Increasing the Odds on a Bull Put Trade

In my previous article, What are Seasonals and Why Should I Care?, I introduced the value of stock seasonals and how they can be used to increase the chances of success of trades. Incorporating seasonal analysis into your trade evaluation helps get you into the right trades at the right times (and stay out of the wrong trades at the wrong times).

I use seasonal analysis in most of my trading. It often seems to give me an edge, a way to ride the ‘coattails’ of big players. I am more confident about staying in trades, not exiting so readily on small pullbacks or counter-movement days. It is the bigger, longer moves that even short-term traders tend to make the best profits on.

I have a handful of strategies I use regularly. They include covered calls, diagonal calendar spreads, and credit spreads. Even though I trade regularly, and have for more than two decades, I often put on paper-trades just to get even more experience, especially in strategies I do not use regularly.

Recently, I noticed one stock had a pattern that has usually worked well for me when doing Bull Put credit spreads. I investigated more, made notes on it and logged a paper-trade. This article is a ‘putting it all together’ example of planning, entering, and staying in a good trade, using that paper-trade as an example.

The Bull Put Spread

As your MarketTamer options training has enlightened you to, a Bull Put spread is a credit spread. If entered and managed properly, it is a limited risk, high probability trade that is good for monthly income. The key to the probabilities is you are not betting on where the stock is going, you are betting on where it is not going. That subtle difference in how you think about the trade can make a big difference in the likelihood of extracting the maximum profit out of the trade.

In a sideways-to-rising market I look for a stock that has a well-defined support line, where all recent selling has dried up as the stock approached that line and it just doesn’t seem to want to go lower. If that particular level is slightly above a strike price of the available options, the numbers can typically work out to around a 5% to 10% gain over a month, with an 80% to 90% probability of capturing that full gain.

My research has always focused on how to increase the apparent odds on most trades even more. Most of the times I use seasonals, the analysis of the historical patterns of stocks, as well as other statistical and empirical approaches to support or reject various trade candidates. While I will use information from the Stockquirks.com site in this article, you can easily determine such seasonal information yourself just by looking over historical price charts or data for the stock you are analyzing. You can also make use of various free or low-cost web sites.

In the case of a Bull Put credit spread, even with the probability of a successful trade being high, the losses can at times be significant enough where I seek an additional edge, something that will convince me there are more factors in favor of the stock staying above a certain level than just statistical probability.

Exxon Mobil looks interesting

On Saturday, March 24th, 2012 I noticed that Exxon Mobil (XOM) had an interesting chart. The overall market had just made another bounce upwards, starting with a high volume day. XOM had formed a nearly three-month trading range with the 83 area seeming to be a price it did not want to go below. As long as the overall market did not tank, I felt there was a strong chance XOM would stay above the 83 level.

XOM in well-defined trading range on 3/24/12

It probably would reverse, or at least pause, at the upper resistance area around 88. So that strongly suggested a trade like a Bull Put spread would work well. I would not need to bet on XOM going beyond 88, or even making it to 88. I would only need to bet on it not falling below 83, and it had not shown any inclination to do that for three months.

Of course if the overall market, or even just the oil-related sectors, began pulling back strongly, XOM (and many other stocks) would likely follow. But I could not predict that. I had to work with the most likely case, and the overall market had been stepping upwards since late November. Many energy-related stocks had pulled back recently and therefore XOM’s sideways motion was actually showing strength relative to the other oil-related stocks. I gave XOM a passing grade on this part of the analysis.

Picking the strike prices

A Bull Put credit spread means I would sell (‘short’) some number of contracts of a put option with a strike price just below support and buy the same number of contracts of a put option one or more strikes below that.

The exact strike price I pick to short the puts at makes a big difference on the probabilities and the maximum possible profit on the trade. The price distance between the two sets of options affects both the maximum profit as well as the risk.

I could easily fill a chapter in a book with a discussion on picking the best strike prices for this trade. My focus here is on increasing the probability of Bull Put spread trades, so I won’t go into detail at this time. But I will cover a few rules-of-thumb I’ve developed from my own trading.

Many examples of Bull Put spreads tend to show the use of strikes at or slightly above the support level. This produces better Reward-to-Risk ratios and higher maximum theoretical profits. But the statistical odds of success are lower.

I tend to be more conservative with credit trades. I am willing to settle for a lower return and a smaller Reward-to-Risk ratio in exchange for a higher probability of success.

XOM closed on 3/23/12 at 85.55 and the support level I identified was around 83. XOM’s strike prices were increments of 2.5, meaning puts were available at 80, 82.5, 85, and so forth. I initially picked the April 82.5 Put as the one to sell. Why? For Bull Put spreads, especially on a stock in a well-defined trading range, I want the short put to be a short distance below the support line – not right at it, but just below it. Too far below and the current Bid/Ask spreads on the options won’t make this trade worth doing. April had 82.5 Puts available, with a narrow Bid/Ask spread and good Open Interest (I usually want to see O.I. > 100).

