Options Trading and Investing Service for the Week of June 25th

The Options Trading and Investing service provides perspective on high quality setups and option trading strategies. We carefully select these setups due to their quality and profit potential and we report back on results. In the weekend free webinar I review current portfolio performance and I also discuss techniques that I utilize to help reduce risk and, in some instances, lock in profits from previous trades. This week I discuss a short-term strategy I refer to as a Binary Trade.

Please refer to our education video HERE for more information in the option strategies used in this post.

The entries and cost basis of new positions will appear on our private twitter feed during the coming week.

The closed position’s profits remains at $4,899 because no additional positions were closed this past week. The net profit overall is $207 and, as has been the case for several months now, a move lower in the major indices will lead to a large increase in the open profits in the portfolio. Below is the breakdown of all positions. The most recent closed positions are listed on the page on the left and the open positions are listed on the 2 pages on the right.

Today I will be discussing one of my personal favorite short-term strategies which I refer to as the Binary Trade (not to be confused with binary option trading). The reason I haven’t really talked about it before is because I am primarily a longer-term options trader. I wanted to build a base of mostly longer-term positions in the portfolio. That has been accomplished and I will continue to add mostly longer-term positions to match Stan’s price and cycle targets in the future however there are times that I will add a position simply to profit from a short-term bet on whether the underlying instrument will be higher or lower on or before expiry. In the position I am about to discuss it is as simple as; if /ES is up, I lose. If /ES is down, I win. Now, there is nothing special about that concept in options trading; I can simply buy an at-the-money (ATM) Put Vertical Debit Spread (or sell the ATM Call Credit Spread) to place a 50/50 bet to the downside. Generally speaking in those positions you risk $1 to make $1.5 (on put debit spreads, call debit spreads are often less than $1 to $1). I can also easily establish positions with a much higher probability of profit but then you get into an area where you are risking more than you can make. The higher the probability of profit in a position the lower the reward/risk. That makes perfect sense if you think about it. Why would you ever place a low probability trade unless your potential payoff was higher? What I am looking for in this position is to improve the maximum reward/risk ratio to greater than 2:1 while still having around the 50% probability of profit. I am also trying to increase my profit without necessarily seeing a large move lower. Because I am already short considerable Deltas in underlying instruments that are strongly correlated to the S&P 500, a big move lower will already be very profitable to the option portfolio. You may have noticed however that currently the S&P has had a difficult time going lower. The position I established on Friday needs less than a 1% move lower to make a very nice profit. Let’s take a look.

Below is the new position in the E-mini S&P 500 Index Futures (/ES) that I initiated about 1.5 hours before the close on Friday. The /ES was at 2436 at the time and Friday’s closing price was 2432. Let’s consider this position from a probability standpoint which means, for purposes of this slide, I am not considering the nuances of Stan’s chart analysis, I am simply considering a binary outcome. Does Stan project the /ES to be higher or lower than 2435 (the break even price of this spread) on or prior to Jul7. Since the break even price was essentially the same as the /ES price when I placed the trade, it is by definition a 50/50 trade. I chose to have this position profit to the downside because on Thursday’s update Stan said “if we mill around 2442 for a couple hours on Friday that is a good place to get short”. Well, that is almost exactly what happened so I bot 2 of the 2440/2415 Put Debit Spreads and sold 6 of the 2415/2410 Put Credit Spreads all in one transaction to create an Unbalanced Broken Wing Butterfly (BWB) for a net Debit of $5.00. This position establishes a potential Asymmetrical reward/risk ratio. Anywhere below 2410 sees a $500 profit which is the same as the $500 risk in the position however above 2410 and below 2430 and the profit exceeds $500 with the maximum profit of $2,000 occurring at the 2415 price. That would represent a 4:1 reward/risk. Below you can see the comparison of the profit or loss of a plus/minus .5% move.

It is important to understand how this spread is constructed because when it is time to unwind the position it often is more efficient to take off 1 of the sides instead of both. I will save the unwind discussion for the future as I may have to do just that prior to the Jul7 expiry. Today I want to focus on the cost basis reduction that this type of spread produces. It has been my personal experience over the years that as I learned to reduce the cost of my positions my overall profitability increased. In this current position I start by buying the 2440 put for $14.50. Then, to reduce cost, I sell the 2415 put for $6.50. Now my cost has gone from $14.50 to $8.00, a cost basis reduction of 45%. Then I decided to sell 3 times as many 2415/2410 put credit spreads for $1.00 each. Now, my cost basis is just $5.00. That is a cost basis reduction of 65% over just buying the 2440 put. When the spreads are combined you can recognize the shape of the spread as an unbalanced BWB. For those baseball fans out there, this is an appropriate analogy. I am the manager of a team and I have decided to send my best hitter as far as batting average is concerned to the plate, even though he is mostly a singles hitter, instead of my top home run hitter who strikes out every other time. Both types of hitters can contribute to the team effort but here I am looking for the higher probability of getting a hit, any hit will do.

Let’s take a look at how Theta is generated with this spread. The yellow box in the risk profile below shows approximately what the profit in the position would be if /ES was at 2415 today. That $437 profit would represent an 87% return on risk if the position was closed out immediately. However, as I mentioned in the previous slide, the profit if /ES is at 2415 @ Jul7 expiry would be $2,000. The difference between $2,000 and $437 is $1,563. That $1,563 (yellow arrow) represents the Theta in the position at the 2415 strike price. You need no further price movement to generate that amount, it accrues simply due to the passage of time. That is the power of Theta in option positions. The only way to generate Theta is by selling options. In this spread, I sold 8 of the 2415 puts for a total of $2,600 in option premium. At expiry, if /ES is at or below 2415 that is mine to keep. That is why there is so much potential Theta in the position. The long options were purchased to ‘cover’ the short options but make no mistake, the primary profit driver in this position is the short puts.
If you have always been a buyer of options and never considered selling options against your long positions just be aware of how much money you have lost due to the effects of Theta. Your positions are constantly losing value due to the passage of time. Make time your ally, not your enemy!

