RUT Iron Condor trade for June

I’m not a very regular Iron Condor trader. There was a time when I spent a lot of time doing credit spreads and condors. There is overwhelming logic in using these time selling strategies as you are more likely to make money without having to be as spot on with your trades as with simple long or short directional trading. Simply put, you can make money when the market goes two directions and to some extent three of the three possible directions the market can go. Ultimately, though, I found that despite the logic behind trading from that angle, it doesn’t suit me very well. The very argument for using them, that the probabilities are in your favor and time decay makes things better as the days pass, was also what seemed to consistently confuse my better judgment. Rather than strictly heeding my observations about significant breaks in technical levels and such, I would tend to give a position the benefit of the doubt and watch it slowly but surely get worse and worse. Anyone who trades spreads, knows that there is a point beyond which the Greeks can suddenly start putting the squeeze on your very fast. In short, for me personally, the strategy seemed to make me a bit lazy and over-confident. As most of you know, the trick with credit spreads is that while your win/loss ration should be higher, the profit/loss ratio will not be nearly as high as the potential with directional trading. So taking just that one or few big losses can drastically affect any profits you may already have.
Of course, I learned a lot from the experience and the time at it, and I don’t entirely avoid selling strategies. I am just a lot more selective about using them and try to keep a mind of the much bigger picture. At the moment, one of the things that strikes me is that while volatility has come down significantly from the panic highs of the last 9 months, it is still quite high compared to recent history. As a result, option premiums are still relatively high compared to the days when I was having such frustration with spread trading. Because of the high volatility, we can put on trades that are further away from the money and still find decent premiums to sell.
Take a look at the VIX.  It seems to me the most likely next move on the VIX is a pop higher, but until that happens, it is where it is. The 40 line seems a significant resistance level, we are below all the major MAs and the indicators don’t give much reason to expect a reversal.

Here’s a long term look. Barring some reason for another major panic, I don’t see why this should go back toward 50.

SO, after that long winded into, I’m looking to do a nice, simple far out of the money iron condor for June. One of the reasons I don’t like credit spreads is that you just have to wait and let the time decay do its thing. I’m a little too jumpy while watching the day to day fluctuations of stocks for spread trading stocks. But doing smaller positions on way OTM spreads on the indexes is a nice way to pick up some “easy” money. (Famous last words!)
I tend to stick to options on the Russell 2000, RUT, because it trades electronically and you are not subject to the guess work and luck involved with getting fills in the SPX pit with the open out cry that goes on there. Of course, we can always trade the SPY, QQQQ, IWM, etc., but then you have to trade many more contracts to equal the same money at work with the actual index options and that means more commissions. I know there are reasons that the TOS guys prefer those products anyway….better fills, tighter spreads, whatever. But this is just me.
I’m no Iron Condor expert, but one quick an dirty rule of thumb I’ve learned for the far out of the money IC approach is to sell the short strikes with a delta of around .10 or lower. When and if the delta on those strikes gets to .25 defensive action is needed. Either close out, roll further away, or add something like a calendar spread to balance out your deltas to a more comfortable level.

Here’s what I’ve come up with for RUT June contracts.

As a $10 wide spread, the margin requirement is $1000 for the trade. For every lot, the profit potential is $147 and the max loss potential is $853, not including commissions. Of course, this is using the data after the close on Friday, so it will surely change a bit on Monday morning.

Here’s the Risk Profile using TOS’s snazzy analyze page.
The Green line shows the p/l potential for the trade at expiration in June. The white line shows the theoretical value of the trade at any given price at the current date. As time goes one, it inches toward the green line. I have set price slices at the current price in the center, plus and minus 15% from the current price, and the break-even prices for the position. By adding the probability numbers in red toward the top, we can see that the probability is a bit over 60% that the RUT will be within the range of plus or minus 15% from the current price at June expiration. There is only a 19% chance that the RUT will be on either side of our break even points at expiration. As long as it stays between those two levels, in that big window of just over 210 points, we make money.

High Probability of success, which comes with a lower profit/loss potential. Makes sense.

Now for a look at the chart. We’re right now between the down-trending 200 MA and the 50 day which is turning upward. The 20 MA is below us and firmly headed upward. Considering the action in this area back in the fall, I don’t expect us to surge through here very easily, particularly after the strong run we’re had. Some consolidation or a reasonable pullback would be healthy. The MACD and Stochastic show potential for a bit of a pullback, but also no overwhelming signal for such. I would expect a pullback to no further than the 50 MA, currently at around 425.

Pretty cool how the strikes found with delta around .10 put our spread just outside of the high and low ends of the range from the panic in the fall.
Looks like a pretty good trade. And if you’re really feeling randy, one might try to put on the call spread now and give the index a few days or a week or so to come down some to put on the low side a little further away just for extra safety. This is probably what I will do in actuality.
Next time, I’ll show what I did for May on the RUT using this same basic approach.
Ciao for now.

Global Glance: Sell in May….Buy in September? (Fixed)

****Sorry Folks.  I just realized that the charts weren’t fully showing before.  I’ve fixed it now.*******

****All charts and text, however, are unchanged and still reflect the original date of publishing, 8/23/08.****

Most of us are familiar with the saying, “Sell in May and go away.” Apparently it is also referred to as the “Halloween indicator“. The idea, according to the Wikipedia writeup in the link is to start buying again after October. We spoke some meetings back about the Stock Trader’s Almanac and the various patterns seen over the years that can be helpful to be aware of. Even though there is no certainty to such cycles, there is clearly reason enough to pay attention to seasonal or yearly patterns just as we look for price patterns on charts. Check out this story on the Almanac from BusinessWeek TV.

