From the August 01, 2011 issue of Futures Magazine • Subscribe!

Option spreads in the dog days of summer

Understanding the dilemma

If you are a holder of a given stock whose price action suddenly shifts from a period of expansion to one of contraction, the dilemma you face is whether to sit it out in the hopes that the stock will, at some point, continue in a favorable direction, or if you should exit the trade altogether. Sadly, this is where a lot of traders fall apart in that they either don't have a set of rules to dictate their actions beforehand or they will just wing it and decide as time passes. Of the two possible alternatives, the latter is the most dangerous and, unfortunately, the one most chosen.

In this scenario, the two possible choices — hold or sell — put the trader in the position of not only wrestling with how to make the best choice possible given the situation, but they also create all kinds of psychological conflicts involving emotions such as fear and greed. It's easy to have strong feelings of fear of potential loss by exiting the trade too early to avoid the negative emotional aftereffects while, at the same time, wanting to stick it out because there is the hope that the stock might go on to make you a sizable profit.

However, the good news is that you can tailor your approach to avoid these types of mental/emotional positions while also designing an optimal position to collect income and, at the same time, minimize risk and increase the odds of success.

The summertime doldrums option spread strategy was developed to adapt to the range-bound price patterns that are commonplace during summertime trading by using options to form effective income spreads. These spreads are based on proven statistical edges to help increase your probability of success and avoid unnecessary losses.

The cornerstone of using this strategy correctly is understanding how to filter out bullish and bearish option spread trades by utilizing the 200-day simple moving average (see "Stagnant Apple," below).

image

In the book, "How the Stock Market Really Works," Leo Gough approached trading the stock market using statistical analysis. He did this by studying what actually worked in technical analysis with the goal of quantifying key statistical edges that can give the speculator a competitive advantage. One of the things Gough put to the test was the trader's adage that, "Bulls live above the 200-day SMA and bears live below it." What he found was a grain of truth in the old saying that, by using the 200-day SMA, you could identify a directional bias in the short-term.

Simply, if price action is above the 200-day SMA, then use a bullish option spread strategy. If price action is below the 200-day SMA, then you want to use a bearish strategy option spread.

<< Page 2 of 5 >>
Comments
comments powered by Disqus