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Trader Notes: Tips for Trading Options

As you know, the US main brokers (Ameritrade, Fidelity, Charles Schwab, eTrade) are now offering zero-commission in stocks, ETFs and options trading. A piece of great news, by far the best this year for retail traders.  It's a great opportunity to start trading options more aggressively, creating an options-based portfolio as now commissions are no longer cutting our profits.

1. Options as a substitute for Stocks: Delta > 0.80

Substituting stocks with options has two unique advantages: only options bring leverage and protection.

- Options provide tremendous financial leverage to users when they are used in a conservative way: you can control the same amount of shares with less money, and mainly, the % returns are much higher when you trade with options. This carries another advantage: with more money available you can diversify better your portfolio.

- And provide protection: with the appropriate strategy, in case of devastating fall of the stock, your maximum loss is always limited to the amount of the call purchase.  The use of stop-loss in stock trading works reasonably well but not always prevent losses due to frequently morning gaps. Stop-loss orders offer protection that is path-dependent (depends on the "path" the stock takes), while options offer time-dependent protection (and never trigger you out of the position just because of the path the stock, as stop-loss did).

Options are two-dimensional assets: you must guess correctly the direction and the speed of the underlying stock. When a stock-trader becomes an option-trader they often buy at-the-money call options (since they are cheaper) as a substitute for the stock. Doing so subjects them to a two-dimensional asset when they are used to trading stocks, a one-dimensional asset. When you starting out, buy short-term options in-the-money (ITM), calls with relatively high deltas in the 0.80-0.85 range and you will have an asset that behaves similar to the stock you are trading. They are more expensive but less risky.

The reason is that a call option with a delta of 1.0 is no longer considered an option, it's a perfect stock substitute. There is no time-premium there, and a lot of intrinsic value that we would rather not pay for. So you don't need to find a delta of 1.0 but should get close, and the 0.80-0.85 range will suit your needs. On the other side, if you buy a higher strike, there is too much time premium in the option and it may not respond to smaller changes in the stock price.

2. Use Credit Put Spreads

As you know, trade options are more complicated than with stocks. You need to guess not only the direction of the stock but also how quickly the stock's price will get there (the speed). We can combine two concepts for a solution, selling puts and the vertical spreads, to create a great strategy, the credit put spread.

- You can create a bullish trade not only by buying calls: you can sell puts. A short put, being on the opposite side of a trade of a long put, is bullish. Most traders, who are bullish, tempted to immediately reach for the long calls, also due to its unlimited gains, but they need the stock to move. A short put also makes money if the stock rises. And more important, also make money if the stock standstill. It's a big difference: by selling puts you don´t need the stock rise for us to make money; you just can't have it fall. You eliminated the speed component of the option.

- Sell puts creates an unlimited downside risk that you could control by creating an option spread, that's combining two different option strikes as part of a limited-risk strategy.  This called vertical spread, consider buying and selling a call, a call spread, or buying and selling a put, a put spread, of the same expiration but different strikes Essentially, trading put credit spreads is very similar to the short put. Preserves its advantages, but without its dangerous downside risk. And that's great!

A vertical spread can be bullish or bearish and can be for a debit or a credit. Let's review my favorite of all, due to its many great features, the credit put spread.

Click to enlarge.

Typical P/L (profit/loss) chart of a credit put spread. This month I'm bullish in silver (follow by the ETF SLV), now trading at $16.77. The spread was created with two legs: sell put 17 and buy put 16, for a net credit of $0.49. If SLV rallies, the put credit will decrease in value and result in a profit. Conversely, a sell-off results in a loss. As max-gain is similar to max-loss ($500), we had a good risk/reward ratio of 1. When the expiration date is near, the spread will benefit from theta decay, unless legs are completely ITM. 

