How Wide Should Your Strikes Be In A Credit Spread?

Got the following question this week:

First, thank you for providing a great service. I have been trading options for about a year and have learned a lot from your tips and alerts.

Now, I have a question about position sizing.  I am trading $100k of my funds using your alerts. When you send out an alert I multiply the number of contracts by 10 when putting on the trade. My question is: instead of just multiplying the contracts, can I use a combination of increasing the contracts and/or increasing the width of the strikes?

 

For example, if the alert was to sell 2 SPX 1200/1210 Calls, instead of selling 20 10 point spreads, could I sell 10 20 point spreads? What would be the pros/cons of doing something like this?

It seems to me, if I widen the strikes, then when I need to make an adjustment, I could sell the near strike and buy the next strike as opposed to rolling the whole spread. Is there any advantage to this other than lower commissions and (possibly) better fills? More risk? I feel like I am missing something or not really thinking the strategy all the way through.

Thanks,
Adam

My reply:

How Does Option Time Decay Work?

What is option time decay and how does it work in the context of stock options?  Option time decay is denoted by using the Greek word theta. Theta continues to be one of six indicators in option trading known as the Greeks. 

Options are a decaying asset. Option time decay is a feature of all options that basically means that an option will lose value as time goes on and it gets closer to expiration. So when you are looking to buy an option, the more time until expiration means the more the option will cost versus an option that has less time to expiration in which the underlying can move.

Theta specifically measures the sensitivity of an option’s value according to the passing of time.  Another way of saying this is that theta is the ratio of change in an option price according to the fleetingness of time before the expiration.  An easy way to remember this principle is to think of options as living assets that are wasting away as they age.  The value of an option naturally declines as time goes on.  If an option is fast-approaching the expiration date and is not ITM (In-The-Money) then its value will quickly decline, since it’s highly unlikely it will turn out to be profitable. 

Option time decay really starts to pick up speed in the last 30 days before expiration, assuming that the option isn’t already OTM or Out-of-The-Money).  How about options that are deep In-The-Money?  Ironically, in this case time value actually decays even more rapidly.  Why?  Probably because the market thinks these options are too expensive to hold especially when compared to other strike prices.  Therefore, holders of deep ITM options are wise to discount the time value (for a contract quickly approaching expiry) in order to attract new buyers.  The best way to remember this principle is this: the more certainty about an option’s expiry value you have, then the lower the time value is.  Likewise, the more uncertainty as to the option’s expiry value, then the greater the time value you get. 

This is an important part of choosing when and where to buy selling options.  Theta or option time decay is not precisely the same thing as Time Value, though they are related in thought.  The meaning to take home is basically that the time to expiration will have a major impact on the price of the option.  As the option comes closer to expiry then its chances of becoming more profitable are actually decreasing, and counting against it. 

Besides, predicting a stock price eventually becomes easier as every day passes and seems to resemble the last.  Therefore, it’s the time value that is decreasing as maturity approaches (and particularly so once past the 30 day mark). As the option ages, it loses what is called extrinsic value.

For an OTM contract, the option is made up of extrinsic value anyway, so understanding this time principle is paramount.

When trading options, the amount of time left for an option is what can make or break you. Look at a chart of a stock moving in an uptrend and you can tell it is going higher, but you cannot tell how high it will go and by when. If buying options, buy yourself enough time to be right on your bet.

When selling options, selling close to expiration limits your risk. The farther away from expiration you sell, the more premium you get but you do not get the quick decay benefits of option time decay until there are less than 40 days to expiration.

This is why I like to refer to selling options as “Selling Time”. As time passes, the options you have sold lose value. Making money while sitting around. Not a bad job if you can get it. And you can, if you sign up for my service.

Option Trading Books Reading List

What are Some Good Books on Option Selling?

What should you do if you are interesting in learning more about option selling?

The best way to get started is to read a few good books on the subject.

When I first got started I went to an expensive seminar. After two days I knew enough about options to be dangerous – to my myself. After trying to trade options based on what I had learned at the seminar I realized, after losing a lot of money, that there was more to it.

So I started researching books on options, videos online, websites, etc. Here are some of the best books I found on options and trading in general.

Options Books

One of the most advertised books is The Complete Guide to Options Selling: How Selling Options Can Lead to Stellar Returns in Bull and Bear Markets by James Cordier and Michael Gross. It goes into detail about option writing strategies that can improve your profit. It reviews all of the basic mechanics of selling options and profiting as well as strategies that are insider-quality, easy to follow, and that have a high-probability approach. The book is written to appeal to the new investor, not a mathematician. In this book you can look forward to learning why selling options is more profitable than buying, and specific strategies for selecting various types of markets. Keep in mind that this book is about futures options, not equity options.

