It's the eternal question. You've got a setup that you like, on an index that you follow. Now... do you go directional, or do you sell some option premium?
The first question I typically ask myself about a pending trade goes like this. Is this market consolidating or trending? If it's consolidating, then I look at selling some premium. If it's trending, and the market has just pulled back to support, then I could do either—such as buying a .70 delta call for an in-the-money directional trade, or sell an at-the-money put vertical spread. Both trades make sense.
But what if a market is about to make the “switch”? The switch? Yes, the switch.
The switch takes place during those moments when a market transitions from consolidating into a full-on trending market. Although it's easy to identify in hindsight, I look at tools in the thinkorswim® trading platform that can help detect when a switch might be near.
Connect The Dots
Figure 1 shows a chart of the Nasdaq 100 Index (NDX) with the TTM Squeeze indicator on the bottom. The red dots along the horizontal axis at Point 1 show a market that is “squeezing” out the last bit of consolidation from a period of sideways price action; and is now building up energy to “make the shift” to a trending market.
The first green dot at Point #2 suggests “the squeeze is on,” and this market is ready to move.
In this case, with the histogram above zero, a bullish options strategy might make sense. So, do you go directional, or sell some premium?
At these moments, I prefer to leg into a bullish call vertical spread, which essentially turns into a “poor man's covered call.”
Initially, I will buy in-the-money calls. I prefer a delta of at least. 70, in order to get price movement in the option that closely mimics the underlying.
And then I wait... and wait... for the momentum on this trade to end. And that takes place at point #3 on the chart, when the momentum on the histogram changes color, indicating that the trending price action is coming to an end.
This is where I typically like to sell some at-the-money calls close to expiration to complete the vertical spread.
A best-case scenario at this point is a market that goes back into a choppy consolidating phase. Under these circumstances, our long in-the-money calls hold mostly intrinsic value and suffers minimal premium decay. Our short call, on the other hand, starts losing premium at a quick clip.
In sum, the TTM Squeeze indicator represents a unique moment in the life of the underlying asset. The key here is to identify that critical moment and utilize delta in the options, to maximize the potential of the situation.
John Carter is a recognized authority on technical analysis but is not a representative of TD Ameritrade.
To access the TTM Squeeze indicator, log in to the thinkorswim trading platform, and select the Charts tab. In the upper right of any chart follow click path to Studies > Quick Study > John Carter’s Studies.