OPEN: RUT Broken Wing Butterfly Feb 690/670/730 Call

This is a wild trade...my trading mentor on Insane Money turned me onto this new trade strategy.

Here's the best way it can be described:
"Posted on January 24th, 2008 by Mojo (Insane money)

OK, volatility is high, I’m still bearish on the market and I’m looking for some larger returns. I would like to setup a trade on the RUT where I can be bearish, with a little room for bullishness, and put theta and vega on my side.

WARNING: This is an advanced trade. Limit yourself to no more than 1% and only take this trade if you are a wildly profitable and consistent options trader (and if you are please send me an email!)."

Here's what I did...
It starts out with a butterfly like this (Insane Money states "With a butterfly, you have time and volatility decay on your side. You also have a large upside."):
Buy 6 Feb 670 Calls
Sell 12 Feb 690 Calls ATM
Buy 6 Feb 710 Calls

however, we added a bear call spread because we thought it was more likely to head downward...
Sell 6 Feb 710 Calls
Buy 6 Feb 730 Calls

So when you actually place the trade, this is what the order looks like because if you notice, the Feb 710 Calls cancel each other out.

Bought 6 Feb 670 Calls
Sold 12 Feb 690 Calls
Bought 6 Feb 730 Calls All for a total credit of $5.55

I was looking at this trade the night before with my mentor expecting to get a credit near $3.70 however, I placed the trade GTC that night and it got filled the next morning at open right when the stock gapped up, so I made a killer credit of 5.55! NICE!

So, if the stock is at 690 at expiration in Feb, I make the most profit, however it lands within the range of 690 plus or minus my debit from the original butterfly, I will be at breakeven. This is a high risk, low probability trade so I am trying this out to see what happens.

So in the end I make a $5.55 credit on a risk of $14.45 ($20 diff between 670 & 690 Call - credit)

Jan Monthly Returns

I opened my paper trading account on 1/23/08 so this is my first month expry close. I started doing mostly diagonal spreads as volatility has been low and several stocks have been trending steadily.

OPEN: WMT Call Calendar Feb 47.50/Jun 47.50

Per a meeting with my new trading buddies, OptionsMonkey brought up this WMT call calendar so I thought I would give it a shot. This is my first calendar...

Notice how the stock stays within a range from 42.00-51.00 all year long, and the middle seems to be around 47.50. At the time I got into this trade, the stock was around $47.40. This is a perfect set up for a calendar since you are buying & selling at the same strike (just different months like a diagonal). With calendars, you want volatility to be less than 35% while for diagonals, you want it to be above 35% since that is a more directional trade.

The volatility today was around 29% so I am sticking with the calendar.

Or goal is to have WMT be close to 47.50 when we roll into March. This could happen anywhere within the few weeks before expiration. We are setting a stop loss on calendars for 50% loss since the stocks fluctuates so much and you don't want to get stopped out if you can help it. Therefore we are sizing the trade for max loss so I am doing 1 contract. You typically size for only losing 1% of total portfolio for calendars. This way emotions will not move in if I get stopped out.

I sold the Feb 47.50 call for $1.60 and bought the Jun 47.50 for $3.60 giving me a debit of $2.00
Total cost= $1,024.95 (5 contracts=1% of portfolio)

Stop Loss set to $1.00= $950.05 stop credit

If not called out I make: 1.60/3.60= 44% ROI in 4 weeks!

STOP: AAPL Bull Diag. -21%

This trade was silly. First of all-I miscalculated and purchased too many contracts (3 instead of 1). Secondly, I ignored my trade rules about trend as AAPL had been consistently under the 30 & 50 day moving averages (MA) for over a week!

So, needless to say, when you're wrong-you should get out. I didn't so i got stopped out at a credit of $34.11 at ~ 3:10pm.

