April 24, 2017

Just One More Reason to Use Credit Spreads

The VIX closed above 20, just shy of the year-to-date high.

Not even three weeks ago the volatility, known by some as the “fear index”, was trading around 12.50…roughly 60% lower.

10-8-13 VIX

Indeed, fear is back in the markets. How long will it last? Who knows, but while the stalemate in D.C. continues we, as options sellers, are rejoicing. As most investors begin to squirm options sellers become wide-eyed with glee. Because, as volatility increases options prices increase. But I want to keep things simple today, so I’m not going into a full blown post on one of the main components of the options pricing model…implied volatility.

Until then I want to go over how I am approaching this market in very simple term. I will have a few specific examples later on in the week.

With options, you can control with precision the amount of risk and type of risk you wish to take in any given trade in any situation.

One of my favorite strategies is selling vertical call/put spreads.

Let me explain. And please understand I am keeping it simple for conceptual reasons. Once you understand the basics we can really dig deep to understand how to apply risk-management.

For example, a trader who only trades stocks or ETFs (not options) is bullish and buys one for $50 and at the same time I am able to sell a 44/42 vertical put spread (which is a strategy that bets the same underlying stock will stay above $44 by options expiration) for $.25 ($1.75 is max risk). If the stock rises to $53 by expiration the vertical put spread (let’s say 30 days), the stock trader makes $3 or 6%, but I would have made 14.2% on my spread.

If the stock stays at $50, the stock trader would have made absolutely nothing (while tying up capital) and I still would have made 14.2%.

If the stock drops to $44, the stock trader would have lost $6 or 12%, and I would have still made the 14.2% because the stock did not close below my the short strike price of $44.

As you can see my “probability of success” is greater, but I also cap my return at 14.2%. But I don’t mind making that sacrifice because what are the chances that the stock will move up 14.2% or $7.10 over the same 30 days. And remember, if the stock does rise that quickly over a 30 period what is the likelihood that you actually are going to keep the stock and take the prudent action by locking in gains? Of course, appropriate position-sizing should always be the most important part when choosing to use OTM credit spreads because you always want to keep a statistical edge.

The bottom line is that options get a bad rap, mostly because they are vastly misunderstood by most in the financial world. And if they are vastly misunderstood among financial professionals, how in the world should the retail trader or investor expect to learn about the effectiveness of options?

In many cases, with certain options strategies, the inherent greed of most investors deters them from capping their profits by using a spread strategy. Even if the chances of success is ten-fold of what it would be if you bought a stock or even a long call.

That is not my game. I choose to hit a ton of singles and doubles with a high rate of success.

10-8-2013 5-07-47 PM

If you are a believer in a statistical approach towards investing please do not hesitate to try my options strategies. I use simple mean-reversion coupled with probabilities for each and every trade. Give it a try, it’s free for 30 days.

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