'm impressed by the large pullback yesterday and the huge breakout today. The trade is consistent with my long term view of the interest rate rise. I'll change it to diagonal call spread later when I see TBT become far extended in price.

Another major beneficiary of the rising interest rate is the regional banks ETF KRE which also made an impressive breakout with huge volume today. I'll continue to investigate the possibility of playing with this ETF in the future. The real estate ETF's IYR got hammered again as a result.

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Created with ProphetCharts®

Balancing risks, profit targets, account margins and volatility

As noted in one of my previous post, I had been improving my exit plan for the high probability option income trade portfolio. The goal was to balance the risks and realistic profits under various market conditions.

Under low volatility environments or up-trending markets, the sold option premiums are smaller and the smooth profit zones are narrower. In high volatility environments or down-trending markets, the sold option premiums are bigger and the profit zones are larger. The differences in premiums and profit zones should be taken into account in my target profit for the monthly income trades.

In market conditions that are not extremely up-trending, if profit reaches 8% ~ 10% of portfolio margin or 30% of potential max profit, we should close positions to lock in profit of the month. This reduces the risks of staying in the market. In these types of conditions, the portfolio usually includes 2 to 3 IC’s plus 2 to 1 DC’s. In strong up-trending markets, the portfolio may include 4 IC’s or 3 IC’s plus 3 bull put spreads. In these cases, the targeted profit is smaller due to smaller credits in low IV environment.

Thus, the targeted profit for the following types of positions is listed below, assuming each IC receives a minimal credit of $6.5.

2 IC + 2 DC:        Margin $4000,   Target Profit $800

3 IC + 1 DC:        Margin $6000,   Target Profit $600

4 IC:                    Margin $8000,   Target Profit $450

3 IC + 2 Vertical: Margin $10000, Target Profit $360

This table is derived from my calculation based on the principle mentioned here and the trading experiences in the last couple of years.

To maintain high probability of success, my non-directional option trading portfolio uses different combinations of option strategies in different markets, creating different margins or buying power and portfolio risks. Since my option income trades involves premium selling mainly, I decided to use margin as the basis for my accounting purpose. The other possibility may be using the absolute portfolio risk. For my current portfolio of August options, I have two IC's and two DC's. The margin requirement is $4,000 (same as buying power) while the absolute risk is around $6,500 (IC Wing spread width - credite + debit of DC).

Closed July option inventories on new profit target for non-directional trades

After about 3 weeks since initiating the July option premium sales and 2 weeks since completing the July option selling portfolio, the market returned to my portfolio center with a neutral Delta today. In the last few weeks, I have firmed up my profit exiting rules and included them in my plan. So I took the action to follow it through by closing all of my smooth portfolio option positions for a limited profit. I'll describe my profit exit rules in a separate post.

The above image showed the portfolio status at the point I decided to exit all positions. The actual profit is usually smaller than the value shown in this type of charts due to slippage of option trades.

One of the effects of my current profit target appears to be the early exit. I'll continue to work on my ThinkScript to track the performance of these July options so that I can come up with good exit criteria if necessary.

How portfolio Greek changes within last 2 weeks of expiration

After a series of adjustments to my December high probability option trade portfolio, its P&L chart does not look really smooth anymore. The red expiration curve shows more profits if price goes higher by 10 or more SPX points while the portfolio delta is -26 which indicates more profits if price goes lower.  So I studied its Greeks verse time and prices using the ThinkOrSwim Analyzer.

First, let's take a look at how Delta changes as days get closer to expiration and prices fluctuates . After analyzing the delta changes in time, I found my delta would continue to go more negative in the next few days and it would start to increase only in the last 7 days to expiration as shown in the image below. The daily delta changes would be smaller if price increases to 1423 vicinity. I think it is most likely caused by the butterfly spreads that the portfolio has.

Secondly, let's review the daily changes of portfolio Theta. It's likely to change $10 to $20 each day next week at the current price range. However, if price goes a little over $10 which correlates to the top spot of the portfolio P&L curve, the Theta decay will be maximal for this portfolio. Theta decay will be smaller outside the indicated range in the following image.

Thirdly, the portfolio Vega is small (16) right now and it will double or triple in the next week even if price does not change. This is because the volatility will make up most of the time value in the last few days of expiration while Theta diminishes. The Vega will also shot up if price drop by 15 points.

Forth and lastly, let's see how profit and loss changes in the next 2 weeks. The following P&L chart shows profit will double 8 days later if price remain the same. If SPX price drops a bit, the profit will also increase. I believe the profit curve will have its top shifting to the 1430 area in the last 4 to 1 days of expiration to match the original expiration curve.

There are probably a number of conclusions that can be drawn from this type of Greek analysis and be incorporated in option trading rules. At the moment, I'm particularly interested in the daily Theta decay and Vega enrichment in the last 2 weeks before expiration. These two components are the time value of OTM options. For a market neutral portfolio comprising of many iron condors, the decrease of time values in the last 2 weeks will not be as dramatic as one would typically expect as long as the short strikes are still out-of-money.  It's an evidence supporting early IC exit (about 2+ weeks before expiration).  There is probably no significant loss of time decay if one starts IC 2 month ahead. Further study will be done to check it out.

Completed Jan High Probability Paper Portfolio

After setting up a position every other trading day in the last week or so, I finally completed the 2-month out paper trading portfolio today with a double calendar as usual. This is the 2nd option cycle for this test. I played Jan/Feb vs Jan/Mar DC's of identical strikes shown in the image below, and found the Jan/Mar DC provided about 1.9 to 2 times of the values of Greeks and cost, when compared with those of Jan/Feb DC. The main reasons I chose Jan/Mar DC are flatter P&L top and higher theta (9 vs 4.8). Note the margin requirement is $8,000 at the analyzer, while it was $6,000 for last option cycle which had similar positions.

In the two month out portfolio, the probability of expiring beyond break-even points in Jan is around 6 to 20% at the moment, even if the short options usually have delta around 0.25. This portfolio has a significantly higher probability than the front month portfolio for a trading period of 30 days approximately.

In the last cycle for December options, the portfolio ended with a small gain. But it's more encouraging in that it had reached current target of 10% profit before dropping to final closing value. This 2-M portfolio also is characterized with low maintenance efforts due to its wider profit zone.