Below is the current position in AAPL. It is a long-term Stock Replacement Strategy that deserves a place in any of my option portfolios. Why do I call it a stock replacement strategy? What advantages does it have over simply buying the stock? As you can see below, the position is profitable as long as AAPL’s price is below $158.34. There is no risk to the downside. That feature is not available if you purchase the stock. This position doesn’t benefit from a large, immediate move higher like owning the stock does. That has been the big advantage to owning the stock over the past year. Will that continue? Stan doesn’t project that to continue in the Big Five Chart Service view of AAPL. If you are not a subscriber consider the 30 day free trial to see where he and Jack think AAPL (as well as NFLX, AMZN, FB, TSLA) is headed over the next year.

On June 11th I began keeping an updated comparison of how this strategy has performed in comparison with owning the stock so we can all see how it is working. As of the close on Friday 6/23/2017: The option position I established used up $5,000 of margin. For that amount of margin, I could have instead bought 72 shares of AAPL stock at $139.79 on 3/1/2017. On 6/23/2017, AAPL closed at $146.28/share. If I had bought the stock my profit would be $467.28. The option position currently has a gain of $103.04. That means that the option position has under-performed the stock purchase by $364.24.

This was the question I asked on the June 11 webinar when the stock position was out performing the option position by $918.68:  If I was allowed to switch positions and take the stock position and the open profit but I had to hold whatever position I owned through Jan2018 expiry, would I make the switch? My answer? Not a chance! As we get closer to Jan2018 it will become obvious if I made the right decision.

What if the price of AAPL on Jan19, 2018 is the same as the current price($146.28/share), what will the stock and options positions be worth then? The stock will still maintain it’s current $467.28 gain plus accrue $136.08 in dividends for a total stock profit of $603.36. The option position will have a total option profit of $2,963.

Why longer-term option positions make up the majority of the Art of Chart’s portfolio.

Consider the AAPL position I just discussed. I established the position when AAPL was trading at $139.79 on 3/1/2017. To be profitable, AAPL could trade higher or lower or unchanged but the area where the position would lose at expiry was above $158.34. The area where the trade would be unprofitable immediately after the position was established was any price higher. In other words, the position was short-term bearish and long-term neutral to bullish. So what happened after I established the position? Of course the stock moved against the position and traded as high as $156.65 on 5/15/2017. Any bearish to neutral short-term (less than 60 days) strategy gets blown up and takes a loss as it expires. With this position I was able to ride out the storm and keep the position which has now turned profitable.

So what about the short-term traders? You can still be a short-term option trader and utilize longer-term option positions. Let’s look at the week of  6/12 – 6/16 in AAPL with the Jan2018 position that I own in the portfolio. Let’s say I felt AAPL was going to have a bad week and I wanted to take advantage of that. What if I didn’t already own my current position and I initiated it just before the close on Friday, 6/9/2017. So the stock drops by 4.5% but the option position would have had a $600 profit in one week which is a 12% profit on $5,000 margin requirement. If I was a short-term trader I could have closed the position 6/16 and booked the $600 profit. Now, if I knew that AAPL was going lower that week I could certainly have used a much more profitable short-term strategy instead but the problem is nobody knew what the price of AAPL was going to do last week. Stan estimates that good chart patterns play out about 70% of the time which is a huge advantage in trading however no one should take that to mean 100% certainty! Art of Chart option trading is about maximizing the range of profitability that you can get with longer-term positions while incorporating Stan and Jack’s price and time targets to reduce the cost basis of entering the positions. This method will produce slower profits but fewer losses and, over time, more consistent profitability with lower trading costs.

That is all for this week. If you have questions or comments you can post them here on the blog or if you are an Art of Chart subscriber you can post it on the private Twitter feed. If you are not a subscriber you can sign up for a 30 day Free Trial to try out the service. What have you got to lose, it’s free!


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Paul Frey is a 30+ year trader with experience in equities, options, and futures. In addition to trading he manages Vega Options providing option educational services to new and experienced traders who are looking for improved results. He teaches strategies and techniques that reduce or even eliminate the initial cost of a trade while still maintaining potential future profits.

25th Jun 2017

0 thoughts on “Options Trading and Investing Service for the Week of June 25th”

  1. Hi Paul, one question regarding the binary trade u put on on Friday. Could one put the same trade on utilizing the same strikes in the SPX. Marcie

    1. Marcie, You absolutely can use the SPX instead of the /ES to put the position on. Just remember that the SPX is twice the size so if you were looking to have $500 of risk you would do a 1-4-3 BWB instead of 2-8-6. You also may need to tweak the strikes slightly tomorrow depending on how the SPX opens. If SPX opens higher and you keep the same 2440/2415/2410 strikes then you can put the position on for a better price than I did. If SPX opens lower you would pay more for the spread or you could roll down the strikes to say 2435/2410/2405 to account for the lower open.

  2. You mentioned u might take off the binary trade prior to Jul 7. At what point would u do this? What will determine when u take this trade off? Marcie

    1. Marcie, sorry for the delay in replying, was away yesterday. I posted an alternative to closing the position on the private twitter feed, did you see it?

      1. Yes, I saw that. I did my trade in the SPX and decided to close for profit since I am out of town next week. Thanks.

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