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:

“The Iron Condor is not boring.”

Hi, I just went through the course.  I have a question on the iron condor.  I had subscribed to another site that did those.  They said they picked strike prices far away from the current price so that the odds were better than 90% that they would make money.  Of course the market started to gyrate 100s of points per day and everyone was holding their breath for days. So I learned that these spread trades are not boring at all but can be extremely stressful.  I was glad to see that you weren’t just touting you make money 90% of the time.  I see that all the time but they fail to explain that you can lose 100% of your money up to 10% of the time.  That makes the strategy not conservative at all.  So my question is how much capital would you allocate to iron condors?  Also, in your example, when the price dropped near the lower strike price you closed out the options on that side and then entered into new options just farther down in price.  I can’t figure out why that couldn’t be done all the time so you really could have entered into this trade even when the market was swinging wildly in Oct.  I guess a follow up to that is how did you end up losing 30+% in that one month?  It would be great to learn what can go wrong.  Thanks.

First you have to limit your loss. 100% loss is not acceptable. I am out of a trade when I am down around 20%. The month I lost was a very large, sharp, quick, move. That is the worst enemy of the condor.
 
Most months you have no problems, like this month. i though it would be wild, but even with earnings I have not had to adjust my condors at all. Both are doing nicely.
 
If the price moves towards my strikes, at a certain point I will roll the options away from the money. That is a simple adjustment and one of the ways that help me to stay in the trade and profit even when the market does move. But last September, it was just too much too fast and i just got out of the market instead of try to play with it. I took my loss and exited. Which saved me because Oct was another horrible month for the condor. Through experience I felt that the market was not acting correctly and stayed out of the market.

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.

Free trade: October 07, 2009

I got this trade idea from a very smart member. His observation was that POT

was channeling and that it would be a good set up for an income strategy.

The only problem was that earnings are after expiration which is in 10 days.

Earnings could move the stock but it also keeps the volatility of the options

high and that means high premium.  There is also a dividend to be paid on the 15th, which is one day before expiration. A dididend will lower the price of the stock by the amount of the dividend which in this case is 10 cents.

His idea was a butterfly. I decided to do a calendar because it is easier to adjust and share it here.

Buy 1 Nov 90 Call and Sell 1 Oct 90 Call. This trade cost me $315. My breakevens are at 86.14 and 94.40.

I feel this trade will work. But it will have to be held close to expiration. 

If POT gets outside the breakevens, exit the trade. or if you are experienced enough, add another calendar on the side of the brreakout.  If POT stays around 90, stay in as long as you can.

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.

Buying Calls/Puts to Lower Delta

Great question from a member:

Last time with MCD position you opened another Butterfly to bring the Delta Neutral. Which I have been following and I thought it is very interesting. And maybe that’s the reason to raise me this question.
So my question is related to Iron Condor. Why do usually we close the

 position and open a new one when the price comes after us, instead

of adding some positions to bring the Delta Neutral.
For example: our last RUT we closed 640/650 and opened 660/670.

If we had keep 640/650 and add something to bring the Delta low levels

 again would have similar effect??
I know since we are just handling low quantity is more difficult to create this kind of sceneario, but assuming that the quantity would be greater, do you think that the mechanism of adding positions to bring the Delta low has the same effect as to roll up/down the position?
Just trying to get a better understand from the options world.
 
Tks a lot,
 
Paulo

Excellent question.
 
You are right, the same adjustment can be used in a condor. You can add options to lower the delta. That is one of the adjustments I look at. And it can work. But it depends on what is going on in the market. This month, the market was advancing regularly. Just about everyday it was going up. Adding some calls would only protect the deltas for a couple days and we would then have to do something else. That is why I moved the calls. It is a more drastic adjustment but I thought it was warranted in this environment. if you have a condor where the market makes a huge move upwards in a day and it might go back down, that is when you can add some calls to lower your deltas. Or if there is fear of a big move you can lower your deltas before the move so that no matter what happens you do not get hurt. You can then remove the bought options after the fear has passed.
 
Allen

New Trade and Adjustment

For OptionGenius.com members:

I just entered a new trade. I have also made an adjustment to a current trade.  Our SPX trade has given us the opportunity to exit one side of the trade. The other side is still doing well.

http://www.optiongenius.com/amember/login.php

So far this month, all three trades are doing very well. And this fourth trade which I added today also looks to be very profitable. This trade is on WMT. Wal-Mart just had earnings last week and the stock is in a well defined range. The volatility of this stock has also been declining meaning that the chances of huge wild fluctuations is declining.