First of all I want to wish everyone a happy holiday and a prosperous 2017!
So, how am I preparing for the year ahead?
By doing the same thing I’ve done for the last 18 years. Selling options using credit spreads with a high probability of success.
The market once again moved higher in 2016, vacillating between slightly negative and defiantly positive. But there is no doubt that uncertainty has moved into the market.
So, as an investor, are we supposed to sit on our laurels and allow Mr. Market to dictate our returns?
We all look like financial geniuses when the market is going higher. Investors take all the credit for their success when the market is soaring, but blame other factors – such as geopolitical concerns or central bankers – when investments sour. The talking heads make sure the culprits are front and center to make the blame game that much easier.
But, I don’t really care.
I don’t care because the ongoing news cycle never ends. I don’t care because it has been proven that professional analysts can’t outperform the market. But, more importantly, I don’t care because stock picking is a coin flip, and the probability of success is only slightly higher than 50% due to the risk-free rate.
I care about volatility. I care about probabilities. I want every single trade I make to have a high-probability strategy wrapped around it, and an increase in volatility allows me to increase my pot odds even further.
But before I go down that road, let us get back to market uncertainty for a moment.
The S&P 500’s performance over the past few months has had a direct correlation with the decline in volatility and that we are once again at near historical lows in the VIX. As a contrarian, these are the types of opportunities I seek.
My Approach: Options Strategies in 2017
The strategy is known as a vertical call spread or bear call spread.
It’s a type of options strategy used when a decline, or at least limited upside, in the price of a stock or ETF is expected. It suffers when an underlying security pushes significantly higher over a 30-45 period much like what we saw post-Brexit and post-election. But we know that those were anomalies.
So let’s get back to what typically occurs.
The chart displays the average gains/losses for the S&P 500 on a monthly basis. IF we know that these are the norm, with obviously a few expectations in the mix we can plan ahead by using strategies that account for a margin of error . . . because again, no one can predict where the market is going directionally.
For example, let’s assume that the SPDR S&P 500 ETF (NYSEArca: SPY) is trading at roughly $226 and you expect there is limited upside over the next 30 to 60, especially after the bullish move we have experienced post-election. As a result, you decide to use a bear call strategy. I say 30 to 60 days because with options we have the ability to customize the duration of our trades.
By definition, a bear call spread is achieved by selling call options at a specified price while also buying the same number of calls, but at a higher strike price.
For instance, with SPY trading at $226, an options investor could sell the 231.5 strike for at least $0.88 and buy the 233.5 strike for $0.52. If you subtract the two you end up with a total of $0.36, which equates to a 21.9% return over 37 days.
Now, if you look at the strike sold at 231.5, the probability of success (Prob. OTM) is 79.22%. That means that there is a 79.22% chance that SPY remains below $231.5 at the time of January expiration in 37 days. So basically, as long as SPY stays below $231.5 over the next 37 days, you will make 21.9%, and the chance of that happening is 79.22%.
If we wanted a more conservative trade we could sell a higher strike, let’s say the 233 strike. This would increase our probability of success to 85.01%, but it would also decrease our return on the trade, which is perfectly fine. We could sell the 233 strike for $0.57 and buy the 235 strike for $0.35. If you subtract the two you end up with a total of $0.22, which equates to a 12.4% return over 37 days.
It’s a more conservative trade, but we have increased our probability of success by roughly 6% while maintaining a decent 12.4% return over the next 37 days. That being said, I prefer the former because I always look to buy back the spread, thereby locking in profits, long before the trade is due to expire.
More Options Strategies
Another choice is to use an iron condor strategy. You could maintain the probability of success that resides in the 233/235 spread (85.01%) and bring in another $0.20 or more by selling an out-of-the-money bull put spread with a probability of success around 85% as well. The benefit . . . because a stock can only close above or below a short strike at expiration, you are only responsible for the maintenance requirement on one side of the condor. Yes, you are exposed to the downside, but again, we are not trying to predict anomalies. This is just another reason why we are initiating a new Iron Condor portfolio in 2017. If you would like to know more please click here to view my latest webinar where I discuss the strategy and my approach to iron condors at length.
Are you starting to see why so many professional options investors use bear call spreads as their bread-and-butter strategy?
I realize that for some of you these concepts and options strategies are completely foreign, but I can promise you that once you begin learning about how options can work to your advantage, you will never go back to just using a buy-and-hold strategy.
There’s just too much opportunity in these options strategies to put your hard-earned money to work in more effective ways. Whether you want to provide another source of monthly income or just protect the hard-earned profits in your buy-and-hold portfolio, options are the ticket.