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1.

Bear Call Credit Spread

2.

Bull Put Credit Spread

3.

Combining two spreads to create an Iron Condor

4.

Why we primarily place trades on the SPY and RUT

5.

Why we usually trade 10 point credit spreads, and not 20 or 30 point spreads on the RUT and MID indexes

6.

Why we usually open 2 and 3 point wide credit spreads on the SPY and IWM

7.

Why we care about Implied Volatility (VIX)

8.

Identifying Strike Prices

9.

Market Timing to help dictate when/if to open trades

10.

Getting Started

11.

Defining Some of the Terminology Used in our Advisories

12.

What if the market surges unexpectedly;  how do we protect ourselves?

13.

What if the market drops unexpectedly; how do we protect ourselves?

14.

What if the underlying index climbs right up to our short call leg in the last few days before expiration?

15.

Opening credit spreads and shaving the price

16.

How to close-out credit spreads & iron condors

17.

Closing-out credit spreads & iron condors early to free up cash

18.

Rolling-out spreads into the following month or rolling-down into the same month

19.

How to read the option risk/reward graph and why it's important to understand

20.

How to place a credit spread order when the "bid" is shown as N/A on the options chain

21.

What if one of our spreads go deep in-the-money, how can we preserve our risk capital?

22.

How to hedge against a drastic move in the market, or take advantage of a slowly recovering market that just crashed

23.

Recommended methodology to roll deep ITM credit spreads

24.

How the open interest of calls and puts on particular strike prices can influence the movement of the underlying stock or index

25.

Major candlestick patterns

26.

The 5-35 oscillator

27.

The 17/43 weekly exponential moving averages

28.

The MACD indicator

29.

The Relative Strength Index

30.

The Average Directional Index (ADX)

31.

Bollinger Bands

32.

Accumulation/Distribution (A/D Line)

33.

Chaikin Money Flow

34.

ISE Equity-only Call/Put Ratio Sentiment Index

35.

Investors Intelligence Bull/Bear Ratio & Spread Investor Sentiment Indicators

36.

McClellan Oscillator & Summation Index

37.

Stochastics Oscillator

38.

Williams %R Indicator

39.

Advance/Decline Ratio Oscillator (ADRO)

40.

Parabolic SAR

41.

Elliott Wave Analysis

42.

Aruoba-Diebold-Scotti Business Conditions Index (ADS)

43.

Economic Cycle Research Institute (ECRI) Weekly Leading Index (WLI)

44.

The Conference Board Leading Economic Indicator (LEI)

45.

US Treasury Yield Curve

46.

Interest Rate Spread Between Similar-Maturity Corporate Bonds and Treasuries to Monitor Health of the US Credit Markets

47.

Revolving Consumer Credit

48.

TrimTabs Demand Index

49.

Money Flow IN/OUT of long-term, domestic equity mutual funds

50.

DOW Jones Economic Sentiment Indicator (ESI)

51.

The difference between a straight call and a bull call spread for a bullish, directional trade

52.

On Balance Volume

53.

8/22 Day Exponential Moving Average (EMA)

54.

Relative Strength Comparison (RSC) of the QQQQ to the DOW Jones Industrial Average - INDU

55.

Smart Money Dumb Money Confidence Spread

56.

Sector Rotation Analysis and Relative Strength Comparison to the Broad Market

 

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1.

The Bear Call Credit Spread

Figure 1 below shows a risk/reward graph for a Bear Call Credit Spread on the Russell 2000 index (RUT).  In order to create this Bear Call Credit Spread we would open the following two "legs" shown below:

Buy to open, RUT 10 contracts, 750 strike, January 2006 Call

Sell to open, RUT 10 contracts, 740 strike, January 2006 Call

Or alternatively:

Buy 10, RUT 750 Jan 06 Call

Sell 10, RUT 740 Jan 06 Call

Or Alternatively:

10 RUT Jan 740/750 Bear Call Spread

selling index credit spreads options trading system

Options Risk/Reward Graph courtesy of Optionetics Platinum

Figure 1

Dissecting the name "bear call credit spread", "Bear" denotes that we want the underlying RUT index to remain below 740, our short Call that we are selling, or writing.  "Call" denotes that the trade is made up of Call options; "Credit" denotes that we are collecting a net credit (premium) and depositing the funds into our brokerage account upon opening the spread; the credit is the difference between the 740 Call that we sold, less the 750 call that we purchased.  Because the 740 Call is closer to the underlying RUT index, it's worth more than the 750 call, thus the reason that we end up with a net credit.   "Spread" denotes that we are opening two legs - buying a Call at once strike price, and selling a Call at different strike price, but both in the same expiration month.  In this case, we are selling the 740 Call  (we're getting on the "other side" of the trade, like being the "house" in a casino) and then we're buying the 750 call for protection to limit our risk.  The 740/750 Bear Call Spread is a "10 point" spread...i.e. 10 points between the buy leg and the sell leg.

This risk/reward graph (Figure 1) shows the Russell 2000 Index (RUT) on the left, (Y axis on left is the price of the RUT index) and how the seller of this Bear Call Credit Spread on the right will either make or lose money. The X axis on the bottom right is the gain or loss on the spread in dollars.

When this trade expires in 55 days, and if the RUT stays below 740, the credit spread will expire worthless for the "buyer", and we the "seller" of this spread would keep the premium of about $500.  If the RUT starts to climb into the 740 strike, we then would make adjustments; these adjustment strategies are also covered in this Learning Center.

For this particular credit spread, we the seller would need to lock-up $10,000 in maintenance in our brokerage account to open the trade, and these dollars will be un-locked when the spread is closed.  Our total risk capital to open these 10 credit spreads is the $10k of required maintenance, less $500 in premium that we collected when first opening the trade, or $9500.  In order to calculate a simple return on investment (ROI) one would divide the premium collected by the total risk capital, which is 500/9500 = 6%.  We generally collect 6% to 10% ROI on 30 day to 45 day credit spreads.

 

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2.

The Bull Put Credit Spread

Figure 2 below shows a Bull Put Credit Spread on the Russell 2000 index (RUT); as discussed above, this type of trade is called a credit spread because when we as a seller open this type of trade, we will collect a net credit in premium.  When this trade expires, usually in 30 to 45 days, and if the RUT stays above the 610 strike price, the credit spread will expire worthless for the buyer and we as the seller will keep the premium collected, which is about $500.  We  would open this credit spread by placing the following order:

Sell 10 contracts, RUT 610 strike, January 2006 Put

Buy 10 contracts, RUT 600 strike, January 2006 Put

Or alternatively:

Sell 10, RUT 610 Jan 06 Put

Buy 10, RUT 600 Jan 06 Put

Or alternatively:

10 RUT Jan 06 600/610 Bull Put Spread

Maintenance requirement for this trade is $10,000. ($1k required per spread)

Figure 2

 

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3.

Combining two credit spreads to create an Iron Condor

Figure 3 below shows an Iron Condor.  This risk graph is created when we combine both a bull put credit spread and a bear call credit spread. (the trades shown above in Figures 1 & 2) If the RUT stays above 610 and below 740, called the "safe zone", for 55 days, both spreads will expire worthless for the buyer and we as the seller will keep the premium of about $1000. Maintenance for this trade is equal to the maintenance of just one of the spreads.  For this particular trade, the maintenance requirement would be $10,000 total, which is one of the powerful aspects of the Iron Condor.  By opening both the "bottom" Bull Put credit spread, and the "top" Bear Call credit spread, we only have to lock-up maintenance dollars for one of the spreads, thus allowing us to double our ROI.  For a typical month where we "complete" the trade with both a bottom spread and a top spread to create an iron condor, we usually achieve a 5% to 8% ROI on the bottom spread and a 3% to 4% on the top spread, for a total of 8% to 12% return in 30 to 45 days.  Sometimes, however, we will not have the opportunity to complete the iron condor and we will only have the chance to open either the top spread or the bottom spread;  and for these months our returns will be a little less.

Figure 3

 

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4.

Why we place option trades primarily on the SPY and RUT

Monthly Cash Thru Options focuses on Bull Put Credit spreads and Bear Call Credit spreads, and combining them to create Iron Condors on the SPY, RUT and MID.  The RUT is the Russell 2000 small-cap index and the MID is the S&P400 mid-cap index. The SPY is an ETF (exchange traded fund) that tracks at 1/10th of the S&P500 index.  Options that trade on the RUT and MID trade as European style, meaning that they cannot be exercised until the Friday before expiration.  Options that trade on the SPY ETF trade American style, meaning that these can be exercised at anytime during the life of the option.  All of these indexes move enough to collect a reasonable premium each month, but move slowly enough where we'll win on about 90% of our trades and can get out quickly enough if the market begins to surge-up or sell-off.  For more on 90% probability trades, please read 90percentVs70percent.  European style options that trade on the RUT and MID cannot be exercised until expiration, thus giving us more flexibility to adjust our trades if necessary.  Our philosophy is not to get greedy and to create the largest “safe zone” for the index to move where it will have an 89% to 92% probability of expiring profitable for us, the seller of these options.  This simple approach will consistently throw off a 6% to 10% monthly ROI for a 45% to 65% annual ROI, needing only 1 to 2 hours per week.  You can also allocate up to 75% of your portfolio to this single index credit spread system (holding 25% of your portfolio as reserve cash), which is not the case for most other trading systems.  (for more on why you need to hold reserve cash, please read the entry below entitled "what if the market surges, how to we protect ourselves?") 

Note:  We would not recommend one to allocate 75% of their portfolio into the 2 or 3 credit spreads that we recommend each month until he/she has built up at least a year of trading experience, preferably two, with this strategy, have closely followed our recommended trades and ongoing education for a year, and have studied all of the material in our Learning Center to thoroughly comprehend the risk/reward nature of credit spreads.

 

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5.

Why we usually trade 10 point credit spreads, and not 20 or 30 point spreads on the RUT and MID indexes

We usually trade 10 points between the sell leg and buy leg on our credit spreads on the RUT and MID because it allows people with varying sizes of trading accounts to participate in the MCTO recommended trades.  Because the available options strike prices come in 10 point increments for the MID and RUT, the smallest spread we can open on these indexes are 10 points.  The difference between the sell and buy legs of a credit spread dictates how much maintenance is required by the broker to open the spread, which also dictates total risk capital.  A 10 point spread requires $1000 in maintenance by the broker;  a 20 point spread requires $2000 in maintenance, a 30 point spread requires $3000....etc.   As an example, the total risk capital for a RUT 790/800 Bear Call Spread with a 10 point spread between the buy leg and sell leg is $1000 in required maintenance less the premium that is collected when we open the trade.  Usually we collect about 60 cents of premium for a bear call spread so the total risk capital for this trade would be $1000 - (.60 * 100 shares) = $940.  (one options contract controls 100 shares of the underlying stock or index so we multiply 60 cents by 100).  As another example, the total risk capital for a RUT 790/810 Bear Call Spread with a 20 point spread is $2000 in required maintenance less the premium collected.  For a 20 point spread we would normally collect $1.20 in premium, so the total risk capital would be $2000 - ($1.20 * 100 shares) = $1880.   The MCTO advisory usually recommends 10 point spreads allowing everyone to participate because it requires less maintenance per spread.  With this said, sometimes a trader can squeak out a few extra % points of return by moving to a 20 point spread. We demonstrate below that after going to a 20 point spread, widening the spread any further will not increase the % return and it actually will reduce your % while requiring more maintenance to place the trade.  Below shows an example using the MID (S&P 400 Mid Cap index) where we widen the point spread on the top Bear Call Spread and on the bottom Bull Put Spread and we compare the % return for each trade. 

Figure 1 below shows the risk/reward graph for 10 contracts of the MID 670/680, 790/800 Iron Condor with 44 days to expiration.  Each credit spread has 10 points between the buy and sell legs.  Premium collected is $750. Maintenance required is $10,000.  Total risk capital is $9,250.  The % return in 44 days is shown to be 8%.

.Figure 1

Figure 2 below shows the risk/reward graph for 10 contracts of the MID 660/680, 790/810 Iron Condor with 44 days to expiration.  Each credit spread has 20 points between the buy and sell legs.  Premium collected is $1850. Maintenance required is $20k. Total risk capital is $18,150.  The % return in 44 days is shown to be 11%.

 

Figure 2

Figure 3 below shows the risk/reward graph for 10 contracts of the MID 650/680, 790/820 Iron Condor with 44 days to expiration.  Each credit spread has 30 points between the buy and sell legs.  Premium collected is $2750. Maintenance required is $30k.  Total risk capital is $30k minus the premium collected, or $27,250.  The % return in 44 days is shown to be 10%

Figure 3

Figure 4 below shows the risk/reward graph for 10 contracts of the MID 640/680, 790/830 Iron Condor with 44 days to expiration.  Each credit spread has 40 points between the buy and sell legs.  Premium collected is $3400. Maintenance required is $40k. Total risk capital is $40,000 minus the premium collected, or $36,600.  The % return in 44 days is shown to be 9%.

Figure 4

Figure 5 below shows the risk/reward graph for 10 contracts of the MID 630/680, 790/840 Iron Condor with 44 days to expiration.  Each credit spread has 50 points between the buy and sell legs.  Premium collected is $3900. Total risk capital is $50k of required maintenance less the premium collected, or $46,100.  The % return in 44 days is shown to be 8%.