Trade Totals:

Adj. Cost Basis= $42.85
Stop= $34.11

1/2 BOT= -$17,100.00
1/7 Roll= +$1,323.00
1/8 Roll= +$1,275.00
1/11 Roll= +$1,650.00
1/15 Stop= +$10,233.00

Total Loss= $2,619.00
34.11/42.85= 21 % loss

ROLL: DRYS Jun 100/Jan 70 to Feb 60 put diagonal

Stock ~ 60.20

Here is another trade where I experienced delta inversion. Notice how the stock gapped down (in my direction) on 1/10.

I bought back the Jan 70 puts for $10.00 and sold the Feb 60 puts for $6.40 giving me a total debit of $3.60. Still not a bad deal-I get to control $10.00 extra of the stock (difference between the Jan 70 & Feb 60) only for $3.60!

Total cost= $365.90 w/ commissions
Adj. Cost Basis= 27.65 (from Jan) - $3.60= $31.25
New Stop Loss set to $25.00= $3,684.10 stop credit

Had I done this trade on 1/11 instead, I would have only paid $3.20. Next time, I need to roll quicker.

ROLL: BG Bull Diag Jan 120 to Feb 135/Apr 100 Call

Rolled on 1/14/08 at 3:53pm

Stock ~ 133.05

Today is approximately 1 week prior to options expiration day, so it is time to roll into Feb. I don't wait until the last week so I can a) get a good fill & b) get better pricing on my roll. The absolute last day you should ever roll for a diagonal is the Tuesday the week of expiration, but I wouldn't recommend waiting that long.

I bought back the Jan 120 & sold the Feb 135 for a debit of $6.05. The Feb 135 had the most extrinsic value (EV). Notice how I get a debit and not a credit on this roll. This is a phenomena called "Delta Inversion." This happens when the stock moves dramatically in Your favor, but the short leg is gaining in value faster than the long leg. My mentor and I are still trying to figure out how this could happen since the stock is going in your direction! I will follow up in the future when we crack this case!

So what happens is you end up with a debit instead of a credit to roll to the next month. This may seem as unusual since you are "paying more" to get to the next month, but what this allows you to do is control more of the stock at a discount. So for $6.05 I get to control an extra $15.00 of the stock (difference of strikes from my Jan 120 to the Feb 135). So I got a discount of 40%on the stock!

I actually wanted to roll on Thursday or Friday of last week, but work got too crazy so I missed the boat. I did notice that I would have only had to pay $4.60 instead of $6.05 had I rolled on Friday instead of Monday of exp. week...interesting example on how crazy pricing can get on the last week of expiration.

So now, my new adjusted cost basis is $19.25 (from Jan) + $6.05 debit= $25.30

My new stop is set to $20.24 (20% loss) = $2,889.10 stop credit

ROLL: AAPL Bull Diag. Jan 170 to Feb 175/Jan '09 150

Traded at 2:30pm Stock at 173.12

Seems that AAPL is retesting the lower channel line (in white) therefore I am rolling into Feb by buying back my Jan 170 for $8.20 debit and selling the Feb 175 for $13.60 credit, giving me a total credit of $5.50.

I chose the Feb 175 because it had the highest EV (extrinsic value) at $13.60 (full credit from selling the Feb 175).

My total credit is $5.50= $1,632.30 credit

New adjusted cost basis= $48.35-5.50= $42.85

Max Profit:
5.50/42.85=12.8% ROI in 35 days

Max Loss:
New stop set to $34.28 (20% loss)= $10,654.80 stop credit

OPEN: WYNN Bear Diag. Feb 105/Jun 130 Put

Traded at 3:57pm

Notice the downward channel lines in white....the stock was currently in the lower half of that channel. Also, the stock was below the 30, 50 & 200 day moving averages...very nice bearish signals.

I chose the Feb 105 because it had the highest time value ($6.40 extrinsic value + $2.05 intrinsic value= $8.45 credit for Feb).

