May's NDX Trade

by Jay Pestrichelli on May 9th, 2012

May’s NDX Trade

For those of you that subscribe to the Out-of-the-Money (OTM) credit spread strategy, its been quite an interesting 2 months. If this doesn’t make any sense see the feature article we published in SFO Magazine’s March issue. This is a strategy we use to generate monthly income based on option time value and probabilities.

First there was the April (2500/2450 APR bull put spread) trade that paid off if you were in at the beginning of the options period, but anyone that entered after the first week had to exit (at a loss) after the index topped out at 2795. Subsequently those that exited went bearish to finish out the month and recouped some of those losses. Since that high on 4/3, the NDX is down about 6% to yesterdays close of 2629.

The May NDX trade was once again a bullish put spread at the 2475/2425 strikes. This trade opened after the volatility of Apple’s earnings were out and improved its probability from 95.5% chance of success on April 25th to 99.5% chance at May 1st. Things were looking good. However since that time, the market has sold off in volatile way…too factors that work against the trade.

As a reminder, the exit price is when the spread doubles from its original credit. In this case that means the spread that was written at $1.75 doubles to $3.50. The position takes a $1.75 loss and is flipped to the bearish call side to alleviate some of the losses.

Well that exit price was almost met yesterday, May 8th, while the market was at its lows and the NDX was down nearly 50 points to 2588. As a matter of procedure, the exit trade is not executed until the end of the day, so the market did get some time to recover and bounce back. Hence the position was not exited and by the end of the day the spread was back to $1.75 by the close.

It looks again like the markets may have a choppy open Wednesday morning, so we’ll be watching again for the exit point. However, with only 8 more opens to go before the actual end of month NDX price is marked there is still over 150 NDX points to go before the trade losses money. There are also 3 minor support levels along the way the market will need to break down through as well to get to the 2475 level that we need to be above.

The chart below outlines the 2 support levels in red, the potential price that would trigger an exit in blue and the actual level the index needs to stay above before it will lose money at expiration in orange. In addition the trade still has a 95.5% chance of success as of yesterday’s close.

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