Conclusion: For most traders who have small to medium sized trading accounts it's good to stick to credit spreads with 10 points between the buy and sell legs.  For traders with larger accounts, it's possible to squeeze out a few extra % return by going with 20 point credit spreads.  Placing credit spreads with 30 point spreads or larger is not recommended because the % return drops back down to what can be achieved with a basic 10 point spread.

 

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6.

Why we usually open 2 and 3 point credit spreads on the SPY and  IWM

This case study analyzes and compares 1, 2, 3, 4, 5, 7 and 10 point wide credit spreads on the SPY. The SPY is an ETF that tracks at 1/10th the value of the S&P 500 index.  We make the case that the 2 point credit spread usually provides the best returns if we don't anticipate the need to make a lot of adjustments during the month.  However, if we are early in the cycle (a full cycle is typically 25 to 40 days) and if we believe we'll need more flexibility to make adjustments during the month, we'll use the the 3 point credit spread.

Here are the assumptions used when making our calculations:

1) Commission = $1/options contract or $2/spread.  (we show additional commission rates in the spread sheet summary below)

2) $5000 of cash is available to open the spreads

3) The trade stays out-of-the-money (OTM) and profitable, and we let the spread expire worthless, which is 100% profitable for us, the seller.  Thus, we only pay commission to open the spreads and we call this "one-way" commissions.  (in contrast to round-trip commissions where we pay to open and close the trades)

4) All spreads have 31 days until expiration

5) We simplify the number of spreads that we can open by dividing the available $5000 of cash by the required maintenance.

 

Below is the SPY Aug 89/90 bull put spread which has the following characteristics:

 

1) It's a 1 point spread (i.e. 1 point between the sell leg and the buy leg)

2) Required maintenance by the broker is $100 per spread (1 point spread * $100/point)

3) 50 spreads can be opened ($5000/$100 of required maintenance per spread)

4) Premium collected is $15 credit x 50 spreads = $750

5) Risk capital is $5000 in maintenance - $750 of premium collected = $4250

6) One-way commission at $1/contract is 50 spreads x $2/spread = $100.

7) Commission as a % of premium collected is 100/750 = 13.3%

8) ROI after one-way commission is (750-100)/4250 = 15.3%

 

 

Below is the SPY Aug 88/90 bull put spread which has the following characteristics:

 

1) It's a 2 point spread (i.e. 2 points between the sell leg and the buy leg)

2) Required maintenance by the broker is $200 per spread (2 point spread * $100/point)

3) 25 spreads can be opened ($5000/$200 required maintenance per spread)

4) Premium collected is $25 credit x 25 spreads = $625

5) Risk capital is $5000 in maintenance - $625 of premium collected = $4375

6) One-way commission at $1/contract is 25 spreads x $2/spread = $50.

7) One-way Commission as a % of premium collected is 50/625 = 8%

8) Return after one-way commission is (625-50)/4375 = 13.1%

Below is the SPY Aug 87/90 bull put spread which has the following characteristics:

 

1) It's a 3 point spread

2) Required maintenance by the broker is $300 per spread

3) 16 spreads can be opened ($5000/$300)

4) Premium collected is $35 credit x 16 spreads = $560

5) Risk capital is $5000 in maintenance - $560 of premium collected = $4440

6) One-way commission is 16 spreads x $2/spread = $32.

7) One-way commission as a % of premium collected is 32/560 = 5.7%

8) Return after one-way commission is (560 - 32)/4440 = 11.8%

Below is the SPY Aug 86/90 bull put spread which has the following characteristics:

 

1) It's a 4 point spread

2) Required maintenance by the broker is $400 per spread

3) 12 spreads can be opened ($5000/$400)

4) Premium collected is $44 credit x 12 spreads = $528

5) Risk capital is $5000 in maintenance - $528 of premium collected = $4472

6) One-way commission is 12 spreads x $2/spread = $24.

7) One-way commission as a % of premium collected is 24/528 = 4.5%

8) Return after one-way commission is (528 - 24)/4472 = 11.2%

 

Below is the SPY Aug 85/90 bull put spread with the following characteristics:

1) It's a 5 point spread

2) Required maintenance by the broker is $500 per spread

3) 10 spreads can be opened

4) Premium collected is $50 credit x 10 spreads = $500

5) Risk capital is $5000 in maintenance - $500 of premium collected = $4500

6) One-way commission is 10 spreads x $2/spread = $20

7) One-way commission as a % of premium collected is 20/500 = 4%

8) Return after one-way commission is (500 - 20)/4500 = 10.6%

Below is the SPY Aug 83/90 bull put spread with the following characteristics:

1) It's a 7 point spread

2) Required maintenance by the broker is $700 per spread

3) 7 spreads can be opened ($5000/$700 required maintenance per spread)

4) Premium collected is $58 credit x 7 spreads = $406

5) Risk capital is $5000 in maintenance - $406 of premium collected = $4594

6) One-way commission is 7 spreads x $2/spread = $14

7) One-way commission as a % of premium collected is 14/406 = 3.4%

8) Return after commission is (406 - 14)/4594 = 8.5%

Below is the SPY Aug 80/90 bull put spread with the following characteristics:

1) It's a 10 point spread

2) Required maintenance by the broker is $1000 per spread

3) 5 spreads can be opened

4) Premium collected is $65 credit x 5 spreads = $325

5) Risk capital is $5000 in maintenance - $325 of premium collected = $4675

6) One-way commission is 5 spreads x $2/spread = $10

7) One-way commission as a % of premium collected is 10/325 = 3%

8) Return after one-way commission is (325 - 10)/4675 = 6.7%

Below is a grid that summarizes our analysis - if you would like access to this spreadsheet, please contact us at support@monthlycashthruoptions and we'll forward it to you.

credit spread point
width (diff. between buy & sell legs)
# of credit spreads that can be opened with "cash avail to trade" variable Req'd Maint
Per spread
Credit premium per spread (from risk/reward charts above) Total premium collected when opening the credit spreads Total Risk Capital (req. maint. less total premium collected) ROI
with
1-way Comm Rate 1
ROI
with
1-way Comm
Rate 2
ROI
with
1-way Comm Rate 3
ROI with
1-way Comm Rate 4
ROI
with Round
-trip Comm Rate 1
ROI
with Round
-trip Comm Rate 2
ROI
with Round
-trip Comm Rate 3
ROI
with Round
-trip Comm Rate 4
1 50 $100 $15 $750 $4,250 16.0% 15.3% 14.1% 17.4% 14.4% 12.9% 10.6% 17.2%
2 25 $200 $25 $625 $4,375 13.5% 13.1% 12.6% 14.1% 12.7% 12.0% 10.9% 13.8%
3 17 $300 $35 $583 $4,417 12.7% 12.5% 12.1% 13.0% 12.2% 11.7% 10.9% 12.8%
4 13 $400 $44 $550 $4,450 12.0% 11.8% 11.5% 12.1% 11.6% 11.2% 10.7% 11.9%
5 10 $500 $50 $500 $4,500 10.8% 10.7% 10.4% 10.9% 10.5% 10.2% 9.8% 10.7%
7 7 $700 $58 $414 $4,586 8.8% 8.7% 8.6% 8.8% 8.6% 8.4% 8.1% 8.6%
10 5 $1,000 $65 $325 $4,675 6.8% 6.7% 6.6% 6.7% 6.7% 6.5% 6.3% 6.5%
                           
                         
credit spread point width (diff. between buy & sell legs) 1-way Comm
Rate 1
1-way Comm Rate 2 1-way Comm
Rate 3
1-way Comm Rate 4 Round
-trip
Comm Rate 1
Round
-trip Comm Rate 2
Round
-trip Comm Rate 3
Round
-trip Comm Rate 4
         
1 $70 $100 $150 $10 $140 $200 $300 $20          
2 $35 $50 $75 $10 $70 $100 $150 $20          
3 $23 $33 $50 $10 $47 $67 $100 $20          
4 $18 $25 $38 $10 $35 $50 $75 $20          
5 $14 $20 $30 $10 $28 $40 $60 $20          
7 $10 $14 $21 $10 $20 $29 $43 $20          
10 $7 $10 $15 $10 $14 $20 $30 $20          
                           
                         
credit spread point
width (diff. between buy & sell legs)
Comm
as % of collected premium
1-way
Rate 1
Comm as % of collected premium 1-way Rate 2 Comm
as % of collected premium 1-way
Rate 3

Comm
as % of collected premium 1-way Rate 4

Comm
as % of collected premium round-
trip
Rate 1
Comm
as % of collected premium round-
trip
Rate 2
Comm
as % of collected premium round-
trip
Rate 3
Comm
as % of collected premium round-
trip 
Rate 3
         
1 9.3% 13.3% 20.0% 1.3% 18.7% 26.7% 40.0% 2.7%          
2 5.6% 8.0% 12.0% 1.6% 11.2% 16.0% 24.0% 3.2%          
3 4.0% 5.7% 8.6% 1.7% 8.0% 11.4% 17.1% 3.4%          
4 3.2% 4.5% 6.8% 1.8% 6.4% 9.1% 13.6% 3.6%          
5 2.8% 4.0% 6.0% 2.0% 5.6% 8.0% 12.0% 4.0%          
7 2.4% 3.4% 5.2% 2.4% 4.8% 6.9% 10.3% 4.8%          
10 2.2% 3.1% 4.6% 3.1% 4.3% 6.2% 9.2% 6.2%          
                           
                         
Variables                          
Cash available for trade   $5,000                    
Commission Rate 1 per contract $0.70                    
Commission Rate 2 per contract $1.00                    
Commission Rate 3 per contract $1.50                    
Commission Rate 4 (flat rate) $10.00                    

Conclusion:  From the analysis above, the 2 point wide credit spread provides the highest return, but commissions can be a problem if one pays more than $1/option contract.  When trading 2 point wide credit spreads it's best to find the lowest cost broker.  When we are early in the cycle and feel that we might need more flexibility to make adjustments during the month, the 3 point spread is optimum.  When we say that we need "flexibility" to make adjustments, we mean that when the spread gets under pressure from a fast moving underlying index (the SPY in this case) we implement the "stay ahead of the wave" strategy by "clicking-up" or "clicking-down" our strike prices to move further away from the underlying index and we open more spreads to bring in more premium.  If we use the 3 point spread we have the flexibility to "click-UP/DOWN" 2 times if needed.   For example, let's say we have a SPY 90/93 bull put spread and 10 days after we open this spread the SPY sells-off putting our 90/93 bull put spread under pressure.  In this situation, we would not yet close-out the SPY 90/93 spread but we would watch it closely, and in parallel we would "stay ahead of the wave" and click-down a strike to the SPY 89/92 bull put spread (in the same month) and open some to continue to bring in premium.   If we need to click-down again, we have the flexibility to click-down one more time to the SPY 88/91 bull put spread to allow us to keep bringing in premium.  If we need to click down even further, we won't be able to open the SPY 87/90 bull put spread until we close-out the original SPY 90/93 bull put spread because the 90 strike overlaps and will cancel each other out;  however, this is ok because if the underlying SPY is dropping this fast, and just by the fact that we've already clicked down twice, we probably will need to close out the original SPY 90/93 anyway to cut our losses and to minimize any further downside.  With this said, and especially for bull put spreads, we would not engage in the "stay ahead of the wave" strategy unless the market timing indicators were giving us the green light that the economy and the market are "healthy" and therefore it's ok to keep clicking down and bringing in premium.  For more on how we Market Time, please go to  WhyMarketTiming.htm.  For more on the "staying ahead of the wave strategy", please read the entries "what if the market surges, how do we protect ourselves"? and "what if the market crashes, how do we protect ourselves?" in this Learning Center.

 

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7.

Why do we care about Implied Volatility - the VIX?

Implied Volatility (IV) is a measure of how much the "market place" expects the price of an underlying stock or index to move;  i.e. the volatility that the market itself is implying for the underlying stock or index.  The VIX index represents the Implied Volatility for the S&P 500 index (SPX), therefore giving us a prediction of the potential size of future price swings for the SPX. Wall Street, in general, uses the VIX to represent the volatility of the stock market as a whole, and not just the SPX.  One of the variables of pricing an option is IV.  Thus, when IV for an underlying stock or index increases, the price of options on that stock or index increases.  Conversely, when IV for an underlying stock or index drops the price of options on that stock or index decreases.  For traders like us who write (sell) index credit spreads and iron condors, we like higher IV because we can collect more premium for the options that we write. 

Implied Volatility (IV) is also called the fear index.  When the market goes down the VIX goes up - i.e. investors are getting more fearful.  On the contrary, when the market rallies, IV drops and fear subsides because investors start feeling more comfortable with the market.  Therefore, there is an inverse relationship between the underlying index or stock and its IV.  Figure 1 shown below demonstrates the inverse relationship of the Russell 2000 index (RUT) to the VIX.  As you can see, when the RUT sells-off, investors get more fearful and the VIX climbs; and when the RUT rallies, investors feel more comfortable with the market and the VIX subsides.

Figure 1

Sometimes the VIX moves in the same direction as the underlying index or stock.  Figure 2 below shows that in May, June, and July of 2007 the VIX trended upward along with the market.  This is a sign that the market could be topping-out and is ready for a pause or correction.  The psychology behind this is that even though the market is trending upward and "looking" healthy, investors are getting worried that the market is getting over extended and/or the fundamentals behind the economy are slowly deteriorating. Therefore, when we see the situation where the VIX (fear) trends upward along with an upward trending market we need to be careful and watch the market closely for a possible correction. 