As far as the strike price of the put to buy, experience has shown me that with a stock in this price range, say greater than 30 to 40, a strike price difference of 5 usually gives acceptable numbers for doing the trade. I looked at the April 77.5 Puts, and while they were not selling for much, their Bid/Ask spread was narrow and they had decent Open Interest.

As far as the number of contracts to trade, I go for quantity because commissions can eat up profits when doing only a few contracts. I often find myself doing 5 contracts on each side, but sometimes 6 to 12. With a credit on the lower side of what I typically find, I picked 8 contracts on each side.

The trade I decided on was Sell 8 XOM Apr 82.5 Puts and Buy 8 XOM Apr 77.5 Puts. The Bid/Ask prices on the spread was .29 Bid, .32 Ask. Even though just .03 apart and we’re talking about only 30 cents, I usually aim for one or two cents better than the Bid on the actual trade, so my trade as recorded was Sell 8 XOM Apr 82.5 Puts/Buy 8 XOM Apr 77.5 Puts at .30 credit. If I actually placed this trade, I would have used a limit order to guarantee that I would get at least a $.30 credit.

I won’t go into the calculations of maximum possible profit and risk on this trade. But roughly, using an arbitrary $25 commission to place this trade, the maximum profit would be $215, and the maximum risk would be $3,760.

My possible return, over the four weeks until expiration of the April puts, would be ($215 / $3760) * 100% = 5.7% (after commissions).

It may not sound like a lot of reward for the amount risked. But there are key factors in a trade like this that make it worth doing at the right times.

  1. The probabilities can be determined to be strongly in favor of the trade ending profitably. Determining the odds is the subject of the next section.
  2. Experience, and knowledge of advanced options techniques, allows you to adjust Bull Put spreads to prevent taking a loss at all or at least minimizing it, by converting it into a totally different type of trade. Paper trading before actual trading will give you the experience, and your MarketTamer training will help you understand this trade and the possible adjustments.

In actual trading, I would have waited for XOM to fall a bit closer to the support line, which would have given me a better maximum profit and Reward-to-Risk ratio. With paper trades, I tend to be less demanding, as I like to get experience with less-than-ideal situations.

The probabilities

To determine the likelihood of ending up with the maximum profit, there are multiple factors to consider:

  1. The recent action of the overall market, the sector the stock is in, and the fundamentals and the chart patterns of the stock itself.
  2. The statistical probability of the stock ending up above the strike price of the short put.
  3. Is there a seasonal tendency, a track record of the stock rising this time each year?

I covered the first item in the beginning of this article – it was the identification of the confluence of positive market bias and a well defined trading range in XOM that led me to think about a Bull Put spread. There was a strong case for XOM staying above the 82.5 level for the following month, which would be necessary to achieve the maximum profit on the trade.

I could calculate the statistical probability of XOM staying above the 82.5 level through the April expiration of the puts. The current stock price, the number of trading days left until expiration, and the recent volatility of the stock were all that was needed – that, and a probability calculator, since the calculation is very complex.

There used to be several probability calculators available online but they seemed to have turned into subscriber-only tools. Fortunately, most option-specializing online brokers calculate this for you. OptionsXpress and Thinkorswim for instance provide you with the probabilities of the stock closing at or above/below a strike price on expiration date. Larry McMillan’s website, Option Strategist (Analysis Tools), offers one of the best probability calculators you can buy. Explaining why will cover an important point about probability calculations.

At expiration the stock price relative to the strike price of the short puts will be your major concern. If the stock closes above the strike price of the short put, you get to keep the full amount of credit you originally received from the trade.

If the stock closes below the short strike, but above the long put strike, you will either make a lower profit, or log a loss anywhere from zero up to the maximum possible loss. You do not want that to happen. You want a Bull Put trade to end up with the maximum profit. Therefore, you want the stock to close on expiration date above the short strike price.

While evaluating my XOM Bull Put spread trade, I entered it into OptionXpress’s trade calculator. It showed the probability of XOM closing above 82.5 on the expiration date (Friday, April 20) was 83.26%.

As I trade Bull Put spreads more conservatively, I ideally want to find good quality stocks with well-defined support, liquid options, and numbers that work out to at least 90% chance of closing above the short strike, a credit of .40 to .60+, and a max profit to max possible loss ratio of 1:5 to 1:8. In practice, I seldom find these setups on higher quality stocks. Typically, my Bull Puts are in the 80-90% range, .30 to .50 credit, and 1:9 to 1:12.

You can enter Bull Put trades where the short strike is above support. However, you trade off a lot of probability. You can evaluate a trade where the short strike is well below support but you will probably not be able to even cover commissions with your profit.

