As an options trader I am often asked about my favorite options strategy for producing income. I have been bombarded with questions from investors for years about how to trade small cap stocks for income using options. In my opinion, the best way to bring in income from options on a regular basis is by selling vertical call spreads and vertical put spreads otherwise known as credit spreads.
Credit spreads allow you to take advantage of theta (time decay) without having to choose a direction on the underlying stock. This is great when you aren’t 100 percent confident in the mid-term direction of say, an ETF.
Vertical spreads are simple to apply and analyze. But the greatest asset 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 limited risk, but also limited rewards.
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.
Stock traders can only take a long or short view on an underlying ETF, but options traders have much more flexibility in the way they invest and take on risk.
So what is a vertical credit spread anyway? A vertical credit spread is the combination of selling an option and buying an option at different strikes which lasts roughly 10 – 40 days.
There are two types of vertical credit spreads, bull put credit spreads and bear call credit spreads.
Here is an example of how I use credit spreads to bring in income on a monthly and sometimes weekly basis. I will use a bear call credit spread for this discussion.
Fear is in the market. Look no further than the Volatility Index, or the VIX (otherwise known as the investor’s fear gauge) to see that the fear is palpable. However, opportunities are plentiful with the VIX trading at 35 – especially those of us who use credit spreads for income.
Why? Remember, a credit spread is a type of options trade that creates income by selling options.
And in a bearish atmosphere, fear makes the volatility index rise. And, with increased volatility brings higher options premium. And higher options premium, means that options traders who sell options can bring in more income on a monthly basis. So, I sell credit spreads.
As we all know the market fell sharply in the beginning of August 2011 and the small cap ETF, iShares Russell 2000 (NYSE: IWM) traded roughly 18 percent below its high one month prior.
So how can a bull put allow me to take advantage of this type of market, and specifically an ETF, that has declined this sharply? Well, knowing that the volatility had increased dramatically causing options premiums to go up, I should be able to create a trade that allows me to have a profit range of 10-15 percent while creating a larger buffer than normal to be wrong. Sure, I could swing for the fences and go for an even bigger pay-day, but I prefer to use volatility to increase my margin of safety instead of my income.
Think about that. Most investors would go for the bigger piece of the pie, instead of going for the sure thing. But as they say, a bird in the hand is worth two in the bush. Take the sure thing every time. Do not extend yourself. Keep it simple and small and you will grow rich reliably. Back to the trade.
Basically, IWM could have moved 9.8 percent higher and the trade would still be profitable. This margin is the true power of options. IWM was trading for $70.86:
- Sell IWM Sep11 78 call
- Buy IWM Sep11 80 call for a total net credit of $0.24
The trade allowed IWM to move lower, sideways or even 9.8 percent higher over the next 32 days (September 16 was options expiration). As long as IWM closed below $78 at or before options expiration the trade would make approximately 12.0 percent.
It’s a great strategy, because a highly liquid and large ETF like IWM almost never makes big moves and even if it does, increased volatility allowed me to create a larger than normal cushion just in case I am wrong about the direction of the trade. So, selling and buying these two calls essentially gave me a high probability of success – because I am betting that IWM would not rise over 10 percent over the next 32 days.
However, I did not have to wait. IWM collapsed further and helped the trade to reap 10 percent of the 12 percent max return on the trade. With only 2 percent left of value in the trade it was time to lock in the 10 percent profit and move on to another trade. I am always looking to lock in a profit and to take unneeded risk off the table especially if better opportunities are available. I bought back the credit spread by doing the following:
- Buy to close IWM Sep11 78 call
- Sell to close IWM Sep11 80 call for a limit price of $0.04
I was able to lock in 20 cents in profit on every $2 invested for a 10% gain in less than 5 days. Not too shabby.
Can We Make Money in Range-Bound Markets with Credit Spreads?
Since the beginning of 2011, the small cap ETF, iShares Russell 2000 (NYSE: IWM) had traded in a fairly tight range vacillating between support at $77.50 and resistance at $86.00.
The ETF was range-bound, so committing to a big directional play higher or lower was a high risk decision. I preferred to make a low-risk, non-directional investment, using credit spreads. As I have said before, we can also use range-bound markets to make a profit. How can credit spreads allow us to take advantage of a market, and specifically this ETF, that has basically stayed flat for seven months? Well, knowing that the market has traded in a range for the last seven months we can use this as our guideline for our position. Credit spreads allow you take advantage of a sideways or directional market while also giving you some breathing room if/when the range is broken. So, let’s take a look at the trade using IWM, which was trading at $83.67:
- Sell IWM Sep11 90 call
- Buy IWM Sep11 92 call for a total net credit of $0.25
The trade allows IWM to move lower, sideways or 7.5 percent higher over the next 53 days (September 16 is options expiration). As long as IWM closes below $90 at or before options expiration the trade will make approximately 12.5 percent.
Inherently, credit spreads mean time decay is your friend. Most options traders lose value as the underlying index moves closer to expirations. This is not the case with the credit spread strategy, as the underlying ETF moves closer to expiration and remains below/above the short strike of the spread, the strategy makes money.
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