Cost Basis:
I bought the Jun 130 put for $32.45 and sold the Feb 105 put for $8.45.
This gave me a total debit of $24.00= 5 contracts= $12,024.95 debit


Max Profit:
If not called out:
8.45/32.45= 26% in 35 days (to expiration)

If called out:
25-24.00/24.00= 4.2% ROI


Max Loss:
I set my stop for $19.20 (20% loss=$2,424.95)= $11,975.05 stop credit

STOP: HRS Bull Diag. Feb 50/Jan 60 -29%

Stopped at 3:59pm

Seeing that HRS broke through support line at 60 yesterday, I did not get out of this trade on time. So I got stopped out at $6.95 credit although I set my stop for $7.20

My last cost basis was $9.45, therefore my overall loss was $280.00= -29% loss

ADJUST: AAPL Jan 180 to Jan 170

At 3:58pm, I got filled to adjust my position by buying back my Jan 180 for $4.43 and selling the Jan 170 for $8.68. This gives me a total credit of $4.25 ($1,257.30 w/ commissions).

Looking at the lower channel line in white, I see that AAPL used this as a support and tested the line and shot back up today on high volume in my direction. Also, the ATR (is

This reduces my cost basis again from $ 52.60 to $48.35.

My new stop loss is set to $38.68 ($12,049.80 w/ commissions).

If not called out:
4.25/48.35=8.8%

ADJUST: AAPL Jan '09 150/Jan'08 195 to Jan 180

I adjusted my position down today by buying back the Jan '08 195 for $2.59 debit and selling the Jan '08 180 for $6.99 credit.

I see on the chart that the stock dropped below the 30 & 50 day moving average, however looking at the past times this happened (Aug & Nov), the stock pulled back up within a week.

Max Profit:
This gives me a net credit of $4.40 (=$1,302.30 w/ commissions).

Max Loss:
This brings my cost basis down from $57.00 to $52.60.
Therefore my new stop loss was set to $42.08 (credit of $13,542.30 w/ commissions)

OPEN: AAPL Bull Diag. Jan'09 150/Jan'08 195

AAPL has been the "baby" for many people who have wanted to jump on the bandwagon and profit from AAPL's wonderful business moves (i.e. IPOD, iphone, and now the future competitor of MS Vista).

Looking at the chart, I saw that AAPL broke resistance at 190 and used the 30 day moving average (blue line on chart) as a support line. Also, I drew the white channel lines that the stock has also been following. Today when I got in, there wasn't a perfectly bullish entry signal....instead, I see that there was a down day today on higher than average volume. This trade is riskier but worth the risk if I can adjust my position correctly and ride out the waves.

However, what I considered is that it's 30% about entry and 70% about the exit of any trade. This is the case especially for diagonals, since you are buying several months of time and selling against it for profit.

Stock at $194.90
I bought the Jan '09 150s for $65.85 and sold the Jan '08 195 for $8.85 for a total debit of $57.00= ($17,117.70 debit after commission)

Time Value Calculation:
In order to pick the best strike price to sell, you need to find out how much time value you are selling. This is otherwise known as extrinsic value or "fluff" in the trading world. Here's how to get that figure...

1st: figure out if you are ITM (in-the-money), ATM (at...), or OTM (out...).
If you are OTM, the entire credit amount becomes E.V. because there is no intrinsic value in that option.
If you are ATM or ITM, you take (Credit from sale of short front month option- Difference of 2 strikes).

In this case for AAPL,
-It cost me $65.85 to buy the Jan 09 150s so I subtracted the difference between the strike I bought and the stock (65.85-45) & divided that by 380 (dys to expiration of Jan 09)= $0.05 a day EV (amount I am spending per day)
-I made $8.85 to sell the Jan 08 195s. You take the stock price (194.90)- strike you sold (195)= $0.10, then I subtracted the $0.10 by the credit of $8.85 and divided it by 16 (days to expiration of Jan 08s)= $0.55 (amount I am making per day)
So in summary, it is costing me $0.05/day to make $0.55/day! AWESOME!

Max Profit:
If not called out: 8.85/65.85= 13.4%
If called out: 45- $57.00/57.00= -21%

Max Loss:
$11.41 max loss (20% loss of total)
Stop Loss set to $45.59= (credit of $17,007.30 after commission)

Exit:
Will roll into the Febs 1 week prior to expiration. Adjust my position as the month moves forward only if the stock is still in my direction (i.e. I have no signals of a trend reversal).

