Hedging Call Option Risk by Selling Short Calls on MU

When upward momentum loses steam for stock price movement, the long call options face the dilemma of losing time value if the stock moves sideways or losing intrinsic value if the stock falls in the near term. If we believe the stock’s longer term uptrend is still valid, we can hedge the call option risk by selling short calls. The sold call option also helps to overcome the time decay of the option.
The downside of the hedge is the possibility of a surprise big surge of the stock price soon. It will cause the trade to gain less value than the original naked call position, since the short call option will cost more to be bought back. This is the cost of the hedge in this option strategy.

Today, the price of MU on which I have a naked long call position (Oct 20, $27 Call) expressed the first signs of its weakness. A few days ago, I bought the MU call option as MU broke out of a bullish flag chart pattern as posted in An Analysis of 3 Bullish Stock Chart Patterns. About 5 trading days later, MU had two days of price drops in a roll and looked going down today as well. Its MACD histogram also declined 2 days consecutively as shown in the chart below. These are the specified signals for me to hedge with short call option for such a position. As a semiconductor company, it also showed weaker relative performance against the SMH semiconductor ETF.

Therefore, I sold June 9 $30.5 call for a credit of $0.34 to leg into a diagonal call spread position on MU. As usual, I chose the option Delta to be greater or equal to 0.25. The OTM call Delta is the roughly the same as the probability of this option strike to expire ITM. So there is approximately 25% probability that MU will expire above $30.5 at this point. The new cost of the trade is reduced to $4.21 - $0.34 = $3.87.

As always, we need an action plan for the future in case the stock prices reverse its current course. If MU ends its short term pull-back and starts to rise strongly for at least one day, it means the stock is back to its up-trending pattern. Then, I’ll buy back the short call option.  This is what I had done for EEM as posted in EEM Diagonal call spread adjustment as emerging market outperforms. Otherwise, if the prices grind upward and the Delta reaches over 0.60, I'll roll out the short call.

There are many helpful free introductions to the basic concepts of diagonal call spreads. The one that I found with relatively complete descriptions on the characteristics of this strategy is at TheOptionsGuide.com:  Diagonal Bull Call Spread. It explains the following aspecs of the diagonal call spread:

• Spread construction 
• Profit potential 
• Downside Risk 
• Commissions 
• Theoretical Example 
• Similar Strategies 

Trading chart pattern from a bull flag turning to a high base with diagonal spread

Sometimes, stock chart patterns do not progress as expected. A bull flag pattern could fail and turn into bearish or flat patterns. With the diagonal spread option strategy, you can continue to benefit from the time decay of the sold option, as long as the stock does not break out of the consolidation range. The premium of the short option is able to cover some of the loss of the long option as a hedge. It may also generate eventual profit for the position if the stock prices stay in the range or move in favor of the long option later.

Here’s a live example of this type of trade. About 3 weeks ago, I started the bull flag breakout trade on PVH with the purchasing of September 15 $95 Call. Then PVH hit resistance level around $104.35 and started to pull back. I sold short May 19 $105 Call after the price dropped for about 2 days in a roll, as posted in 2 live examples of Legging into Diagonal Spreads.

Since then, PVH never rose for over 2 days in a roll which is my guideline to keep the short call (without uncovering it). Today, PVH which is an apparel hold company fell hard intraday along with other retail stocks, as they were sold off in the last couple of days after a couple of bad earning reports. The stock market is concerned about the future prospect of brick and mortar retailers against on-line shops.

After touching the 50 day moving average (DMA) and horizontal support which was a little bit above my mental stop at $97.79, PVH started to bounce up. The short call did meet two of my exit rules:

• Delta reached below 0.10
• Premium dropped over 80%

So, I placed a limit order to buy back the May 19 $105 Call for $0.16 to lock in 80% of its profit. It got filled after a couple of hours.  Now, the cost of the position is $12.22 - $1.00 + $0.16 = $11.22 + $0.16 = $11.38.

Since PVH has its 50 DMA up-trending, the general market is still bullish and PVH outperforms XRT at this moment, I decided to hold the long call for now. The next actions will be based on my plan as follows:

• Exit the long call if the stock price continue to show weakness and breaks below 50 DMA or my mental stop loss point
• Sell another call if the stock price rises, then pulls down for another 2 days in a roll with a declining MACD histogram

We’ll never know the outcome of the trade before the market finally shows it real face as it evolves. At present I think there is still a high probability for this trade to profit and I’m enjoying the diagonal spread trade until proven otherwise.