Figure 2

Another observation that we can see in Figure 2 is that the VIX many times will increase just prior to an event such as the Federal Reserve Open Market Committee meeting where they make the decision to either raise interest rates, hold them steady or lower them.  The VIX climbs because there is uncertainty on what the outcome will be. This is what happened in late June, as shown, where the VIX spiked up to almost 19.  However, as soon as the Fed announced their decision on interest rates and the uncertainty diminished, the VIX immediately deflated back down to 16.  We sometimes want to time the writing of our credit spreads with events like this since the quick spike of the VIX will substantially increase the price of the credit spreads options that we are writing (selling).

To summarize, below are some general trading rules using the VIX when deciding to open 30 to 40 day index bull put credit spreads, bear call credit spreads or iron condor options:  1) If the VIX is holding steady and is not dropping from day to day when we are about 30 to 40 days out to expiration, we can usually take our time to open our spreads for that month and gradually "collect" premium over a two week period.  2) If the VIX is slowly dropping day to day when we are 30 to 40 days out to expiration, we then will have to move more quickly and open our trades before the premium of the credit spreads that we're selling "dries up".  3) Once we open our bottom bull put spreads, and if the VIX starts to creep up from the time we opened our trades, we need to closely monitor the VIX because it could be warning us that a "hurricane" is coming, where we might need to close our bull put spreads early and only focus on the top bear call spreads for that particular month.

 

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8.

Identifying Strike Prices

Knowing what strike prices to select and when to get into a trade is a very important aspect of generating consistent returns. This is why it's good to subscribe to an advisory service such as Monthly Cash Thru Options to "give you another set of eyes" on when to pull the trigger for each trade. When we are about 45 days out from expiration, (expiration is every 3rd Friday of every month) we begin the process of identifying strike prices for the top and bottom credit spreads that will make up the iron condor. Our goal is to get filled with about a 5% to 10% return for each spread and to maximize the size of our “safe zone”, giving the index that we're trading a large zone to move around in. The secret sauce of selecting the safest strikes is in our ability to perform technical analysis on the Index. We primarily watch the moving averages, Bollinger Bands, Bullish/Bearish crossovers, MACD, DMI, volume, support/resistance levels, 5/35 oscillator, and various candlestick patterns. These indicators give us a good picture of where the index most likely will go.

 

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9.

Market Timing to Dictate When/If to Open Trades

The Monthly Cash Thru Options team spends a lot of time each week watching big-picture, macro level market and investor sentiment indicators, also known as market timing.  Watching macro-level indicators is extremely important as it helps us reduce our downside exposure when the indicators and overall health of the economy start to look unhealthy.   Most of our competitors do NOT spend enough time, if any at all, on market timing and we believe this is key in growing and protecting our capital over the long run.  For more information on our approach please read Why Market Timing.

 

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10.

Getting Started

1) Open a Brokerage account that can handle options. OptionsXpress is an excellent choice and is preferred by the MCTO team.  You will need to request Level 4 trading privileges (this is what is required by OptionsXpress to trade credit spreads; other brokers might have different terminology so you will need to check with your broker).  All brokers will ask you to fill out a questionnaire asking about your level of experience in trading options.  All brokers will require a certain level of options trading experience before they will grant you Level 4. Brokers like to see the applicant buying about 20 or more calls and puts per year and writing 30 or more credit spreads per year as their required threshold to grant Level 4 trading privileges.  This will give you some guidance as you fill out the questionnaire. The brokers need to protect themselves, and this is why they collect this info, regardless if this information is accurate or not.   If you don't show any past options trading experience on the questionnaire, they will not grant you level 4 trading privileges, and you will not be able to execute any trades that are recommended through this advisory.  If you need more help on this please contact us.

2) We recommend to start small with as little as $1000 in your trading account and then to slowly increase the size of your account as you gain experience in the types of trades that we recommend.  As a reminder, we do not manage money;  we provide trade recommendations and ongoing education to our subscribers and each subscriber is responsible to place and manage their own money in their own trading account.

3) Subscribe to an options analysis package such as Optionetics Platinum or Platinum Express. This software will allow you to visualize the risk/reward graph for each trade. This is not absolutely necessary, but it is encouraged.

4) Link your checking account to your brokerage account allowing you to easily transfer funds back and forth. (ACH is the recommended type of linkage)

5) Have access to additional funds for the one or two difficult months per year where we will need to make adjustments to our trades to break even due to an unexpected surge or drop in the market.  MCTO recommends to have access to at least 25% of your total active funds. For example, one who has $50k active in their options brokerage account should have access to an additional $12.5k a few times per year. An excellent source for these funds would be a Home Equity Line of Credit.  If you do have a credit line, link your credit line into your brokerage account or your checking account giving you an easy way to move funds back and forth.

6) Set up an excel spreadsheet to track your trades and Return on Investment.  If you would like the spreadsheet that the MCTO team uses, CLICK HERE to download the Spreadsheet.xls file.

7) Start out small and slowly add funds to your brokerage account as you gain more experience and confidence with this particular options strategy.....and don't give up. Learning and feeling comfortable with this strategy takes time and patience, but it's well worth the effort. And by using the MCTO Advisory Service will reduce your learning curve dramatically and save you a lot of time and money by avoiding costly mistakes.

 

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11.

Defining some of the terminology used in our advisories

Below is a typical trade recommendation from one of the MCTO advisories:

We recommend the following trade this week:

RUT Bull Put Credit Spread
Sell to open Jan 680 put
Buy to open Jan 670 put - for 75 to 90 cents....and only attempt to get filled on the down-days.  If this one starts paying more than $1, stop getting filled on it and click down a strike to the RUT Jan 660/670 and try to get back into the sweet spot of collecting 75 to 90 cents.  Make sure to put this in one of your accounts where it does not overlap with any of your existing RUT trades.  

Below is an explanation for the terminology that is used in the above trade recommendation:

1)  We are opening up an Bull Put credit spread on the Russell 2000 index;  selling to open the RUT January 680 put, and buying to open the RUT January 670 put for protection.  For more on Credit Spread, please refer to the "Bear Call" and "Bull Put credit spread" entries in the Learning Center.

2)  "Only attempt to get filled on the down-days"  -  Put yourself on the other side of the trade where you're a speculator, you believe that the RUT is over valued and is due for a correction, and you've decided to buy some 45 day Puts on the RUT index...because you think it's going to go down.   If the market is now having a heavy down-day, and the RUT is also down, you as the speculator get excited that the RUT might continue to drop as you predicted, and as a result you are willing to pay more for Puts on the RUT index.   Because we are on the "selling" side of the Puts (we are selling the RUT Jan 680 Put;  and we are buying the 670 for protection to limit our downside...thus creating a spread)  we are able to sell the RUT 680 Put for more money on the down-days to the speculators.  That's why we wait until down-days in the market before attempting to open Bull Put Spreads.  And the opposite holds true when selling Calls...we want to sell our Calls to the speculators (i.e. open our Bear Call Spreads) on the up-days.

3)  "If this spread starts paying more than $1, stop getting filled on it and click down a strike" - Our goal is not to be holding a short Put that has a good chance of going in-the-money, or "getting hit";  i.e. where the RUT index drops and starts getting too close to our short 680 Put.   In this case we "wrote" the RUT Jan 680 Put and our goal is for the RUT index to stay above 680 until expiration.  Let's say a few weeks before expiration the RUT index has a heavy down-day and it drops 30 points;  because the RUT index is now much closer to the 680 strike price, the 680 Put costs more, and if we were to open the RUT 670/680 Bull Put credit Spread,  it would be paying more than what we initially collected in premium, maybe a $1.20 credit, for example.  (credit is defined as the difference between the 680 Put that we are selling and the 670 Put that we are buying)   The market is telling us that investors are willing to pay $1.20 for this credit spread (a high price) because there is a higher probability that the RUT index will continue to fall.   Based on our trading experience, the MCTO team is saying that if the RUT index drops and gets close to our short 680 Put, and if the 670/680 credit spread starts paying a credit of more than $1, we are recommending to suspend any further fills on this spread and to "click down" a strike to the RUT Jan 660/670 Bull Put Spread....taking us further away from the RUT index.  (but we want to hold onto all of our existing spreads and not close anything out early)   As a result, our new spreads are further away from the RUT index and have less of a chance of "getting hit".  As an analogy, it's like standing on the beach where we want to get as close to the water as possible, but we absolutely don't want the waves to hit our shoes; if the waves start getting too close, we'll step back one step and stay there for a while (and we'll sell more credit spreads, clicked down one strike);  if the waves start getting too close again, we'll step back another step and stay there for a while (and we'll sell more credit spreads clicked down another strike...but holding onto our existing spreads;  we do not close out any of our spreads early)  For more on this, please read the case study entitled "stay ahead of the wave" strategy in the Learning Center. 

4)  "Make sure to put this spread in one of your accounts where it does not overlap with any of your existing RUT trades"  -  We do not want to put "overlapping" spreads in the same account.  A RUT Jan 660/670 Bull Put Spread overlaps with the RUT Jan 670/680 Bull Put Spread....thus these two spreads would have to be put in separate accounts.  (each spread has a 670, so they overlap).  If we did place these two spreads in the same account, the 670 puts would "cancel" each other out, because in one of the spreads the 670 is "short" and in the other spread the 670 is "long",  so they cancel each other out);  the result would be "20 point" RUT Jan 660/680 Bull Put Spread and this is not what we want.  We want to keep all of our spreads as "10 point" spreads.  (the difference between the Long and Short Puts).

 

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12.

What if the market surges unexpectedly, how do we protect ourselves?

Because this information is advanced in nature, below is a summary of this entry; we cover this entry in its entirety in the Members Only Learning Center.  To view the complete entry, Click here to go to the Members Only Learning Center.  If you are not an active member, please consider signing up for a FREE 30 day trial.

This section covers two primary adjustment strategies.  The first adjustment strategy is called "stay ahead of the wave", which allows us to keep bringing in premium as the market surges.  The second adjustment strategy, if required, is that we will roll-up our spreads that are getting into danger into the same month, or roll-out our spreads into the following month for "even", i.e. at no cost, or for a small debit.  By leveraging these adjustment strategies, we usually can break even during a "difficult month" when the market surges-up unexpectedly and threatens our bear call spreads;  and if the market continues to climb into our spreads,  typically we can keep our loss of risk capital below 10%. (most of our losing months in the last 3 years have been in the negative 5% to 8% of our risk capital;  for more on our track record please visit the ROI Page)  In general, the index credit spread strategy will be profitable 9 to 10 months per year without the need to use any adjustment strategies, and it will have about 2 to 3 losing months per year where we do need to make adjustments.  And having a few difficult months each year is just the cost of being in the business of writing index credit spreads.  Even with a few losing months each year, this strategy still achieves 45% to 65% return annually.

For this case study, below is what the iron condor looked like when we first opened the trade.  And then what it looked like after the underlying index surged into our bear call credit spread.  This section discusses adjustment strategies to minimize our loss for the month.

And here is what the trade looks like after the index surged into our top bear call spread.  This section covers the methodology to handle this situation.

To view this entry in its entirety, Click here to go to the Members Only Learning Center.  Because this information is advanced in nature, it is reserved for active MCTO members.  If you are not a member, please consider signing up for a FREE 30 day trial.

 

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13.

What if the market drops unexpectedly, how do we protect ourselves?

Because this information is advanced in nature, below is a summary of this entry; we cover this entry in its entirety in the Members Only Learning Center.  To view the complete entry, Click here to go to the Members Only Learning Center.  If you are not an active member, please consider signing up for a FREE 30 day trial.

Similar to when the market suddenly surges-up and places our short Call position at risk, if the underlying index that we're trading starts dropping unexpectedly, this will put our short Put positions at risk.  In this situation we place adjustments that allow us to minimize our loss for the month, which is typically no more than 10% of our risk capital;  and many times we're actually able to break even for the month as long as we follow the "stay ahead of the wave strategy", which is covered in more detail in the entry above. (most of our losing months in the last 3 years, and we have about 2 to 3 losing months per year, have been in the negative 5% to 7% of our risk capital;  for more on our ROI please visit the ROI Page)

This case study looks at when the market corrected in June of 2006. The MCTO team was fully invested and we lost 7% of our risk capital.  This correction represents one of the more difficult scenarios for our strategy since the market dropped precipitously right after we opened our June trades.  Figure 1 below shows the strike prices and the risk/reward graph for our iron condor 1 day after it was opened on May 4, 2006.

Figure 1

Figure 3 below shows what the June SPX Iron Condor trade looked like 6 days from expiration. 

Figure 3

Figure 4 shown below zooms in on the Bull Put Spread portion of this iron condor because this is the credit spread that is at risk.  Because the underlying index it too close to the short 1240 put, we need to make an adjustment.  We discuss an adjustment that allows us to push this spread down to give us more breathing room.

Figure 4

Figure 5 shown below shows the new July iron condor that we created

To view the above entry in its entirety, Click here to go to the Members Only Learning Center.  Because this information is advanced in nature, it is reserved for active MCTO members.  If you are not a member, please consider signing up for a FREE 30 day trial.

 

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14.

What are the risks when the underlying index climbs right up to our short call leg in the last few days before expiration?

This case study analyzes what happens to a credit spread and its associated risk/reward graph when the underlying index surges in the last week of trade just before expiration.

