One of the great things about options trading is that you can make a directional bet, be wrong, and still make excellent money on a trade. As many of my closest relatives are fond to point out how wrong I am on so many life issues, it is a comfort to know that there is a way to trade options where being wrong is not necessarily a liability.
Yesterday I received an interesting email from one of my mentoring students reacting to one of our training videos. The video is on the subject of directional options spreads. The premise of the training session was that the trader had a directional bias on a particular stock and was going to use that directional bias to construct a directional credit spread.
So for example, if you sell a put credit spread, you are betting that the stock will go either up, sideways, or even down slightly, to make the maximum profit on the position.
Most people who are not familiar with options trading will probably think that the last sentence has a typo in it, but fortunately they would be incorrect about that. Credit spreads are flexible enough that the only outcome that really gives the competent options trader a challenges is where the directional prediction was way wrong. While we teach techniques for rectifying even these situations, an extreme enough adverse move will most likely create a loss for the directional options trader, for that particular trade.
So my mentoring student’s question was simple: What are some good methods for determining a 30-60 day directional bias in the first place? There are probably thousands of answers to that simple question, and in fact our training program does not advocate any particular technique. Rather, we discuss how to structure trades around the technical bias that the trader brings to the table.
For example, I know of directional credit spread traders who will enter a put credit spread whose short is one standard deviation from the current market price if a stock makes a new 20-day high (in the case of a put credit spread). The interesting thing is that these traders don’t necessarily believe that the stock will rally particularly strongly from that point. Rather, they think that the stock is not likely to have a particularly strong sell-off from that price. In other words, they think that this criterion is a directional indicator that is not likely to be too wrong over a 30-day period into the future. It’s a subtle distinction, but an important one.
What are your favorite directional indicators? More precisely, what do you think are the technical indicators that are likely not to be too wrong over a 30-day time frame?
Seth Freudberg
Director, SMB Options Training Program
The SMB Options Training Program is a program designed for novice and intermediate level options traders who are seeking an intensive training process to learn how to trade options spreads for monthly income. For more information on this program contact Seth Freudberg: [email protected].
4 Comments on “Directional Indicators That are Not TOO Wrong”
Seth,
This is a great article. I have been trading credit spreads for many years with precisely the mindset that you describe in your post. You CAN be quite wrong about direction, it really depends on WHEN you are wrong and the SPEED at which the market travels when you are wrong. The spreads can be set up in a LOT of different ways depending on your opinion. If you have a volatility view as well as a directional view you can set them up 45 to 70 days from expiration. If your view is purely directional or you have an opinion about where the market WON’t go, you can set them up as pure theta trades. It’s a pretty versatile spread. I like it because it contains elements of both directional and income trading and you can skew the trade to contain more of one element than the other. The spread has dramatic risk curves and dramatic risk/return so I’m interested to see future postings on how SMB deals with the risk.
Hi Seth,
Determining direction can vary depending on time frame. Basically, I look at 5 year, 1yr and 60 day charts and then mark the trends on varying time frames as well as support and resistance areas to determine where the stock is in its cycle relevant to the time frame I am trading.
When I do that, as well as look at where the general market cycles on the indexes are and how the stock follows those indexes, I find that I can very accurately determine the direction the stock will go.
Hi Seth,
I’ve found that there are a couple of things to be wary of when trading option credit spreads. The first would be, to try and avoid stocks with upcoming earnings reports before expiration date, as these can cause unpredictable volatility and are probably better suited to straddle strategies rather than credit spreads.
As far as the directional indicators are concerned, I’m a firm believer in trading with the trend. To me, once a trend is confirmed by two higher troughs or lower peaks (as the case may be), it’s more of a question of looking out for reversal indicators. Until then, as you point out, a credit spread will give you at least an 80 percent chance of profiting – and if you want to increase your risk to reward even further, then do a credit spread facing both ways with a range in between – calls to the upside and puts to the downside, otherwise known as an iron condor. Adjusting iron condors is a bit of an art, but if you get the hang of it, these can be like credit spreads on steroids.
The Average Directional Index is an indicator that measures the strength of a trend. It helps identify trends. The average directional index that is used to measure the presence of an uptrend.
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