As you verify in the chart above, a credit put spread has important features advantages against other option strategies. Let's summary them:

- Maximum profit: limited, and is the credit or premium received.
- Maximum loss: limited, and is the difference between the two strikes minus the premium received.
- Risk Level: low, if you use a Risk/Reward ratio near 1.0 or less. You could get it with ATM legs (that's one ITM and the other slightly OTM).
- Break-Even: is the strike price of the short pull minus the premium received.
- Environment: ideal when you have a bullish, neutral or slightly bearish position and don´t need a great move in the stock price.
- Legs: two, a bullish short put (the main) and, further away, a bearish long put (the protection).
- Goal: receive credit and hope both legs expired worthless, or the same, the stock price stays above the short put strike, as you can review in the chart above.
- Stock Volatility: as it affects both legs at the same time, its effect is mitigated.
- Implied Volatility: in terms of cost, for high IV, use the spread Buy OTM Put/Sell ATM Put. For low IV use the spread Buy ATM Put/Sell ITM Put.
- Time decay: acts in favor of a put credit spread, as short put gains with the passage of time, and its theta offsets the long option theta.
- Close Position: as other options, a spread could be closed at any moment, better prior to expiration if it reached its max profit. Sometimes you only need to close the short put since it can't gain more and leave the long put in case it rises. And if you reach the max loss, wait: always there's a chance that the position turn in your favor.
- Expiration Risk: be careful if the underlying expires within the short and long strikes, or the short ITM and the long OTM. You have the obligation to buy 100 shares of stock for each short put. If buying power isn't enough it will activate a margin call from your broker.

Selling options strategies with a favorable risk-reward and a high probability of success is the way an Income Trader works. Think like them and treat your portfolio as an insurance company: they live selling policies (options) for a premium, a successful business. The goal is to do the same: collect as much premium income as possible and never pay out the policies. So, maximize the number of credit trades, diversifying between index, ETFs and stocks, in different sectors, through bull or bear market conditions, analyzing only the stock direction. Now that brokers offer commission-free trades, it's perfectly possible.

In the next Trader Notes, we take a step forward with another popular risk-defined option strategy, the iron condor, that combines two verticals (a call credit spread and a put credit spread), for use when you have a neutral bias in the underlying.

This practical chart summarizes what options strategies work better depending on market direction and implied volatility size. Straddle, Strangles, Butterflies, and Calendars are not treated in this post, but in some next.

3. Best Options for Earnings Play

Buy a stock just before its earnings report is a bet: it can be highly profitable or devastating for your portfolio. You decide the risk you face. I always prefer to wait for the report, to compare their numbers with the estimates in EPS, sales, and guidance, review the conference call for some additional data and see the next day analyst's ratings, which usually increases or decreases their weighting and price target. Also, high-volume transactions with price and implied volatility moves, are guaranteed before and after the earnings date.

And, of course, you can use specific options strategies during these events. Let's overview some ideas as to choose the right strategy. You need to know the following principles:

-  A strategy that involves long options (been calls or puts) will typically gain value as IV increases and lose value quickly with IV decreases.
- On the contrary, a strategy that involves short options (been calls or puts) will typically gain value quickly with IV decreases and lose value as IV increases.
- During an earnings event, the implied volatility IV of the underlying usually increases some days before the report (due to typical great attention given by traders, creating orders like bets). And when the report was released it drops sharply.

Click to enlarge.

Thinkorswim includes this great feature in its platform, in which, at a glance, you could review the latest earnings of any stock, in this case, Disney DIS (my favorite 2019 stock), showing its price move and implied volatility before and after the event. 
Here is an example of what usually happens during an earnings event: despite the result (if the stock beats or miss EPS, sales or guidance), the implied volatility increases before the earnings date, and decreases quickly after it, the next day, hurting the premium. The goal is to take advantage of this movement.

If you decide your directional bias in the underlying near the earnings report, buy OTM calls (or OTM puts, depending on the direction) just before it, with cheaper premiums, looking for a big profit if the stock explodes after the report. It also works with spreads (OTM credit puts or OTM credit calls) for bullish or bearish bias, respectively. Traders love this simple strategy (really, it's a bet): low-cost, minimum risk but also very little profit probabilities in your favor. But it's valid: sometimes works.

If you have a neutral position or presume the underlying wouldn't have a sharp move before/after the earnings report, you could consider taking advantage just from volatility changes:

- Before earnings: entry long positions (long calls, long puts or ATM debit spreads) one or two weeks before earnings day, and then closing the position the day before the event, so to take advantage of the volatility increase mentioned above.

- After earnings: entry short positions (short calls, short puts, or ATM credit spreads) just before earnings, to take advantage of the volatility decrease mentioned above. The position could be closed just after the report.