As always, whatever the conventional wisdom, theory or superstition, the charts tell the story and give the signals. It’s interesting to look at the last five years with this particular pattern in mind. In particular, I began thinking about this when I put together a comparison chart of the SPY versus the ETFs representing the other major markets around the world. Using the old “eyeballing it” method, it actually looks like the world markets did have pullbacks of varying degrees in the past five years beginning around May. More importantly, I looked to see when these may end and turn to rallies. With hopes of September being a time for rallying, I’ve highlighted the beginning of each September with the vertical orange oval. It’s kind of remarkable to see that in most of the markets, rallies have taken place with pretty good consistency each year around this time.

Not surprisingly, there is strong performance from the countries known as BRIC, Brazil, Russia, India, China.

Unfortunately, the only ETF I know for Russia, RSX, only goes back to sometime in ’07, so it is not included here. Also, the China ETF, FXI, begins in late ’04.

So here’s a look from the beginning of ’05 to better include China.

What is most interesting to me is that we hear the talking heads on TV most often focused on China and India as if a mantra of some sort, though Brazil has been the clear leader. I’m sure their ethanol fuel program has had a profound affect on their economy and I imagine its progression and effects are still to unfolding. According to this Wikipedia article on the subject:

• The Brazilian ethanol program provided nearly one million jobs in 2007, and cut 1975–2002 oil imports by a cumulative undiscounted total of US$50 billion.

• In 2006 Brazil produced 16.3 billion litres (4.3 billion U.S. liquid gallons), which represents 33.3% of the world’s total ethanol production and 42% of the world’s ethanol used as fuel. Total production is predicted to reach at least 26.4 billion litres (6.97 billion U.S. liquid gallons) for 2008

• There are no longer light vehicles in Brazil running on pure gasoline. Since 1977 the government made it mandatory to blend 20% of ethanol (E20) with gasoline (gasohol), requiring just a minor adjustment on regular gasoline motors.

• Today the mandatory blend is allowed to vary nationwide between 20% to 25% ethanol (E25) and it is used by all regular gasoline vehicles, plus 3 million cars running on 100% hydrous ethanol, and 6 million dual or flexible-fuel vehicles

• The comparison between Brazil’s sugar cane based and the U.S.A.’s corn based ethanol industries show that their corn based industry blows ours away in most metrics.
  

Here’s a look at the long term chart for Brazil. A multi year, beautiful uptrending channel was broken this year, but there seems to be support around the 68-70 area. After three months of quite orderly but consistent downward movement, we see an “inside” week or maybe we could call it a bullish harami candlestick pattern. Either way, this indicates the potential for a trend reversal. For long term investors, this area could be a very nice entry for a return to the former high. It could also make for a good vehicle for consistent covered calls as it noodles its way around from here.

On a closer look, we can see a bullish divergence with the MACD histogram showing higher lows while price shows lower lows. A break of the downtrending resistance line could be a nice entry with a stop just below the recent intraday low of 67.66. As an intermediate to long term trade and an initial target of the former high around 100 or better, this could be a 1 to 2.5 risk/reward ratio or better.

One might also use the much discussed C pattern entry, buying on a move above the 30 MA or the 50 MA and setting a stop somewhere below the 30.

India has a much longer and well defined downtrend in place making it less appealing for a bullish entry. Nevertheless, the break of the downtrending resistance line would be the first signal to look for. Until then, playing to the downside would make the most sense.

Mexico looks more stable than most and in a pretty well defined sideways range. How about a play from support to resistance? Could be nice to leg into covered calls, selling the 60 or 65 strike price if it gets up there.

Looking at China, it has come down significantly from the high back in late ’07. My uptrend line here may not be very clean with the fudge back in late ’05, but otherwise it has 4 points of contact for support including the last two weeks. Besides, as they say, “Beauty is in the eye of the beholder.” In any case, the horizontal line here just above 40 makes for a very clean entry and defined stop for a bullish entry here. Likewise, a break of that line, would be a nice and clean entry to the downside with, again, a clearly defined line to set a stop with.

The US market, notable at the bottom of global performers in the comparison above, doesn’t look too pretty. Downward moment seems to be waning, but still the rally of late looks more like a bear flag than anything, and more likely to break to the downside. One promising detail, however, is that the recent lows around 120-125 looks to be a potential capitulation with extreme volatility and high volume reacting to the level. A return to that level and successful bounce off support would set a much more stable footing for the market to move up from.

The U.K. doesn’t look very pretty. Here’s an article on their perilous dependance on oil.

Finally, Germany, the world’s third largest economy in US Dollar Exchange rate terms and the largest in Europe, could be in trouble. Though the exact placement of the neckline could be debatable, it looks to have broken below a 16 month head and shoulders pattern. A retest and bounce down from the 28 area would make for a clean bearish entry. The height of the pattern makes for a downside target prediction of about 21.5.

So after all that, I’m not all that convinced that it’s quite time to buy with respect to the “Halloween Indicator,” but there do seem to be some good setups to watch for in the global markets, both to the up and the downside. For those less inclined to be in and out of stocks and uninterested in short term trading, this would be a great batch of ETFs to look to for long term plays.