An Analysis of 3 Bullish Stock Chart Patterns

When stock market is bullish, there usually are a good amount of stocks that exhibit bullish chart patterns. Quite often, we have to choose one or two best stocks to trade out of many stock charts at a given day. This is exactly what happened to me today.

My bullish portfolio allowed me to take one more bullish position. So I ran my bullish search scripts in the last few days and could not find any chart patterns that were interesting to me. One of the possible reason might be my search criteria requires estimated daily volume greater than 150% of 20 day average trading volume. But this morning I found more than 3 stocks that showed bullish chart patterns and active trading volumes.  I was interested in the following 3 stocks mainly:

• AZN (A pharmaceutical company) with a cup and handle pattern;
• WYNN (Hotel) with a bull pull back pattern;
• MU (Semiconductor Company) with a bull flag pattern.

The stock chart patterns are drawn for illustration purpose in the image below.  Note the volume shown was intraday volume around noon time. The final volume was projected to be twice as much based on my rudimentary algorithm.

I liked the 6 week cup and handle pattern of AZN. But I found its option liquidity was an issue for me since the bid & ask prices for out of the money (OTM) call strike at Delta around 0.3 were over 20%. I decided to skip this option trade since my short call usually use this type of strike if I need to leg into a diagonal spread.

WYNN was bouncing up from both horizontal and up-trending support lines. But I saw a negative divergence in its MACD line. It suggested slower momentum for WYNN since the distance between the recent highs were shorter than that of the prior one. The stock also formed some level of over-head resistance in the prior two weeks. These were not desirable bullish signs.

Therefore, I settled on the 10-week long bull flag chart pattern on MU, which had very good option liquidity as well. I bought October 20 $27 Call for $4.21 as a position trade. The mental stop loss was set to $26.28 which was slightly below the last low in more than 3 weeks. My target price was $33.98 according to my trading spreadsheet. I plan to leg into diagonal spreads when the stock shows weakness (2 days in a roll with declining MACD & price).

In summary, here is the outline of my stock option trading selection steps. Hopefully, this multi-step procedure is not a stock analysis paralysis.

1. Verify recognizable price chart pattern that you plan to trade
2. Verify option bid & ask price spreads to be less than 20%
3. Review momentum of the prices (i.e. MACD indictor)
4. Verify bullish trading volume
5. Look for good relative strength
6. Look for bullish sector behavior

Did I make the right choice among multiple stock patterns? I used to have some concerns about the right pick or not. After year’s trading activities and the application of the principles of trading psychology as posted before (Additional thoughts on the successful mindset for high probability traders), I’m much more comfortable to face this uncertainty now. By following a solid trading process, I felt the profit probability is high although it’s not a certainty. My blog readers may have other thoughts. Please share with me if any.

Recent History of Election's Impacts on the US Stock Market

As traders, we are interested in the short term impacts on the stock market by major elections. Will tomorrow's French presidential election impact the US stock market again? Based on my study below, the Wall Street is telling us: No, as the VIX is at very low level, which is quite different from that on the day before the initial French election result about 3 weeks ago.

As part of the study on major election impacts on the US stock market, I looked at the prices of both SPX and VIX in the past year as shown in the chart below.

SPX & VIX's Reactions to Major Elections

• More than 50% of time when VIX reached 16.5 and above were due to pending elections
• British EU Exit (Brexit)
• US Presidential Election
• French Presidential Election (Initial)
• VIX created negative divergences when foreign elections were pending
• SPX price does not fall deeper but the fear on the stock market (VIX) increases to higher level
• The negative divergence suggests over-abundance of fear
• It's usually bullish for stock market

These are my observations only. What are your findings as a seasoned trader?  For the long history of how stock market reacts to US presidential elections, I found the following article very helpful: How the stock market performs on, and after, Election Day on MarketWatch.com.

Since traders need to prepare for major events before they occur, we are interested in FED announcements as well. I had studied the impacts of FED announcement on stock market before in my post: A Study of Market Moves, VIX and FED meetings. I plan to update and review the recent impacts of FED announcements in the future when I get a chance.

EEM Diagonal call spread adjustment as emerging market outporforms

Just 2 days after legging into a diagonal call spread on EEM, it invalidated the possible pullback sign and outperformed the general market SPY by rising for about 3 days. It looks like EEM will behave like other strong stocks that will advance for about 3 or more days and fall only 1 to 2 days at this time.

