Tuesday, May 22, 2012

Income trade thanks to Dan Sheridan

I watched a webinar on options trading last week from which I learned a valuable trade:

Use out-of-the money calls or puts, depending on the chart direction of the underlying ... choose calls for a falling stock, puts for a rising one (use 20-day moving average, maybe adding 50 as a tiebreak) ... with about 30 days to go, find the strike with a delta of 12 to 15%, making that the middle of the 3-leg butterfly ratio trade. Thinkorswim calls it an unbalanced butterfly.

(Unfortunately, OptionsXpress calls it "sorry, you can't do this in a single trade". *grumble* Makes me wish I hadn't just consolidated my wife's IRA with OX ...)

For example, if the RUT June strike showing the right delta is 800, make that the middle leg. The lower leg is $10 below, the upper leg is $10 above. The trade was as of Monday the 21st:

Buy to open 3 June 2012 810 calls
Sell to open 4 June 2012 800 calls
Buy to open 1 June 2012 790 call

... with RUT around 753.

This trade produces about a 10% return! Better yet, the risk graph shows that 10% return all the way down to 0 (for calls). Terror attack, Euro dissolves, whatever -- you still make 10%.

There is a simple and not too expensive adjustment you can make if your trade goes haywire (in this case, if RUT rallies toward 800). The adjustment is:

Sell to close 1 of the 810 calls
Buy to open 1 of the 790 calls

... thus making the trade into a 2-4-2 butterfly with the typical limited risk and high reward spike in the middle of the graph.

So one can (for example) in a $50K account, risk $45000 of margin (saving $5K for adjustments) and make $4500 most months (only occasionally losing 7% or so, about $3000). Not bad!

Thanks again to Dan Sheridan for putting on his webinar on this.


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