 

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15.

Opening Credit Spreads and Shaving the Price

In this example we enter the Russell 2000 Index symbol, RUT, and click on the "Find Chain" link;  the options chain for the RUT in Figure 2 & 3 shown below displays.

Here is an example of opening a March 610/620 Bull Put Credit Spread on the RUT (Russell 2000) index. The easiest way to place an order is to go to the options chain in your brokerage account and click on the "Bid" price for the trade that you want to place.  This will usually populate the order form automatically and you will not need to bother knowing the option symbols for each leg.   Below are the steps to follow in OptionsXpress.  If you use a different on-line broker the steps might vary a little, but they should be similar.

From the OptionsXpress main window click on the "Trade" tab, and then the "Options" sub-tab.  The form in Figure 1 shown below will display.  In the "Option Symbol" empty box type in the name of the index that you want to trade.  In this example we are interested in opening a Bull Put Credit Spread on the RUT, so we'll type "RUT" in the box;  then click on the "Find Chain" link to the right of the box to bring up the chain. 

Figure 1

Using the pull down menus in the chain below, we fill in the following:  Select "All" which will show all available strike prices;  click on "Put Spreads" since in this example we want to open a Bull Put Credit Spread;  select the expiration month (not shown on the screen shot; for most of our trades we are selecting an expiration month that is 30 to 45 days out...in this example we select "March");  and select 10 for the "set interval", representing the spread between the buy leg and the sell leg of the spread that we're opening (e.g. the RUT March 610/620 Bull Put Spread is a "10 point spread", since there are 10 points between the 620 Put that we're selling and the 610 Put that we're buying for protection);  and then click "View Chain" to update the chain. 

In this example, we are showing the options chain for the March Bull Put Spread strike prices on the RUT.  Because we want to open the RUT March 610/620 Bull Put Spread, we click on the "Bid" price shown as 60 cents. 

Figure 2 (left side of the options chain)

Figure 3 (right side of the options chain)

Figure 4 shown below is the auto populated order form that displays once we click on the "Bid" price.  (note the convoluted option symbols on the left....we really don't need to understand them or worry about them when entering orders this way)  Figure 5 shown below is another form on the same page showing the most up-to-date Bid/Ask prices of the RUT March 610/620 Bull Put Spread.  Note that the "limit/credit" box in Figure 4 auto populates to 60 cents. (because we clicked on the 60 cent Bid price)  At this point we would increase the limit/credit price to be about half way between the bid and ask prices, or 75 cents;  this is called "shaving" the price.  Note:  We never want to place an order "at the market";  we always want to place a "limit" order giving us control over the credit price that we can get when opening our credit spreads.  Next, type in the number of contracts that we want to open.  (here we entered 1 contract each - the number of "buy" legs and "sell" legs need to be the same in order to create a spread)  Next, click on "Preview Order", review our order to make sure everything is correct and then click "Place Order".   Once the order has been placed we will need to monitor our order at our requested limit/credit price to see if the market maker will "fill" the order at the price we are requesting.  (if we are willing to sell our credit spread for a credit of 60 cents, it would most likely fill immediately....but since we're trying to "shave" the price and are asking for more, and if our order does not fill in about 10 to 15 minutes, we'll probably have to lower our requested price by 5 cents and try again)  We then wait again...maybe another 10 to 15 minutes to see if it fills; if it doesn't, we then continue to lower our requested limit/credit price a nickel at a time until the market maker fills our order.  In general, we don't want to get filled at the Bid price and we always want to try to shave the price to receive maximum premium for the credit spread that we're writing (selling).  However, if the bid/ask prices are tight, maybe just 15 cents between the Bid and Ask prices, then we might have no choice but to take the Bid price when filling our credit spread, or the best we'll do is get a nickel over the Bid price.

Figure 4 and 5

 

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16.

How to close-out credit spreads and iron condors

Below is an example of how to close out a credit spread within the OptionsXpress platform.  Figure 1 below shows the positions page of an account with 20 SPY Jun 151/156 bear call spreads, 20 SPY Jun 122/127 bull put spreads (that make 20 SPY iron condors), 50 RUT Jun 610/620 bull put spreads, and 30 RUT Jun 630/640 bull put spreads. (Ignore the THMCZ position at the top)  The RUT is the symbol for the Russell 2000 Index and the SPY is the symbol for an Exchange Traded Fund (ETF) that tracks at 1/10th of the S&P 500 Index (SPX).

Figure 1

One way to close-out the SPY Jun 151/156 bear call spread is to click on the "Sprd" link on the right side of the positions page to the right of either the 151 leg or the 156 leg.  If the computer does what it's supposed to do properly, it will pair up the correct legs and auto-populate the order form, shown below.  For this particular spread, we can see that the bid/ask prices are -.01 and .02 cents.   We are trying to close this spread out for the smallest debit possible, so we select a limit/debit of .01 cent, which is between the two prices.   When we first open a credit spread we bring in a credit, so when we close out a credit spread it will cost a debit, thus the reason we have to put in our desired price in the "Limit/Debit" field.  We then click on the "Preview Order" button and that will complete the order.

 

 

 

 

 

 

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17.

Closing-out credit spreads and iron condors early to free-up cash

After we open a credit spread it's wise to close it out as soon as possible for a debit of 5 cents if/when we can get it.  This will allow us to free-up our cash sooner so we can possibly reinvest it again for the same month, or start opening credit spreads for the following month.  For example, let's say we open 1 of the RUT June 620/630 Bull Put Spread for a credit of 75 cents, where the RUT is trading at 700.  A few days after opening this spread the RUT surges to 780.  Because the RUT has moved over 150 points away from our 620 and 630 strike prices, the value of this spread has dropped considerably to the point that it's probably only worth 5 to 10 cents.  Understanding this, we put in a good-to-cancel (GTC) order to close-out this spread for a debit of 5 cents, and we'll let the order sit there until it fills, if ever.  If it does, great...we just made 70 cents (about 7% on our risk capital) in less than a week.  This is calculated as follows: we brought in a credit of 75 cents when we opened the Bull Put Spread, and then we closed it out for a debit of 5 cents, thus we made 70 cents or $70 while risking $925 in maintenance.   (Maintenance is calculated as follows:  $1000 of maintenance is required by the broker per each credit spread that we open; we brought in $75 in credit when opening the spread, thus our total risk capital is $1000 - $75 = $925.)

Below shows an easy way to identify which spreads we could possibly close early to free-up cash, and the process to place the order.  All screen shots are from OptionsXpress.   First we view our positions and sort via "strategy".  The broker's computer automatically assembles the legs that make up each option strategy.  Here, shown in Figure 1, we see that we have 4 iron condors and 4 spreads.   In order to free-up cash the first positions we should focus on are the individual spreads since by closing them will immediately free-up their associated maintenance.  Conversely, we would have to close-out the entire iron condor (4 legs) to free-up the maintenance. The next thing we do is look at the current price for each of the positions.  We can see that the RUT Jun 620/610 Bull Put Spread is priced at 1 cent, making it a perfect candidate to close-out early. (when we opened this spread it was worth 75 cents...now a few days later it's worth 1 cent)  Next, we would click on "trade" to the right of the RUT Jun 620/610 position (not shown...right side of screen shot is cut off).  This will auto populate the order form as shown in Figure 2.

Figure 1 above

Figure 2 below shows the order form auto-populated showing that we are placing an order to close out 20 of the RUT Jun 610/620 Bull Put Spread in a single transaction, Good Until Canceled for a debit of 3 cents.  (remember that we open credit spreads with a "credit", and we close them out with a "debit")  We entered a 3 cents limit/debit since the NBBO Quote shows a bid/ask price of -.05, .10, so we are entering (guessing) the smallest debit possible that the market makers on the trading floor might accept to close this spread out.  More often than not, two things will happen:  1)  it will cost a minimum of 5 cents to close-out the spread...and it if we are able to close it for a nickel, we'll be very happy;  2) many times the broker's system will only allow you to put in limit prices in increments of 5 cents, but try to put in less to see if the system will allow you to put in a debit that is less than a nickel.  If/when the order fills to close 20 of the 610/620 spreads, we just immediately freed-up $20k of maintenance that we can use for additional trades.

Figure 2 above

 

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18.

Rolling-out into the following month or rolling-down into the same month

Because this information is advanced in nature, below is a summary of this entry; we cover this entry in its entirety in the Members Only Learning Center.  To view the complete entry, Click here to go to the Members Only Learning Center.  If you are not an active member, please consider signing up for a FREE 30 day trial.

When our credit spreads are under pressure, especially in the last week before expiration, we will usually "roll-out & down" our spreads to the following month or "roll-down" in the same month.  We use this procedure to minimize our losses when forced to close out a spread early.  The traditional approach is to close out a spread that is in danger first in one transaction, and then open a new spread further away from the underlying index in another transaction either in the same month or in the following month.  The negative for this approach is that when you close out the spread that is in danger in a separate transaction, you will get less maintenance back than you originally locked-up since you will be incurring a loss by closing the spread early.  As a result, less cash is now available and you will be able to open fewer spreads at the new strike price bringing in less premium to offset your losses.  In contrast, if you close out the spread that is in danger and open the new spread in a single transaction, called a "roll", more often than not the broker will allow you to roll your old spread into an equal number of new spreads allowing you to better offset your losses.

For example, let's say we have the SPY July 118/123 Bull Put Spread and the underlying SPY index has sold-off and is now getting too close to our short 123 put.  Below is an example of "rolling-out & down" in OptionsXpress.  "Out" means we are rolling out one month to August, and "down" means we are clicking down several strikes putting more distance between the underlying SPY index and our short Put.  We will use a 4 legged order form as shown below to perform the "condor" roll.

We then show how to place the actual orders.

To view this entry in its entirety, Click here to go to the Members Only Learning Center.  Because this information is advanced in nature, it is reserved for active MCTO members.  If you are not a member, please consider signing up for a FREE 30 day trial.

 

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19.

How to read the option risk/reward graph and why it's important to understand

Below are example risk/reward graphs showing 1 contract of the RUT Aug 07 760/770 Bull Put Spread. The first graph shows what the RUT Aug 07 760/770 Bull Put Spread risk/reward graph looks like 37 days from expiration.  The next graph shows the risk/reward graph for the same trade 14 days from expiration.  The third graph shows the risk/reward graph for the same trade 2 days from expiration. 

Looking at the second risk/reward graph, you can see that the RUT is correcting and closed at 784, 14 days from expiration.  The gain/loss of the spread is now -$220.  The red line on this graph represents 14 days out and notice, based on the slope of the red line, how the loss that is incurred is accelerating as the RUT corrects.  The small black arrow shows the maximum that can be lost ($920) if the RUT should continue to fall and end up below 760 after expiration and settlement.

Looking at the third risk/reward graph, this shows the dynamics at 2 days from expiration. The main thing to notice is that if the RUT moves up and down a lot during the last few days before expiration, and if the RUT is near the 760 to 770 range, we are at tremendous risk of incurring a 100% loss of maintenance dollars.  Note how the price of the option moves more dramatically (right X axis) to small moves in the RUT  (left Y axis) based on the slope of the curve.  If the RUT is in the 760 to 770 range, the value of the option ranges from a gain of $80 (100% profitable) to a loss of $920  (100% loss of maintenance dollars).  Thus, if we get to the last few days of a contract and if the underlying index is Near, At, or In-the-money, we need to close out our spread as quickly as possible to avert a possible disaster of losing 100% of our maintenance dollars. 

 

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20.

How to place a credit spread order when the "bid" is shown as N/A on the options chain

Below shows an options chain where some of the "bid" prices are shown as N/A, which stands for "not available".  When a "bid" price is N/A it means that the price is less than zero.  Just because the bid is less than zero does not necessarily mean that we can't get a fill for that particular spread.  For example, below is an option chain for the SPX, 15 point spreads.   Let's say that we are interested in getting filled on the SPX Sep 1320/1335 Bull Put Credit Spread.  The "bid" price is N/A and the "ask" price is $1.65.  If we are interested in placing this order if we can get a fill of 60 cents or greater for this trade, this trade is a good candidate due to the large spread of the bid and ask prices.  (that is, because the "ask" is $1.65, we think there is a chance that we could get 60 cents for this trade.....making this determination purely from experience).   To place the "bull put credit spread" order you would normally click on the "bid" price where the order form will auto-populate.  However, when the "bid" is N/A, it will not allow you to click on it as it will tell you that the "bid" price is below zero.  The way to trick the system to auto-populate the order form is to click on the "ask" price where the order form will auto-populate as a Bull Call Debit Spread, as shown in Figure 2.  You then would change "buy to open" to "sell to open" and "sell to open" to "buy to open", and change the limit order from a debit to a credit.  Because we think we can get 60 cents for this trade, we put the price of 60 cents in;  Finally, because we want 10 contracts for this particular example, we populate the quantity fields with 10 and 10.

Figure 1 above

Figure 2 above

Figure 3 above

 

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21.

What if one of our spreads go deep in-the-money, how can we preserve our risk capital?

Because this information is advanced in nature, below is a summary of this entry; we cover this entry in its entirety in the Members Only Learning Center.  To view the complete entry, Click here to go to the Members Only Learning Center.  If you are not an active member, please consider signing up for a FREE 30 day trial.

Once in a blue moon one or more of our spreads will go deep in-the-money (ITM).   If the market crashes fast enough we won't have time to react, and this could happen like it did in October 2008.  There are several strategies that we can use to minimize our loss.

