The racetrack spread trade

August 24, 2016 09:00 AM
You can approach trading stocks like a gambler, or approach it like “the house.” Guess which strategy will put more profits in your pocket?

In the stock market, most traders have their wires crossed. They gamble instead of speculate and end up selling when they should buy and buying when they should sell.

Like a day at the racetrack, traders line up, hand over their money and then waive their hands while shouting for their horse to come in the winner. At the end of the day, the racetrack still ends up the biggest winner in the field.

This irrational approach is the equivalent of lemmings diving off a cliff, and the outcome is just as predictable. But, recognizing this distinction of predictable irrationality gives you an opening to profit. Instead of betting at the racetrack, you own the racetrack by insuring reckless trade decisions.

Your tool chest

In the stock market, no trading instruments offer you the kind of advantages that options do. Options offer an unbeatable combination of leverage and limited risk. Compared to stock trading, Options give you the ability to control 100 shares of the underlying stock for 20% of its value. This is far superior to the two-to-one leverage offered by buying stock with margin.

However, options’ key advantages on the surface have glaring weaknesses underneath. If you do not trade options with the proper awareness, those weaknesses can negate any of their advantages, leaving you worse off than before.

Options’ complexity is only an advantage to those that understand it and can potentially be negated by its weaknesses. As with any set of tools, you have to fully understand their strengths, weaknesses and purpose to use them effectively.

Black swans

Imagine that while the markets are closed, a so-called “black swan” event, such as the Brexit vote, is announced, that could cause you to experience a catastrophic loss. 

A “black swan” event, like its namesake, is an extremely rare, unexpected development that no rational person would expect to happen at a particular time. Such an event could result in a huge downward price gap between yesterday’s close and the current day’s open.

If you’re holding a stock position, an event like this could result in a massive loss — a loss so steep that it could take you out of trading completely.

But, with options, rather than a straight position, your risk is limited. With a long option position, the most you could lose is the cost of the option itself. This is one of the greatest strengths of options trading, the ability to limit risk.

Even basic price setups can allow for option trades. When a trade signal occurs (see “Up move setup,” below)
the best choice may not be a position in the stock. We’ll detail the exact trade rules later, but in short, you’ll want to turn your attention to the underlying’s options, 
and seek opportunity there. On May 6, 2016, Citigroup’s closing price was $44.61. The in-the-money (ITM) June 44.50 puts were overbought based on a four-period Relative Strength Index (RSI). Selling this option paid a premium of $1.25, which quickly evaporated in value, yielding the seller a profit.

However, there are some serious disadvantages of using options that could outweigh their strengths.

Price, time, volatility

To make better buying and selling decisions when it comes to options, price and volatility need to be weighed carefully when dealing with these instruments.

Fast moves in stock prices will result in spikes in volatility, and this causes option premiums to increase. Knowing that, it’s also important to keep in mind that volatility tends to revert to its mean. This means that volatility will spike and snap back at some point, which causes the price of options to fall.

This phenomenon is why some option buyers scratch their heads and can’t understand why their options haven’t increased in value; a change in volatility had more effect on the option premium than the price move in the underlying stock.

Further, option buyers have to experience a larger-than-expected price move to increase the value of the option, especially if they are bargain shopping out-of-the-money options. Unfortunately, this presents another problem because there is only a short window of time for it to happen before the approaching expiration date for the option erodes its price beyond recovery.

Trading aikido

Time and volatility can pose serious obstacles to profitability for the option buyer.

However, for a seller, both time and volatility can be your biggest allies. You just need to apply a little “trading aikido” to flip it around to your advantage.

The Chicago Board Options Exchange reports the following facts:

  • Approximately 10% of options are exercised (The trader takes advantage of his right to buy or sell the stock);
  • Around 55% to 60% of option positions are closed prior to expiration;
  • Approximately 30% to 35% of options expire worthless.

