Anatomy of an Options Trade on the S&P 500

by Bob Kirtley
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Submitted by SK Options Trading as part of our contributors program.

We have received a number of requests from our readers to explain in a little more detail how we make use of options trading as a vehicle to provide some leverage to our investments. As we have just completed our one hundred options trades we thought an explanation of this centurion trade would be a good example in order to demonstrate the mechanics of a real live trade.

This trade involved the S&P 500 (SPY) and was executed as follows:

Based on the view that the US stock market would rally leading into the Fed meeting we decided to buy call options on the S&P 500 ETF (SPY) with the intention of moving into and out of this trade quickly.

On the 11th of June we signaled subscribers to “… buy SPY Oct ’12 $138/$140 Vertical Call Spread for a $0.82 net debit with 5% of our capital allocated to this trade”.

On the 19th of June, eight days later we told subscribers “We hereby signal to close our SPY Oct 20 ’12 $138/$140 vertical call spread for a $1.03 net credit with 5% of our capital allocated to this trade”. This means we have banked a 25.61% profit in just eight days!

As you can see on the above chart, the S&P 500 rallied prior to the Federal Reserve FOMC meeting on the 19th.

We were aware the Fed could’ve disappointed by not announcing QE3 at the meeting and hence equities would’ve dropped.

We therefore decided to bank our profits on the 19th by closing out the position prior to the FOMC meeting.

As it turned out the Fed didn’t announce QE3 and as the chart shows equities sold off as we predicted.

If we hadn’t made the decision to close our trade prior FOMC meeting, we would be sitting on a small loss. This shows the importance of being nimble and being able to trade around significant events.

We do not operate on a buy, hold and hope basis. We are a trading operation and this flexibility has enabled us to deliver strong returns ever since inception.

The success of this SPY trade is not in isolation. This trade was our 100th closed. Out of those 100 trades, we’ve had 91 closing at a profit. Each trade (including losers) has generated an average return of 35.39% (meaning the 25.61% return on our latest trade is below our average).

Prior to signaling this trade, we communicated our thoughts on equities to subscribers in our weekly subscriber update, where we discuss the markets and offer analysis on where we think markets are headed and what our trading strategy is going forward:

“… we are seeing some bullish signals for US equities. The signal we consider to be the most important is the sub-zero bullish MACD crossover. The chart below attempts to illustrate when the crossover has occurred before over the last five years, with successful signals in blue and unsuccessful ones identified in red.

This crossover has occurred 18 times in the last five years, arguably being accurate on 14 of those occasions. This signal, combined with the fact that the S&P 500 has retraced roughly 50% of its rally since September and the possible lift equities could get from further Fed easing has now caused us to now become bullish on the US stock market.

In terms of trading this move, we will look at taking some positions this week…”

Shortly after updating subscribers on our outlook, on Monday the 11th of June we observed favorable buying conditions and signaled to our subscribers to do the following:

We hereby signal to buy the SPY Oct 20 ’12 $138/$140 vertical call spread for a $0.82 net debit with 5% of our capital allocated to this trade.

To execute this trade we are buying the $138 calls and simultaneously selling the $140 calls for a net debit for $0.82

The risk in this trade is limited to the net debit. Therefore for every option contract in the spread we have $82 at risk.

The return in this trade is limited to 143%, since this spread cannot be worth more than $2.00″

The value in our service is not limited to the profits we generate for subscribers, we also provide full updates on a weekly basis outlining our thoughts and offering market analysis and guidance on our future trading strategy.

We communicate our actions and intentions extremely clearly, spelling out in full detail what is involved when entering into each trade we place.

For the more complex option trading strategies that involve buying or selling more than one call or put at different strike prices or expiration dates we give precise instructions on how to enact each leg of the trade in order to eliminate subscriber confusion and error.

All of our trading signals contain strictly limited risk and that the full risk of any trade is always stated clearly.

Not only do we instruct subscribers on what is involved and how to place a given trade, we quote live market prices at the time of sending to further eliminate uncertainty and maximise returns for our subscribers.

We also advise on how much to allocate to each trade as a percentage of tradable capital based on our assessment of risk.

It is these fine details that differentiate our service from many others that over-complicate, confuse and frustrate their customers with poor communication and muddy instructions. On top of our crystal clear trading signals, we are more than happy to answer any questions subscribers have about our trading recommendations or other inquiries about the service.

Paramount to our success lies in the flexibility of options and the opportunities they provide. Had we of simply bought into the SPY ETF, we would have had zero leverage.

We could have bought SPY shares at $132 on the 11th of June. We could have sold those shares on the 19th of June for $134.5 for a profit of 1.9%. Instead we banked at 25.61% profit by effectively using options!

By using options we outperformed the purchase of the SPY shares 13.47 times over!

We knew when entering into our options contract that the funds at risk were only $0.82 per contract – an observable amount we could quantify before entering into the trade.

The maximum gain we could have achieved was 144%, as the spread was limited to closing at $2. This predictability is fantastic for calculating upside and downside potential and therefore, how attractive a given trade is based on one’s outlook and risk-reward preferences.

If one doesn’t have the time to regularly monitor their emails in order to place our trading recommendations or simply wants a more passive way to use this type of service, then Global Autotrading and e-Option could be useful. These two services place trading recommendations on our subscribers behalf, meaning when we signal a trade the Autotraders automatically enter into it with the precise amount of your capital allocated based on our recommendation. There are some fees involved but the Autotrader services allow for zero subscriber participation for those seeking the ultimate in trading ease. We do not receive any compensation from Autotraders, they simply provide a service to make trading easier for the subscribers who are just too busy to take action at the appropriate time. The Autotraders are completely separate and independent of SK Options Trading.

Hope this helps and please feel free to send in any questions that you may have about options trading and how you can gain leverage to some of the smallest moves in the financial markets.

Disclaimer: or makes no guarantee or warranty on the accuracy or completeness of the data provided. Nothing contained herein is intended or shall be deemed to be investment advice, implied or otherwise. This letter represents our views and replicates trades that we are making but nothing more than that. Always consult your registered adviser to assist you with your investments. We accept no liability for any loss arising from the use of the data contained on this letter. Options contain a high level or risk that may result in the loss of part or all invested capital and therefore are suitable for experienced and professional investors and traders only. Past performance is not a guide nor guarantee of future success.

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