This entry covers several approaches to handling deep ITM credit spreads. It discusses several approaches such as closing it, rolling it down, closing the short put and leaving the long put ride, converting the spread into a debit bear put spread, or rolling it out.   We use the below trade that was opened on 5/5/06 as a case study to cover from start to finish on how to keep rolling a deep ITM credit spread month to month to eventually recover most of our "locked up" risk capital. 

Below is what the trade looks like on 6/13/06, 2 days before expiration.  For this case study we let the spread go deep in the money (ITM) where the RUT drops down through both the short and long strike prices, and then we use different strategies to adjust it.

To view this entry in its entirety, Click here to go to the Members Only Learning Center.  Because this information is advanced in nature, it is reserved for active MCTO members.  If you are not a member, please consider signing up for a FREE 30 day trial.

 

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22.

How to hedge against a drastic move in the market, or take advantage of a slowly recovering market that just crashed

Because this information is advanced in nature, below is a summary of this entry; we cover this entry in its entirety in the Members Only Learning Center.  To view the complete entry, Click here to go to the Members Only Learning Center.  If you are not an active member, please consider signing up for a FREE 30 day trial.

The MCTO service primarily focuses on index credit spreads and iron condors that represent a non-directional, income generating strategy.  Periodically, we also mix in directional trades to augment and/or hedge our income generating trades. Therefore, in addition to generating monthly income with credit spreads, we can also profit on longer term macro-level cycles of the major indexes and specific industries with directional trades such as calls, puts, debit spreads and butterflies.

One opportunity to open some longer term bullish trades came after the crash in October 2008. Volatility climbed to historic levels where the VIX hit 80 during the week of Oct 13th, and most stocks took a 35% to 50% haircut.  Because volatility (fear) was very high at this time we needed a bullish, directional options trade that could... a) neutralize volatility risk, and  b) be partially financed by creating a bull call spread making them cheaper to open.

This section then covers different directional strategies that we use from time to time.

a) Short Calendar Spread

Below we cover the short calendar spread comprising two legs, each with a different expiration month. 

And then we summarize the trading rules for the above short Calendar Spread:

b) Butterfly

The butterfly comprises 3 legs, all with the same expiration month, and where we buy the "wings" and sell 2x the "body".  Below is a butterfly that we built on 10/23/08 when the RUT was at 489 and the VIX (volatility) was at 67. 

Below is the same trade above but adding a 2nd butterfly. 

We then review the trading rules.

c) Bull Call Debit Spread

Below is a bull call debit spread on the IWM, and ETF that tracks and trades at 1/10th the value of the RUT index.  This trade was built after the close on 10/31/08 and it looks better than the bull call spread on the RUT above.  We then look at slippage, Delta and Vega risk.

We then do a volatility risk check on the above trade.

We then summarize the trading rules for the above debit bull call spread.

d) Bear Put Debit Spread

We could open a bear put debit spread if we think the underlying index will drop in a certain period of time.  We use the IWM (an ETF that trades at 1/10th the value of the RUT) below because a bear put spread on the RUT index had too high of a slippage.  Below is a risk/reward graph of a Feb09, 50/44 bear put spread that is a 4 point spread, it's on the IWM ETF, it's out-of-the money (OTM) by 3.7 points and gives us 112 days before the trade expires. 

We then do a volatility crush analysis on the above trade, and below is what the risk/reward graph looks like if implied volatility (VIX) drops by 35%, which could happen if the market continues to trend upward. 

We then summarize the trading rules for the above debit bear put spread.

e) Straight Put

In contrast to the Bear Put Spread, below is a straight RUT Jan 09 500 put. Note some of the differences:  1) profits are unlimited, as long as the RUT continues to drop   2) it's expensive to buy this Put because volatility is at historic highs right after the Oct 2008....etc. 

We then cover the trading rules for the straight Put and also how a volatility crush affects profits.

f) Strangle

Below is a risk/reward graph of a Jan09 strangle that comprises an OTM 30 point Bull Call Spread, and an OTM 30 point Bear Put Spread, that has 84 days before expiration.  We built this trade after the close on 10/23/08 when the RUT closed at 489, the VIX closed at 68, and the market just spent the last 2 weeks crashing over 35%. 

strangle trade above when closing it 30 days prior to expiration. 

We show the same strangle trade but when we close it at 30 days prior to expiration and when the implied volatility drops 35%...which makes the trade very nice where it tightens up.  We then review the trading rules for the above strangle:

To view this entry in its entirety, Click here to go to the Members Only Learning Center.  Because this information is advanced in nature, it is reserved for active MCTO members.  If you are not a member, please consider signing up for a FREE 30 day trial.

 

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23.

Recommended methodology to roll deep ITM credit spreads

Because this information is advanced in nature, below is a summary of this entry; we cover this entry in its entirety in the Members Only Learning Center.  To view the complete entry, Click here to go to the Members Only Learning Center.  If you are not an active member, please consider signing up for a FREE 30 day trial.

This entry focuses on a case study on rolling-out a RUT Oct 610/620 Bull Put Spread that was opened on 9/9/08 for a credit of 80 cents.  Total risk capital was the required maintenance of $1000 less the $80 of premium that was collected, for total risk capital of $920.  This trade looked pretty nice until the massive sell-off that we had in mid-October 2008.

Below is the same trade 3 days to expiration where the market crashed and it's now ITM.  Some of us luckily got out, but many of us held on a few days too long and ended up with the picture below. 

Our goal now is to keep our original credit spread "alive" by rolling it month to month until it expires out-of-the-money (OTM) allowing us to get back our original $920 of risk capital.   This case study goes through the process of rolling it for "even", i.e. at no cost, or for a small debit.  We also cover the recommended process of preparing to roll our deep ITM spreads when we're down to the last 8 trading days before expiration.

To view this entry in its entirety, Click here to go to the Members Only Learning Center.  Because this information is advanced in nature, it is reserved for active MCTO members.  If you are not a member, please consider signing up for a FREE 30 day trial.

 

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24.

How the open interest of calls and puts on particular strike prices can influence the movement of the underlying stock or index

Academic studies have confirmed the phenomenon of underlying stock prices becoming "pinned" to particular strike prices as expiration approaches.  This behavior is caused by the activity of market makers who are in the business of facilitating public orders by buying from option sellers and selling to option buyers.  As they broker the buying and selling of option contracts, they have to hedge their positions and they trade in volumes that actually has an effect on the price of the underlying stocks and indexes.  More specifically, when the market makers buy call options - the right to buy a stock- they hedge themselves by selling shares.  And when they buy put options - the right to sell a stock- they hedge themselves by buying shares.  On days when options are set to expire, market makers adjust their hedges, buying and selling thousands of shares of stock, and in doing so, they are able to push a stock toward a strike price of the options that they hold.

 

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25.

Major Candlestick Patterns

Hammer or Hanging Man:  A candlestick with a small body and long lower shadow This candlestick tells us that when the market opened sellers started to sell pulling the price of the stock or index down, but toward the end of the day buyers jumped in, started to buy and pushed the stock or index back up, where it closed for the day near where it first opened.  Overall, it tells us that the buyers thought that the stock was undervalued and oversold.

   

Hanging Man: If the stock or index has been in a up-trend and we see this formation, it's called a Hanging Man, and many times it's an indicator that the trend is topping out. 

   

Hammer: If the stock or index has been in a down-trend and we see this formation, it's called a Hammer, which many times is an indicator that the down-trend has hit a bottom.

   

Doji:A candlestick with a very small body and long upper and lower shadows.  The open and close for the day, therefore, was the same or almost the same telling us that investors have indecision of where to take the price of the stock or index next.

   

Gravestone Doji:  A candlestick with a very small body and a long upper shadow.  This formation is an excellent indicator in calling a market top where buyers push the stock or index up, usually on lower volume, and then sellers jump in and push it back down to where it initially opened.

   

Shooting Star:  An additional formation that is a good indicator of calling the top and where the probability of the stock or index rolling over and beginning to head down increases substantially.

   

Bullish Engulfing Pattern:  This is a bullish formation where day 1 closes as a down-day, but day 2 starts with a gap-down at the open, and then buying ensues where the buying pressure completely "engulfs" the prior day's price range.

   

Bearish Engulfing Pattern:  This is a bearish formation where day 1 closes as an UP-day, but day 2 starts with a gap-UP at the open, and then selling ensues where the selling pressure completely "engulfs" the prior day's price range.

 

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26.

The 5-35 oscillator

The 5–35 oscillator is a momentum indicator that is derived by calculating the difference between the value of the 5 period moving average and 35 period moving average. The red histogram on the bottom portion of the chart shown below is a 5-35 oscillator.  In this example, the 5 day simple moving average (SMA) of the SPX index is shown on the chart in black, and the 35 day SMA is shown in dark blue. You can see how the value of the 5-35 oscillator/histogram tracks the difference between these two moving averages.  Sometimes analysts will describe the 5-35 oscillator as buying or selling "pressure" on a stock or index.  When the histogram is above zero there is positive buying pressure, and when the histogram is below zero there is negative selling pressure.

 

 

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27.

The 17/43 Weekly Exponential Moving Averages

Below shows the S&P 500 index, SPX, from 2003 through early 2010 and its associated 17/43 weekly exponential moving averages (EMA).  Several analysts at Standard & Poor's back tested 30 years of stock market data and found that the 17/43 EMA did a good job of keeping investors in the market during UP-trending periods, and triggered investors to move to the sidelines during bear markets.  A bullish trigger is when the 17 week EMA crosses above the 43 week EMA, and a bearish trigger is when the 17 week EMA crosses below the 43 week EMA.  Note how the 17 week EMA stayed above the 43 week EMA from mid 2003 through January 2008 keeping investors in the market during the 5 years of an up-trending market.  Moreover, note how it warned investors to get out of the market in January 2008, which happened to be the exact start of the '08/'09 recession.

 

 

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28.

The MACD Indicator

Developed by Gerald Appel, The Moving Average Convergence/Divergence Indicator (MACD) is one of the simplest and most reliable indicators available today.  The first line created is the MACD Graph (thick black line) and is calculated by taking the difference between the 26 day Exponential Moving Average (EMA), based on closing price, and the 12 day EMA, which creates a momentum oscillator that oscillates above and below zero.  The second line created is the MACD trigger line (thin red line) which is a smoothed, 9 day EMA of the MACD graph.

Below is an example of the MACD indicator using the daily chart for Cisco Systems.  The top price graph of CSCO is shown with its associated 12 day (light blue) and 26 day (dark blue) EMAs.  The MACD Graph is the thick black line and we can see when the 12 day EMA crosses above the 26 day EMA, the black MACD Graph crosses above its center line.  The thin red line is a smoothed, 9 day EMA of the black MACD Graph, and this creates the MACD signal line.  The green/red histogram on the MACD indicator is the difference between the black MACD graph and the red MACD signal line.  When the histogram is above the centerline and is green, this is a bullish indicator, and when the histogram is below the centerline and is red, this is a bearish indicator.  Due to how the red signal line interacts with the black MACD graph, this indicator does have some leading, predictive qualities where it will trigger a bullish or bearish signal prior to the actual price move of the underlying security.

The traditional way to use the MACD indicator is to consider each point of intersection between the black MACD graph and the red MACD signal line and use these crossovers as a trading signal.  Therefore, one might decide to buy a stock when the black MACD line crosses above the red MACD Signal line pushing the histogram above the centerline, and to sell the stock when the black MACD line crosses below the red MACD Signal line pushing the histogram below the centerline.

 

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29.

The Relative Strength Index

The Relative Strength Index (RSI) is a popular momentum oscillator that was developed by J. Welles WilderThe RSI compares the magnitude of a stock or index's recent gains to the magnitude of its recent losses and converts this information into a number that ranges from 0 to 100.  Below is an example of the DOW index with its 20, 50, 100 and 200 day simple moving averages (SMA), and its RSI oscillator. 

 

There are a few ways to interpret and use the RSI:

Oversold/Overbought:  If the RSI falls below 30 the stock/index is oversold, and if the RSI rises above 70 it is overbought.  Additionally, if the stock/index trends above 30 it is considered bullish, and if the RSI trends below 70, it is a bearish signal.  Some traders identify the long-term trend of a stock/index and then use extreme readings of the RSI as entry points.  For example, if the long-term trend of a stock/index has been bullish, then a temporary RSI reading near 30 could mark a potential entry point.
 

Centerline crossover:  The centerline for RSI is 50.  A reading above 50 indicates that average gains for the stock/index are higher than average losses, and a reading below 50 indicates that losses are winning the battle. Some traders look for a move above 50 to confirm bullish signals or a move below 50 to confirm bearish signals.

As we can see for the DOW index chart above, the RSI dipped below 50.  As a result, the RSI is telling us that average losses have been higher than the average gains over the last few weeks and sentiment is currently slightly bearish.

 

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30.

The Average Directional Index (ADX) Technical Indicator

The Average Directional Index (ADX), developed by J. Welles Wilder Jr. and also sometimes called the Direction Movement Index, or DMI, is used to evaluate the strength of a trend, be it up or down.  The ADX indicates when a trend is present and the overall strength of the trend. The higher the ADX the stronger the trend.

The ADX system comprises three lines; +DI,–DI and the ADX line.

