I have had a few people ask me recently about 2 of the option trading strategies that I use - Credit Spreads and Iron Condors, so I thought I would post this info for anyone interested.

Credit Spreads and Iron Condors are very similar. Basically an Iron Condor is TWO credit spreads. A Bear Call Spread and a Bull Put Spread. So, if you can get your head around credit spreads then you can easily master Iron Condors.

Credit spreads are something I have only mastered in the last couple of years. Prior to that, I never really understood the attraction as the potential losses can far outweigh the small gains. But since trading them I understand that the keys are:

1) Adjusting the trade if it gets into trouble
2) Placing the spread far enough out of the money that it hopefully won’t need adjusting.

The great thing about credit spreads is that you can be completely wrong in your analysis of where the market is going and STILL make money!! I will try to give you a couple of examples.

On Jan 19th, RUT had a pretty big selloff and finished the day at $785. It looked to me like the market was headed for further selling so I sold a Bear Call Spread above the market. Here are the details of the trade:

RUT Price on Jan 19th: $785

Trade: Sell RUT Feb 19th 845 call @2.08, Buy RUT Feb 19th 850 call @ 1.63

Premium received: $0.45 (or $45 per contract). I sold 5 contracts so I received $225

Total Capital at Risk: Difference between the strike prices LESS the premium received. 850-845-0.45 = $4.55 or $455 per contract. (with 5 contacts my total CAR was $2275). This is also the amount of your maximum loss and therefore the amount of margin your broker will require you to put up.

Max Return: $255 / $2275 = 9.89%

Break Even Price: $845 + $0.45 = $845.45. This means RUT has to stay below $845.45 for me to keep the entire options premium and achieve my maximum return

RUT % Return Before Entering Loss Territory: $845.45 / 785 – 1 = +7.70%

Time To Expiry: 31 days


This all seems pretty simple on paper, and it is when things go well. The key is managing the trade and having a good plan for when things go bad. Looking at this trade, RUT would have to rise by 7.70% before I lost money. If you look at the chart of RUT, it sold off for a couple more days and then rallied solidly into the Feb expiry, which was not what I wanted. The option premium had increased and I was sitting on unrealized losses part way through the month, but the option premium had not risen enough to hit my stop loss, so I stuck with the trade. Eventually RUT topped out at $838 on Feb 18th which was the day before my options expired. I was very tempted to adjust the trade on the 18th because if they market had a huge up day I could have been hit with some pretty big losses. I was ready to adjust or close my trade the next morning if the market continued to rally, but instead the market sold off 2.5% and my position expired with the maximum profit.

This is an instance of my market analysis being COMPLETELY wrong, yet I still made money on this trade. I thought the market would keep heading south, but instead it rallied about 6.70% and yet I STILL made money!


At the moment I have a Bull Put Spread on RUT for the May expiry, here are the details:

RUT Current Price: $821.51

Trade: Sell RUT May 19th 700 put @1.26, Buy RUT May 19th 690 put @ 1.03

Premium received: $0.23 (or $23 per contract). I sold 34 contracts so I received $782

Total Capital at Risk: Difference between the strike prices LESS the premium received. 700-690-0.23 = $9.77 or $977 per contract. (with 34 contacts my total CAR is $33,218). This is also the amount of my maximum loss and therefore the amount of margin my broker requires.

Max Return: $977 / $33,218 = 2.94%

Break Even Price: $700 - $0.23 = $699.77. This means RUT has to stay above $699.77 for me to keep the entire options premium and achieve my maximum return

% Return Before Entering Loss Territory: $699.77 / 821.51 – 1 = -14.82%

Time To Expiry: 30 days

With this trade my maximum return is lower, but the % movement that RUT needs to make is MUCH greater at 14.82% rather than 7.70% in the previous example. However the market tends to fall much faster than it rises so you sometimes need that extra margin for error with put spreads. Also you need to monitor the trade closely and get out of the position if it starts to go against you in a bad way. For a trade like this, I set my stop loss at 200% of the premium received. I received $0.23, so I will close out the trade if the premium on the spread reaches $0.69. If this happens my loss will be -$1,564.

If I wanted I little bit of extra protection on this trade, I could sell a Bear Call Spread above the market, thus creating an Iron Condor position.

