How To Sell Credit Spreads For Extraordinary Returns

TradingPub Admin | April 28, 2014

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Peter Schultz, President of Cashflow Heaven Publishing and Chief Strategist of The Winning Secret Newsletter, shared some interesting and fun ways to make money by using credit spreads during a recent event held at the TradingPub.

Trading credit spreads traditionally involves less stress and risk compared to other options trading. If you are already familiar with this particular approach to the market the education shared in this article will add a few new angles to your knowledge. If you are not familiar with credit spreads this trading education can help with standard directional trading in futures, forex, options and even stocks. For those wondering what is the credit spread strategy that will be covered in this education the answer is that it is an income strategy that builds  income and wealth.

All of us have a ton to think about or do, that is why learning a new complicated strategies may not be a priority. When you approach anything new the number one question to answer should be what will be your reward to learning it?! The great thing about learning something new, when it comes to trading, is that it can bring you income  leading to your financial independence.

So what is in it for you?! Unlike other trading strategies offered out there, the one revealed here has 2 big advantages. The first one is the likelihood of winning. If you trade with leverage, like most retail traders do when they trade forex, futures, options and even stocks, this strategy is great. New traders focus on how much they can make whereas experienced traders focus on their likelihood to win. The higher the probability to have a winning trade, the likelier you are to take it as you get more and more experienced as a trader.

The second big advantage is the ease with which you make your profits when using this strategy. For example, if you sold options the goal is that you sold an option that expires worthless. In that case you keep all the money from the premium. In the case with options selling you are practically a time merchant. Your trades are all stacked so heavily in your favor that in most cases once the trade is entered you don’t need to do anything to win. Typically only about 2 positions out of 10 will need some adjustment.

So why does this options strategy work so well?! Trading options, the way most people do, can be challenging. Most people buy an option on a stock they think is going to move in the direction they expect with the intention of making a killing. But unfortunately, this does not work well most of the time.

There are many estimates of what percentage of options expire worthless every month. It is believed to be somewhere around 85%.  Research shows arguments going both ways. The CBOE insists that a big percent of options get bought back before they expire worthless. However, there are more claims of the opposite. The truth is  that by the time an expiration rolls around all the value of that option has expired- there is no time value left.

Here’s something to consider. According to the Options Clearing Corporation over $1.2 Trillion worth of options were traded last year (2013) and this year is projected to be even higher. So, the interest in options keeps increasing and people like them for hedging, their stock accounts, and speculation.

The big question here is if 85% of options expire worthless, where does all this money go?! It is good to know that in the options trading world money does not get destroyed it just changes the hands of the owner. The money goes to the options' sellers,  those are the ones collecting the premiums that get lost. It’s estimated that there will be about $1.4 trillion worth of options bought and sold this year. If 85% of them expire worthless that means there will be an astounding $1.19 trillion worth of expiring options premium this year.

To put that number in perspective that’s 1.19 billion worth of premium that options sellers are going to get to keep just this year. And that number just keeps growing every year. How much of a slice of that 1.19 trillion do you need to be doing VERY well?

These are all powerful reasons for one to become an option seller, but the questions is now what kind of options should one sell?

Covered Calls are those options when a trader buys a stock and sells an options against it. The downfall here is that it takes a lot of capital to buy the stock at the first place, so this may not be the best retail trader strategy. Also, the ROI may be a bit lower, but the income is generated from the volume traded and the premiums are kept by the trader.

Naked Options? Those can be extremely risky and are not a very great income strategy anyway.

Credit Spreads? Those traditionally are great for retail traders. See image below to learn some basics and see a depiction of a credit spread.

Credit Spreads 1

So here is how this particular example works. It is an uptrend market and it seems likely to continue to go in the same direction, possibly with a few bounces off the support. You can sell right underneath that market at 1775 puts for 5.20. To limit the liability a trade can go underneath it and buy the 1770 puts for 4.70 and we limit out liability to the distance of the two strikes or $5.00. The difference is $.50- that is our credit spread. So the maximum loss,  if the stock plunges all the way down is $4.50. This is derived from the $5.00 we bought it minus the $.50 we already got for it from the credit spread. So if we take $.50 and divide by $4.50 it is 11% potential return. See picture below:

Credit Spreads 2

Here you have to keep in mind that this is for only about 3 weeks, or until expiration.  Let's analyze this a bit further. There are only 5 possible things a stock can do. It can go up dramatically or a little bit. It can go down dramatically or a little bit. It can stay unchanged.

If it goes up dramatically it is going away from our spread, the spread will expire worthless, and we will get to keep all the money. If it goes up a little bit in the direction it has been and the direction it is likely to continue to go, in this case the option will expire worthless and we will get to keep all the money as well.

The stock can trade sideways and this is what this stock, from the picture above, had been doing. If it continues to do that the spread will expire worthless and we will get to keep all the money.

If it goes down gradually then the spread will expire worthless and we will get to keep all the money as well. The only position in which the option gets threatened is when the stock goes down quick and a lot. However, there are a number of ways to counter that move and protect your position. So, 4 out of 5 times, or 80% of the time you will be ok. And if the stock finishes at expiration anywhere above the sold strike of 1775 you will keep the profits, which in this case as calculated above is 11%.

But can we do better? What if we could double our returns while keeping our probability of winning the same?

