An article I wrote on December 3, 2008 titled "Single-Click Stock Pair Trading at Its Finest" has generated a lot of interest from our customers. So in the TOS tradition, let's ramp it up and utilize Theta decay and High Probability trading to the Stock Pair Trading strategy. As you might realize, stocks have the most risk as they respond most directly to the pair change. If the spread moves your way, the stock positions move point for point with the spread. But if you're wrong on the direction of the pair spread, then you'll lose point for point with the spread. We could use a single option; that is, you could buy an SPY call and buy the IWM put. But the problem with single options is that you're battling time decay and potential drops in implied volatility. ***Editors note; presently the volatility index, VIX, has traded below the 50+ level for the first time since its spike to 80+ in October, which I am told by many charting experts would signal an implied volatility move to the more historical volatility level of 30+.

1. Verticals are the High Probability way to trade using the pair trading strategy. The advantage of verticals is that in the right circumstances, you can find long and short verticals in the two stocks or indices that will generate a small credit, and that credit can turn an otherwise scratch trade (no profit or loss) into a small winner if the spread of the pair does not move the way you want it to.

2. You also could consider using both slightly OTM (out of the money) short verticals to form the "Iron Condor" pair position if that will make the most of the way you think the spread will move. I find myself using this most with pair trading! For our example sell the SPY OTM put vertical (bullish) and sell the IWM OTM call spread (bearish) creating a high-probability, Theta-positive position- Ah, my favorite!

In this example we presently we have an approximately 70% probability of success in the stand alone trades with a combined risk of 2.90$ and a combined reward of 1.10$ with an impressive combined 1.17$ of positive Theta decay. Nice!

thinkorswim, Inc. and its employee, Tony Battista, do not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.

Crack open that protein shake, start pumping that iron- here is the strategy that takes your Iron Condors to the next level. It is called the Double Diagonal and it is like an Iron Condor but has two distinct differences. These differences, when certain market conditions exist, can crank up your delta-neutral trading in a big way. To understand these differences let's take a look at the makeup of an Iron Condor.

Below you will see that an Iron Condor utilizes the same expiration months for the options you are buying and selling. It is a delta-neutral strategy whereby all you need the SPY to do is trade between your short strikes of 97 and 82. Its Greek makeup is delta neutral, theta positive and vega negative. So if your price is in a trading range and volatility is falling, an Iron Condor is what you want.

However, we know that the VIX doesn't fall all the time, it can rise as easily as it falls. So what do you do if the volatility is low, you want a delta-neutral trade and some good old fashion time decay? You crank up the condor by selling a front month option and buying a back month option. This is known as the Double Diagonal. You still need the underlying to trade in the same range as the iron condor, between 97 and 82.

So what does a Double Diagonal give you that an Iron Condor doesn't? A Double Diagonal has a calendar component that allows you the opportunity to roll. Because you're buying the back month option your time decay in the front month will be that much greater. The roll also allows you to pick up credits along the way. The back month option also creates a vega-positive position. As mentioned above when the VIX is low, you should look to be vega positive. This will add the extra kick you'll need to the position.

In summary, more time decay, positive exposure to volatility and credits along the way. When the market says to "pump up" your positions, do it.

Successful Trading!

thinkorswim, Inc. does not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.

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I have noticed that a growing number of people outside the world of Commodity Trading are gaining a familiarity with the terms used to describe the prices of Commodities Futures. I hear the term Contango all over the media now and I thought it was reserved just for us trading geeks. Contango refers to a condition where the futures are pricing that particular commodity or instrument at a higher price as time goes on. In many commodities, there are futures for any number of months or years going forward. The subsequent futures reflect the expectation for that commodity going forward.

The commodity responsible for bringing the attention to our world is Oil. The futures 1 to 3 months out are trading at a radically higher price than the current price of oil. It was close to 13 % higher at the time of this writing. That is dramatic and it is causing many speculators to scramble to secure barges or storage facilities to hoard oil and park it offshore until the price rebounds as they are anticipating. They reason that if the futures are accurately predicting the distant price of oil, the storage costs will be just a drop in the barrel of the profit they will garnish. Many players who don't know a tanker from a dinghy are looking to get in the game.