Credit spreads have the potential to be more risky than other option strategies as the maximum loss is quite large. You really need to know what you’re doing with these trades before you attempt them. If you decide you want to try them out, you should paper trade them first to get an understanding of how they work, then when you go live with your trading, make sure you keep your position size small to start with until you are more experienced.


Anyway, I hope this helps, please let me know if you have any questions.
Gavin.

Gavin,

I'm still not totally sure I understand but I'm trying. So in these examples, are you holding the underlying stock as well?

CEBenz said:

Gavin,

I'm still not totally sure I understand but I'm trying. So in these examples, are you holding the underlying stock as well?

Click to expand...

Hi CEBenz,

I'm not holding the stock in these examples, it's a pure options play. There is no need to hold the stock to be able to make these trades. If you're interested, i'm doing a free webinar on Saturday night to go over this strategy. Email me if you're interested and i will send you the invite.

Thank you for the analysis as I have a big interest in options, but I don't like the risk profile of limited upside and unlimited downside. It doesn't make sense to me, to risk $33,000 to parlay a maximum gain of $997. Am I missing something? I tend to take opposite positions ... risk $1000 (max risk) for an unlimited gain.

How long have you been trading these? What happens when one big loss wipes out 20 wins? I'm not challenging you on this strategy; just genuinely interested and want more education!!

MJDeMarco said:

Thank you for the analysis as I have a big interest in options, but I don't like the risk profile of limited upside and unlimited downside. It doesn't make sense to me, to risk $33,000 to parlay a maximum gain of $997. Am I missing something? I tend to take opposite positions ... risk $1000 (max risk) for an unlimited gain.

How long have you been trading these? What happens when one big loss wipes out 20 wins? I'm not challenging you on this strategy; just genuinely interested and want more education!!

Click to expand...

Hi M.J.,

No worries, I appreciate the question and am happy to help. I actually had the exact same question when I first heard about this strategy about a 6 months ago. It just didn’t make sense to me that you would risk such a large amount for only a small gain. It’s certainly not a strategy for everyone, and definitely not one I would recommend to beginners, which I should have mentioned in my post above. With any new strategy it’s always a good idea to paper trade for a few months first.

In regards to your questions, let me try and answer as best I can.

With this strategy you are looking to have a lot of small winners while avoiding any big losses. There are a couple of strategies you can use to avoid these big losses:

1. Sell the spreads as far out of the money as possible – In this way the market would have to move by a significant amount in a short period of time for you to suffer losses. In the second example that I gave above, RUT would have to fall by nearly 15% within 1 month for me to lose money. Not impossible, but fairly unlikely.

One thing to note here is that this is purely looking at the trade at expiry. If the stock or index moves very quickly against you, even if it’s only by 4-5%, you will be sitting on unrealized losses, this is where you need to decide if you still think the trade is a good one or if the risk is too great. If you think the market will continue to fall, then you should probably take a small loss and exit the trade. You also need to set stop losses which leads me to my second point.

2. Stop Losses – You need to set a maximum level of pain before you close out the trade. Personally I use a 200% rule which is very common for options sellers. Using the same example above, the premium I received when opening the trade was $0.23, so if the premium on the spread rises to $0.69 I will close the trade. Therefore my maximum loss is only $1,564, not $33,218 as I will be out of the trade LONG before I hit that loss point.

The major risk with this strategy is the market making a sudden and very sharp move against you (usually this occurs on the downside). If you’re worried about this, what you can do is enter a stop loss order ONLY on your sold option. That way if the market moves quickly, you will get out of your sold option and hold only the long option. If the market continues to move against your original position, your long option will continue to make money and the gain will help offset the losses you suffered on the sold option. This can be a great way to protect yourself if you’re worried about a “flash crash” type event.

3. Market Analysis – Talking about the flash crash, before using credit spreads you need to be an experienced investor in the stock market. You need to have good market analysis to determine the trend of which way the market is headed. In the days and weeks before the flash crash the market had turned quite negative, so taking this into account you would want to have call spreads on rather than put spreads. Bear call spreads would have done well during the flash crash despite the increase in volatility.

