where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
Short Selling Markets
This edition of Profit Talk we’re going to revisit a subject we touched on a few weeks ago regarding the bearish side of trading. This edition will review some of what was covered previously and I’ll share the details on how to create a scan query to help locate bearish trades.
As you’ve learned a bearish trade, often referred to as “short selling”, is a type of trade or investment that profits when the underlying asset falls in price. If trading stocks or futures the trader sells short the asset in order establish the bearish style position. The action involves selling the asset first with the intention of buying the asset back later at a lower price. The difference between the sold and bought price creates profit.
When it comes to creating a bearish position with options. This can be done by either selling Calls or buying Puts. Either of those scenarios will create a negative delta position. As you’ve learned deltas and shares are equivalent as it pertains to how the directional movement of the underlying asset affects the value of the position. In that sense shares and deltas mean the same thing. For example, an option position that is short 100 deltas or negative 100 detas is like a stock position that is short 100 shares. And, vice versa. An option position with a delta value that is positive 100 deltas will act like a stock position of 100 long shares in the same underlying in terms of how the value of the position is affected by the movement of the price of the underlying. To keep it simple, just think of share and deltas as the same thing in terms of directional exposure.
It’s true, deltas and shares are very similar when it comes to the directional exposure a position carries. However, there is a key difference between the two that must be understood. The difference is deltas are dynamic. The delta amount of a position will change based on whether the option is in the money or out of the money and to what degree. At the money options carry a delta value of approximately .50. The further in the money an option is the higher the delta value will be until reaching the maximum delta value per option which is 100. The further out of the money an option is the lower the delta value will be.
Negative deltas can be acquired when using options by either selling a Call option or buying a Put option. Both of the two different products used to create a short delta position have pros and cons. A position that employs the purchase of an option as the profit driver is considered a debit style option position. As we’ve covered previously, debit style option positions should be used when the implied volatility percentile (IVP) is on the lower end of the scale. 50% or lower IVP is best when using debit style strategies.
On the other hand, when the IVP is above 50%, a credit style position is best used. A credit style option position is one that uses a short option as the profit driver.
As mentioned, negative deltas are created by either selling a Call, which is the foundation behind a credit style bearish position or through buying a Put which is the foundation of a debit style bearish position. In the March 20th 2017 edition of Profit Talk we covered many of details involved with bearish trading, including the risks involved. In addition, we outlined the construction of a debit style bearish position called a “Bear Put Spread”. This edition of Profit Talk, we’re going to look at constructing a credit style bearish position called a “Bear Call Spread”. In addition, we’ll cover the process of creating a scan query to find bearish prospects.
Let’s quickly review the idea behind a bearish trade and then go through steps for creating a scan query for finding bear trade prospects.
Bearish Trade Prospects
Most people are very familiar with the idea behind a buy style trade or investment. The goal is to buy an asset now with hopes of selling the asset some time in the future for a higher price, pocketing the difference. To create profit the asset must be sold at a higher price than it was purchased. An investor or trader applying this strategy would be considered “bullish” on the price of that asset. That is, they believe the asset is going higher in the future. If holding a bullish position they may say they are “long the market”.
Bearish style strategies have the exact opposite outlook for the particular market. The bear trader believes the assets value is going lower. The method for profiting is also the exact opposite of a bullish trade. The bearish trader sells the asset first with hopes of buying it back later at a lower price and pocketing the difference. This type of trader is also referred to as a short seller. If holding a bearish position they may say the are “short the market”. The financial marketplace allows traders to sell an asset they don’t own. Selling an asset you don’t own is referred to as “shorting” the asset. When you do this, it means you are “short” the shares or negative the shares. In order to close out the position you must buy the shares or contracts you are short. This is often referred to as “covering” the position.
20 EMA Zone “Bear” Scan
As mentioned, the bear style trade profits when the asset is sold when the value is higher and then bought to close when the asset price is lower. This means we look for the exact opposite scenario we look for when bullish. We look to place bearish trades in markets that are downtrending. As you’ve learned, the Profit Effect style of trading is contrarian in nature. At least in terms of the near term price action. I’ve said before, I consider my style of trading to based on the idea of a short term contrarian but long term conformist. This means the trade direction is always based on the longer term trend direction, that is the long term conformist portion of the philosophy. But, entry of the position is normally carried out during a near term counter trend move. This means that if looking for a bearish trade, the best candidates are in a long term downtrend but recently experiencing near term strength. That is the contrarian part of the philosophy. In practice, this means we look to enter bullish trades when price pulls back in the context of a long term uptrend and we enter bearish trades when price rallies in the context of a big picture downtrend.