What does that mean for the trader who does not want to install a storage unit in their yard or secure a tanker and park it offshore? The spreads we are seeing are unprecedented. We can look at this a couple of different ways. I believe something is out of whack with respect to oil prices. Either the future prices will stay at the current levels or they will pop back to the levels the futures contracts are indicating in the next couple of months. It is my opinion that last year when oil was approaching $150.00 a barrel it was completely overdone to the upside and we are currently seeing the same thing on the downside. I realize demand is vanishing but they are still fundamental needs for petroleum which must be met. Regardless of whether you are taking fewer trips to the movies or using public transportation to get to work, you still need to heat your home. Recession or not, nobody is going to willingly turn themselves into a Popsicle to save a few bucks. And knowing what I do about futures traders, as soon as their little ears start to freeze running to the exchanges they will think twice about shorting oil.

Well that's all fine and dandy, but how can we play this without leasing a $30,000? NYMEX seat and trading oil futures? We can play it a couple of ways, I prefer to use the USO, which is an ETF that tracks the price of oil and is fairly liquid and has options as well. I like to sell puts 1-3% below the current trading price as a way to get the stock (and thereby the commodity) at a discount. I am not bright enough to pick the absolute bottom so I trickle trades in as it goes lower and bring my average purchase price down. As it turns back upward, the puts I have sold and not received stock also help bring my average price down nicely. I started this a couple of weeks ago and was unexpectedly rewarded by the turmoil in the Gaza Strip as oil prices popped a bit, but they are now coming back down so I like the levels and the trade again. I consider it a hedge for my heating bill and constant shuttling of my kids to practices, games, and so on...

Good Luck and Happy Trading!!

thinkorswim, Inc. and its registered employee, Steve Quirk, do not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.

We know death and taxes are the only sure things, right? Now you can add implied volatility spikes during earnings season to that list. Option prices traditionally increase as the earnings date approaches with more and more uncertainty arising about the data. More often than not, implied volatility in the front month options trades considerably higher than that of the next corresponding expiration months. Many option traders employ spreading strategies that look to take advantage of this difference amongst expiration months. Some of these strategies include: calendars, diagonals, and straddle/strangle swaps. Each of these strategies incorporate time spreads for short gamma trades that make their money through time decay. These strategies also provide the opportunity for more time decay collection over multiple expiration months if rolls are implemented. I tend to implement these time spreads during earnings plays when I don't have a directional bias on the stock and I assume that the stock will remain range-bound.

What happens when you do have a directional bias on the stock going into earnings? Should you just buy a call or buy the stock, or a combination of the two? Remember, you are trying to take advantage of the fact that the increase in implied volatility provides excellent opportunities for increased time decay collection. If you are currently slightly bullish on any stock heading into its earnings date, you could consider call ratio spreads as a possible trade. If slightly bearish, then put ratio spreads might be more effective.

Let's take a look at an example in YHOO. The company had announced earnings for January 27, 2009. With a day to go before the release, the February 10 calls were trading for $1.80 and the February 13 calls are trading for $0.47. If I were very bullish on the stock, I might consider solely purchasing the February 10 calls for $1.80. However, with the stock trading at $11.22, I am not willing to pay the $0.58 in extrinsic value, or time value, heading into earnings. Remember, as I stated above, the implied volatility spikes right before the earnings date, so we want to take advantage of that spike. If we consider selling two of the February 13 calls to finance our purchase of the one February 10 call, then we are eliminating most of the time decay concern from our trade and our new cost for the slightly bullish trade becomes approximately $0.86 instead of $1.80. Look at how the trade is constructed down below:

This trade is a non-defined risk trade. If YHOO is to rally to $15.14 before February expiration, then we will be short one naked call from our ratio spread that is not covered by our long position in the February 10 call. This naked call could represent unlimited risk to the upside. However, in terms of probability, we are assuming about a 9% probability of YHOO settling above $15.00 at February expiration. This is why I stated above that this trade is assuming a slightly bullish bias. We have two break even points on the trade. The first is at $10.86 which is our long strike plus the $0.86 debit that we paid for the trade. The other break even point occurs at $15.14. Thus, we have a possible range of $4.28 of profitability on a stock that trades $11.22. I like those odds. Instead of owning the stock, we are using spikes in implied volatility to finance our long call purchase by way of the ratio spread. The maximum value of this spread occurs at our short strike, or the $13.00 level. If we construct only one of these ratio spreads, then our $89.00 debit could be worth over $200 if YHOO settles at $13.00 on expiration day. My biggest concern for this trade would be an announcement of another deal with GOOG or MSFT before February expiration. Then, we might have to be concerned about our upside risk, as our position becomes a naked short call after the $15.14 price level.

Good luck and happy trading!

thinkorswim, Inc. and its registered employee, Joe Mazzola, do not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.