The trade highlighted in this piece is an “example” of a bull put credit spread using options on ticker QQQ, the ETF that tracks the Nasdaq 100 Index. It t would should NOT be construed as a recommendation. However, it does offer a classic example of a number of elements that a trader should consider when evaluating a certain type of trade.
PowerShares QQQ Trust Series 1 (O:QQQ) Snapshot
As of 1/15/16:
*Implied Volatility for options on ticker QQQ is presently near the high end of the historical range (See Figure 1). This tells us that there is presently a lot of time premium built in price of QQQ options and suggests that “selling premium” might be the best approach to trading QQQ options.
Figure 1 – Implied volatility is high for QQQ options – meaning lots of time premium in the price of QQQ options(Courtesy www.OptionsAnalysis.com)
“Spikes” in implied volatility most often – though certainly not always – accompany at least short-term bottoms in price (See Figure 2).
Figure 2 – “Spikes” in IV often highlight (at least short-term) lows
*QQQ was extremely oversold and was threatening the recent low range of $98.01-$98.75 (See Figure 3). This area may serve as a useful “line in the sand”. If it holds – and especially given the current oversold state of the market – a sharp reversal could occur. However, if that price range is breached to the downside it would suggest abandoning any near-term bullish hopes.
Figure 3 – QQQ with clear support levels (Courtesy AIQ TradingExpert)
When we put all of these factors together it may seem reasonable to believe that QQQ may hold – and possibly bounce off of its recent support level, at least for a short while. So the example trade that appears in Figures 4 and 5 below attempts to take advantage of such a scenario.
QQQ Bull Put Spread
The example trade displayed in Figures 4 and 5 is referred to as a “bull put spread” as it creates a bullish position by selling an out-of-the-money put option and buying a further out of the money put option at a lower strike price. In this example, this trade will make money as long as QQQ – presently trading at $100.84 remains above $96.52 through January 29th.
The trade involves:
*Selling 10 Jan Week 5 97 strike price puts
*Buying 10 Jan Week 5 94 strike price puts
Figure 4 – QQQ Jan Week 5 Bull But Spread (Courtesy www.OptionsAnalysis.com)
Figure 5 – QQQ Jan Week 5 Bull Put Spread Risk Curves (Courtesy www.OptionsAnalysis.com)
As you can see in Figures 4 and 5:
*The maximum profit potential is $480
*The maximum risk is -$2,520 (which we will attempt to minimize in a moment)
*The options expire in less than two weeks on January 29th
*The downside breakeven price is $96.52
*If QQQ is above $96.52 at the close on 1/29 this trade will show a profit
*If QQQ is above $97.00 at the close on 1/29 this trade will earn the maximum profit potential of $480
So the gist of this trade is that a trader who would enter into this type of position would have to be confident that QQQ will decline no more than another -4.3% prior to 1/29.
Stop-Loss Considerations
If a trader entered this example position, held it until expiration and at that time QQQ was below $94 a share, this position would show a loss of -$2,520. Allowing this to happen is simply not advisable. A trader could decide to exit the trade if price drops below the breakeven price of $96.52 – which is below the “Line(s) in the sand” displayed in Figure 3.
Getting stopped out at this price would result in a loss of approximately $620-$680, depending on how soon this price is hit.
Summary
The example QQQ trade highlighted here combines a number of elements:
*Selling premium in the face of high implied volatility
*A clear “line in the sand” (i.e., an identifiable support level)
*A decent reward-to-risk ratio (for a short premium trade)
*And a relatively short holding period (14 or less days)
*A breakeven price that is 4.3% below the current underlying market price
Does that mean it’s a good trade? Not necessarily. The obvious risk is that it doesn’t take much to imagine QQQ cutting through the “line in the sand” and the breakeven price like a hot knife through butter. In other words, this trade could have already been stopped out by the time you read about.
But hey, that’s the nature of trading. The real point is not the actual trade highlighted but the underlying principles and steps used to identify the trade. If you consistently put the odds in your favor you stand an excellent chance for long-term success.