My diagonal spread short call adjustment rule dictates that if the stock has good rises and relative strength, the short call used for hedging possible weakness should be uncovered to leave the long call uncovered (naked).

Therefore, I exited the short call June 2 $41 by buying it back for $0.39. Now, the new cost of the position is $3.15 + $0.39 = $3.54. For the record, the entry cost was $3.39 and the hedge cost = $0.39 - $0.24 = $0.15 for the moment. My last trade on this position was posted here.

Looking at my other bullish positions entered shortly after the initial French election result 1 week ago, they are performing just fine. NFLX performed the best as of today since it had a good pop up yesterday. PVH continues to move in sync with XRT and is still in expected trading range. The Indian ETF EPI also outperforms S & P 500 in the last few days.

2 live examples of Legging into Diagonal Spreads

5 days after stock market’s big surge due to French election result, the S & P 500 ETF SPY started to show a small sign of fatigue by moving down today from a prior 2 day sideways movement. A couple of my bullish positions (EEM 2017 LEAPS & PVH Sept 15 $95 Call) that were entered on the market surge day (4-24-2017) cooled down for about 2 days in a roll. So I sold calls against the long calls and legged the option positions into diagonal spreads as the MACD histograms and the prices of these stocks started to drop about 2 days.

My diagonal spread rolling rule will let me close the short calls when the stocks rise for two consecutive days, or roll to new short calls if the short call premiums result a good amount of profits. I also have stop losses in place to cut loss short in case the stocks go against me.

Among them, EEM has good liquidity of option trades. I sold June 02 $41 call with a Delta around 0.25 for $0.24 credit when EEM traded slightly below yesterday’s close price and it got filled quickly. The option entry was posted before and the price was $3.39. Thus, the debit of the diagonal spread is $3.39 - $0.24 = $3.15.  I’ll continue to track the performance of this trade position as we go.

PVH has less liquidity and has monthly options only (It’s not a good stock for option trades in my opinion as the bid/ask prices were wide).  I sold May 19 $105 call with a Delta around 0.25 for $1.00 credit when PVH was sold off and it got filled eventually as it bounced up intraday. The option Sept15$95c entry price was $12.22 on 4-24-2017. Thus, the debit of the diagonal spread is $12.22 - $1.00 = $11.22. PVH, an apparent shop holding company, seemed to follow the retail ETF XRT closely. This sub-sector did not perform well when compared with the general consumer section IYC.

Bought top performing emerging market ETF

As stock market shot up 2 days ago after the French Election, the 2 best performing emerging market ETF (EEM & EPI) that I have been watching were also outperforming as well. These two ETF's has been showing strong relative strength to SPY recently. EPI, the ETF for India, was particularly strong in the last couple of months. But the ETF's option interests was relatively low and the bid and ask differences are over 20%. So, I just purchased the ETF stock as it broke out near term resistance on April 4, after the French election.

I plan to hold these intermediate term positions for a few months. The stop exit will be somewhere they break 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.

For EEM which has abundance of option liquidity, I bought the 2018 Jan 19 $38 Call (LEAPS) and plan to use my favorite diagonal spread strategy to manage this position. The stop & profit exit rules are similar to that of the EPI, with one extra rule of the profit exit: I plan to exit the position when the Delta of the LEAPS exceeds 0.80.

On the other hand, NFLX broke out with strong volume from a 3 month base today. I bought the September 15 $145 call as an intermediate term position as well. I'll follow up on these trades when I get time.

Big market impacts by the French election result today

Today, markets reacted to the results of the French election in which the pro-EU candidate won for the initial round. SPY & QQQ had the biggest surge (up 1.1% & 1.2% respectively) since they started to fall about 7 weeks ago. The VIX volatility index had a biggest drop (25.9%) in years.

Besides the stock market rally, the bond market (TLT) dropped as investors exited US bonds to take more stock market risks. The Gold market (GLD) also took a beating as investors reduced the level of concerns for world affair uncertainties.

The strong market impacts of the French election is shown in the market chart below. With the big rally of the stock market, the market outlook is definitely turning more bullish now. I had entered bullish positions on a few stocks (EPI, EEM, PVH) and plan to document them later when I get time.

