The Great Strategy of Legging Out!

I have been trading options for about 3 years now, starting in the late Summer of 2012. I have made a ton of mistakes, missteps, and bad decisions over that time frame. Most traders when they are novices will scour far and wide to find the "best methodology/strategy." Well, I can tell you, I think I'm on to something here.

The concept of legging out of a spread is great. When you use a spread, you limit your risk and keep the capital requirement small. This way if the stock goes against you, you can get out without taking much of a hit.

But, if the stock does go your way, all you have to do is take off that profit capping short side of the spread. This allows you to pick up "pure Delta/Gamma" as the stock moves, because you don't have negative Deltas from the short side offsetting the positive Deltas from the long side.

Ordinarily, on a dollar wide spread, say 45/46p for 0.50, the most you can make is $50. But once the stock declines past 45, you can buy back that 45p for a loss and ride the move lower on just the naked long put. This allows you to capture much more profit than was originally available in the spread, and you took on very little risk to put the trade on.

Legging out can be an immensely profitable strategy while utilizing little capital.

Today, TLT filled the gap and hit my profit target. I legged out soon after the open after it opened below 125.50, meaning I bought back the 128p for 4.10 after originally selling it for 2.00. So, I lost $440 on the short side. Then, TLT proceeded to fill the gap, and I sold the 129p for 5.76, buying it originally for 2.50. That's a profit of $1304.

So take the losses from the short side (-$440) and the profit from the long side ($1304) and BOOM
Total profit of $864 on an original $200 max risk spread! A 332% return on capital!

So without legging out, I could have sold the spread for around 0.77 for a modest $108 and 54% return. Still not bad and very acceptable for the risk taken. By why settle for that?

Update on Current Positions and the Twitter Earnings Debacle: A Lesson in Tail Risk

Current Positions:

• +75 USO shares @ 19.00, now 20.11 = +$83.25
• +4 TLT JUN 128/129p @ 0.50, now 0.75 +$100

Back on the 15th I bought some USO shares when it got above 19, which at the time was a short strike in an iron condor I had. I was expecting that it would run up to 20 and might break out, but it was going to be a tough fight and I didn't know how long it might take to get above 20. It's been two weeks, so I wasn't wrong.

Instead of buying a call spread, which could have worked easily, I went with shares because of USO's tight range and the Delta/Gamma of a spread. If USO breaks out of its current 19-20 range, it will move swiftly higher or lower, but as mentioned, it could take some time. If I bought options too far out, the move wouldn't produce enough of a Delta/Gamma move, and too far in, you have the Theta decay, and it could move swiftly downward. I saw this as a prime example of when to use shares over options... low risk, medium reward. Plenty of time to get out for a scratch yet enough time to ride it higher.

What does USO look like now? Well, we got a close above 20, but it still doesn't look like it's gotten above that line in the sand...

If USO can break out of that zone, then I think it will quickly run to the next point of resistance, stopping just above 21 or 22. Upon a break out, I will double up and ride to those red lines.

On the 22, TLT broke down below some short term support, then fought to get back above it, and now today it gapped down pretty hard. What's annoying is that I wasn't able to leg out of my spread at the level I wanted to, because it was passed by the gap down! Who complains when they get short that the thing went down too far?? Either way, I will now leg out if we get a move that hold below the blue line, then look to take profits at either the 1st red or 2nd red line, depending on the "velocity" of the move, ya dig?

The biggest reason I didn't leg out today, however, was because the entirety of today's move was outside of the bollinger bands. Therefore, a snap back up is likely tomorrow, although I think it is likely that we will at least see the 1st red line before too long.

Now, on to Twitter. TWTR was scheduled to release earnings yesterday after the close. However, some company got a leak of the numbers and ironically tweeted them out at 3pm. The stock tanked and trading was halted for around 45 minutes before resuming, tanking even further. Today, it was also down more than 9%.

Often times I will sell what I call a 2SD strangle on earnings announcement days, meaning that my short strikes are 2 standard deviations away from the current price. Well, I was too busy studying for finals to bother with TWTR, although I did want to put on a strangle.

An earnings leak is an extremely rare occurrence, probably 3 or 4 standard deviations out on the probability curve! I would have been HAMMERED. This was a real wake up! Just because there's only about a ~5% chance of losing a bunch of money.... it's still there!

Why is Spoofing Illegal, Again?