One entry set-up scan query I like to use I call the 20 EMA Zone setup. The entry rules for this setup is based on the philosophy just outlined. This is a trend style trade.
The rules for the 20 EMA zone bearish set-up are as follows:
1.Price must be below the larger “big picture” time frame’s 20 EMA
2.Price must be in a zone on the controlling time frame no higher than the 20 EMA down to ½ of a standard deviation lower than the 20 EMA
3.The entry zone must be in conjunction with a supply zone as outlined by our Trade Quality Score Sheet rules
4.Risk defense point is just above zone, no more than 1 X ATR maximum from entry
5.The first profit target is 2 X the distance between our entry point and risk defense point and our second target is 3 X that distance
The scenario looks like this on a chart. (Figure 1) The black line represents the big picture trend.
If you recall from previous lessons, the big picture time frame used to determine the trend direction and therefore the trade direction is 3 to 5 times larger in time duration than the controlling time frame chart. We typically use the daily chart as the controlling time frame. In that case, the weekly chart, which is 5 times larger than the daily chart is used to determine the trend direction.
Let’s go through the process of creating a scan query for the 20 EMA Zone bearish setup. We’ll use the daily chart as the controlling time frame and the weekly as the trend direction time frame.
Go to the scan page. Choose the universe in which to scan through by using the “Scan in” drop down menu, under category select “All Optionable”. Place the standard filters we use on every scan query which is the minimum stock price and volume. I set my minimum share price to $15 per share and the minimum volume traded to 1,000,000 shares per day. (Figure 2)
Next, add the specific filters for the Bearish 20 EMA zone scan. Remember, we are looking for markets that are downtrending on the big picture time frame. In this case that is the Weekly time frame. Create a filter for stocks that have price trading below the 20 period EMA or exponential moving average on the weekly time frame. Click “Add study filter”. Then use the drop down menu and select “custom”.
Delete the default filter. Then change aggregation to Weekly time frame. Click “add condition” The condition we are looking for is price, close to be less than or equal to the moving average exponential type. Set the period to 20. Then click save and then OK. (Figure 3)
The next step is to filter for price that is in a zone between the controlling time frame 20 ema and ½ standard deviation below the 20 ema.
We do that by adding two filters. One for price below the 20 ema and one for price trading above .6 standard deviations below the zone. The bollinger band indicator uses the 20 period average and standard deviations away from that average to derive its values. We’ll customize the setting for our use
Click on Add study filter. Delete the default. Click add condition which is price close trading less than or equal to, then choose study and select the bollinger band. We want the MidLine and set the type to exponential. The click save. (Figure 4)
Now click add condition for our second condition which is price trading above a point that is ½ standard deviation away. Click the add condition button. Choose price close is greater than or equal to bollinger band study. Then set the “Plot” line as the Lower Band. Then set the lower band to the correct deviations away from the average. The setting for that line says “nums dev dn” .
I actually set the filter to look for price within .6 standard deviations below to make the net a bit wider to catch candidates just before they enter the ½ standard deviation zone. That way I can be ready when they enter the zone. You can set the filter to .6, .65 or even .7 to alert of the potential entry. Then just put a sitting limit order at the price you wish to enter.
Once you’ve got the deviations set for the lower band, set the average type to exponential. Then click save and OK. (Figure 5)
That’s it. You’ve now got a scan to find equities that have price trading below the big picture time frame average plus are trading in a zone just below the 20 period exponential moving average on the daily chart.
Click scan and see what comes back. If too many come back as in this case, I will sort by the highest volume and take the very top of the list. And/or add a filter to eliminate those with pending earnings announcements in the nearby future.
Filter for earnings by clicking Add study filter, then use the drop down and select Corporate Actions then choose earnings. Adjust the filter to look for those that do not have earnings announcements anytime in the next 45 days or so.
Click scan. Then, save the list by dating and naming it. Then you can pull it up in a quote window. It can be found under personal lists. I always gravitate to the highest volume names. There is no advantage, but only disadvantage in trading low volume markets. Then jump over to the chart and narrow down the best candidates based on some visual chart analysis. Look for candidates where the zone lines up with a supply area formed before. Use the daily chart to set entry and exit points. Both risk defense points and profit taking points.
If need be, review previous Profit Talk issues on chart reading or directional trading. They can be found in the archives under the Directional Trading category. Quality supply and demand zones were discussed in the February 20th, 2017 edition of Profit Talk called “Directional Trading Essentials”.