Credit Spreads 3

As depicted in the above image we can lose at most $4.00, but we are already making $1.00 ($.50 from both credit spreads), thus the return is 1/4= 25% with pretty much the same risk as before. Those two credit spreads are like two big wings of a bird and that is why this trade is referred to as condor. Now you see that a 25% return for just 3 weeks of time is HUGE.

But what happens if the trade goes against us? Peter reiterates that,  before you go to learn a new strategy that matches your preference and style,  you have to learn about the risk it presents to you as a trader. Regardless how low the likelihood of trades going against you a trader has to know all possible ways that things can go wrong and what are the steps to take to minimize losses.

Credit Spreads 4

As seen above, if a stock is going down and breaks through the support and then does it again you have the opportunity to adjust your position and minimize your potential loss. As you know it does cost money to offset closing a position. Traders can close the losing spread and then enter in a new trade keeping in mind the newly forming trend. In most cases not only will you offset your loss, but possibly even profit. This process is called rolling.

Yes, but what happens if disaster strikes? What happens if the stock gaps BIG against us? The company depicted in the image below gapped up more than 30 points after an announcement that it is becoming an MLP and the price broke both resistance lines. At that point the spread was closed at a high cost.

Credit Spreads 5

Here is the defense that the credit spread strategy had after the stock gapped up so much. The top CF wings are the original wings and then the bottom two are the ones put on after the position was closed in hopes to offset the costly exit and possibly bring in a gain. After all was said and done the trade made 9% even thought it had gone against the original position.  Here is exactly how it was executed:

Credit Spreads 7

The position was closed and then two new wings were opened. In this case the expiration was matched and the money that were tied in the original trade were now just moved to another trade with the same expiration. So the top spread was closed for $2.20 and the bottom for $.10 for a total cost of $2.30 then two new ones were sold for $1.74 for a credit of $2.59. Then we take $2.59-$2.30 for a net gain of $.29 or 9%. Yes, this is not a big gain, but it is infinitely better than a loss. And this is the great thing about selling Credit Spreads the strategy is very flexible and forgivable.

The beautiful thing about Credit Spreads is you have Options, meaning that there is almost always something you can do to make a trade better.

Speaking of making trades better,  how can we improve our returns while reducing our risk?
In other words, how can we create extraordinary  returns? The title of the presentation is "How to Sell Credit Spreads for Extraordinary Returns?" and we are about to go in that part of the content.

We will look at 5 Strategies to reduce your risk, increase your returns, and increase your frequency of returns.

#1- Pick the Highest Odds Underlying: Indices vs. Stocks; When Stock News Risk Works.

The reason why Indices are preferred to stocks is because they eliminate the  single stock risk. However, there are times when trading stocks will be better. One of those times is right after announcements. Those times the stock is gapped one way or the other and those are great opportunities due to volatility spikes. After announcements the stock gaps one way or the other, but after the news has been out it trades sideways or with gradual movements up or down. We know that in all those 3 cases, as discussed above, you can make a great return selling Credit Spreads.

#2 -Sell Outside the Predicted Range paying attention to Market Direction, Individual Trend and Future Events.

In this trading strategy a trader can look at upcoming events and make predictions on how the market will likely be affected. Then trades can be set. In this case you have to make sure the options expire before the announcement.

Credit Spreads 8

#3-Make sure your probability of winning is at least 80% to 90%.

This particular strategy was discussed above. An underlying asset only has 5 possible ways to move. In this case you have about 80% probability to make a profitable trade (4/5=80%). Even in the event of a disastrous development in the market a trader can adjust and come back from a trade that has turned against them.

To quantify options you can use the Black-Scholes Pricing Model:

Credit Spreads 9

The great news is that you do not have to know math to be able to use this formula, but this formula will show you the probability of success you have. If you are using ThinkOrSwim you can use the layout tab and see this probability. ThinkOrSwim offers great ways to see all other formula parameters right on your trading platform.

#4- Make Time Decay Work Harder for You. Sweet Spot—1 ½ to 2 ½ weeks

Weekly options were made available for trading in the spring of 2012, which has made it easier for retail traders to pick expirations and have an array of opportunities. Those type of options are exciting and allow for great earnings with quick equity returns. You can pick your spot on the time decay curve, whereas in the past you had to wait to the third Friday of the month because monthly options were the only ones available.

The time decay curve just shows that options do not expire in a straight line rather that the closer they get to their expiration the lesser their value becomes. Some traders trade options that are one or two months before expiration. This strategy is a bit harder for retail traders as it ties money for too long periods of time. That is why weekly options are great for the retail trader.

Selling credit spreads is an art. However, it is not a secret that the sweet spot for trading those options is at the 1 ½ to 2 ½ weeks. That way you can get ROI twice in one month.

Credit Spreads 10

#5- Get Bigger Credits by Selling Your Wings at Different Times.

An example here is a trade that was executed when the S&P500 was on the rise. A trader can sell the 1905/1910 (3.26.14) for $1.00. Then the market went down and put spreads were sold at the 1825/1820 (3.07.14) for a $1.00. In this case $2.00 were earned (one on the put and one on the call side) and all that is left to lose of the $5.00 is $3.00, thus leaving ( 2/3=67%) 67% return.

Credit Spreads 11

See the video below for a full overview of the trading education shared in this article.

For more education from Peter and Cashflow Heaven Publishing and to learn how to trade with 90% probability of success use this special offer here.