A Few Random Thoughts
Before I get to the nitty-gritty I want to discuss a few random thoughts.
It's been twelve days of range-bound trading for the S&P 500 (SPY). The benchmark ETF has been stuck between $140 and $142.50, but the journey through limbo land could be over soon enough.
The march into a short-term overbought today could be the last gasp for the bulls. The bears have been salivating waiting for the opportunity to push this market and the pot odds say its a go. The move since November 16th has finally extended itself so the odds are heavily weighted towards the bearish side.
If you had employed a few out-of-the-money bear call spreads over the past few weeks you should be in very good shape right now. A high-probability spread would have created a large margin for error just in case the bulls manage one push higher, but any advance over the next few days should be short-lived.
The Dow (NYSEARCA:DIA) and Russell 2000 (NYSEARCA:IWM) are officially in a short-term very overbought state with 9 other of the highly-liquid ETFs I follow. The S&P has also joined the ranks of overbought which leaves only the tech-heavy Nasdaq 100 (NASDAQ:QQQ) in a short-term neutral state.
Gangnam Style - South Korean Index Fund (NYSEARCA:EWY)
The market is offering a few wonderful high-probability set-ups at the moment. As I said before the quite a few of the highly-liquid ETFs I follow for my high-probability strategies are in a short-term overbought state and hitting strong overhead resistance. This often spells trouble for the bulls going forward.
While bear call spreads in any of the very overbought ETFs are a decent pay at the moment one of my favorites is in the South Korean Index Fund . The current overbought reading over various time frames is off the charts. Since the ETF took off in mid-November, EWY has managed to gain roughly 9.0%, which is why we are seeing the extreme short-term very overbought reading in the South Korean index.
Here is a good example of what I look for in a high-probability trade for my options strategies.
First, I have to decide how much risk I want to take.
By using a bear call spread I can define my risk by choosing my probability of success. In this case, I prefer 80+%, although others might choose a lower probability to bring in a bit more premium.
But I am okay with going out 38 days and selling the 64/66 vertical call spread for approximately $0.23 for a 13.0% gain. The probability of success is 80% and my margin for error on the trade about 5%. Not bad, given the index has already gained 9.0% in just 15 days.
Some might say the risk associated with the trade is too high…well, that is the nature of a high-probability trade. I can tell you firsthand that most of the skeptics have never traded high-probability credit spreads, so most don't understand the ins and outs of the trade. One being that to take a max loss the underlying would actually have to move through the 66 strike. The likelihood of that happening - 7.5%. Moreover, the move would have to be swift for me to take a max loss, because I can always adjust. Although, if I keep my position-size small I allow the probabilities work themselves out without making rash decisions.
While the probabilities are high, nothing is full-proof. For instance, how many times would you bet on the 15th seed beating the 2nd seed in the NCAA tourney. It only happens once every 15 to 20 times, so you are not going to make much money speculating on the higher seed. Same goes for the high-probability trade. Remember, we are basically selling the speculator the ability to bet on the 15th seed, knowing that he will occasionally win, but also knowing that more often than not we are going to come away the winner.
Slow and steady, that's the name of the game. No heroes here.
Disclosure: I am long SPY, IWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.