As you see in the three option "tips" mentioned in this post, risk management is the main factor I consider in all of them.  Protect your portfolio and protect your gains is the key to become a profitable trader.

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A Decade in Charts

The ten years period, from  2010 to 2019, finished and leave us many transcendental changes in different branches, like the economy, technology, work, home, or retail. Let's review those moments through the way we love: charts.
Many of the charts and texts are taken from Morning Brew daily newspaper, definitely a great weapon for our Wall Street stock trading. Thanks, Brews!

Stocks (SP500 SPX and the Dow Jones DJIA) experienced the longest bull market in history, while Crude Oil /CL is still recovering from its 2014 dramatic drop. Gold /GC is still below 2011 and 2013 highs, while 10-year U.S. Treasury Bonds TNX swings during the decade in a range from 1 to 4%.

It's called the Tax Cuts and Jobs Act, and it reduced the corporate tax rate from 35% to 21%. Tax reform has led to a divergence in how much corporations earn and what they pay the government in taxes. A success from Trump's economic policies.

U.S. private equity deals have climbed steadily upward in both quantity and value, according to PitchBook. IT, healthcare, and B2B sectors made up the majority of deals.
From 2006 to 2017, the number of PE-backed companies increased by 106% while the number of publicly traded companies fell by 16%. In 2018, the number of private equity deals finally rose to pre-recession levels.

In 2019, U.S. venture capital (private equity and financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential) are expected to top $100 billion for the second straight year, according to PitchBook, with 185 deals above $100 million already recorded. The number of deals above $50 million has increased since 2012, though angel and seed rounds have been slowly declining since 2015.

NFLX In dollars, easier to view: the savvy investor who sank $25,000 in Netflix in 2009 would now be sitting on $1 million. Taken from @CNBC.

The FAANGs: in Aug. 2018, Apple AAPL became the first company in history to reach a $1 trillion valuation. One month later, Amazon AMZN joined the club (though it has since fallen back to the billions), and this April, so did Microsoft MSFT. But it's not just the number of 0's that has regulators and other businesses worried. These big tech companies have evolved from mostly singular missions (search engines, retail, phones) to businesses than span content creation, cloud computing, artificial intelligence, ad platforms, self-driving cars, and more.

Cryptocurrencies were one of the best-performing assets this decade.
That's mainly due to bitcoin. Bitcoin is a digital currency created in 2009, and for the first half of the 2010s, it flitted between obscurity and heavy skepticism from consumers, the finance industry, and governments. Then all hell broke loose in 2017 when it shot up to nearly $20k and turned some early backers into millionaires. Now...some are comparing bitcoin to the financial bubbles of centuries past. 
But over the latter half of the decade, something happened. Cryptos like Ethereum, Ripple, Litecoin, and (yes) bitcoin gained more legitimacy. Wall Street started thawing, and this year Facebook FB corralled some of the biggest names in payments, banking, investment, and tech to back a cryptocurrency project, the Libra Association

The U.S. unemployment rate fell from almost 10% at the start of the decade to 3.5% at the Bureau of Labor Statistics' last count. BLS's 2009 predictions that employment growth would be concentrated in the services sector, especially professional/business services and healthcare/social assistance, were pretty spot on.
The chart above represents broad industry categories. While manufacturing technically posted a net gain over the decade, it was still home to some of the worst-performing sub-industries over the last 10 years, including many apparel manufacturing sectors.

                                                 FAMGA acquisitions since 1999

The FAMGA (Facebook FB, Amazon AMZN, Microsoft MSFT, Google GOOG, and Apple AAPL) has made over 750 acquisitions in the last 30 years. @CBInsights has a nice chart on the $1+ billion acquisitions from 1999 to 2019.

                                            Trades, a threat for the economy

In 2008, the majority of the U.S. people considered trade more of a threat to the economy than an opportunity. Now, 74% view it as an opportunity for growth.

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Trader Notes: Tips for Trading Stocks

Stock trading, through technical analysis, is an art. There are full of ideas, strategies, and tips for doing it. You need to be alert to all of them and choose the adequate before you trade. Here are some simple, but useful ideas, that can help in your daily work.