4. Trade indexes not individual stocks – I rarely use this strategy on individual stocks, mostly I use it on indexes as there is less volatility due to earnings etc. Take RIMM for example which had a bad earning report last week and dropped about 15%. It is very rare that you would see an index drop by this amount in one day, but it is quite common with individual stocks especially stocks in the tech sector or small caps stocks. Also the bid-ask spread is much lower for indexes and index ETF’s.

I guess the main risky is a flash crash / Black Friday type event, but hopefully I have shown you a couple of ways you can protect yourself, at least partially. Even during the flash crash the RUT only dropped 8.72% at its lowest point and recovered about half of those losses by the end of the day.

Hope that helps, happy to chat further if you want.

MJDeMarco said:

Thank you for the analysis as I have a big interest in options, but I don't like the risk profile of limited upside and unlimited downside. It doesn't make sense to me, to risk $33,000 to parlay a maximum gain of $997. Am I missing something? I tend to take opposite positions ... risk $1000 (max risk) for an unlimited gain.

How long have you been trading these? What happens when one big loss wipes out 20 wins? I'm not challenging you on this strategy; just genuinely interested and want more education!!

Click to expand...

MJ, let me give you a relatively simple explanation. Snowbank and I were just discussing this the other day on IM.

It is very similar to his presentation about expected return at B&P.

I will use a simple (hypothetical albeit realistic) example:

Apple, AAPL, is currently trading at about $346/sh. In the June month, you can sell a 330/335 put spread for $1.40, or $140 (1.40 x 100 shares per contract).

Selling a 330/335 put spread means selling the 335 put option and buying the 330 put option for a net credit of $140.

This gives you a max profit of $140 and a max loss of $500 (335/sh - 330/sh x 100shares).

Historically, about 80% of all option contracts expire worthless. So 80% of the time you will make $140 and 20% of the time you will lose the $500. However, you actually only lose $360 because you collect the $140 premium up front. So;

(80% x $140) + (20% x -$360) = $40

In other words, if you do this month after month, year after year, this is what you will average out with.

In order to get this return, you must put up a 20% margin on the underlying stock at your short strike price. In this case, you would need to invest $6,700 ($335 x 100shares per contract x 20%).

Keep in mind though, you are now long the 330 put, so you are only risking the $5/share.

If you made this, or similar, trade once per month, you would make $40/month on a $6700 cash investment, or about 7.2% annualized.

Keep in mind, this is just one example, and not a very profitable one at that.

One more example that is much better;

Sell the June MO 26/25 put spread for $.20 or $20. Put up $520 in margin and make $20/mo on this trade or 46% annualized.

I hope this helps.

Bobby, I understand how they work; I just don't like the risk profile.

How To Make $23,000 In One Freaking Day … Own the Slaughterhouse. | Fastlane Entrepreneurs

MJDeMarco said:

Bobby, I understand how they work; I just don't like the risk profile.

How To Make $23,000 In One Freaking Day … Own the Slaughterhouse. | Fastlane Entrepreneurs

Click to expand...

Fair point MJ, they are not for everyone. They've been working very well for me so far. This year i have had 15 winning trades out of 17. One of my losers was basically break even (I lost a total of $35). The other losing trade would have made money if i kept it till expiry, but it hit my stop loss and i had to stick to my trading rules and close the trade.

I like your SLV trade though, and i do make these trades occasionally as well if i see a good setup. did you check out ZSL? You could have bought calls in that instead.

MJDeMarco said:

Bobby, I understand how they work; I just don't like the risk profile.

Click to expand...

The problem I have with being long any option contracts is that statistically, you only make money 20% of the time.

Sure, you can knock it out of the park like the SLV trade you made last week, but those are few and far between.

By selling credit spreads, you only have to be about right, not exactly right like with being long options.

Look at it this way, an option seller is equivalent to your auto insurance company. He sells policies and collects premiums for profit.

He uses risk management to ensure that when he loses money, he minimizes his losses.

Sure, when you crash your car, you get a big payoff from the insurance company (ie. hit the timing of the SLV trade perfectly), but most of the time you just renew your policy again and pay the piper.

I prefer to be the piper.

GlobalWealth said:

The problem I have with being long any option contracts is that statistically, you only make money 20% of the time.

Click to expand...

