A Tale Of Two Options

06/01/10 12:01:09 PM

by Donald W. Pendergast, Jr.

Finding it hard to make accurate directional calls in such a volatile market? Why not just consider selling short-term options that are beyond strong resistance barriers instead?

Security: IWM, SPY
Position: N/A

Let's face it, even if the nominal odds for a given stock, index, or commodity to go in a certain direction are 50-50, the fact remains that once you actually commit capital to a directional trade, the final result means that you're either 100% right or 100% wrong. Calculating the odds is fun from a statistical viewpoint, but at the end of the trade, you're going to be left with either a profit or a loss (100% right or 100% wrong, with no room for odds, chance, or luck to influence the outcome). Paraphrasing the words of a famed modern-day theologian:

"Are life's outcomes really determined by luck, chance or coincidence? Not a chance."

My main point here is this. Once you have real money on the line, all theorizing or probability studies go out the window, and your only real concern is to actually turn a profit or minimize a loss. Let's look at a couple of option trades I have on right now to see how traders can construct simple short call sales in index exchange traded funds (ETFs) that can hopefully result in more winning trades than losers. See Figure 1.

FIGURE 1: CALLS. When you want your short calls to expire worthless, the existence of low deltas (preferably below 30) and progressively increasing time decay (theta) is very reassuring.

Graphic provided by: Thinkorswim.

At the outset, I must admit that my personal bias is for the broad markets to resume their downtrend some time within the next three weeks, and this particular worldview weighed heavily on these two call sales in IWM and SPY. The trades:

Sold 1 IWM June $69 call for $0.68 ($68)
Sold 1 SPY June $114 call for $0.65 ($65)
----------------------------------------------
Net credits received after commissions: $127.20
(How about that! A Fibonacci expansion [1.272] ratio! What was that about a hidden order within the financial markets?)

I sold these out-of-the-money calls last week; right now, the IWM call is shedding $4.12 per day and the SPY call is shrinking by $4.50 per day. With only 17 days until the June option expiration, my main job here is to make sure these options don't expire in-the-money, as I don't wish to be assigned long stock positions the Monday after expiry. Since both the IWM and SPY daily charts feature substantial Fibonacci confluence resistance and/or moving average resistance just a little below each of their respective option strike prices, there is plenty of reason to expect these calls to either be covered at a profit if not actually expire worthless (meaning that I keep all of the credits received at the time of sale). The biggest danger to either trade is a sudden spike higher toward the strikes and/or a dramatic increase in implied volatility. If that occurs, I will reevaluate the trades, most likely buying these short calls back if they get close to doubling in price or get close to going in-the-money. The deltas on the options are still quite low (-29.15 and -22.43, respectively), another boon for someone desiring for their short calls to expire worthless. The vega factor is also modest -- even though it does exist -- meaning that increases in implied volatility will more than cancel out the benefits of daily theta (time decay).

Anyway, for now, all I will do with these short option positions is to watch, wait, and wonder. That the options have such small deltas along with progressively increasing daily time decay means that I already have two powerful option trading dynamics stacked squarely in my favor, a big plus in such a wild market.

You may wonder why I only sold one each of these ETF index options and not three, four, or even five of them. The answer is simple enough: I don't feel safe being short more options than one each in this frantic market phase. However, in the unlikely case that IWM or SPY actually manages to scramble back up toward the May 13th swing high (about $117 in the SPY), I would feel much safer preparing to go short a larger number of out-of-the-money front-month calls. And that's simply because of the overwhelmingly bearish evidence that seems to be suggesting a major summer decline down toward 950 in the Standard & Poor's 500 (or 95 in the SPY) and about 500 in the Russell 2000 index (or about 50 in the IWM). That's when the four-year cycle low is due (sometime around September 2010) for the broad US markets.

So short term, we may see a bit of a rally this week, but after that, beware, because the bear tends to claw down, hard and fast -- and without much warning. If the past month of trading has taught us anything, it should be this: Be prepared for the unexpected, probably sooner rather than later.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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