A) Positive Directional Indicator +DI; thin green line) indicates the strength of upward price pressure

B) Negative Directional Indicator (–DI; thin red line) indicates the strength of downward price pressure

C) Average Directional Index (ADX line; thin black line) shows the overall strength of a trend without regard to direction. The higher the ADX, over 20, the stronger the trend.

The ADX line combines +DI with –DI and then smoothes the data with a moving average to provide a measurement of trend strength. Because it uses both +DI and –DI, ADX does not offer any indication of trend direction, just strength.  The ADX line fluctuates between 0 and 100, and readings above 60 are relatively rare. Low readings, below 20, indicate a weak trend, and high readings above 40 indicate a strong trend.

The ADX line can also be used to identify potential changes in a market from non-trending to trending. When ADX begins to strengthen from below 20 and/or moves above 20, it is a sign that the trading range is ending and an upward or downward trend could be developing.

The ADX indicator is traditionally interpreted as follows:

An ADX line rising above 20 indicates that a trend may be forming

  • +DI crossing above –DI is a buy signal

  • –DI crossing above +DI is a sell signal

  • The ADX line falling below 40 is an early indication of a change in trend

  • The ADX line should be between the DI lines when the market is trending

  • An ADX line below 25 indicates no particular trend is in place

Below is an example of IBM and its ADX indicator.  Vertical line A shows an early stage of a deteriorating market about 2 1/2 months before the October 2008 crash.  At this point the price chart still looks somewhat healthy where IBM is trading above its 100 day simple moving average (SMA; thick blue dotted line), and the 20 day SMA (thin blue line) is oscillating above and below its 50 day SMA (thin black line).  However, we can see an early bearish indicator in the ADX line where the red line has crossed above the green line.

Three weeks later vertical line B shows the price chart getting weaker where the stock has dropped below all of its major simple moving averages, including its 200 day line. (thick black dotted line).  At this point the ADX is telling us that bearishness is increasing since the red line has climbed and the green line has dropped.  We can also see the ADX line (thicker black line) is trending upward, telling us that a bearish trend is probably forming.

An additional 3 weeks later we see that the stock has been hanging tough and trying to find support at its 200 day SMA.  However, its 20 day SMA has crossed below its 200 day SMA, which is a major bearish signal.  Additionally, we see negative divergence where the price chart is attempting to find stability at its 200 day line, but the ADX line is trending upward, shown via the trend line as drawn, telling us that a bearish trend is attempting to form.

Finally, 1 1/2 weeks later at vertical line D, we see that the stock is dropping hard and that the ADX line crossed above its center line, telling us that a bearish trend is gathering strength.  These were some of the best early indicators telling us to sell our stock or to close-out our bullish or sideways option trades.

 

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31.

Bollinger Bands

Bollinger Bands are widely used by professional traders and fund managers, and are designed to answer the question whether the price of a stock or index is high or low on a relative basis. Armed with this information, traders can make buy and sell decisions by using additional technical indicators to confirm price action of the stock or index that they are trading.  The Bollinger band does not give absolute buy and sell signals simply by having been touched; rather, it provides a framework within which price may be related to other technical indicators.

Bollinger Bands are formed by calculating two standard deviations around a 20 day simple moving average of an underlying index or stock.  Two standard deviations include about 95% of the chart's price data between the two trading bands.  Because the standard deviation calculation is based on volatility, as the stock or index's volatility changes the width of the "envelope" will increase or decrease correspondingly.

Below is a chart of the DOW with its 20, 50, 100 and 200 day simple moving averages along with its Bollinger Bands (pink lines).  The 20 day simple moving average is the thin blue line, which is the center point of the Bollinger envelope.  Note how the width of the envelope opens and closes as volatility of this index changes. (when an index goes down, volatility usually increases)  The main observation of this chart is that the DOW dropped by more than 390 points on the last trading day shown and it touched the bottom band.  Therefore, on a relative basis, we know that the DOW index is low and some traders/professional money managers, after looking at additional technical indicators, might come to the conclusion that the DOW is oversold and is ready for a Bullish reversal - and at this point they might decide to open a Bullish trade.

 

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32.

Accumulation/Distribution (A/D Line)

The Accumulation/Distribution Line (A/D line) was developed by Marc Chaikin and is one of the most popular volume flow indicators to assess the early cumulative flow of money into and out of a security in order to anticipate price moves of the stock.   An up-trending A/D Line suggests that buying pressure is building on higher volume, and a down-trending A/D Line indicates that selling pressure is building on higher volume. The basic premise behind the A/D line is that an increase in the volume of shares traded, e.g. per day, will precede an eventual move in the price of the stock.  Many times before a stock advances there will be a period of increased volume in the stock on the UP days just prior to the price move of the stock.  The A/D line focuses on the price action for a given period (e.g. daily) and generates a value based on the location of the close, relative to the range for the day. We will call this value the "Close Location Value" or CLV. The CLV ranges from plus one to minus one with the center point at zero.  Below is a summary of the the rules to calculate CLV.

1. If the stock closes on the high, the top of the range, then the value would be plus one.

2. If the stock closes above the midpoint of the high-low range, but below the high, then the value would be between zero and one.

3. If the stock closes exactly halfway between the high and the low, then the value would be zero.

4. If the stock closes below the midpoint of the high-low range, but above the low, then the value would be between zero and minus one.

5. If the stock closes on the low, the absolute bottom of the range, then the value would be minus one.

Once the CLV is calculated, it is then multiplied by the corresponding period's volume, and the cumulative total forms the A/D Line.  Below is an example of CIEN and how the A/D line is calculated, courtesy of stockcharts.com.

 

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33.

Chaikin Money Flow

Building on the Accumulation/Distribution Line that is discussed above, the formula for the Chaikin Money Flow (CMF) is the cumulative total of the Accumulation/Distribution Values for 21 periods divided by the cumulative total of volume for 21 periods.  Below is an example, courtesy of stockcharts.com showing what the CMF looks like.  The purple box encloses 21 days of Accumulation/Distribution (A/D) Values.  The total A/D values over 21 days divided by the total volume over 21 days forms the value of CMF at the end of that 21 day series, denoted by the purple arrow. To calculate the next day, the A/D value from the first day is removed and the value for the next day is entered into the equation.  Generally speaking, CMF is bullish when it is positive, indicating that the security is under accumulation.  And CMF is bearish when it is negative, indicating the security is under distribution.

 

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34.

ISE Call/Put Ratio Sentiment Index (ISEE)

The International Securities Exchange (http://www.ise.com) call/put ratio investor sentiment index (ISEE) is more refined than traditional put/call ratios because it only uses opening long customer transactions to calculate bullish/bearish market sentiment. Opening long transactions, i.e. where the investor "buys-to-open" a call or put leg, are thought to best represent market sentiment because investors often buy call and put options to express their actual market view of a particular stock.  Short orders (i.e. sell-to-open) are excluded since myriad options strategies could be involved and thus are not representative of true investor sentiment.  Furthermore, trades from market makers and institutional broker/dealers are excluded since their trades are usually part of more complex trades, such as spreads, butterflies, diagonals...etc. so these trades can "muddy the waters".  As a result, the ISEE calculation method allows for a more accurate measure of true investor sentiment than traditional put/call ratios.

The ISEE value is calculated by dividing the number of long call "buy-to-open" transactions divided by the number of long put "buy-to-open" transactions, and then multiplied by 100. The calculation is then written as (long calls/long puts) * 100.  If ISEE is > 100, investors are buying more calls than puts and this can be interpreted as bullish investor sentiment.  If ISEE is < 100, investors are buying more puts than calls and this can be interpreted is bearish investor sentiment. To further refine the number we apply a 10 day simple moving average (SMA) to the ISEE, which filters out the daily fluctuations.  And finally, we use their "equity-only" number which filters out call/put buying on ETFs and Broad-based indexes; many of these are used as hedging instruments, so they reflect less accurately on true investor sentiment.  Because retail investors tend to buy more calls than puts, the equity-only ISEE number tends to be at "equilibrium" near 130.  Looking at an example, if the equity-only ISEE value is 163, this means that for every 163 long calls that were purchased, 100 long puts were purchased, and this would represent bullish investor sentiment.  On the other hand, if the equity-only number were 105, this would represent bearish sentiment among retail investors, since equilibrium is closer to 130. 

Below is an example of the traditional use of put/call ratios as a contrarian trigger to go against the herd when extremes of apparent imbalance develop between the trading volume of calls versus puts.  The logic states that excessive volume in either calls or puts highlights extreme levels of bullish or bearish conviction.  Excessive bullishness, for example, often foreshadows an overbought market condition;  when too few buyers are finally left on the sidelines then long liquidation or short selling will force the market to auction lower.

Below is the S&P 500 index (SPX) price chart for 2008 through Feb 27, 2009 and its corresponding 10 day simple moving average (SMA) of the ISEE equity-only call/put sentiment indicator (ISEE).  For this time period 140 represents equilibrium (the mean), values > 165 represent extreme bullishness, and values < 115 represent extreme bearishness.  We can see that we hit extreme bullishness in early January 2008 giving us a warning of upcoming bearish price action in the SPX.  Additionally, the ISEE hit extreme bullishness again in early June 2008, foreshadowing the immediate sell-off in June/July.   At this point the collapse in Sept/Oct 2008.

Below is the S&P 500 index (SPX) price chart for 2008 through Feb 27, 2009 and its corresponding 10 day simple moving average (SMA) of the ISEE equity-only call/put sentiment indicator (ISEE).  For this time period 140 represents equilibrium (the mean), values > 165 represent extreme bullishness, and values < 115 represent extreme bearishness.  We can see that we hit extreme bullishness in early January 2008 giving us a hint of some bearish price action in the SPX;  additionally, the ISEE hit extreme bullishness again in early June 2008, foreshadowing the collapse in Sept/Oct 2008.

Below is the S&P 500 index (SPX) price chart for Jan 18, 2006 through Dec 28, 2006, and its corresponding 10 day simple moving average (SMA) of the ISEE equity-only call/put sentiment indicator (ISEE).  For this time period 180 represents equilibrium (the mean), values > 210 represent extreme bullishness, and values < 150 represent extreme bearishness.  We can see that we hit extreme bullishness in early January '06 but this incorrectly predicted any type of sell-off.  The ISEE hit extreme bullishness again in early May '06 and this one correctly predicted the May/June sell-off. The ISEE showed extreme bearishness in Mid Aug '06 and this correctly predicted the rally that ensued Aug through Dec '06.

Another example shown below is how the ISEE can be used on a broad-based index, like the NASDAQ 100 Index, to predict short-term rallies and sell-offs.  We are using the QQQQ ETF (known as the Q's) as the underlying security where it tracks at 1/40th of the NASDAQ 100 index.  The rules are:  1) when the ISEE for the QQQQ ETF remains high for several consecutive days, usually above 100, the QQQQ ETF will rally;  and 2)  When the ISEE for the QQQQ ETF remains low for several consecutive days, usually above XXX, the QQQQ ETF will sell-off. One would think that this should be a contrary indicator, and high readings should lead to lower prices, but we might need a different interpretation for hedging instruments like QQQQ.  One theory is that institutions will short the QQQQ ETF heavily, but may buy  call options to temporarily hedge their short position.  So when we see a short-term spike in call volume, translating into a short-term spike in its ISEE value, it could be a sign that traders are shorting QQQQ itself heavily for the longer term.  Below is a chart of the of the Q's and how a short-term spike in its ISEE reading preceded a rally.

As a test of this theory, since the beginning of the data in 2006, the ISEE has had seen short-term consecutive readings over 100 on 11 different occasions.  On 10 of those, the QQQQ ETF rallied over the next three sessions, by an average of +1.4%, much greater than a random three-day return during that period of only +0.1

Conversely, when the ISEE value for QQQQ  was less than 30 for two consecutive days, the corresponding three-day return in QQQQ was only -0.6% and the average drawdown was twice as high as the average gain.   For more on this example please visit http://www.sentimentrader.com/comments/20070402_ise.htm.

 

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35.

Investors Intelligence Bull/Bear Ratio & Spread Investor Sentiment Indicators

The Investors Intelligence Bull/Bear ratio (IIBBR) is a well respected gauge of overall investor sentiment.  Below is the IIBBR chart from May 2005 through May 2009, and the price chart of the weekly S&P 500 index (SPX) with the same time period. 

And when we subtract the two indexes from each other we create the Investors Intelligence Bull/Bear Spread (B/B Spread) as shown below.  When the B/B Spread is zero, this means that there are an equal number of Bulls and Bears.  For the particular case below, we see that the B/B Spread is 12.5%, telling us that there are 12.5% more Bulls than there are Bears.

One popular way to leverage investor sentiment is to look for bullish or bearish divergence.  For example, note how the % of bulls were dropping and the % of bears were climbing from Nov '05 through May'06, as noted by the trend lines drawn.  During this time period investor sentiment was becoming more and more bearish, even though the SPX was continuing to climb; and then the SPX sold-off in June '06.  Bearish divergence can be helpful to time when to enter and exit the market.

Another way to utilize investor sentiment data is to take the contrary viewpoint and look for extremes in either bullish or bearish sentiment.  Note how the bullish sentiment peaked in Sep '07 at about 62%, which represented the top of the market in Oct 2007.  For more information on the IIBBR, please visit http://www.investorsintelligence.com/x/default.html.

 

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36.

