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What is your favorite strategy for producing income?
As an options trader, I am often asked this question. I have been bombarded with questions from investors for years about how to trade stocks and ETFs for income using options.
In my opinion, the best way to bring in income from options on a regular basis is by using options selling strategies like selling puts, vertical spreads, iron condors and the like. But truly, the best options strategy is the one that’s currently working. I know . . . it’s.obvious, right? But, it’s true and it’s why it is imperative that you diversify among a basket of these options trading strategies. Because when a few are struggling, several others are most likely outperforming.
Anyway, today I want to focus on vertical call spreads and vertical put spreads, otherwise known as credit spreads.
Vertical spreads are simple to apply and analyze. But the greatest benefit of a vertical spread is that it allows you to choose your probability of success for each and every trade.
And in every instance, vertical spreads have a defined risk, so you always know how much you can make or lose on each and every trade.
My favorite aspect of selling vertical spreads is that I can be completely wrong on my assumption and still make a profit. Most people are unaware of this advantage that vertical spreads offer.
Can you explain your process for choosing trades in your income-producing strategy?
First, I look for efficient markets. Professional options traders know that there are only 80 to 100 products (ETFs and stocks) out there that offer efficient markets. For clarification, I define an efficient market by a tight bid-ask spread.
Next, I watch for overbought/oversold extremes within the short list of ETFs that I follow. I use the RSI over different timeframes to compare an entity’s performance to itself over a period of time. RSI allows me to gauge the probability of a short-term to intermediate-term reversal. It does not tell me the exact entry or exit point, but it helps me to be aware that a reversal is on the horizon.
Knowing that a short-term top/bottom is near, I am able to increase the probability of a potential trade. Conversely, knowing that a reversal is on the horizon I am able to lock in profits on a trade.
Lastly, I allow probabilities to give my strategy (credit spreads) the final edge.
And why do credit spreads give me an edge?
Let me explain it in poker terms.
Professional poker players are known to seek out “soft” or “weak” tables as a source of income. This means that the more inexperienced players there are at the table, the easier it will be for the seasoned pro to take their money.
It’s really no different in the world of options, particularly when using trading strategies with a statistical edge like credit spreads.
Finding the consistent loser or novice trader is how the poker pros generate the bulk of their gains. When I trade credit spreads, I take advantage of the speculation of others, typically newbies who are buying out-of-the-money calls or puts with the hope that they will eventually move into the money.
There is, however, a skill in knowing who those amateurs are and what behaviors they exhibit to clue you in on their lack of experience.
In poker, the individual who shows too much emotion or doesn’t truly understand the game will be cleaned out in short order.
In options trading, everything is laid out in the options chain – a list of option characteristics at different strike prices. By looking at the “probability of expiring in the money” – the chance that a stock or ETF will close above (for calls) or below (for puts) the chosen strike – the options trader can make decisions based on the speculation of others. But unlike poker, the participants show their hands when trading credit spreads.
This is THE advantage credit spreads offer over any game or investment vehicle out there.
For instance, with the SPDR S&P 500 ETF (NYSEARCA: SPY) trading around $260, some traders are making wagers that SPY will move above $266 by January options expiration in 58 days. The chance of that happening is 16.87%.
What about traders who think SPY will push above $268 by January options expiration in 58 days? The chance of that happening is 10.69%.
With those types of odds, why wouldn’t I want to take the other side of the trade? Depending on which options I choose, my probability of success is 83% to 89%.
In most cases, I would choose to sell the $266 call options and buy the $269 call option.
The trade would look like the following:
- Sell to open SPY January 266 call
- Buy to open SPY January 269 call for a total credit of $0.34.
The goal of selling the SPY bear call (credit) spread is to have the underlying ETF, in this case SPY, stay below the 266 strike through the January expiration in 58 days.
Here are the parameters for this trade:
- The Probability of Success – 83.12%
- The max return on the trade is the credit of $0.35 or 13.2% based on the required margin ($265) over the next 58 days.
- Break-even level – $266.35
Next week, I will be bringing you a special issue regarding the current state of the market and my look ahead for 2018. Stay tuned!