The Stock Momentum Trade
Momentum traders try to profit from a short term future outlook on a stock. Traders will often utilize options contracts to play a stock's momentum. Options allow you to
- increase your odds of success
- use leverage to maximize your profits
- limit your risk
Let's look at a strategy that aims to take advantage of a stock's upward momentum. I am going to show you how to structure a strategy that gives us a higher probability of profit, enhances our returns while limiting our risk.
Finding a momentum trending stock
In order to scan for momentum stocks trending up, we must look at the stock's past performance. For this example, we are specifically looking for stocks that exhibit bullish momentum. A simple requirement is for the stock price to show it is making higher highs and higher lows through an extended period of time. With this behavior of higher highs and lows, we can assume that the stock has a strong underlying bid, which we can interpret as the market continually pushing the price up. The fastest way to narrow down our list of candidates is to use a stock screener. In our recent scan, we had over 600 positive momentum stocks including SPY (the S&P 500 ETF). (To find current momentum stock ideas go to https://marketchameleon.com/Screeners/Stocks and search Momentum Stocks under the Stock Ideas filter).
As you can see from the screenshot below, SPY has made a higher high and higher low in the last 6 months, 3 months and 2 week periods. This would lead us to believe that there is a good likelihood that the stock is trending upward with a strong underlying bid.
See the current Performance Over Time in the Trade Stats section for SPY here: https://marketchameleon.com/Overview/SPY/
Now that we found a stock that has momentum indicating an upward trend, we can structure an option strategy to get the most out of this outlook. In this example, I use an out-of-the-money option credit put spread because it will allow me to profit if SPY continues to climb, stays flat around the same price or even declines by a small amount. This greatly increases my odds of success when compared to just a short-term buy and sell stock strategy of a more traditional momentum trade. Such a strategy would only profit if the stock moved higher.
As of this writing, SPY is trading at 345.45 and a MarketChameleon.com scan for the best credit put spreads reveals a high probability trade in the 18-Sep-20 339P - 336P put spread. In this strategy, you are selling the 18-Sep-20 339 put and buying the 18-Sep-20 336 put for a net credit of $.66. See the payout diagram at expiration below to visualize your maximum gain, break even point and max loss.
As you can see from the above diagram, as long as SPY stays above the $339 stock price by expiration (note that SPY is currently at 345.45), your maximum gain will be realized.
Increase your odds of success
We can estimate our probabilities of success using historical data and pricing models. Of course, historical data does not guarantee any future results, but we can use it for guidance.
Win Rate Using years of historical data and analysis, we can see that, if we tried the approximate same trade (based on past data of similar option strategies), historically, we would have profited 87% of the time.
Theoretical Edge Since options are priced using complex formulas and statistical data, you would want to check how much the options price deviates from the theoretical value. Professional options traders refer to this as edge.
In this example, we use actual historical stock returns to calculate a theoretical value and probability of profit. You can see from the screenshot below of the trade card, the theoretical value of the spread is $.38 cents. If you sell the spread at $.66, the theoretical edge, or extra amount you sell it above its theoretical long term break-even price, is .28 cents. This gives you a theoretical edge of 12%.
See the current Trade Ideas for SPY here: https://marketchameleon.com/Overview/SPY/
Use leverage to maximize your profits Let's look at how this strategy takes advantage of an options leverage. If we assume that SPY stock price is above $339 on 18-Sep-20 expiration then both puts will expire worthless and you will keep the original .66 cents for which you sold the credit put spread. Since your maximum loss, or money at risk, is $2.34, your return on your risk is 28% (i.e. $.66 / $2.34). You are also "stopped out" if SPY keeps falling below $336 because you have the 336 put as protection from a downside move in the stock. Furthermore, take notice that, in this scenario, SPY doesn't even have to go up for you to profit because the stock price is already above the $339 strike. By comparison, if you buy SPY stock outright it would have to go up by $96 (up to $441.45!) for you to get a 28% return by September 18, 2020 (the 18-Sep-20 expiration).
Limit your risk In this credit put spread strategy, your potential reward is the credit you receive for selling the spread for $.66. This will be achieved if the stock remains above the $339 (the strike price of the option you sold) because both options will expire worthless at expiration. Your maximum potential risk is $2.34, which will happen if the stock price goes below the $336 (the strike that you bought as protection) at expiration. That would happen because you would end up buying back the spread for a total of $3. And, if you subtract the $.66 credit you initially received when
selling the spread, it will cost you $2.34 to close the position. Therefore, your loss on the transaction would be calculated as follows: $3 - $.66 = $2.34.
Main Takeaway Playing a momentum trade with a credit put spread can
- enhance your potential returns using leverage
- increase your odds of success
- limit your risk