One of the first books I got was Options As A Strategic Investment by Lawrence Mcmillan. I would say this is the “bible” of options books. Why? Because it is huge and covers all the basics of option trading and then some.

Most option books cover the basic strategies but they leave out when you should use these strategies and what to do when the trade goes bad. Very few books talk about adjusting trades. The best one I found that does is The Option Trader’s Handbook – Strategies and Trade Adjustments by George Jabbour and Philip Budwick.

My favorite book on Option Selling is Generate Thousands In Cash On Your Stocks Before Buying or Selling Them, by Samir Elias. I myself have only used a couple chapters of this book but it was a very interesting with good ideas.

Wall Street Money Machine by Wade Cook is also a good read. But read this book for motivation only. Most of the examples and numbers in this book were over exaggerated but still, I liked it and enjoyed it when I was starting out so you might too. Most of the book was on covered calls.

A couple other “should” read book on option volatility are Option Volatility and Pricing by Sheldon Natenberg, and The Volatility Edge in Options Trading by Jeff Augen. Both are technical and for advanced options traders.

Books On Trading

How To Trade In Stocks by Jesse Livermore is a must read. Livermore was the best stock trader of all time and his strategies are now copied by just about every firm on Wall Street.

Trade Your Way To Financial Freedom by Van Tharp is good to give you some basic guidelines on trading.

Trading For A Living by Alexander Elder is also very good. I have all of Elder’s books even though they focus a lot on technical investing, he does show how traders with different styles can all make money if they get the basics right.

Credit vs Debit Spread—Which is Better?

Are you wondering which is better: option trades that result in a credit or trades that result in a debit?  Simply put, you’re asking whether you should choose a credit spread or debit spread strategy.  Let’s consider both options in more detail. 

A credit spread (also called a net credit spread) involves the investor selling one option then buying another option.  The second option is in the same class and also shares the same expiry date.  However, there are different strike prices between the two options.  In this instance, the new investor gets a net credit for entering this position.  He is looking forward to the spreads either narrowing or expiring in order to get a profit.  A credit spread is basically a conservative strategy in investment.  It is designed to earn a moderate level of income while also limiting your potential loss.  In this circumstance, you are buying and selling options on the same index in the same month.  Remember, the only thing different is the strike price.  The most common credit spreads are the Bull Put Spread and the Bear Call Spread.

What about debit spreads?  First of all, investors have to pay to enter a debit spread (or net debit spread).  This option is when the investor buys an option with a higher premium but must sell the option for a lower premium.  How will this bring profit?  Because the investor is hoping that the premium of his two options will widen due to the market.

Another issue to consider is that of what type of strategy you are going for with credit or debit spreads; as in bull or bear?  The bull or bear strategy involves doing what you’re doing—selecting selling two options, but choosing both call or put options, and with the same expiration dates.  (The strike prices can be different)  The basic philosophy of bullish in stocks is that you buy low and sell high, which can be called an optimistic outlook, or bearish, buy high and sell low, which is a pessimistic approach.  Both of these may work with any given strategy.

When you bring credit/debit into the equation, there are more issues to resolve.  First know that with a credit spread, the required margin will be the same as the difference between both strike prices.  This is the most you can lose.  Your capital requirement will be reduced since you can apply the credit of premium to the margin.  Now let’s consider debit spreads on the opposite end of the spectrum.  These are called debit spreads because your broker is actually going to debit your account for the net premium, as opposed to giving you credit.  The most you lose with the debit spread is the premium net.  Gains are limited and this option does not require a margin.

In deciding which works better for you consider the time value involved.  If you know a stock or underlying is going to move in a certain direction and you know to what price a debit spread can result in more profit. On the other hand, if all you know is a stock is going to move in one direction or not much, than you can place your trade in the other direction.

Let’s look at an example. If you use technical analysis, you can determine support and resistance lines, as well as trendlines. Say a stock is trending up and has support at $50 and is trading at $54.39 right now.

You feel the stock is going to go higher but you do not know by when. Your best bet is to sell a 50/45 Put spread. You sell the 50 put and buy the 45 put in the same month. For the sake of the example, you will trade the current month with the fewest days to expiration. As long as this stock stays above $50 you make the full amount of the credit.