They also say that every 4 out of 5 businesses fail within 5 years (20%). Does that mean I should forget about starting a business too? I don't care about the statistics because the probabilities can be manipulated w/the right entry/exit strategy -- in fact, I can't remember the last "long" option I took a loss on. . . (I don't trade them often). Should I be concerned with the 20% statistic? Nope, just like it doesn't make a difference to me that the same failure rate exists in business.

I'm not knocking the strategy ... it just isn't for me.

MJDeMarco said:

I'm not knocking the strategy ... it just isn't for me.

Click to expand...

Touche. Agreed on the 4/5 biz analogy.

For me I think I am just too lazy to be a net long option trader. I find it easier to be right some of the time and just minimize my risk on the downside.

If I am a seller, I just do my research on the front end on the company then wait for the theta (time value) to erode.

Options don't have to be made that complicated. Different scenerios obviously call for different strategies and to try and use the same strategy over the whole market to me is flawed. I basically have 20 stocks which I know very well. I started with 5 and after 15 years of trading options I'm up to 20 and have no desire/need to go further. Sure, I find interesting trades outside the 20 stock box once in awhile but those are usually fun trades with tight stops. Within those 20 stocks I try to buy an option anywhere from 6 months out to 2 years out. I prefer to stay in the 8-12 month range. Then every month I sell the current month option of the same stock but not necessarily the same price. If the price starts moving against you, you can either axe it or better yet roll it to a different price in the current month or double roll it to the next month. This is my main strategy but I also use brackets which I won't cover now. Whatever strategy and system you use, if you don't understand premium and time decay and how to recognize what each are, you're going to lose. Speaking of systems, many traders have perfectly good systems but break their own rules and end up screwed. Stick to the rules and leave emotions out and you'll win. That's why I don't like paper trading, there's no emotion when no money is involved.

dday97 said:

Options don't have to be made that complicated. Different scenerios obviously call for different strategies and to try and use the same strategy over the whole market to me is flawed. I basically have 20 stocks which I know very well. I started with 5 and after 15 years of trading options I'm up to 20 and have no desire/need to go further. Sure, I find interesting trades outside the 20 stock box once in awhile but those are usually fun trades with tight stops. Within those 20 stocks I try to buy an option anywhere from 6 months out to 2 years out. I prefer to stay in the 8-12 month range. Then every month I sell the current month option of the same stock but not necessarily the same price. If the price starts moving against you, you can either axe it or better yet roll it to a different price in the current month or double roll it to the next month. This is my main strategy but I also use brackets which I won't cover now. Whatever strategy and system you use, if you don't understand premium and time decay and how to recognize what each are, you're going to lose. Speaking of systems, many traders have perfectly good systems but break their own rules and end up screwed. Stick to the rules and leave emotions out and you'll win. That's why I don't like paper trading, there's no emotion when no money is involved.

Click to expand...

So ur pretty much doing covered leaps...how is that working out...is it consistently profitable?

I've traded the type of spreads mentioned by the OP...but truthfully, I dont like his latest RUT trade...i dont know the size of his trading account but putting up 33k to make 1k doesnt make sense when there are tons of 4-5-10% trades out there every month with as low a risk profile as that trade...in addition...why not throw on the bear call spread far OTM as well turning it into an IC?...u can pretty much put that trade on for free (aside from brokerage fees) with no margin requirements.

To clarify...Im not knocking the OP...if his plan is to make 24-36%/yr on a 100k+ account then i can see the point of taking such low risk/high prob trades...but i think most beginner traders (once they are past the paper trading stage) will look for something a bit more juicier to generate income.

@OP...Im curious to know your screening process, do you use HV/IV, Vol skews, price history or do u only trade the RUT no matter what?

Boo Blizzi said:

So ur pretty much doing covered leaps...how is that working out...is it consistently profitable?

I've traded the type of spreads mentioned by the OP...but truthfully, I dont like his latest RUT trade...i dont know the size of his trading account but putting up 33k to make 1k doesnt make sense when there are tons of 4-5-10% trades out there every month with as low a risk profile as that trade...in addition...why not throw on the bear call spread far OTM as well turning it into an IC?...u can pretty much put that trade on for free (aside from brokerage fees) with no margin requirements.

To clarify...Im not knocking the OP...if his plan is to make 24-36%/yr on a 100k+ account then i can see the point of taking such low risk/high prob trades...but i think most beginner traders (once they are past the paper trading stage) will look for something a bit more juicier to generate income.