SPY Bull Put Expiration and Insurance Purchases

Around July 8, SPY fell below $205, threatening the short strike of $202. Along with the threats for the XLE bull put spreads in the portfolio, I decided to purchase some insurance to mitigate some risks. I analyzed the SPY chart and felt there might be a short term descending triangle pattern as shown below. Thus I bought 2 SPY Aug21 $198 put for $2.74 triggered at SPY below $205.06.

I used a spreadsheet to calculate my entry, stop and target points, as well as the reward to risk ration as shown below. In the end, this pattern failed and I sold the put at $1.2 after SPY gapped up on July 13. The insurance loss was $174 x 2 = $348. Thus the July SPY position had a minor loss $12 (=348 - 6 x 56) after SPY puts expired worthless yesterday.

Short Stock	Price
ATR	2.19
Swing low/Breakout	205.28
Resistance	208.02
Trade Trigger - Below prior day low by 10% ATR	205.061
Entry limit order - Buy stop limit at 10% ATR below trigger	204.842
Initial Stop - Sell stop market is higher value of (1) 0.1 ATR above resistance, (2) Trigger price + ATR	208.239
Price to set break-even stop - equal Entry limit - (Initial Stop -Buy stop limit) - Drop new BE stop after a new swing high of 5 days+ is made	201.445
Target - Lower horizontal support - Range % within down trend line in last 5 weeks - Sell half & Trailing another half at 0.1 ATR above prior swing high or break-even - Sell last half at new target based on new pattern or larger time pattern (whichever is closer)	198.5263
Reward/Risk ratio - Must be greater than 2	1.8592028

In the meantime, the XLE was also moving against my position after my adjustment last time. Since I have a larger position on XLE, I felt safer to insure for this position in order to reduce risk. It looked to me that USO was falling faster than XLE. So I decided to use USO put for the insurance to trade its low base break down pattern. My order was triggered on Friday as USO fell below $16.97. I bought 4 USO Aug21 $18 puts for $1.36. I plan to sell the puts if USO rises above $17.97 by setting a GTC conditional order for stop loss. My other trade management rules are shown in the table below. If XLE continues to show weakness, I might have to add more insurance to limit overall risks. Due to the high level of risked capital for XLE, I’m withholding any new entries in case I need additional capital for another round of adjustment.

Short Stock	Price
ATR	0.58
Swing low/Breakout	17.03
Resistance	17.91
Trade Trigger - Below prior day low by 10% ATR	16.972
Entry limit order - Buy stop limit at 10% ATR below trigger	16.914
Initial Stop - Sell stop market is higher value of (1) 0.1 ATR above resistance, (2) Trigger price + ATR	17.968
Price to set break-even stop - equal Entry limit - (Initial Stop -Buy stop limit) - Drop new BE stop after a new swing high of 5 days+ is made	15.86
Target - Lower horizontal support - Range % within down trend line in last 5 weeks - Sell half & Trailing another half at 0.1 ATR above prior swing high or break-even - Sell last half at new target based on new pattern or larger time pattern (whichever is closer)	14.08381
Reward/Risk ratio - Must be greater than 2	2.6851898

XLE spread rolled out to August $70/66p

The Delta of the my short XLE put strike July$76 fluctuated around 0.65 in the last couple of days as XLE was around $75 with about 16 DTE. I had placed the adjustment orders to close the existing position and sell Aug$70.5/66.5p for a credit of about $44 yesterday. But they were not filled.

Today, the Delta seemed to break down 0.65 level (which was my adjustment level) firmly as XLE traded near $74.4.  Today, I found the IV for XLE actually dropped a bit even though XLE fell hard. Though this was not desirable for premium sellers, I still sold 41 contracts of Aug$70/66p vertical put spread which has 51 DTE with a credit of $0.43. The return was 10% which met my target. I did not sell the normal $5 width, because the Aug$65p had relatively wider bid/ask spread and the associated return would be under 10% target (credit of $0.48).

As I was waiting for my August vertical spread to be filled, I could see that the value of the closing July spread order was increasing faster than that of the August vertical. This was due the Gamma of the July vertical was larger. In the end, my August order was filled first and my July closing order was filled 30 minutes later with a debit of $1.73 as XLE prices pulled up.

To determine the adjustment size, I used my spreadsheet. Basically I rolled out the July spread to August which gave me much more time to receive the desired profit. Again, the closing target is 50% of maximal potential profit of the spread which was described in a previous post. I had not bought any put as insurance at the moment. The rest of the portfolio (SPY) was behaving OK today. I intentionally hold off opening other positions to reduce the capital consumption as the adjustment used a lot of buying power.