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It never ceases to amaze me how many sophisticated investors dismiss the power of technical analysis.

Scores of economists and institutional investors, usually the more academic types, still believe that markets move in random patterns and do not follow trends.

This belief was actually introduced to the world in 1973, when Burton Gordon Malkiel, a Princeton University economist, released his book “Random Walk Down Wall Street.”

Using the S&P 500 and a very popular moving average, today I am going to show you the latest in a long line of examples that prove how silly this assertion is. In addition, I’ll walk you through a high probability options trade that can now be used to take advantage of the recent shift in the S&P 500’s long-term trend.

What Is the Random Walk Theory?

According to Investopedia, “Random walk theory suggests that changes in stock prices have the same distribution and are independent of each other. Therefore, it assumes the past movement or trend of a stock price or market cannot be used to predict its future movement. In short, random walk theory proclaims that stocks take a random and unpredictable path that makes all methods of predicting stock prices futile in the long run.”

Just by looking at this first chart of the S&P 500 ETF (SPY), it’s clear as day how ridiculous this line of thinking is.

Figure 1

Of course, I am not suggesting that we as market participants can predict the future.

What we can do, however, is use the proper tools to speculate on the future direction of a stock price, establish a position based on this assumption, then stay with the trend until our trading rules tell us to exit the trade.

Trend following strategies are the most commonly used strategies, and they have been hugely successful in recent decades.

Now that SPY’s adherence to the hugely popular 50-day moving average has faded to where the index is now using this smoothing line as resistance, I’m going to continue to carry a lighter book than I normally would while I hunt and search for trading opportunities that I like.

If I wanted to employ an options strategy to take advantage of SPY’s recent weak range, my go-to strategy would be a “bear call vertical credit spread.”

Why would this be my first choice rather than simply buying put options to bet on further weakness?

First and foremost, right now I do not have any indication that the market is about to fall hard from here, which is what we would need to happen in order for puts to have the best chance of gaining in value.

Instead, I just want to sit back and take advantage of the passage of time, through a phenomenon known as “decay.”

Trading Lesson: Time Decay

Time Decay is a great tool for option traders, especially option sellers!

Time decay is a measure of the rate of decline in the value of an options contract due to the passage of time. Time decay accelerates as an option’s time to expiration draws closer since there’s less time to realize a profit from the trade.

3 Key Aspects To Time Decay:

Time decay is the rate of change in value to an option’s price as it nears expiration.

Depending on whether an option is in-the-money (ITM), time decay accelerates in the last month before expiration.

The more time left until expiry, the slower the time decay while the closer to expiry, the more time decay increases.

How Time Decay Works:

Time decay is the reduction in the value of an option as the time to the expiration date approaches. An option’s time value is how much time plays into the value—or the premium—for the option. The time value declines or time decay accelerates as the expiration date gets closer because there’s less time for an investor to earn a profit from the option.

Figure 2 shows a chart of Time Decay :

Figure 2

You see, the closer you get to expiration the faster the option value races towards 0% value!

Vertical spreads are easy to apply and offer favorable success probabilities

When it comes to learning multi-leg options strategies, vertical credit spreads are among the easiest and are therefore a great place to start.

Why are they relatively easy to comprehend?

Because they include either selling one put and buying one put (bull put spread) or selling one call and buying one call (bear call spread), and only include options of the same expiration month.

The maximum gain that can be earned from a credit spread is the net credit, realized when both options expire out of the money.

The maximum loss potential is the difference in strike prices – net credit. Realized when both options expire in the money.

In the case of SPY, the trade setup would be as follows:

Identify the trading bias (we’ve identified a bearish setup).

Identify where the stop-out level is (let’s call this the anchor point).

Identify the strike levels that will allow you to enter the trade with what would ideally be no worse than a risking 4 to make 1 setup. There is some leeway here, but generally, you should try not to risk more than 4 to make 1.

Figure 3 explains what this trade would look like.

Figure 3

Let’s break each bullet down a bit further.

For bullet 1, the highest probability trades usually occur when a trader is trading with the trend, not against it.

In this case, we’re using the newly lower slope of the 50-day moving average as our indication that the intermediate-term trend is now lower.

For bullet 2, we’ve identified that the 10/07 pivot high is the level that must hold as resistance if the newly bearish intermediate-term trend characteristics are going to remain in effect.

Therefore, the 10/07 pivot high of $441.68 is the ideal stop level (i.e., the anchor point).

When it comes to bullet 3, this is where we must start exercising patience.

I’m constantly preaching how important it is not to chase trades and to let the trade come to you.

When it comes to this SPY trade scenario, the trader’s ideal spread entry would be for him or her to be able to sell a call option that anchors as close to the $441.68 pivot high as possible and buy a call option with a strike that is roughly $5 above that area.

Conclusion

The unsung hero of a successful trading plan is risk management. In this scenario, deciding to implement a trade that benefits from the passage of time (vertical credit spread) and anchors near a technical level that defines the downtrend (the most recent pivot high) increases the probability of success and establishes an absolute stop out area.

Author:
Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

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