1. Fibonacci "Golden Zone"

Traders love Fibonacci retracements. They are easy to learn and draw, and certainly accurate as alert zones.  Obviously, it doesn't work all the time (there's no infallible indicator or strategy), but as many retail/professional traders and big banks use them, its lines become important levels of support/resistance to place or close trades as price reversals can happen there.

But not all Fibonacci levels have the same importance or attention from traders and investors: the area between the 38.2% and 61.8% is called the Golden Zone, since its the most powerful of all.  They are many (payable) strategies on the web, about this zone, all of them based on the same principle: is an area of a relatively big length and if the price trend not change its direction there, use the 61.8% level as a reversal alert zone.  Simply check different timeframe charts with its Fibonacci lines draw to verify that. So, when you detect a tradeable Golden Zone, use all your arsenal: price action, adequate technicals indicators, and fundamental analysis. Your possibilities for a successful trade will increase.

The Fibonacci retracement never works alone: you need to use other indicators. Notice in this weekly chart of XBI (the ETF that follows biotech companies) how the shares pullback from mid-2018 highs.  In November-December crossed the golden zone not changing direction until finding an important reversal alert in early 2019 when touched the 61.8% level and at the same time the MACD did a bullish crossover and also the key 3-year uptrend line support was touched. A real powerful technical signal: shares began to rebound.

2. Volatility VIX spiking

These days, when the SP500 is moving in all-time highs, all investors' eyes are in developments of the Trade War: the US planned on initiating new tariffs with China, with December 15th as the deadline decides by Trump. We have news from both sides: reports that China and US were unlikely to reach a trade deal this week, however today news of another delay in tariff give some hopes to Wall Street. The fact is that markets could see more volatility ahead of the weekend, especially on Monday when markets open. The stock rally will continue or a huge pullback could begin, probably no more flat sessions. So, VIX is a good instrument for a simple strategy next weeks only if markets fall and volatility spikes.

More than a strategy, its a tip when trading the VIX. In its daily chart notice the clear difference between its relative tops and bottoms: tops are spikes (rapid rise due to market fear), like an inverted V, while bottoms (more complacence due to market greed) are more rounded and full.

The diligent trader has already grasped the idea of this strategy: trade in the spikes of the VIX daily chart, operating shorts or puts. To find an acceptable entry point, the Bohlinger Bands are useful: waiting for the moment when the bullish candle leaves the upper band with some slack. Then expect a next bearish candle that wraps it completely (or almost) the previous bullish. This candlestick is known as engulfing. The open of the next candle is my entry point. However, there are a couple of undefined points in this strategy. One of them is not being clear about the exit. Perhaps the best idea is to set in advance a risk-reward, like the popular 1: 3 used by many traders, to determine the exit.

The other complicated point of this strategy is the location of the stop loss. The usual is that the VIX continues its fall the following days and is difficult it returns above the engulfing candle, however, it can happen. A double top would be formed, the most reliable figure in the technical analysis according to Alexander Elder, where we could confidently sell VIX. The best plan is to trial daily the stop loss to a safe level.

The "VIX spike strategy" works best in its daily chart. Every year happens, few but powerful. In this chart, taken from 2015, we noticed two big spikes overcoming the upper band of the Bohlinger Bands (mid-October and mid-December, in the yellow circle), both followed by an engulfing candle that generates the quick and important reverse. Two more spikes happen in January and February 2016 (also in a yellow circle) but in both cases, its price didn't overcome the BB, so its reverse isn't as powerful as the 2015 spikes. Finally, in the pink circles, we had two spikes that haven't an engulfing candle enveloping them, so the reverse seems very unclear.

3. The feared Opening Gaps: Buy the Close, Sell the Open

A simple rule: is better, statistically, buy stocks at the close of the session and then sell in the morning of the next session. It's far profitable than "buy the open, sell the close"Bespoke Investment analysts compared both cases with the SP500 since 1993 when it was incepted. The charts and numbers are shocking, check it:

A $100 investment in 1993 using the "buy close, sell open" rise more than 480% to $587, while "buy open, sell close" lost near 20% ($79) in the same period. Of course, this is just statistics, didn't happen every session, but gives an interesting idea: if you are a swing trader who wants to follow the trend but you are afraid of the frequently opening gaps, don't close your position, hold the gap: you can get a decent trade. Finally, remember, in the long-term, the best odds are in your favor.

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