X - debit spreads

It's anybody's guess these days but I think before heading lower there's a good chance to the upside. It's still pretty hard to justify trading options but using spreads will make the risk manageable while still allowing for some profits. In this example, consider US Steel with a short-term price target of low 60s.














Volatility has come off its highs... relatively speaking of course.


















Trade calc screenshot -

SPY

The S&P finally broke out above an important technical level and closed above it's 200 day MA. SPY closed at 142.55. While this sounds bullish - remember tomorrow is expiration day and most of the market has become wildly overbought. SPY has a 2 day RSI of almost 97 and so does much of my watchlist. Some key levels, going forward, for the SPY at least, are 144/145 to the upside and 138 to the downside. I recommend getting out at either of these levels should we get there. Further, if we do get as high as 144/145 I recommend selling some OTM credit spreads or ratio spreads on SPY (or similar behaving ETFs) as I think some pullback is imminent. I don't recommend buying Puts, since overbought doesn't mean the stock's going down, it usually represents exhaustion and/or overextension which equates to either a pullback or simply sideways movement until overbought conditions are worked off. This is why a ratio spread can be a good idea. If done right (usually means you have to go a few months out) you will profit on a move up, down, or sideways and only lose from a huge move up. They are similar to selling OTM credit spreads except you have a greater range to make a profit but it does carry more risk should the stock continue past your long leg.

Here is a short list of stocks with their 2 day RSI above 99: MDY, DRYS, IJH, VMC, NAVS, VRSN, DOV, CRS. I believe statistically it's more profitable to go long on oversold stocks (i.e. 2 day RSI less than 05) than it is to go short on those with 2 day RSI above 95. Overbought stocks seems to have more staying power. Either way, some of these, you will find, are otherwise nice looking charts and they should stay on your watchlist - there is a reason why some of these are overbought...

UNP - top of its trading range

With the S&P closing above 1400, a lot of traders have become short-term bullish. This includes myself as I have also made short-term directional bets (via debit spreads) that SPY will make it to 144/145 before finding more resistance.

It is certainly possible that this bullish sentiment has gotten a little out of control, or even perhaps that this move is just a head fake. If you agree of this possibility then you might want to consider balancing your option portfolio by keeping some bearish bets open. Below is a specific way to do just that.

I have been championing the recent move of UNP, ever since it broke out of its ascending triangle pattern at the beginning of April. That said, I think it has become a little bit overextended for the following reasons:
1) UNP has a 2 day RSI of 98.99
2) UNP is now trading at the top of its trading range
Long-term I'm still bullish on UNP; I just like its chance of a pullback. I also think that a realistic price target for this pullback would be former resistance (or 137ish)


Given the aforementioned price target, you could always buy AMT or ITM puts. If you wanted to shoulder some of that expense to help spread out your capital, you could buy a put debit spread (same as vertical spread, same as bear put spread).

Buy the 145 Puts and sell the 135 Puts
This will give you a breakeven point of 142 while risking $305 for a reward of $695. This has a decent risk/reward ratio. The breakeven point refers to 'at expiration'. Ideally, UNP would pullback in one week, you could liquidate your position, lock in 80% of your potential profit, and remove 100% of your risk.

You could buy the 145s and sell the 140s. This will give you a breakeven point of 143 while risking $190 for a reward of $310. Your probability of success goes up (higher B/E point) but your risk/reward ratio goes way down. It's a constant trade-off, as always with options, between risk and reward.

Debit Spreads

Obviously a significant technical day today with several 'key' levels being breached to the upside. The strong finish was also impressive for the indices. Of course buying now seems a little risky with the unemployment data (8:30 ET) coming out tomorrow morning. Overall, I would like to see the market pullback here... as to present me with a much better entry point. I will continue to look to buy the dips on some individual stocks/ETFs.


I will be keeping POT on my watchlist. I think the pullback (almost touching its 50 day MA today) will still present a good buying opportunity. Commodities as a group have taken a beating lately, both in the media and in price. Keep in mind though that some commodities, like potash, and unlike gold, have an actual use and thus justify a higher price.
Notice the magnitude of some of the recent POT pullbacks:
1) 8/14/07 --> 20%
2) 11/08/07 --> 31%
3) 1/15/08 --> 18%
4) 4/23/08 (as of today) --> 19%
If you do consider going long, be sure to give yourself plenty of time. Notice, historically, how long these pullback recoveries tend to take and act accordingly. If the thought of purchasing all that extra time doesn't turn you on, consider financing your Call purchase with the sale of some further out-of-the-money Calls - known as a Debit Spread. Debit spread possibilities/combinations are limitless (expirations, spreads, strikes, etc).


Here is one example, if you thought POT would make another 52 week high before September expiration. What would normally cost $2,100 (SEP 200 Call) will only cost $630 when done as a debit spread. Of course there is a downside: you will limit your potential profit to $1,370.

Your breakeven point (at expiration) will be 206 with the debit spread vs. a breakeven point of 221 with the outright calls. Theoretically, the outright calls do have unlimited profit potential. If you believe that anytime before September, POT has the potential to go to 250, for example, go with the calls. Your decision between outright calls and a debit spreads should have more to do with realistic price targets than hope. Personally I like to reserve straight calls for very short-term plays or pure speculation.

SPY - spreads

Suppose you think that SPY is finally ready to break through resistance at 140. Here are a few ways to play it.

First, I'm going to set a realistic price target and then build strategies around it. In this example, I think SPY could realistically get to 144 by June's expiration.


Credit Spread












Debit Spread












Ratio Spread