Trading Rules: The Key to Protecting Capital

We are in the game of protecting capital. Trading defensively. This is why I love diagonal spreads.

Here is the definition of diagonals:
Diagonal Spread
Any spread in which the purchased options have a longer maturity than do the written options as well as having different striking prices. Typical types of diagonal spreads are diagonal bull spreads, diagonal bear spreads, and diagonal butterfly spreads.

Diagonal Spread Income:

When not called out, there is 1 stream of income coming from the credit on the short leg you sell.
When called out, there are 2 streams of income:
1) the difference between the 2 strikes
2) the credit you bring in on the short leg

DIAGONAL TRADING RULES:
1. Do not trade until after 2pm, unless it is an emergency adjustment that still fits with all my trading rules. Remember, the first hour is "amateur hour," then the last 2 hours are for the pros. This is when institutional money, hedge funds, etc. sweep in and "clean house."
2. Size each trade within 5% of total portfolio size (this 5% is calculated from your max loss which is the same as your stop loss)
3. Buy 3 strikes in the money (ITM) and 3-4 months out into the future. Sell at-the-money (ATM) or out-of-the-money (OTM), depending on which one has the higher premium and extrinsic value you can sell.
4. If the stock's trend is moving against you, exit the trade. If the

The following rules for diagonal spreads are from www.insanemoney.com. I have been following these rules in addition.
1) Always have a stop loss on your long position no greater that 20% of the underlying cost basis. 10% per Jesse Livermore.
2) Look for trades that are in between strike prices .
3) Make sure the delta on your long strike is at least .80.
4) Look for a 5% return in the front month or better.
5) Make sure you have a good bullish trend.
6) Buy long call 2 to 3 months out and 3 to 4 strikes ITM.
7) Sell the call to cover that has the most time value in the front month and will still be profitable. This will give the best downside protection.
8) If you want to hold a long call DITM for some straight line appreciation then put a 10% stop loss on it.
9) Make sure that you don’t make up more than 5% of the total open interest on a option. Especially the long, DITM option.
10) Buy back your short option once 70% of its time premium has decayed. Look to roll out to a new month if its time decay vs. underlying movement of the stock. If it is stock price (like a sudden decline) buy back the call and place a stop loss on your long position.
11) Buy back your short option once the delta of the short reaches .25 or less. At that point your short option is only covering 25% of your potential loss to the downside. Sell another ATM short option for protection.
12) If all other things are the same and you can’t decide which strike to sell, sell the OTM strike for the most profit and the ITM strike for the most adverse protection.

Calculating ROI

If called out, you get 2 sources of income.
The 1st is from the difference between the 2 strikes, because you have to buy back your short position and sell your long position.

The 2nd source is from the credit that you earned when you sold your short position to get into the trade (whether initial or roll).

Called Out Formula:
((Difference between 2 strikes) - Cost Basis (or Adj. Cost Basis if you've already rolled)) /
divided by Cost Basis (or Adj. Cost Basis if you've already rolled)


If you are not called out, you get 1 source of income.
This comes from the credit that you earned when you sold your short position.

Not Called Formula:
If 1st time doing the trade:
Credit/ Debit (from purchase of long position only)

If Rolling to next month or Rolling to adjust:
Credit/ Adjusted Cost Basis

Position Sizing

This post is from a very savy trader I know that is showing me the ropes with diagonal spreads. His online trading journal can be found at http://www.insanemoney.com. Position Sizing has saved me so I want to share this with you as it can save your portfolio as well. Read below...

"Help with Position Sizing"

Mojo

8:46am, November 30, 2007

I put together my thoughts on position sizing and would like to your feedback. Here it is:

If there is one thing I would say that has made the most significant difference in my success and stress level as a trader I would say "Position Sizing". What is position sizing? Its determining the maximum number of contracts allowed per trade based against your total portfolio size. Why is this important? Because it determines how many losing trades in a row your portfolio could stand before you lose everything. Professional gamblers call this your "risk of ruin". Remember your job is not to make money, but to protect your capital and extract the most experience out every dollar.