@OP...Im curious to know your screening process, do you use HV/IV, Vol skews, price history or do u only trade the RUT no matter what?

Click to expand...

I mostly trade the indexes so RUT, IWM, SPX, SPY, NDX, QQQ, occasionally I will trade an individual stock but usually I stick to indexes as the volatility is lower. I try and wait for a spike in volatility for these trades as you can get further away from the market. Also depends on my market outlook, I do trade the bear call spreads as well to turn them into an IC, but I’ve been bullish for the last few weeks so have just stuck with the put spreads. Volatility has been low the last 2 weeks or so as well so the premiums just haven’t been there on the call side.

When trading these, my first step is to determine the trend of the market and then decide on a good entry point when the markets become short term overbought / oversold. As I said also a spike in volatility can mean a good time to enter. Also if I have on predominantly put spreads, I will look to place call spreads to even out my exposure and vice versa, but it depends on my market outlook. No point putting on call spreads purely for the sake of evening out your exposure.

With this strategy I’m trying to hit singles every month rather than home runs. My aim is to make 1-2% per month so 12-24% per year. Not too many people can consistently make more than that.

Boo Blizzi said:

So ur pretty much doing covered leaps...how is that working out...is it consistently profitable?

Click to expand...

I don't consider it covered leaps but selling premium. Covering more often implies that I own a certain stock and am covering myself with an inverse play which is not my goal. I am not selling current month options for protection. My goal is to sell off front month premiums to back month options which I own. After a few months of doing this the cost basis of my back month option is lowered substantially and then I can either sell it for a nice profit or roll it out another few months, collect what I made from selling premiums and start again. For clarity, I do the same with puts when my research/system deem it necessary as well. I'm not a permabull.

Consistantly profitable? Yes it is with practice. As long as you follow the rules of the system and roll the trades up/down when necessary, doubling up when necessary and cutting the trade when the win/loss hits your marks, it's very profitable.

I've never experimented with the strategies discussed in this thread. Thanks OP for bringing this up. I'm more into trading options with long calls and puts, like MJ's strategy. I like finding companies with value, and scaling profit with minimal downsides.

OP and GlobalWealth have helped me understand the benefits of this strategy too. Thanks guys.

MJDeMarco said:

Bobby, I understand how they work; I just don't like the risk profile.

How To Make $23,000 In One Freaking Day … Own the Slaughterhouse. | Fastlane Entrepreneurs

Click to expand...

MJ, you must be laughing all the way to the bank with your SLV puts!! What's you're plan, are you holding on to them or cashing out??

Stu_Hefner said:

I've never experimented with the strategies discussed in this thread. Thanks OP for bringing this up. I'm more into trading options with long calls and puts, like MJ's strategy. I like finding companies with value, and scaling profit with minimal downsides.

Click to expand...

Stu, that's the trade I'm talking about with one added step. Buy long calls/puts and sell the front month or second month of the same stock (option) in order to collect premiums and lower your long cost basis.

Example. You like Apple. Last I saw it was 349.36. You buy the Jan12 350 call for 36.90. You now sell the May11 350 call for 5.75. Now if you let it go to expiration and aapl stays below 350, you made 5.75 which now lowers your long premium to 31.15 with 7 more months to do the same thing (you roll this further out as it gets closer, usually withing 3-6 months). Even if it goes a bit above 350 you notice that you can buy it back the closer it gets to expiration due to time decay and still make money (right now it's losing .22/day with 16 days left). If it explodes up to 370 tomorrow then you roll your long up to 370 since you made some nice coin on the long 350 you own and roll your sold call to the Jun11 370's and start again.

Note: This is an example only and if I were to trade Apple I'd use different strike prices, I just used the current at the money calls for ease of explanation. If you're prone to unease and anxiety I suggest use a stock with softer movements like msft (buying Jan12 26 calls for 1.95 & selling May11 26 calls for .42) or something like it. Those types of stocks don't necessarily have to be monitered day to day like apple does. I also don't usually buy and sell the same strike but depending on you're trade level and margin, you may have to.

dday97 said:

I don't consider it covered leaps but selling premium. Covering more often implies that I own a certain stock and am covering myself with an inverse play which is not my goal. I am not selling current month options for protection. My goal is to sell off front month premiums to back month options which I own. After a few months of doing this the cost basis of my back month option is lowered substantially and then I can either sell it for a nice profit or roll it out another few months, collect what I made from selling premiums and start again. For clarity, I do the same with puts when my research/system deem it necessary as well. I'm not a permabull.

