The S&P 500 is up a little bit so far today but not nearly enough to see any significant repairs to the volatility complex. VIX futures backwardation is still there and all my other indicators are flashing yellow right now too so we will remain mostly in safety positions.
However there is a good risk reward trade we can take today within the VTS Discretionary Strategy. If you have a little bit of option trading experience you’ve likely heard of this kind of trade before, they go by several names.
Bull put spread, or credit put spread, or just vertical spread. They all mean the same thing and different traders refer to them differently, but it’s a very common trade and quite a simple one as well. The situation we are in right now is my favorite time to open them so I’ll go over the market conditions right now that make this trade desirable today.
1 year chart of S&P 500:
You can see in the chart the S&P 500 has been waging quite a battle with it’s 200-day moving average (green line) and it’s currently still hovering just above it. Now I’m not much of a technical analysis guy, I’m far more focused on volatility metrics, but basic TA like long term moving averages do have some influence over the high frequency trading algorithms as well as investor psychology so it’s quite common to see this type of resistance line.
As long as we stay above it that means the major selling is over. However if we see a move and close below it that might signal that a further leg down is coming. At the very least that would be a signal to consider moving to full safety positions again.
Selling a bull put spread right here may be a nice trade so here’s what that will look like:
SELL to OPEN 10 x SPY 18 May 18′ 258 PUT
BUY to OPEN 10 x SPY 18 May 18′ 253 PUT
The opening credit will likely change throughout the day as the markets move around so it might not be 1.23$ credit, but the trade will remain materially the same.
* Again I stress, for those new to option trading it’s best to follow along in a paper trading account for a while before allocating real capital. There’s no urgency here, I’ll be here for decades and so will these types of trades 🙂
Let’s go over the major reasons I chose this trade:
1) Because volatility is elevated right now (yellow circle in the first SPY chart above) we do want a Vega negative trade which is one that profits as volatility declines. That’s why we are selling a credit spread to bring in a premium.
2) The short strike 258 is positioned below the 200-day moving average. This is our line in the sand. As long as the SPY remains above the 200-day moving average it will also remain in our profit area for the trade so I like to set my short strike just below the resistance level.
3) I’m using a 5 point spread between strikes, so the long put is at 253. I do this to cut down on trade fees. We could use the 257 put strike, but that would mean we need to open far more contracts to represent the same trade size and that will unnecessarily increase trade fees.
4) I’m opening 10 contracts within the VTS Discretionary Strategy which requires 3,770$ in buying power. Since it’s a 25,000$ model portfolio this trade only represents a small allocation. With vertical spreads you always want to keep the trade size small. It’s far better to open several smaller trades spread out over different price ranges than one larger trade.
5) I’m selling the spread for a May 18, 2018 expiry which is 39 days from now. I always like to give my trades some time to work for me, and 35-65 days to expiry is usually ideal for credit spreads.
6) I’m using the SPY because I do prefer to stick to indexes with my option trading whenever possible. I do occasionally use individual stocks, but indexes are more stable and the SPY is the ETF that tracks the S&P 500 index so I often use the SPY.
7) The next dividend in the SPY isn’t until June so it won’t be paying a dividend during the life of our trade. Remember dividends do affect option pricing so it’s best to stay away from trades that will pay one whenever possible.
I don’t use dollar value stop-losses for these types of trades, but there is a point in this trade when I will be exiting the position. If the SPY breaks down below it’s 200-day moving average and closes below the break even point in our trade that will be a signal for me the trade is breached and it’s time to get out.
So the stop-loss for this trade is SPY closing below 256.77$.
So I really like this trade set up and I very often sell credit spreads when markets are testing a short term low. We really are looking for inflection points with this type of trade where something is likely to either bounce or breach. I don’t remain committed to them and ride the losses down very far which is why we abide strictly to our stop-loss, but these are very effective trades to test the waters in an ambiguous turning point like we see right now.
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