June HPCS Trade: Directional Decision

by Jay Pestrichelli on May 22nd, 2013

Each month we post information about the high probability credit spread strategy we employ in some of our client accounts. Known as the HPCS on this blog, we sell out-of-the-money vertical spreads to generate small amounts of income that have a high probability for success. To get familiar with our previous posts, here are links to the last four.
 
May HPCS Post
April HPCS Post
March HPCS Post
February HPCS Post
 
*Risk reminder: As we always do, we want investors to know that what you put into a fully allocated spread like this is at risk. That means in the unlikely event that the market moves to the point that both your strikes are in-the-money at expiration, the position losses 100%.  So despite how well this strategy has worked for us over the last 30 months, don’t put any money into it that you can’t risk.
 
One of the pieces of this tactic is that we are always assessing the directional bias of the market. After all, we don’t need to be right about the direction of the market for this to work…we just can’t be REALLY wrong. That means we look to build our position on the side of the market that has the higher probability of success. That means looking at the Bull trade and comparing it to the Bear trade and finding the best return to risk ratio.
 
This seems especially relevant now as we are seeing new highs almost every day. On a high level, our method looks at 3 different factors: Distance OTM (out-of-the-money), Probability risk, and the trade’s return. We look at these factors to help us decide the more advantageous side of the market to place our vertical credit spread. Bullish trades are executed by selling a put spread below the market and Bearish trades are implemented by selling a call spread above the market.  
 
Below is the data we calculated before today’s open using the SPX (S&P 500) as our base index, to help us understand which way our bias will lean on the position we plan to put on in the next few days.
All 3 comparisons tell us that the position with the better chance of success is still the Bullish trade.
 
However, we’ll add an observation here as we watch both sides of the trade throughout the options period. The Bear side of the trade actually has some value and has begun to close the gap on most of these metrics against the Bullish put trade. This may tell us that the options market is beginning to look for an end to the recent rally and the bear trade may actually be the way to go in the near future.
 
Given the choice, we would always lean toward the bear trade. We do this because the risk of a major gap up out of the blue is notably lower than the risk of a catastrophe sell off overnight.  We’re not there just yet, but if you use this method before entering the a new trade use this as a gauge as to where the speculative money is being placed.


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