The NDX Trade Continues to Show Promise

by Jay Pestrichelli on February 9th, 2012

If you’ve ever talked to me about how I personally invest over the last 2 years, I’m sure at one point I mentioned what I call “The NDX Trade”. The NDX trade is an out-of-the-money, high probability credit spread written on the Nasdaq 100 index, symbol NDX. This strategy is meant to generate a small percentage (3% to 6%) monthly against an advantageous probability of success ranging from 94% to 97% probability of success. From a risk / reward perspective, keeping those two numbers in line is important.

This strategy can be generated for either direction of the market, up or down, and works as long as there aren’t large movements opposite of your bias. There have been many months where the bullish trade has worked even though the market went down. This is all a factor of how far OTM you want to go.

Most option platforms today will give some kind of probability calculation in the option chain or even a dedicated tool that will do it for you. While they all have their own proprietary means of doing the calculation, the general premise is the same. Based on the pricing of the options in the near month and near strikes, the probability of expiring in the money can be determined and extrapolated out over all dates and price points. In other words, the options with the most action near the money act as a proxy and ripple out and impact all other options in that ticker.

While I wont go into the details about how those trades are established, there’s pleny of pages in the book about it, it is worth noting some interesting things about this February and the upcoming March expiration periods.

February has seen little depreciation in the spread prices for puts (this would be the bullish trade) despite the long and methodical upward movement AND the drop in probability. Usually these two metrics, spread price and probability of expiration will move in lock step. However for February, spread prices have been stubbornly holding onto premium and not dropping (which is what we want to happen) despite the percentages going down.

March is showing something similar. It almost feels like those setting the bid/ask prices aren’t trying to incent action. Meaning it almost feels like they don’t want traders to hit their quotes that they are obligated to issue. And that tells me one thing; they don’t want to get caught off guard by a fast dropping market. Because of the upward movement of the market and dropping volatility, their equations tell them they MUST drop prices on OTM puts. But the reality is that even though math sets the bid and ask, it is still up to people to determine how much they are willing to risk of their company’s assets.

These are the times that its good to be the little guy and take advantage of the rules. The institutions that make the markets, MUST take your trades. They can make it hard to get executions by widening the spreads, but the at least have to put out quotes and have to honor them when you hit them. So take advantage of your advantage and know that when you get fills that are hard to get, it means you’re probably on the right track.

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Jurg - February 9th, 2012 at 12:38 PM
Jay, what levels and expiry would u suggest for a bear call spread/credit call spread on the NDX? Rgds Jurg
Jay Pestrichelli - February 13th, 2012 at 10:28 AM
Jurg-First off, sorry for the length of the answer and let me reply with the standard, depends on your outlook and what you’re trying to do. I’ll assume you’ve got a bearish bias and you’re trying to generate income, as this post discusses. As a rule, we stick to the near month and keep the risk of failure to stay equal or less than the % returns. Unfortunately, the NDX calls aren’t very accommodating right now. For example if you want a 95% probability of success, you would need to consider the 2825/2850 strikes; however there aren’t any options at that strike right now, so that’s out. Going to the 2800 level you could create a 2775/2800 credit call spread for $0.45, but that has an 8% probability of losing money and only returns 1.8% (0.45/24.55).In all honesty, I wouldn’t condone placing any of these kind of call credit spreads for March and there’s way too much time between now and April. The market is pointing you towards credit put spreads if you want to do this trade at all.

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