Bear Call Spread
This edition of Profit Talk we’ll look at creating a bearish position using a short call spread. The Bear Call spread is a a credit style option strategy. This is a great strategy to use when you want to give yourself an opportunity to profit even if you are not 100% right on direction. The bear call spread is a directional trade but can actually profit if the underlying stock price goes down, sideways or even up a little bit. This is due to the nature of it’s construction.
The Bear Call spread is created using two Call options. One short OTM Call which is the profit driver and one long, further out of the money call as the protective wing. Full profit is made on the spread as long as the underlying stock price is below the strike price of the short OTM Call option on expiration.
The spread can profit in three different ways. It profits from the passage of time because of the looming expiration. It also profits from a drop in implied volatility. Finally, it profits when the underlying stock value price drops.
Bear Call spreads are best to use when the IVP of the underlying is 50% or higher. That is the biggest challenge facing us right now. We are currently experiencing an extremely low volatility situation in the markets. Out of our list of candidates, none has an IVP of 50% or higher. The fact is, if you wanted to place a bearish trade in that list of candidates, the current IV situation calls for a debit style bearish trade, such as the Bear Put spread which was covered in the March 20th, 2017 edition of Profit Talk. But, I want to share the Bear Call spread with you this week so we’ll have to make due. We’ll go with the prospect with the highest IVP among the group for our example trades this week that also has the best option markets when it comes to volume.
The trade example this week is a Bear Call Spread placed on the junior Gold Miner ETF symbol GDXJ.
Go to the analyze page to create the spread. Enter the symbol GDXJ to pull up the option chain. Use an expiration that is less than 60 days as is the case with all credit style strategies. Closest to 45 days is best. For this example, let’s go with the May 19th expiration which is 46 days away. The bear call spread is created by selling 1 OTM call closest to current price. This short Call is the profit driver. You also buy 1 further OTM call. This long call is the protective Call which defines the risk in the trade. The most that can be lost per share is the distance between the two strikes minus the credit received.
The goal is to create a spread that has at least 25 deltas. Move the strike prices around to create a spread value of 25 deltas or more. (Figure 6) Once you’ve created the correct spread, the lot size can be adjusted to match your risk tolerances based on your plan. Adjust the lot size (number of spreads) until the total deltas are the correct number based on your plan for the account. More on this subject can be found in the archives under the Risk Analysis category.
Go to the risk profile page to analyze the risk. Use the graph to determine the risk defense point. The risk graph can be used to determine the risk defense point of trade. If a 2 to 1 minimum reward to risk ratio is being used, as is the case for directional style trades, then ½ of the maximum profit of $132, which is $66, can be used as the maximum loss allowed on the trade. That means the point at which the loss per spread is $66 is the point the risk defense measures need to be implemented. (Figure 7)
In the case of a credit style position, the risk defense measures that should be used include, either rolling the trade to a further out expiration for more credit once the risk defense point is breached. Or, closing the trade.
Profit on this type of spread can be taken once 50% of the maximum profit is achieved.
The top takeaways this week are:
First, bearish trades profit when the asset value falls, giving traders opportunity for profit during down phases of the market
Second, Downtrending markets offer the best situation for finding trade prospects. When placing bearish trades focus on weak markets
Third, the Bear Call Spread is a great strategy to use when bearish. It provides profit when price goes down, sideways and even up a little. Use credit style strategies to avoid the trap of pure directional trading.
This past week started out with some weakness but this resilient market turned things around mid. Week and made back some of the ground lost during this recent weakness. The Dow Jones and the S&P 500 have broken the short term trend while the Nasdaq has remained the strongest of the leaders. That market has fought it’s way all the way back to new all time highs.
So, we’ve got a mixed market on our hands at this point.
Today, Monday April 4th the broad markets are experiencing some weakness. The Nasdaq as represented by the ETF ticker symbol QQQ is currently trading into the trend trade buy zone as outlined by the 20 EMA.
The high impact reports due out this week include:
The ISM Manufacturing Purchasing Managers Index numbers were released at 10:00 am eastern this morning. They came in exactly as expected.
Wednesday 4/5/17 - ADP Non-Farm Employment change release is at 8:15 am and the ISM Non-Manufacturing Purchasing Managers Index comes out at 10:00 am. Plus, the Crude Oil Inventories at 10:30 am and the Fed minutes being released at 2:00 pm eastern
Thursday 4/6/17 - Unemployment claim numbers will be released at 8:30 am
Friday 4/7/17- Average Hourly Earnings, Non-Farm Employment change and the Unemployment Rate being released at 8:30 am eastern
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at email@example.com.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.