Thursday, June 4, 2015

Finding the best trades

Trading is decision.

Every trader, every day, is making decisions that will lead to profit, or to loss, making choices from among dozens or sometimes hundreds of possibilities, generally with time to fully analyze only a handful, under time pressure in the midst of a constantly changing environment.

The questions every trader must ask before the opening bell is this: "How can I find the very best trades today? How can I get the greatest profit for the least risk within the time constraints on a working day?"

My present method is this:

1) I use a computer algorithm to run through 500 or so stocks with high market capitalization looking for signals (the signals list), and I produce a list of U.S. companies publishing earnings after this day's closing bell and prior to the next day's opening bell (the earnings list).

2) I narrow the signals list to symbols that have high -- greater than 66% -- or low -- less than 33% -- historical odds of a profitable breakout. High odds symbols are candidates for directional trades, and low odds for non-directional trades.

3) The next test, applying to all lists, is to choose only those symbols with sufficient price and liquidity to allow for construction of the short option spreads that are the backbone of my trading: Iron condors, bull put spreads and bear all spreads. The price must be $30 or greater, and the volume 1 million shares a day or more.

4) I then ensure that tradable options are available. This means that they must have triple-digit open interest in the range of strike prices I would use, and a bid/ask spread on the front-month at-the-money call options of 10% or narrower. Since I've been using a very short time range, most of the time I'm also looking for symbols having Weeklys among their options inventory.

5) I then come to the final analysis, where I actually construct a proposed trade. To success, the trade must provide sufficient coverage of both the one standard deviation range, which can be expected to contain 68.2% of trades between now and expiration, and sufficient coverage of the chart range, while providing an acceptably narrow risk/reward ratio. A ratio of 2:1 or greater will generally cause me to reject an iron condor, and 4:1 or great will turn me away from a vertical spread.

My success rate with that method has been close to what I would expect: I about 70%, the same as the one standard deviation range. My goal is to do better than expected, of course, and that has been the goal of my work during the lazy days this week.

I'll use the iron condor for my discussion below, because that's what I trade most of the time. I've usually found it difficult to reliable pick a direction, and iron condors have the benefit of being agnostic about the future.

An iron condor is a short call and a short put separated by a price span. The strike prices delimit the zone within which the position is profitable.  I call the distance between the two strikes the strike spread.

The short options are given limited loss by long options on either side of the strike spread. They act as a partial insurance policy against loss. The distance between the strikes of the short options and their corresponding long options is called the width. The distances on either side are also called the "wings" of the iron condor.

So, for example, my present position on COST is an iron condor, short the $147 calls and $140 puts, giving a $7 strike spread. To limit loss, I've also bought the $149 calls and the $138 puts. The distance between the calls and the distance between the puts is the width of the iron condor, which is $2 in this case.

In this case I chose to trade the next Weeklys options on COST, which were to expire nine days after I entered the trade. That nine-day period is called the time to expiration.

Each of these properties of the trade has a role to play.

The strike spread determines how far the stock price can move while the position remains profitable. If it moves further, then the position becomes a loser. The narrower the spread, the riskier the trade. However, the narrower the spread, the less the premium, and the therefore the lower the potential profit.

The width of the wings determines how much premium I can earn from selling the iron condor -- the wider the wings, the greater the premium -- but wider wings also increase risk. I've compared the long options to insurance against loss. Widening the wings lessens the amount of insurance, which increases the potential loss.

The time expiration increases the reward, since options that have longer to live generally have higher premiums. But the longer the wait before the expiration, the greater the time risk. This is an application of Murphy's Law: Whatever can go wrong, will go wrong. The longer I hold a position, the greater the chance of a price move sufficiently large to wipe out my potential profit.

Each property is like the Roman God Janus: It shows two faces, reward and risk. Increasing one also increases the other.

Arching over the entire structure is another important measure: Implied volatility. The higher the implied volatility relative to where it has been, the higher the premium to be collected, the broader the strike spreads can be made, and the wider the wings can stretch. When volatility falls from a high level, it adds to the profit.

That being so, traders who sell options spreads want high implied volatility and they want it to collapse during the lifespan of the position. That's why I trade around earnings announcements: Volatility is generally high up to the announcements, and then falls sharply one the announcement has been made, as everyone loses interest and moves on to the Next Big Thing.

Given all of this, how can my methods be improved?

I turned to some studies done by Tom Sosnoff, the founder of the ThinkOrSwim platform, which I consider to be the best options trading platform around. ToS is now part of TD Ameritrade, and Sosnoff and his team talk about trading from their online platform, TastyTrade.

One interesting thing they've done of late is to try to determine quantitatively how best to manage positions? How long until expiration is most profitable, and when should positions be closed?

They've not published their data as formal studies, but they have done a pair of informal videos that describe their findings: "Straddles: Various Time Frames" and "Iron Condors: Management Levels".

Their studies suggest that I would do better if I used a longer time to expiration for my options, but got out of the positions earlier. Their recommendations on where to place the short strikes are pretty much in line with what I'm doing now: Aim for between a 70% and 75% probability of expiring out of the money for maximum profit. The also recommend implied volatility in the 80th percentile or higher of the low and high for the past year.

Specifically, their work implies I should make the following changes:

1) In structuring a trade, I should aim to get premium that is approximately one third of the width of the wings. If the wings are $2 wide, then I should aim for a 67 cent premium.

2) Use options that are about 45 days out, rather than the 10 days or less standard that I have been using. That doesn't mean the positions have to be held for 45 days; see #5 below.

3) Stop using the risk/reward ratio to reject trades.

4) Use high implied volatility as a requirement for trading. They use 80%, but I'm more inclined toward 70%.

5) Exit when profit is at 25% of the maximum profit. For short spreads, the maximum profit is the premium. So if the premium is 67 cents, then I would exit when profit is at 16 cents.

Increasing time to expiration provides more premium, and exiting early provides for lower time risk and higher velocity of money in the account.

Oddly, increasing the time to expiration decreases the impact of a collapse in implied volatility, and also the profit from time decay that is characteristic of all short options positions.

I intend to apply these for changes to my trading, beginning today.

The 5th change, exiting early, is in line with my preliminary findings in a study of my own trades coinciding with 2nd quarter earnings: Positions that become unprofitable after earnings are published tend to remain unprofitable until expiration. I'm not yet read to formulate that into a rule, but I shall keep it in mind in managing my positions going forward.

-- Tim Bovee, Portland, Oregon, June 4, 2015


My volatility trading rules can be read here.


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Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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