If you think the stock is going to go to $60 in 2 weeks, you can use a debit spread. You would buy the 55 call and sell the 60 call in the same month. You would get the max profit if the stock is above $60 at expiration. But if the stock does not move up, your options will lose value everyday and eventually expire worthless.

With a credit spread, if the stock does not move, you still make money.

Basically we are talking about two sides of the same coin. A debit spread for one trader is a credit spread for another.

Beware of Option Trading Advisories

Many of my members belong to other option trading advisories. Some of these are similar to mine.  And normally you have to become a member to determine if their claims and trades are reality.

So this post is to just say beware of option trading advisories. Even mine.  never put money into a trade without papertrading the strategies first. Take everything said at face value and make them (and me) prove to you that they are telling the truth and that their trades do make money.

Here is an email from a member who tried another service. The name of the service is blocked out.

By the way, I had to open a XXXXX account just to see what those guys were up to.  Their 100% auto-trade loss last October was pretty scary (the only thing that saved them was that they came up with 100% gain in one day on what I guess was a $10,000 investment, which was not auto-traded and brings up many other concerns).
 
Anyway, I’ll be cancelling that and thought you must might be interested in hearing about your “competition”.  They’ve been legging into positions from the put side, which has worked out well through the summer, I’m not sure why (maybe to complete the condor, maybe being greedy for returns) but they opened 3 call legs 5-6 days before expiration last month.  One of which they sold for $.06 cents and it was threatened with a $.29 buyback the Wed before expiration and they chose to ride it out.  I had heartburn just watching.  Nonetheless, that proved to me they’re more focused on posting returns even when it would be near impossible to follow the trades, or when they’re breaking standard condor rules and that my returns would be a very distant concern of theirs.  So I’m done paying to watch that nonsense.

Scary stuff indeed.

Everybody Is Trading Options

Options Trading is growing like gangbusters.

Good news for us is that the first step for someone new to options will be will learning to buy and sell options, not sell. And so option sellers like us, will have more volume and liquidity to work with.

Here is a video of the crazy man Jim Cramer interviewing the CEO of OptionsXpress after they released their 2009 3rd quarter earnings.

When Do I Buy Back A Credit Spread?

Here is a question that comes after reading Lesson 2 in my 9 Lesson course on selling options.

When you say, to buy back the option before, the expiration date, don’t you incur additional costs, that reduce your profits even further ?

Good question. In some trades like the Calendar spread you have to buy them back because you don’t want to get long the option. But in an iron condor or credit spread, you can wait and let the options expire. If you buy them back you incur commissions plus whatever you are buying it back for.
 
In many cases it is a question of risk vs cost.  if there is a lot of time left before expiration, you are probably best buying the trade back in case there is a move against you and you end up losing money. On the other hand if you let it expire you can save a few dollars and maybe 1 or 2% points on the trade. 
 
So lets say you it will cost you $20 to buy back a trade, but if the trade moves against you, you could lose $1,000. Do you take your profits or hope for that last $20. Even if the trade moves just once against you in 4 years, you still lose money.
 
Make sense?

Here is a real life example.

On October 12, 2009  I did a credit spread on AAPL. I Sold the Nov 165 Puts and Bought the Nov 160 Puts as protection for a credit of .50 on each spread. There were about 40 days to expiration.

On this trade if the puts expired worthless I would make 11.11% before commissions. (Credit of $50 divided by max loss of $450 per spread = potential return of 11.11%) 

Well AAPL just had earnings yesterday and the stock shot up to about 200 today. This morning, I was able to buy back the credit spreads at .07 each.

So I made .43 per credit spread in 8 days.  That is 9.5%

Why did I buy the spreads back? I could have let them expire worthless. If I did i would make another .07 per spread. But there is still 31 days left to expiration. So I decided to make my profit and money and look for another trade.

Who knows? Maybe AAPL will settle down and I will sell another credit spread on it this month for more credit. Or maybe I will do something else. All I know is that I don’t want to risk losing $450 per spread (anything can happen and APPL could drop in price) to make another $7 per spread.

Yes I did pay the commissions by buying the spreads back. But on each spread I paid $2.50 in commissions.  $2.50 going in and $2.50 coming out which is a total of $5 in commission per spread. So instead of mkaing $43 per spread I made $38 per spread which is still 8.44%.

(That’s why having an option friendly broker is so important. I pay $1.25 per option with no trip charge. If you are paying $10 plus $1 per option or some other crazy commissions then you ae playing a game that is stacked against you. Get a better broker.) 