In the news today, the CFTC and SEC have allegedly caught the person solely responsible for causing the flash crash of 2010:




Apparently, some random guy in his house caused the flash crash. As highlighted in this article, the chances of that being true are probably slim; he may have had something to do with a coalescence of other factors. But, he caused it apparently by what is known as "spoofing."

Spoofing is when you input a bunch of large block sell orders above the current market price so that they are not filled. Then, trading algorithms and robots pick up that information and decide to sell in anticipation of those orders crossing the tape and causing the price to drop. But, the large block orders are cancelled before they can be filled. The price drops, and the spoofer buys the asset at a lower price before it goes back to pretty much where it was.

Sometimes, spoofing is done by other robots. Cool, algo-wars. The great thing though is that a lot of the time it is done just be shear speed of pressing hot keys. Imagine, a human being can actually outsmart a (potentially) multi-billion dollar algorithmic trading robot army and make a profit.

In my opinion, more power to them. For some reason, it is legal to outsmart human beings with advanced technology, but to outsmart computers with... old technology? That's something!

Instead of questioning the practice of spoofing, we should probably question the stability of a bunch of computers zipping orders around based on extensive codes. Humans don't fall for spoofing!

If one guy in a basement in London can crash the entire U.S. stock market, the system is not stable.
We need a re-emergence of human traders, even if they are "less efficient." That system worked (pretty much) fine for decades. Besides, the over-automation of everything can end badly...

Let Me Clarify Something on Rates...

If there are any readers of this blog - highly unlikely - than you know that I do not think the Fed will "raise rates" in 2015.

What I mean by "rates" is the Federal Funds Target Rate, currently at ~0%.
I believe that the Fed is trying to persuade markets to act as if a rate hike was coming rather than actually raising the rate itself. I don't think the economy can afford higher rates, and I don't think the Fed has the balls to raise them in the face of worsening economic data.

What I mean by a rate hike: The Fed, in 2015, will NOT raise rates beyond a "ceremonial" 25, 50, or 75bps at anytime in the near future. The Fed may in fact raise the Federal Funds Rate to 0.25%, 0.5%, or 0.75% in the next year, but nothing beyond that.

What's the difference between 0 and 0.25? A rounding error. This "hike" is therefore ceremonial; its an attempt to show the markets that the Fed has credibility. The Fed knows full well that anything much higher than 75bps will break down the system; they aren't stupid.

TLT Thriller Brings Home the Bacon

I have a rough time when trading TLT options. The setups always look good, the prices are too. So I jump in, and TLT goes where I want it briefly. Then it turns on a dime after giving me a taste and pounds against me until I get out for a loss.

This time, I sold some puts just underneath some strong support at 129.50, the 4/17 127/129p spread for 0.53. TLT has been hanging out right around that support point for about a week, and since the options I'm in expire this Friday, sudden movements cause wild swings in option prices.

Today TLT jumped up 1.35% and the option values tanked 75%. My spread was valued at 0.37 as of yesterday's close and today I closed it at 0.10 for a 75% gain.

Thank you TLT!





In other news, USO is also hanging out just underneath 19, where the call side of my 5/1 iron condor is. Volatility is dropping in USO and time is passing, which is offsetting its slow rise towards 19. Hopefully USO dips a little before the end of the week and then I can hop put of this position alive.

**I have decided to get out of USO at a scratch. If she breaks above that resistance, she's screaming higher. With only weeks to expiration, better take what I can get and move over. I will instead get ready to trade a breakout. A scratch is acceptable because the PoP was only 52% to begin with.
Out @ 0.38 +$20.

Relative Success with TLT (knock on wood) and USO trade

My TLT vertical is up a decently, initial credit was 0.53 and now its at 0.35, so not bad. Today's big up move may continue into the end of the week and IV may drop as well, both good for my position.

I also traded an iron condor in USO, an oil company. It's up better than 4% today and it's IV has remained elevated due to the fluctuations in crude oil. I'm getting a little bit closer to the market than I normally would, but the credit for further OTM options just doesn't justify the risk.

I'm taking a little less risk with the USO trade than with TLT because it has a much lower PoP. TLT had a 71% at inception, and the USO position, a May 1st 15/16/19/20 iron condor has a 52% PoP.

Why so close to the market? USO has resistance at 19ish and support at 16ish, so it's likely to turn around once it gets close to those strikes.

I've sold 10 of them, risking a max $600 and gaining a max of $400. (cr = 0.40)