Here's a simplistic example. Let's say your portfolio is 100K. We will flip a coin 100 times with heads representing a "win" and tails representing a "loss". This gives you a 50/50 chance for each trade. Here are the results:

WLWLLLWWLLLLLLWWLLWWLWLWLWWWWLLLWLWLWLLLLWWLLLLWWL LWLWLLWWLWWLLLWLWLLLLLLLLLWWLWLLLWLWWWLLWLWLLWLWLL

Notice that in this random sample there are several consecutive wins (heads) and losses (tails). These streaks are completely normal and expected in a random sample. These streaks are where your position sizing becomes important. In trading there is something called "surviver bias". Basically its the idea that only the profitable traders survive and only those traders that survive the first three years will be profitable over their entire trading career.

If you are risking 20% on each trade and you have 2 losses in a row your portfolio will be down 40%. Mentally, are you prepared to hold the faith and stick to your trading rules once you've wiped out 40% of your account? Most people aren't (including me!). How would your wife or husband feel about a 40% loss? Would they continue to support your trading? Remember, we are trading to make our lives work for ourselves and for everyone around us.

Since most people's pain threshold is no more than a 40% loss, let's look at how many trades it will take to get us to quit trading and end our trading career.

If you are risking 15% per trade it will take 3 losing trades in a row to generate a 45% loss.
If you are risking 10% per trade it will take 4 losing trades in a row to generate a 40% loss.
If you are risking 7.5% per trade it will take 6 losing trades in a row to generate a 42% loss.
If you are risking 5% per trade it will take 8 losing trades in a row to generate a 40% loss.

At this point you might think "That's impossible, I will never have 8 losing trades in a row!". Well, look at the random sample (line 2). There's a losing streak of 9 loses in a row. Ask any trader with sufficient experience and they will tell you that this is not only possible, but even likely to occur.

If you are risking 2% per trade it will take 20 losing trades in a row to generate a 40% loss.
If you are risking 1% per trade it will take 40 losing trades in a row to generate a 40% loss.

Does this make sense? Yes? OK, good. What percentages do I use? I use the following percentages based on the underlying security (stocks vs. industry ETFs vs broad based ETFs) and the type of trade. These are hard fought rules that I'm constantly refining so I'm always open to feedback.

Single Stock (XOM) + Vertical Spread <= 2% [news risk and because I don't feel that stop losses work well on verts]
Industry ETF (XLE) + Vertical Spread <= 2% [news risk and because I don't feel that stop losses work well on verts]
Broad Based ETF (SPY) + WOTM Vertical Spread <= 5% [limited news risk, stop loss at 3x initial credit]

Single Stock (XOM) + Put Calendar <= 4% [stocks crash down not up, good salvage value on long puts (50% or better)]
Industry ETF (XLE) + Put Calendar <= 5% [industries crash down not up, good salvage value on long puts (50% or better)]
Broad Based ETF (SPY) + Put Calendar <= 10% [markets crash down not up, good salvage value on long puts (50% or better)]

Single Stock (XOM) + Diagonal <= 2% [use a 20% stop loss so your initial position is up to 10%]
Industry ETF (XLE) + Diagonal <= 2% [use a 20% stop loss so your initial position is up to 10%]
Broad Based ETF (SPY) + Diagonal <= 3% [use a 20% stop loss so your initial position is up to 15%]

Single Stock (XOM) + Iron Condor <= 0% [I don't do Iron Condors on individual stocks, too much event risk]
Industry ETF (XLE) + Iron Condors <= 2% [use a stop loss of 3x initial credit]
Broad Based ETF (SPY) + Iron Condors <= 5% [use a stop loss of 3x initial credit]

Remember, our goal is to reduce all risk we can and mitigate everything else. Position sizing is one of the "free lunches" we get so take advantage of it.

Mojo

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