McClellan Oscillator & Summation Index

The McClellan Oscillator is one of the more accurate and modernized market breadth indicators available and is based on the smoothed difference between the number of advancing and declining issues on a broad-based index, such as the NYSE Composite, the S&P 500 Index, or the NASDAQ Composite.  The MCTO team uses the NASDAQ Composite as the underlying index because it comprises 3000 companies, making it a good indicator of the overall market.

We are interested in looking at market breadth, which is based on advancing and declining issues, because it tells us what percent of the broad market is actually participating in a rally or a sell-off.  Because most of the broad-based indexes are "float" weighted (based on number of outstanding shares) or market-cap weighted (market cap = number of outstanding shares * share price), many times just a handful of the largest companies that reside in the index can artificially move the index.  For example, if Exxon and Chevron both rally 1.5% due to a positive report out of the Middle East, because these two companies represent 7.5% of the S&P 500 index, these two companies alone can move the index;  however, the remaining 498 stocks might have all closed down or flat for the day and we wouldn't have known it.  Therefore, it's prudent to watch a market breadth indicator, like the McClellan Oscillator, to give us a more accurate picture of what "all" of the stocks are doing in the index.

Summary of how it's created:

The chart below (top graph) shows an example of daily breadth.  Each tick mark represents one day's reading of advances minus declines.  In order to better identify the trend that is taking place in the daily breadth, the data is smoothed with an exponential moving average (EMA). It works by weighting the most recent data more heavily, and the older data progressively less. The amount of weighting given to the more recent data is known as the smoothing constant.

The McClellan team uses two different EMAs, one with a 10% smoothing constant, and one with a 5% smoothing constant, known as the 10% Trend and 5% Trend for brevity.  The numerical difference between these two EMAs is the value of the McClellan Oscillator, which is shown below in the dark black solid line.

How it's interpreted:

The McClellan Oscillator offers many types of structures for interpretation, but there are two main ones. First, when the Oscillator is positive, it generally portrays money coming into the market; conversely, when it is negative, it reflects money leaving the market. Second, when the Oscillator reaches extreme readings, it can reflect an overbought or oversold condition.

Buy signals are typically generated when the McClellan Oscillator falls into the oversold area of -70 to -100 and then turns up. Sell signals are generated when the oscillator rises into the overbought area of +70 to +100 and then turns down.  If the oscillator goes beyond these areas (i.e., rises above +100 or falls below -100), it is a sign of an extremely overbought or oversold condition. These extreme readings are usually a sign of a continuation of the current trend.

For example, if the oscillator falls to -90 and turns up, a buy signal is generated. However, if the oscillator falls below -100, the market will probably trend lower during the next two or three weeks. One should postpone buying until the oscillator makes a series of rising bottoms or the market regains strength.

A healthy bull market is accompanied by a large number of stocks making moderate upward advances in price. A weakening bull market is characterized by a small number of stocks making large advances in price, giving the false appearance that all is well. This type of divergence often signals an end to the bull market. A similar interpretation applies to market bottoms, where the market index continues to decline while fewer stocks are declining.

The McClellan Summation Index:

By adding up all of the daily values of the McClellan Oscillator, one can produce the McClellan Summation Index.  It is the basis for intermediate and long term interpretation of the stock market's direction and power. When properly calculated and calibrated, it is neutral at the +1000 level.  It generally moves between 0 and +2000. When outside these levels, the Summation Index indicates that an unusual condition is taking place in the market. As with the Oscillator, the Summation Index offers many different pieces of information in order to interpret the market's action.

Among the most significant indications given by the McClellan Summation Index are the identification of the end of a bear market and the confirmation of a new bull market. Bear markets typically end with the Summation Index below -1200. A strong rise from such a level can signal initiation of a new bull market. This is confirmed when the Summation Index rises well above +2000. Past examples of such a confirmation have resulted in bull markets lasting at least 13 months, with the average ones lasting 22-24 month.

 

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37.

Stochastics Oscillator

The Stochastics Oscillator is a technical momentum indicator that compares a security's closing price to its price range over a given time period, usually 14 periods. (1 period = 1 day for this example)  This indicator is calculated with the following formula:

%K = 100[(C - L14)/(H14 - L14)]

%D = Smoothed, 3 day simple moving average of %K

C = the most recent closing price

L14 = the low of the 14 previous trading sessions

H14 = the highest price traded during the same 14-day period

As an example, below is a table of daily highs, lows and closing prices for a particular index over 14 trading days.  On day 14, %K would be calculated as shown below where C=115.38, L14=109.13, and H14=119.94.

%K for trading day 14 where the index closed at 115.38 equals 57.81.  This tells us that the index closed in the 58th percentile of the 14 day high/low range, or just above the mid-point.  Because %K is a ratio, it will fluctuate between 0 and 100.  A smoothed, 3-day simple moving average of %K is then plotted alongside to act as a trigger line, called %D.

Below is an example of a daily chart of IBM and its respective Stochastics Oscillator, courtesy of StockCharts.com.  One of the more conventional and accurate ways to leverage this indicator is to indentify overbought and oversold situations by looking for divergences.  For example, the stochastic oscillator produced 2 solid signals for IBM between Aug-99 and Mar-00.  In Nov-99, a buy signal was given when the indicator formed a positive divergence and moved above 20 for the second time.  Note that the double top in Nov-Dec (gray circle) was not a negative divergence, and thus the stock continued higher after this formed.  In Jan-00, a sell signal was given when a negative divergence formed and the indicator dipped below 80 for the second time.

 

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38.

Williams %R Indicator

Developed by Larry Williams, Williams %R, also known simply as %R, is a momentum indicator that is popular for measuring overbought and oversold evels. The scale ranges from 0 to negative 100 with readings from 0 to -20 considered overbought, and readings from -80 to -100 considered oversold.  The %R indicator shows the relationship of the close relative to the high-low range over a set period of time, usually 9, 14 or 28 days.  The nearer the close is to the top of the range, the nearer to zero (higher) the indicator will be. The nearer the close is to the bottom of the range, the nearer to -100 (lower) the indicator will be.  If the close equals the high of the high-low range, then the indicator will show 0 (the highest reading). If the close equals the low of the high-low range, then the result will be -100 (the lowest reading).

It is important to remember that overbought does not necessarily imply time to sell, and oversold does not necessarily imply time to buy.  A security can be in a downtrend, become oversold and remain oversold as the price continues to trend lower.  Once a security becomes overbought or oversold, traders should wait for a signal that a price reversal has occurred.  One method that Larry Williams used was to wait for the %R line to cross below negative 30 if the indicator was overbought near 0, or wait for the %R line to cross above negative 70 if the indicator was oversold near negative 100.

Below is an example of the daily DOW chart with its associated Williams %R.  For this analysis, we set the %R setting to a 28 day interval, which smoothes the data and eliminates some of the choppiness and false signals.  The trigger to "go short" is set when the %R line drops down from an overbought level (zero) down through -30 (dotted line).   And the trigger to "go long" is set when the %R line climbs from the oversold level (-100) up through -70.  Note that many good triggers where given by the %R indicator in this example.

 

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39.

Advance/Decline Ratio Oscillator (ADRO)

The advance/decline line is one of the most popular market breadth indicators.  It is a very simple measure of how many stocks are taking part in a rally or sell-off and it's usually calculated from NYSE stocks.  The A/D line is calculated as follows:

A/D Line = (# of Advancing Stocks - # of Declining Stocks) + Yesterday's A/D Line Value

The Advance/Decline Ratio Oscillator (ADRO) is a variation on the advance/decline line where it accounts for total market volume beyond the NYSE.  The ADRO has a tendency to identify near-to-intermediate tops when the indicator is above 4.00, and near-to-intermediate bottoms when the indicator is at -2.00 or below.  Below is an example of the ADRO through April 17, 2009, where on March 30, 2009 the market had 12 advancing stocks for every 1 declining stock, representing a strong rally with solid market breadth.  If the ADRO line moves a considerable amount, like it did from March 6th through April 5th, this tells us that there is a high probability that the current trend will be strong and might last longer than anticipated.  Chart courtesy of Market Harmonics.

Developed by Welles Wilder, creator of RSI and DMI, the Parabolic SAR sets trailing price stops for long or short positions. Also referred to as the stop-and-reversal indicator (SAR stands for "stop and reversal"), Parabolic SAR is more popular for setting stops than for establishing direction or trend. Wilder recommended establishing the trend first, and then trading with Parabolic SAR in the direction of the trend.

 

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41.

Elliott Wave Analysis

For a good tutorial on Elliott Wave analysis, please visit the web site http://www.investopedia.com/university/advancedwave/default.asp.

The ADS Index is one of several macro-level indicators tracking the overall health of the US economy.  This index is a diffusion of 6 economic components:  Weekly initial jobless claims; monthly payroll employment; industrial production; personal income less transfer payments; manufacturing and trade sales; and quarterly real GDP.  The ADS index's claim to fame is that it's updated in almost real-time with "high-frequency" economic data.

The average value of the ADS index is zero. Progressively bigger positive values indicate progressively better-than-average conditions, whereas progressively more negative values indicate progressively worse-than-average conditions. The ADS index may be used to compare business conditions at different times. A value of -3.0, for example, would indicate business conditions significantly worse than at any time in either the 1990-91 or the 2001 recession, during which the ADS index never dropped below -2.0.

Below are the 40 year and 9 year ADS Index charts.  The gray bands represent recessions, and the yellow band represents the current recession that is still in play.  A primary observation in the historical charts below is that weakness in the ADS index precedes a possible economic contraction by almost a year.  Another observation is how the ADS Index "stair-stepped" down to negative 1.0 in Q208, telling us that the economy was getting progressively weaker, and was a signal about 4 months prior to the Oct 2008 market crash.

For more information on this index, please go to http://www.philadelphiafed.org/research-and-data/real-time-center/business-conditions-index/.

 

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43.

Economic Cycle Research Institute (ECRI) Weekly Leading Index (WLI)

ECRI is one of the most respected independent economic research houses, and they have one of the best track records in predicting when recessions start and end.  One of their more popular leading economic indicators is the Weekly Leading Index (WLI).  Below is the chart of the WLI as of May 2009.  In general, when the WLI indicator turns upward, there is a high probability that the economy has bottomed out and will start to grow.  For more information about ECRI and the WLI Index please visit www.businesscycle.com.

 

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44.

The Conference Board Leading Economic Indicator (LEI)

The Conference Board is a highly respected independent economic research house.  One of their closely watched indicators is the Leading Economic Indicator, or LEI.   Ten indicators compose the LEI that include the following: supplier deliveries (vendor performance); interest rate spread; stock prices; real money supply; index of consumer expectations; building permits; manufacturers' new orders for nondefense capital goods; average weekly manufacturing hours; average weekly initial claims for unemployment insurance; and manufacturers' new orders for consumer goods and materials.  Below is the LEI chart ending in October 2009 showing that this leading economic indicator continues its climb upward, and predicting that the recession is over and the US economy is now slowly growing.  For more on the Conference Board please visit http://www.conference-board.org/aboutus/about.cfm

 

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45.

US Treasury Yield Curve

The yield curve is the relation between the interest rate and the time to maturity of the debt.  We are interested in monitoring the US Treasury yield curve because it's been a good predictor since 1970 if the US economy will worsen, usually with a lead time of 6 months to 1 year in the future.  For more information on the US Treasury yield curve please visit http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml.  There are 4 types of yield curves - normal, steep, flat and inverted. 

A "normal" yield curve, post 1940, is when yields rise as maturity lengthens (i.e., the slope of the yield curve is positive). This positive slope reflects investor expectations for the economy to grow in the future, and for this growth to be associated with a greater expectation that inflation will rise in the future rather than fall. This expectation of higher inflation leads to expectations that the Federal Reserve will tighten monetary policy by raising short term interest rates in the future to slow economic growth and dampen inflationary pressure. It also creates a need for a risk premium associated with the uncertainty about the future rate of inflation and the risk this poses to the future value of cash flows. Investors price these risks into the yield curve by demanding higher yields for maturities further into the future.  Below is an example of a normal, positively sloped US Treasury yield curve.

The "steep" yield curve is when the spread between the 20-year and 3-month yields is larger than normal.  Historically, the 20-year Treasury yield has averaged approximately two percentage points above that of the three-month Treasury bill.  In situations when this gap increases the economy is expected to improve quickly in the future. This type of curve can be seen at the beginning of an economic expansion, or after the end of a recession.  Below is an example of a steep yield curve.  Note that as of May 19, 2009 the US bond market thinks that the US economy is ready to grow again.

A "flat" yield curve is observed when all maturities have similar yields.  A flat curve sends a signal of uncertainty in the economy.  Below is an example of a flat yield curve.

An "inverted" yield curve occurs when long-term yields fall below short-term yields. Under unusual circumstances, long-term investors will settle for lower yields now if they think the economy will slow or even decline in the future. An inverted curve has indicated a worsening economic situation in the future 5 out of 6 times since 1970. The New York Federal Reserve regards it as a valuable forecasting tool in predicting recessions two to six quarters ahead. In addition to potentially signaling an economic decline, inverted yield curves also imply that the market believes inflation will remain low. This is because, even if there is a recession, a low bond yield will still be offset by low inflation.  Below is an example of an inverted yield curve where we can see that the bond market was predicting a future recession in late February, 2007.

 

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46.