In my opinion, take off your spreads when they are close to worthless if there is alot of time left. Take your profits. Everyday your money is out of the market is a day you cannot lose it.

This is not to say I never let my spreads go to expiration. Sometimes I do, but not too often on a highly volatile stock.

The Calendar Spread

In my last post I listed a Free Trade on POT which is called a Calendar Spread, also known as a Time Spread.

In that trade we sold the Oct 90 Calls and Bought the Nov 90 Calls.

The trade makes money when POT stays in range around 90. Basically what we want is the Oct option to decay and lose value while the Nov option (which we bought) retains its value. Time Decay quickly erodes an option’s value, especially in the last 30 days. That is why I prefer to put these types of trades on with 30 or fewer days left for the front month.

We enter this trade with a debit meaning we paid for the trade. That is because the Nov option was more expensive than the Oct option because the Nov option has more time premium.  POT also has earnings after the Oct option expires which means that the volatility (value) of the Nov option will be elevated (at least a little more than normal).

What we want is for POT to stay in between the break evens until it gets close to expiration. The Oct option loses value everyday and that is how we make money. During the last few days before expiration the fluctuations in prices can move wildly.  That is why I prefer to be out of this trade before expiration week. But in this trade we put it on pretty late and will have to stay in longer.

To exit a Calendar Spread you have to sell it. Otherwise you will still be holding the back month (Nov) option even if the front month (Oct) expires.

The beauty of Calendar Spreads is that they are cheap to trade, easy to adjust, and can result in large profits – 20-40% is common. You can also keep your losses small.

How Do You Scan For Trades?

Hello OptionGenius.

I have been trading credit spreads for about 3 months now with some success.  I read the nine part  course and realize that my past training didn’t discuss much about selection of trades and adjustment of trades.  When I was looking around the website, I saw a brief reference on how you scan for and pick your trade opportunities, how you use the mathematical models with standard deviation to help your selection and how to determine exit points., but there weren’t too many details on these topics.   Do you share the information about scans, about the mathematical models and how to use them as the subscriptions move along?

Eric,

For credit spreads most traders use technical analysis to find support and resistance and use those levels to pick strikes. I have found that, that strategy works except when it doesn’t. support and resistance are guidelines not walls that the stock will not go through and so you will do fine for several months until one month, something happens that was not expected and you lose big on your credit spreads and that wipes out all the profit from the prior months. Credit spreads are pretty dangerous. They are hard to adjust because you are hoping the support stays in place.
 
For example, I have a credit spread on right now in my personal account. It is a POT Oct 85/80 Put credit spread. So I want Pot to stay above 85 at expiration which is 10 days away. yesterday, POT got to 85 and change. Today it is back to 88.80. So the resistance held,(lucky for me). But if I had tried to adjust the trade I would have gotten killed. Credit spreads, from my experience, are trades you put on, wait and take them off if they are going to be a large loss or a total win. There is not much in between.
 
For the other income strategies, you look for stocks.indexes/etfs that are channeling – moving in a sideways direction. any of the strategies can be used on such a stock. But the best thing to do is to focus on a few – maybe 10 that you get very familiar with and trade those month after month. Blue Chip Dow 30 stocks are usually good candidates – MCD, WMT, KO, PEP, XOM, PG, etc. Their volatility is lower and the prices are high enough to make the options have enough premium to work with.
 
But stay away from earnings. Don’t do income trades during earnings.

How Much Money Should You Use For Option Selling

Hi,Like most people I have various accounts. The account in question is what I normaly “traded” out of. This is not my retirement account but an account to hopefully help build wealth not preserve. Historically I’d say I only used 5% of it toward option plays (and not whole 5% in one position) since I usually was naked and a 100% loss was possible. I haven’t been trading much of anything lately but do you feel your strategies are designed safe enough to utilize 100% of this type of account? I guess what I’m asking is once somebody says yes they are utilizing risk capital would you suggest devote entire sum to these type of plays or should some percentage still be in other growth tactics? Asking because I’m trying to simplify my life at this point, not make it more complicated.-Paul

I am not licensed to give specific advice. But I would think that you should not put 100% of your money into anything. Especially if you are un familiar with it.  What I tell new members is to paper trade for a couple months, then start small. Once they get the hang of th etrades and the ups and downs, then they can add more capital to the trades or even do their own trades.

I would suggest the same for you. I use these trades for a large part of my income but I do use other trading strategies as well.
 
Allen