Readers of this blog should be very familiar with option spreads. We have written in the past (Option Spreads Examined Further: Measured Ways to Play Your Market Hunch, Bear Put Spreads: An Alternative to Purchasing Puts, and Bull Call Spreads: An Alternative to Purchasing Calls) about the different ways traders can participate in leveraged markets with measured risk strategies. In all of those cases, we looked at the buy side of those spreads in order to capture a high rate of return with a lower, set amount of risk. Those strategies should always be in a trader’s tool belt, but we cannot be quick to dismiss the other side of those trades, or the sell side option spread, known better as the credit spread.
There will always be a place for buying options. However the option is used, if for protection or outright speculation, buying an option provides the opportunity to have unlimited returns with a set amount of risk. I encourage traders to buy options as opportunities are presented. Occasionally, however, the markets are trading with big daily ranges and high volatility, options get “bid up” and the cost due to volatility gets too high. In those cases, it might be better to simply “fade” that volatility by selling options and collecting premium.
A sale of an option without any other position is known as a naked short option. The naked short option strategy is used as a way to make money based off where the market will not go. The strategy can be profitable, but over the long run it can bring sharp drawdowns or even the dreaded “account debit” if not properly managed. The problem Daniels Trading has with naked option selling is that it carries unlimited risk. Strategies, such as out of the money naked option selling, have a high probability of success which provide small gains that add up. Sure, there are people who have been successful constantly selling naked options. However, ask anyone who sells option premium in the Crude Oil markets during a supply shock, or someone who sold on short puts in the S&P before the Lehman Brothers bankruptcy, what their opinion is on that type of strategy and they will undoubtedly describe the feeling they had as one akin to being tied down with the market bearing down on them like a train rumbling down the tracks. It is impossible to predict the black sheep that create major market swings and the naked option sellers do not need many losers to be out of liquidity and out of the markets for good. One of Daniels Trading’s senior brokers often makes the great analogy that “[s]elling naked options makes an account’s value go up like an escalator and down like an elevator”.
These two types of spreads provide the opportunity to collect premium while still giving them protection so they can handle the unpredictable and inevitable market events. By selling out of the money-option spreads, one is taking on a higher amount of risk for a lower return, but the odds for success will also be higher. Let us look at an example:
Ken has $10,000 in an account. He is looking for a trade with a high probability of success. Over the last few days Ken has been watching the December Corn contract sell off from above 7.00 to below 6.30, which has left the bulls screaming for put protection. Ken is a fundamental trader and he has done some analysis, which in his opinion confirms that prices in corn will not fall below 6.00 before the December options expire. He wants to take a long position. Still, he feels like a futures contract would not be a great strategy because if he is wrong he could be taken out of his position quickly; thus, he is susceptible to the “whipsaw” effect. He decides selling a put spread will provide greater margin flexibility and fits his risk profile better. While December Corn was in the midst of a sell off at 6.30, he decided to sell a 5.50-6.00 put spread in the December Corn options for 21 cents:
Sold 1 Dec 600 put for 46 ($2300)
Buy 1 Dec 550 put for 25 ($1250)
Max profit= 21 Cents ($1050)
Max loss=29 cents ($1450)
Ken’s breakeven is 5.79. He suffers a max loss if his December Corn options expire with Corn anywhere below 5.50. Ken knows his reward is not as high as his risk, but his analysis shows that Corn will stay over 6.00. So, he feels comfortable risking $1450 because Corn will stabilize somewhere over the 6.00 strike price where he sold the put. He also feels comfortable because he can let the markets workout what is taking corn lower. Ken is unconcerned with where he will be next week because his focus is on where he will be in four months. In the worst case scenario, Corn sells off below 6.00 and Ken can lose no more than $1450 dollars on expiration. If December Corn expires over his 6.00 short put, Ken is probably satisfied with the 10% profit he earns over the next five months. Another benefit to the trade is that Ken knows he has an additional $8,000 in free margin which he can use on other trades.
Tips for Trading Credit Spreads
Here are a few simple tips that can help you improve your chance for success and allow you to potentially capture the most profit possible:
- Sell into heavy price moves. When the market is violent options buyers will often pay more for protection from volatility. The best markets in which to use this strategy are those that have had unsustainable recent price action.
- Do not put all of your eggs in one basket. Diversify your spreads across multiple uncorrelated markets. Try to look for the markets that are driven by uncertainty.
- Make sure your account is properly capitalized. Always choose spreads that your account can handle, especially if a max loss occurs.
- Try to sell option spreads at least 30 days before expiration. The time value is higher and this value comes out of the option price on an accelerated level as expiration nears.
These tips can help generate consistent profits which can add up over time. When the next black sheep event occurs–they always do when we least expect–these tips may protect you from a debilitating drawdown. Remember, there are two key goals to trading: the first goal is to make money and the second is to keep it. This tips can help achieve both of those objectives.