Interest Rate Spread Between Similar-Maturity Corporate Bonds and Treasuries to Monitor Health of US Credit Markets

This interest rate spread is defined as the difference between a similar-maturity corporate bond and a US treasury bond.  This spread is one way to gauge the health of the US credit markets.  When the spread is high as compared to historical levels, it implies a greater anticipated default risk of US corporations.  When the spread is low as compared to historical levels, it implies a low anticipated default risk of US corporations and a greater availability of credit.  Below is a chart of this spread from June 1989 to October 2009.  One interesting data point is how this spread climbed to 4.41% by the end of September 2008, giving us a warning that the US credit markets were seizing-up.  One month later the US stock market crashed 35% in 14 trading days.

 

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47.

Revolving Consumer Credit

Revolving Consumer Credit represents total available credit to US consumers via credit cards and personal bank loans.  Similar to how easy credit in the mortgage industry can create a strong housing market (and bubbles), ample consumer credit can help an economy grow because consumer spending makes up 70% of the US gross domestic product (GDP).  Below is a chart of revolving consumer credit from 2004 through 2009.  Note how the availability of consumer credit increased through 2008, and the extra $160 billion of credit injected into the US economy from 2004 through 2008 contributed to reasonably strong GDP growth during these years.  Consumer credit is not a good forward looking indicator since bubbles are usually created by loose-credit, and the credit is only taken away after the bubble pops.  However, consumer credit is a helpful indicator to monitor when an economy is in a recession as it can provide insight into future consumer spending.

 

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48.

TrimTabs Demand Index (TTDI)

The TTDI is a diffusion of 18 stock market liquidity indicators and macro-economic indicators, giving the TTDI some uncanny, predictive abilities.  Liquidity analysis is based on supply and demand of stocks, bonds and commodities and is different from the usual technical and fundamental analysis that is used by the majority of stock market analysts.  Note how when the dark graph drops below zero, the S&P 500 (red line) trends downward shortly thereafter, showing us that the TTDI has some predictive power.  And note when the market was taking out new lows in March 2009, the TTDI index was climbing, giving us a hint that demand for stocks was overtaking the supply of stocks and there was a good chance that the market was going to start trending upward...and this is exactly what happened.  For a book on market liquidity analysis please visit http://www.amazon.com/TrimTabs-Investing-Liquidity-Theory-Market/dp/0471697206#.

And below are the 18 components that compose the Trimtabs Demand Index, which as you can see are mostly liquidity centric types of indicators.

 

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49.

Money flow IN/OUT of long-term, domestic equity mutual funds

This "funds flow" indicator tells us how much money is flowing IN or OUT of long-term, domestic equity (stock) mutual funds.  When money is flowing into US equity mutual funds, it will help push-up stocks and help the major indexes stay above certain support levels.  If money is flowing out, mutual fund managers will need to liquidate stocks to satisfy requested distributions and their selling activity will usually push the markets down.  Below is the funds-flow chart from January 2007 through August 2009.  Note the heavy distribution in July and Sep 2008 just before the October crash, as noted by the two red arrows, giving us a warning that something ugly could be coming.  On this chart we also note how the In-flow of cash in April '09 through August '09 is "running out of steam", thus giving us a warning that a market correction could be coming.

When cash is flowing out of US Domestic Mutual funds, many times it's going into Bonds, which are a safe haven when investors get worried.  We follow the flow of cash into and out of bonds as this gives us further information on investor sentiment. 

 

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50.

DOW Jones Economic Sentiment Indicator (ESI)

The DOW Jones Media Economic Sentiment Indicator (ESI) is a monthly assessment of the "tone" of content in 15 metropolitan dailies.  (an example of "tone" would be scanning for the word "recession")  The ESI is a simple barometer based on a scale of zero to 100—the higher the number, the more upbeat the news and, by extension, the stronger the economy.  Dow Jones back-tested their media sentiment indicator to 1990 and found that it could signal critical turning points in the economy, sometimes a bit earlier than other economic measures.  Below is the ESI from January 1990 through March 2009.  We can see that the ESI did a good job of giving an early predictor for the 2001 and 2008 recessions. 

The ESI team also claims that this indicator can give an earlier signal to a possible recession as compared to the Consumer Confidence Index and the University of Michigan's Consumer Sentiment indicator.  Per the chart below, it does look like the ESI did give a signal earlier as compared to the other sentiment indicators. 

And below is the ESI from Aug 2008 through Aug 2009.  We can see that media sentiment has been gradually climbing, telling us that the economy is improving.

 

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51.

The Difference Between a Straight Call and a Bull Call Spread for a bullish, directional trade.

If we believe that an underlying security will trend upward within a certain period of time, two options that we have is to either open a straight call or open a bull call spread.   Below is an example of Praxair, a well know large-cap company that was sold-off hard during the Oct 2008 crash.   Below is the weekly chart of PX showing a very healthy company until the Oct '08 crash.

Below is the daily chart of PX showing how it hit a low of 48 in Nov '08, rallied back to 70 in early Feb '09, and then sold-off again finding some support at 55.   Assuming we believe that PX is going to rally again, and this time up to its 200 day simple moving average (SMA) (thick black dotted line) near 73 before hitting resistance, we can take advantage of this anticipated short-term rally and open a bullish, directional trade.

Below are two types of directional trades that we could open if we believe that PX will rally up to 73 in before hitting resistance and possibly reversing direction.  The first trade we show below is a straight Oct09 55 call that costs a debit of $8.95 and has unlimited profit potential.  Opening a straight call costs more, but the advantage is that our profits are only a function of the price level of PX, and not the timing of when PX makes the move.  For example, if PX rallies in the next 30 days up to 70, our trade will show a profit of about $800 for a 95% return, and we can close this spread immediately to take our profits.  In this example, we are not discussing how the change of implied volatility will affect our profits.

In contrast, below is a Oct09 55 75 bull call spread.  To create this trade, we buy the Oct09 55 call for $8.95, and simultaneously sell the Oct09 70 call for $3.45, paying a total debit of $5.50.  By selling the 70 call, we partially financed the trade and reduced the total price.  This trade will make money when PX is between 55 and 70, profit will increase as time progresses, and the profits are capped once PX climbs above 70.  Maximum profit is 173% if the price of PX is above 70 AND we hold the trade to expiration, which is the 3rd week of October '09.  Therefore, we need to be correct on both the direction of PX and the timing of when it makes its move, which is a major drawback of bull call spreads.  For this particular stock, we believe that it will rally back up to 73 sometime in the next few months, we don't know exactly when the rally will occur, and once it does rally up to its 200 day SMA there's a good chance that it will quickly change direction and start heading down again;  therefore, a straight call will give us more flexibility to be able to close the trade out when required.

 

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52)

On Balance Volume

On Balance Volume (OBV) is one of the earlier indicators, developed in 1963 by Joe Granville.  OBV provides a running total of volume and shows whether volume is flowing in or out of a given security. 

OBV is calculated by using the change in closing price from one interval to the next to value the volume as positive or negative.  It then maintains a moving cumulative total volume figure, which is adjusted by either adding the current intervals' volume to the cumulative amount if the interval closes higher than previously, or by subtracting the current volume from the cumulative amount if the interval closes lower. 

The formula can be summarized as follows:  

1) If the current interval closes higher than the previous interval's close, ADD the current interval's volume amount to the previous interval's cumulative OBV amount.

2) If the current interval closes lower than the previous interval's close, SUBTRACT the current interval's volume amount from the previous interval's cumulative OBV amount.

3) If the current Interval closes at the same level as previously, do not change the cumulative OBV amount.

The actual numbers used to plot the OBV are largely irrelevant, the important consideration is the trend that becomes apparent from the plot.  In normal circumstances the OBV line will tend to track the price chart, and a trend line drawn on the price chart will appear similar when drawn between the same dates on the OBV chart.  However, when the OBV line fails to move in the same general direction as the price chart, this is an indication that price divergence may exist and a trend reversal is in the cards.

Below shows a daily chart of the SPY, and ETF that tracks at 1/10th of the value of the S&P 500 index - SPX.  What we are seeing is some divergence where the price of the SPY is continuing to climb, but the OBV indicator is pulling back, telling us that the probabilities are increasing that the SPY will have a trend reversal.

 

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53)

8/22 Day Exponential Moving Average (EMA)

The 8/22 day EMA is used to trigger short term buy and sell signals.  When the 8 day EMA (blue line) crosses above the 22 day EMA (thick black line), it triggers a buy signal, and when the 8 day EMA crosses below the 22 day EMA, it triggers a sell signal.  As we can see from the chart below, the 8/22 day EMA does a good job of getting & keeping a trader long in an UP trending market, and getting & keeping a trader short in a DOWN trending market with relatively few whipsaw/false signals.

 

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54)

Relative Strength Comparison (RSC) of the QQQQ to the DOW Jones Industrial Average - INDU

A chart of the Relative Strength Comparison (RSC) of technology stocks to DOW Jones Industrial stocks is shown below.  It shows how the NASDAQ 100 Index moves as compared to the DOW Jones Industrial Average Index - INDU.  We use the QQQQ, which is an ETF that tracks at 1/40th of the NASDAQ 100 Index, NDX, and represents 100 of the largest non-financial companies, many in the technology sector.  The top chart is the daily Qs, and the bottom chart is the relative strength comparison (RSC) that gauges how the Q's move as compared to the INDU.  A value of 100 on the RSC chart means that the Qs is moving in lockstep (same % move) with the INDU.  We monitor how the "more risky" technology stocks move as compared to the thirty "large and safe" DOW stocks because it provides insight into the strength of the market.  Usually, when the stock market is rallying and when the rally is classified as "healthy", technology stocks tend to lead the rally by moving more strongly upward on the UP days.  Said in another way, when investors start to move more cash into "higher risk" technology stocks this tends to be bullish for the entire market.  When back testing, we noticed that when the RSC dropped to 80 this tended to be a bottom of the correction, and when the RSC climbed above 85 this was a relatively safe trigger to go long in the market.
 

Looking at the chart below, we see that the RSC has climbed above 100 in late 2009 telling us that the technology stocks are leading the long-term UP trend that is in place.  This is one indicator that the long-term UP trend is still intact, even though the market corrected in mid-2010 and is currently consolidating.
 

In summary, when the RSC is trending upward, it tells us that investors are feeling more comfortable with riskier trades and this tends to be bullish for the market.   Alternatively, when the RSC is trending downward, it tells us that investors are reducing their risky holdings and this tends to be bearish for the market.

 

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55)

Smart Money Dumb Money Confidence Spread

We periodically show the smart/dumb money confidence spread in our Sunday advisory.  Below is an example smart/dumb money spread (blue chart), courtesy of sentimentrader.com, where it shows that about 79% of the dumb money believes in the rally, but only 33% of the smart money (i.e. institutional money managers) believe in the rally. 

 

Taking a look at this indicator more closely to judge its effectiveness we back test 5 years and mark the extremes of the smart/dumb confidence spread (bottom blue chart) and how it correlates to the S&P 500 index. We can see that when the confidence spread triggers at +0.25 or -0.25 it offers reasonable prediction of either a pull-back or rally, respectively.  However, during the market turmoil and crash in late 2008 through most of 2009 this indicator was less effective and was difficult to read.

 

 

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56)

Sector Rotation Analysis and Relative Strength Comparison to the Broad Market

We watch ten sectors of the broad market and monitor money flow in and out of each sector, which provides us clues to the future direction of the overall market. (aka sector rotation analysis) Each of the ten sectors fall into either the cyclical or defensive category. Technology, Industrials, Consumer Discretionary, Materials and Energy traditionally fall into the cyclical category, where these companies do well when the economy is expanding and do poorly when the economy weakens and/or begins to contract. In contrast, Consumer Staples, Health Care and Utilities fall into the defensive category and these companies tend to chug along at low growth rates regardless of the strength of the economy, and cash will move into these "safe" sectors when there is concern about the health of the economy.

As an example, below we show the daily chart of the Consumer Discretionary Select ETF - symbol XLY. The XLY comprises companies that make products that are not absolutely required to live and are discretionary items such as high-end clothing, fast food, automobiles, and media types of products. Thus, this sector is cyclical in nature and does well when the economy is expanding, and does poorly when the economy slows down and/or starts to contract.

The second chart shows the relative strength comparison of the XLY to the S&P 500 index. The blue dots represent Federal Reserve meetings where interest rates were left unchanged. If the relative strength comparison is trending up it means that this sector is outperforming the broad market, more cash is flowing into this sector as compared to the broad market, and investors believe that the economy will continue to expand.  In contrast, if the relative strength comparison is trending down it means that this sector is underperforming the broad market, less cash (or negative cash) is flowing into this sector as compared to the broad market, and investors believe that the economy will weaken.

When looking at the XLY daily chart we can see that the index rallied hard, it took out a new closing high above the pre-recession high of 40.5, and then pulled back and is attempting to find support at the pre-recession high of 40.5. As long as the XLY holds above its 50 day simple moving average (SMA) near 39.5, it's sending a bullish signal to the broad market.

Per the relative strength chart, this cyclical sector (consumer discretionary) is outperforming the broad based S&P 500 index and it sends a bullish signal to the broad market. As of July 2011, the date of the chart below, even though some of the macroeconomic indicators came in very weak, investors seem to be looking past the weakness and believe that the economy will continue to grow.

In summary, by monitoring how this sector is behaving as compared to the broad market, and by monitoring the other 9 sectors mentioned above, it provides us clues to the future direction of the overall market.

 

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