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Thursday, December 5, 2013

Checklist for trading Vertical Spreads (guest post by Dan from ThetaTrend.com)

I recently had a nice conversation with an experienced trader of Iron Condors and Vertical Spreads. Dan is also the author of ThetaTrend.com, a blog focused on Trend Following with Options. He aims to develop and share (for free) simple rules based systems for trading ETF's and Options. I went to his site and stumbled upon a clever style of trading and an always appreciated no BS approach to trading with total transparency. After just a couple emails I knew it would be great to have an article from him on this blog. It would definitely add value to this site while at the same time promote his work over there. I believe trading blogs like ThetaTrend.com are a specie in extinction, true gems that deserve recognition and visibility. Dan, from the confinements of this blog, The Lazy Trader salutes you! Keep up the amazing work pal!


Struggling with Iron Condors? Here's a 5 Point Checklist for Vertical Spreads
By Dan,  ThetaTrend.com

Trading options can seem exceedingly complex, but sometimes taking a step back and looking at the big picture puts things in perspective. When I first got involved in options trading, I wouldn't look at risk graph that didn't have an Iron Condor on it. Over time, I experimented with Trend Following systems and realized that it might make sense to combine Options and Trend Following. That realization led me cut my Iron Condors in half and focus on out of the money credit spreads.

While Trend Following systems have historically been successful, the large number of losing trades can make the rules hard to follow. The great thing about out of the money credit spreads is that they can make money in three ways: 1) if price moves in your favor, 2) if price doesn't move (because the short option decays), or 3) price doesn't go against the trade "too much." While credit spreads might superficially seem simple, trading them well requires a plan. The five points below form the beginning of a good plan.

1). Identify the market(s) you want to trade
Many options traders focus on trading options on stocks, stocks, and more stocks. However, an important lesson from Trend Following is that trading numerous uncorrelated markets diversifies risk and increases returns. Put another way, if you have positions in the S&P, Gold, and Bonds, you have much more diversification than if you just have positions in the S&P, the Russell, and the Nasdaq. Trading 3-5 uncorrelated markets is a great place to start and there are numerous ETF's with penny increment options. A few of the more liquid ETF's that work well are SPY, IWM, GLD, TLT, and FXE.

2). Consider Volatility
Credit spreads do best in a stable to falling implied volatility environment, however, they can be traded in any environment. That being said, it is best to trade Credit Spreads when Implied Volatility is greater than Historical Volatility. Intuitively, you want to sell Volatility that is greater than the amount price has been moving.
In general, Options Implied Volatility tends to be greater than Historical Volatility, but there are periods where it can be less. If you race into a trade and sell IV that is lower than HV, you're assuming unnecessary risk. You don't have to get super scientific about this, just know that it's a bad idea.

3). Identify the Trend
Many discretionary traders focus on anticipating price or attempting to determine where price is likely to go. Don't. Price will go wherever it wants to go and that can change at any time. The only thing we can do with absolute certainty is identify what price is currently doing and what it has done. I like to use an objective technical indicator, like a Donchian Channel, to describe what price is currently doing. If price makes a new 50 day high in the Donchian Channel, we can objectively say that price suggests a new uptrend is developing. The new high can be used as a signal to get long by selling Put Credit Spreads.
Sidenote: The Donchian Channel is a technical indicator that was developed by Richard Donchian, a famous systems trader. The Channel plots the N-Day High and Low prices over the N look-back period. Trend following traders consider price breakouts to a N-Day high a long entry signal and breakdowns to a N-Day low an exit or signal to short.

4). Determine your exit
You should always know your exit before you enter a trade. Trading isn't about being right, it's about making good decisions that allow us to continue trading and ultimately make money over time. With credit spreads, it's good to have both a risk based exit (your maximum loss) and a price based exit. An Average True Range Trailing Stop can be used to identify a level to place a mental stop. Once price closes below the Average True Range Trailing Stop, we know that the trend has at least slowed down and might be reversing. If either your price stop or your maximum risk stop has been hit, it's time to exit the trade.
About ATR Trailing Stops: Without getting into calculations, an ATR Trailing Stop looks at the amount price is moving on daily basis. It takes the daily value and multiplies it by a factor, say 3, and places a stop at a level 3 ATR below the most recent price high. As price advances, the trailing stop moves up with the market.

5). Decide whether or not to play
Right on, you've done all of the analysis and now you need to decide whether or not to trade. Deciding to trade is the biggest advantage retail traders have and it's a pretty big deal. Whether or not you take a trade should always include some evaluation of risk. For example, if you trade a system with a roughly 50% probability of success and your losing trades are always less than your winning trades, you should make money over time. If you look back to step 4 and you see that your stop level will put you over your maximum loss, it might be better to skip the trade or wait for a better entry. It is always better to miss a trade than to take a bad trade.

Putting it all together:
One of the biggest challenges in options trading is knowing what to do and how to trade. If you put together a trading plan, everything seems to go more smoothly. Fortunately, if you combine the five points above, you have the basic building blocks for a credit spread trading system. If you want to save yourself some time, you can also download my complete (and totally free) 20+ page Credit Spread trading system at http://www.thetatrend.com/system-download. Thanks for reading and please get in touch if you have any questions.



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3 comments:

  1. Dan from Theta TrendDecember 6, 2013 at 7:24 PM

    LT, Thanks so much for the awesome introduction and sharing my post. I have a ton of respect for what you're doing here and really appreciate your support. Best of luck finishing out the year.

    -Dan

    ReplyDelete
  2. Glad to have you as a reader my friend! I bookmarked your site and added it to favorites. Keep it up! And thanks for the contribution over here!
    Cheers,
    LT

    ReplyDelete
  3. Thanks for sharing this post. It is a great strategy....! I traded a slight different version of the strategy and can attest the strategy produced fantastic profits in 2013 (I used IWM this year because of the relative strength advantage it had over EEM, and SPY). I had never met Dan and it struck me how similar our strategies were. I was amazed!!!
    In his strategy he sell OTM spreads. I have been deep doing deep in the money leaps. So benefiting from both theta & delta.

    ReplyDelete