From these statistics, we can easily see that a third of all options expire worthless with another potential third following suit. Overwhelmingly, most outright option positions fail to be exercised with only  10% being assigned.

Knowing this, you now need to work it to your advantage. To do that successfully, you’ll need an approach that exploits all of these weaknesses while emphasizing their strengths.

Own the racetrack

The racetrack spread trade gives you the same advantages of owning your own racetrack where everyone bets but you, the “house,” and you maintain a slight edge over the players. As a result, you put the odds on your side while maintaining a position that is flexible enough to control your risk while earning a steady return.

The racetrack spread trade offers two approaches: One, selling puts on stocks that you would want to own if they were assigned to you and, two, to earn a consistent return.

The initial rules are as follows:

  • Price is trading above the 100-day simple moving average (SMA).
  • The underlying security’s 14-period stochastic indicator should be below 10.
  • The put’s four-period relative strength indicator (RSI) closes above 90 at the same time.

Once those conditions are met, select an at-the-money (ATM) or a slightly ITM put that is more than seven days away from expiration and sell it to collect the premium.

You’ll hold the “naked” put position to capture the whole premium, or, alternatively, have the stock assigned to you. Note that this is a higher-risk trade because the stock could be “put” to you by the put option buyer. However, if you are willing to own the stock, this approach lowers your overall cost basis for doing so. At worse, you’ll collect the premium with no further commitment.

Or, if you want to collect most of the premium without owning the stock, consider these modifications:

  • Trail your stop loss point (aggressive), or
  • Sell when the put’s four-period RSI falls below 15 (conservative), or
  • Buy a lower strike put to hedge your risk (optional).

The 100-day SMA does not need to be pointing upward for the setup condition to be in effect, only that price is trading above it. You use the 100-day average because this is essentially three-months’ worth of price data. This is a short-term trade, so anything longer isn’t necessary.

You’re also going to track the option value using the four-period RSI of the option, not the stock price.

“Apache poised” (below) show another example of this trade setup.

Remember, sharp price moves expand volatility, which in turn affects option values. By using a short-term indicator to measure when an option is overvalued, you take advantage of spikes in premium. It is a short-term value play. Apache closed on June 2 at $55.84 with the June ATM puts overbought at the $55 strike price. This signaled to sell the put and collect $1.30 in premium. With expiration just eight days away, time decay devalued the option rapidly earning a fast return.

You now face how you are going to manage the trade. This will have a lot to do with your goals.

Do you want to use it as a low-cost method to collect premium income while also seeking to own the stock? Then you’ll want to use the first set of rules to time your trade and then hold the position. Either time decay will erode the value of the option, allowing you to keep the premium, or you’ll have the stock “put” to you. If it’s assigned to you, then you lower your cost basis of the stock you desire to own.

If your goal is a steady return and income stream, you want to use the rules of the second half of the trade to control your risk.
Again, the racetrack spread trade is flexible.

Like before, you can time your trade with the rules for the setup condition and the trigger to enter but then buy back the put option when it falls in value. You’ll use the RSI to time your exit or a stop loss of twice the total premium you collected as an exit signal.

Or, you can buy a lower strike put to build a bull put spread and hedge your risk. This is likely the best option because buying a lower strike put option is an insurance policy against an unexpected move against you.

In perspective

Keep in mind, selling options won’t necessarily earn you huge profits, but it will put the market’s probabilities on your side. Playing the odds this way and factoring them into your trading approach can put you on the winning side of trades more often.

As a result, you’ll gain a new stream of income as a steadier return and build wealth by accumulating more stocks at a bargain.

Finally, if you are interested using the racetrack spread trade to build a portfolio of bargain stocks, then consider focusing on high-dividend, blue-chip stocks. This class of mature stocks has stood the test of time as well as throwing off a stream of income themselves in the form of dividends. More than income, they can potentially help you accumulate wealth over time.

This trade setup is flexible in its application whether you can focus entirely on one strategy or use a hybrid approach.

About the Author

Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.