An obvious question at this point is what if the stock drops below the short strike BEFORE expiration? This is the most difficult situation to state a clear set of rules on managing a Bull Put trade. The calculated statistical probability is the likelihood of the stock closing at the short strike at expiration. To determine the likelihood of the stock touching, and possibly moving below the strike sometime before expiration, another type of calculation can help you.

First of all, it is more likely that the stock may briefly touch, or drop below, the short strike sometime during the trade period than close at or below the strike at expiration, due to the variability of day-to-day trading. Expiration probabilities are calculated from the log-normal distribution of expected prices of the stock – you know, those funny ‘bell curves’.

To get a feel for the possible stock movement prior to expiration, a Monte Carlo Simulation must be run. A series of simulations of random movements is performed, usually 10,000 simulations or more. The averages are used to determine a probability.

For example, I ran the XOM trade’s numbers through Larry McMillan’s probability calculator, which uses Monte Carlo Simulation, and got:

XOM's Monte Carlo Simulation gives before-expiration probabilities

This told me there was a 16% probability of XOM closing below 82.5 at expiration, which is an 84% probability it will close above 82.5, which is inline with OptionXpress’s 83.26% number.

But notice it says there is a 27+% chance of XOM ever exceeding 82.5 on the downside. That’s something you have to keep in mind when calculating spread probabilities – the stock has a much greater chance of touching a level during the trade period than expiring at it!

What does this mean in real trading? From my experience, as long as there is some time value remaining in the current price of the short put, and the stock hasn’t gone very far below the short strike, it is very unlikely you will be assigned the stock. You almost certainly will at expiration, which is why you really want to avoid that by adjusting the trade before expiration.

But if the stock briefly falls below the strike, you of course won’t know if it will pick up speed, or quickly reverse and move back above the strike. You must look at the market and the stock’s charts for other clues. I’ll show you an example on the XOM trade in a minute.

So the statistical probability of the XOM trade is within my normal operating range. I won’t disqualify the XOM Bull Put trade based on probabilities.

Looking at the seasonal

An 84% probability is nice, but I’ve learned to look for an edge, something that adds to my chances for a successful trade. In my previous article, What Are Seasonals and Why Should I Care?, I introduced seasonals, the analysis of stocks for historical patterns. There are many reasons a stock could make similar moves at the same time each year. My final analysis step was investigating whether XOM had an upward bias during the same period in previous years.

XOM is an energy-related stock and they tend to have upward biases in the spring. The XOM Bull Put spread I was looking at would be entered four weeks before the expiration of the April options, therefore I focused on that period.

The chart I looked at, focusing on the 4-week period prior to April option expiration, showed me the track record:

XOM has an upwardly biased seasonal for the 4-week period

This seasonal would not be strong enough for me to consider implementing a Bull Call spread, or any other trade that required a several percent move within a short period of time. But for a Bull Put spread, all I needed to see was a strong track record of the stock at least not falling over those four weeks. A 75% track record of gains was that extra ‘edge’ I was looking for.

How it worked out

The market began a pullback on April 3rd. Four trading days later the S&P 500 dropped almost 2% on above average volume. It closed below its 50-day MA, a warning sign. Worse, XOM closed at 82.17, just below the 82.5 strike.

XOM moves below the 82.5 strike before expiration!

The XOM spread position was showing a loss of about $650, which was about 17% of the amount at risk on this trade. There was a significant amount of extrinsic value in the price of the short put, so I was not currently in danger of being exercised.

In my early days of credit spread trading, I would get nervous seeing something like this and convince myself I should take my loss before it got bigger, and wait for the next good setup. That is not bad advice in theory, but I found I was often exiting trades too quickly – they would often come back and end up above the short strike at expiration.

In this case, the market had fallen for five straight days. Even in bear markets, the odds of six consecutive down days is rather low. There was no ‘Black Swan’ event in the news, like Lehman failing. So I decided to wait and see how the market, and XOM, opened the following morning.

XOM gapped upwards on the open the following morning and closed well off the day’s lows. Over the next several days, XOM continued moving upwards with a few above-average volume days. I only had to watch it closely each day and wait for expiration.

XOM closes well above 82.5 strike on expiration day

XOM closed on 4/20, expiration day, at 85.30. I was able to keep the full credit I had received when opening the trade. Too bad it wasn’t a real trade. As I mentioned above, if this had been a real trade, I would have waited for XOM to fall a little closer towards the support level before entering – the resulting credit would likely have been larger, and the Reward-to-Risk ratio smaller.

These are the types of trades I do on a regular basis, and how I increase my odds of success. If you don’t have experience with Bull Put or Bear Call trades, paper trade them for months, through many different market environments, before beginning actual trading.

All information is for educational purposes only.
All price charts courtesy of Worden – www.worden.com
All other material copyright StockQuirks, LLC. All rights reserved.

Article below submitted by Gregg Harris, of StockQuirks.com : a site dedicated to helping professional traders increase their odds of success.

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