Click to expand...

that is the definition of covered leaps...u are using the leap as a surrogate for the stock...but its the same strategy as selling buy-writes/covered calls.

do you buy DITM, a few strikes ITM or ATM Leaps?...i read the example u provided as an explanation but i know that was more for illustrative purposes...this strategy is constantly nagging at me to give it a try but i want to make sure i have my rules/parameters in place in terms of entry and exit (something i have been struggling with my whole trading career, no matter the strategy, due to greed - ie. searching for the juiciest premiums)

OptionTradingIQ said:

MJ, you must be laughing all the way to the bank with your SLV puts!! What's you're plan, are you holding on to them or cashing out??

Click to expand...

I closed the position out on Wednesday at 7.40 and it looks like SLV had more sell in it. Oh well, my timing on on the trade buy was perfect and perhaps, SEC notable. =) The sell, not so much seeing that today the options are worth $10.10.

This is how someone turns $299,000 into over $1 million dollars in just a few short days ... we hear how billionaires are created when bubbles collapse ... this trade was a perfect example on they do it!

Too cool! And they say you can't time the market.

Boo Blizzi said:

that is the definition of covered leaps...u are using the leap as a surrogate for the stock...but its the same strategy as selling buy-writes/covered calls.

Click to expand...

I realize it's the same definition but the goal is different, that's why I don't consider it a cover. A cover is meant for protection most commonly used in the hold & hope strategy, whereas I'm in it for selling premium and rolling it when the premium is gone. I don't give 2 turds about protecting my long. I'd rather protect myself with index plays, buts that's a different game. Sure it's splitting hairs but I guess that's just my mindset. Thanks for clearing it up for those that may have gotten confused though, sometimes it's hard for me to type what I'm thinking without being confusing.

Boo Blizzi said:

do you buy DITM, a few strikes ITM or ATM Leaps?...i read the example u provided as an explanation but i know that was more for illustrative purposes...this strategy is constantly nagging at me to give it a try

Click to expand...

Ok, the long call is easy. Simply buy where you think it will be in that time frame based on your research. Let's use aapl again since we were using it already. If I thought it would be 360 by the time Jan12 rolled around that's what I'd buy, the 360's. That was the easy part. Next I'd look for what range they are trading in using whatever system you use. I see them ranging from 346ish to 350ish lately. Right now aaple is 346.75 so I wouldn't sell a call right now. The premium is too low for me to sell the 350 and I don't want to sell 345's because it's been bouncing off just above that price and I think it's a losing battle. So you have to be patient and wait. Now if we were doing this yesterday I would have sold the 350 immediately because it was toward the top of my range and the premiums were nice. If it climbs soon to 350 or above I'd look to sell the 350 unless it's trending hard, if that's the case let it run and your long call will be happy. If the rising trend lacks conviction I'd sell the 350. We're also getting within 15 days of expiration so there's still some premium left but not for long. Right now there's like 1.25ish of premium left for me to take for may so I would probably still sell it but I'd also look hard at selling the June 350 on an uptick since there's about 6 bucks in premium to be had there with 43 days left.

Boo Blizzi said:

i want to make sure i have my rules/parameters in place in terms of entry and exit (something i have been struggling with my whole trading career, no matter the strategy, due to greed - ie. searching for the juiciest premiums)

Click to expand...

I hope you already have rules in place for entry/exit and allocation before you make the trade!!! I hope I answered your question.

Boo Blizzi,

I realized I forgot to mention. I usually only sell half of my long call. So if I bought 10 long calls, I'm selling 5 short month calls. FYI.

MJDeMarco said:

I closed the position out on Wednesday at 7.40 and it looks like SLV had more sell in it. Oh well, my timing on on the trade buy was perfect and perhaps, SEC notable. =) The sell, not so much seeing that today the options are worth $10.10.

Click to expand...

So you didn't get the sell right on..oh well. No one ever went broke taking a profit. Nice trade MJ!!!