I’m bullish and here’s my game plan

Editor’s note: Today, we are pleased to be joined by 14-year options strategist Charles Sachs. In his column, Charles shares his views on how to best take advantage of opportunities in the markets using options.

My name is Charles Sachs and I have utilized options on the S&P 100 index (also known as “OEX”
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and “XEO”
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options) for the past 14 years, both as a trader and an advisor.

I am pleased to be launching my new column here at TradingMarkets and look forward to sharing my insights about current conditions in financial markets, and discussing the profitable use of options. Before I get into today’s analysis, let me tell you about my approach.

I specialize in structuring options strategies that have a mathematical advantage to profit. The reason these trades have an advantage to succeed is as follows:

Financial markets can do one of three things; rise, decline or sit still. An options position structured properly will enable the investor to profit under all three scenarios.

Most option purchases will profit only when financial markets are either rising or declining. For example, if you purchase a call option on a stock, the option will lose money if the stock price goes down or sits still, and in fact can even lose money if the stock price rises marginally. Therefore, the purchaser of the call option has at best a one in three chance in profiting. It is this statistical disadvantage that explains why upwards of 90% of all purchasers of options lose money.

My Strategy

The strategy I utilize is options spreads which use the time depreciation aspect of the options to my advantage. Without going into great detail, this strategy allows the holder of the options to have significant slack to generate profits regardless of the direction in which the security underlying the option moves.

On one recent trade in which I was bullish, I structured a call spread on the S&P 100 index. The spread was formulated so the S&P 100 index could have gone up, sat still, or traded down by as much as 20 points and the recommendation still would have achieved maximum profits. For a point of reference, a 20-point decline on the S&P 100 is approximately equal to a 400-point decline on the Dow Jones Industrial index. In other words, the trade achieved maximum profits whether the Dow went up, sat still or declined by as much as 400 points.

Structuring options trades, however, is just one part of the equation. The timing for the execution of entering and exiting trades must also be undertaken with precision, and is often undertaken counter to an existing trend. Executing a trade recommendation opportunistically not only means entering the trade at a “bargain price,” but also means undertaking trades when there is maximum liquidity on the trading floor to get the trade executed expeditiously.

My 14 years of experience in trading options on the S&P 100 index, and my background in finance and statistics have assisted me in formulating 24 proprietary indicators that I consult continuously during the trading day. I will not undertake any trade recommendation unless all of my indicators are supporting the same strategy. The proprietary indicators that I utilize incorporate reversion to the mean, volatility, futures action, price patterns, volume patterns, and numerous technical indicators that are not followed by the general public. I combine the use of these indicators with my extensive knowledge about trading options and options pricing to formulate the trade recommendations.

By having strict guidelines and a clear trading plan, I seek to greatly reduce risk. I will only recommend using capital when financial markets are acting predictably, and will only undertake a trade recommendation when it can be structured with a statistical advantage to profit and can be executed opportunistically. Capital preservation is the most important aspect of wealth building, which means knowing when to be out of financial markets should be a conscious decision, just like the decisions to be short or long financial markets.

Today’s Market:

Financial markets declined moderately on Tuesday with the XEO (S&P 100) index trading down 1.7 points to the 561.60 level.

The short-term market trend is up, and the intermediate-term market trend is up.

The daily chart below of the S&P 100 index shows the index had recently been in a trading range between the 543 and 555 levels. The index is now in a rising channel meaning financial markets are likely to rise in price going forward, and we would expect buying interest at the bottom of the channel and selling interest at the top of the channel.

Financial markets had been overbought and have been working off that overbought condition by trading sideways for the past 4 trading days. The XEO index during this period has been trading in a range between the 559 and 564 levels. As evidenced by the red line on the chart, support on the XEO index is first at the 559 level, and then at the 555 level, which was the top of the prior trading range.

Financial markets typically decline when they become technically overbought. Alternatively they can offset their overbought condition by trading sideways, which is what is happening presently. Ultimately, since financial markets are mathematically based, they will return to the norm. Our strategy for now is to await the next short-term decline phase. Option traders should seek to initiate positions with an upward bias on a pullback to the support areas mentioned above.

If you understand spreads, then you will know that it is possible to use the time depreciation aspect of the options after such a decline phase to structure a trade.

Sincerely, Charles Sachs Chief Options Strategist

Charles Sachs has utilized S&P 100 for the past 14 years, both as a trader and an advisor. He uses 24 proprietary indicators in order structure options strategies which can generate gains whether the market moves up, down or sideways. Charles is a graduate of Wharton Business School. For a free trial to Charles Sachs’ Options Alerts click here or call 888 484-8220 ext. 1.