This article is based on my experience from over 45 years of perfecting my stock-trading strategies and risk-control skills.
Learn How Credit Spreads Can Make Profits Safely
This article is for those who have at least some experience with options trading and want to learn something new.
People use many strategies to trade options, such as Iron Condors, Calendar Spreads, Butterflies, Straddles, and Strangles. I will discuss a strategy using credit spreads in this article, focusing on the rules of success rather than the types of strategies.
My 45 years of experience helped me discover how to increase profits and limit risk, which I explain in this article.
Why It's Called a Credit Spread
Note that I'm not talking about buying options. Doing that in hopes of picking the correct direction is a loser’s game. What I am talking about is selling option premium.
Many people I talk to don't understand that we can sell something we don't own. But selling options for credit is just that! It's the premium on the option you get for the sale, and if the option loses value, you keep the difference.
Stocks with high volatility demand more premium on its options, and that's the premium you sell.
You might be wondering why people are willing to buy that option from you. The buyer is hoping the underlying stock will move swiftly in the direction they think it will, in which case they make a quick profit.
The problem with that strategy is that their timing might be off. They have to be right within a short period because the option loses value as it gets closer to expiration if the stock doesn't move as hoped. But that helps you, as the seller.
Their loss is your gain. That's why you are better off being on the selling side of the trade. See my point?
You'll need an online broker that supports option selling, especially credit spread strategies. I'll explain how to define your risk by using a "spread trade" technique.
So, with that preliminary explanation, let's get into the nitty-gritty.
Comparing Options Trading to Stocks
When buying stocks, you have a 50/50 chance of success. It can only go up or down. With only two possible results, it’s a 50% chance of increasing in value at any point in time.
On the other hand, stock options provide the opportunity to improve the odds since there is more than one way to have a profitable trade. With the proper strategy, you can be wrong in predicting the direction and still make money.
Uneducated traders think that options are dangerous and give you a chance to lose all their money. They say options lose value quickly and expire worthless.
All this is true, but that’s the beauty of it. When one knows how options work, they can make money with much less risk than with stocks.
A complete understanding of what I’m about to discuss requires knowledge of the terms I’ll be using. If you don’t know what "option premium erosion" is, or "Option Greeks," or "implied volatility," don’t feel bad. Many traders don’t fully understand these things either. Just ignore anything you don’t understand. You will still grasp the crux of what I’m saying. I assure you. I know you can do that.
Rules for Trading Options Successfully
I learned some rules that made all the difference with my success. When you follow these rules, you'll improve your chance of profit considerably:
- Sell options when Implied Volatility Percentile is high.
- Buy options when IV Percentile is low.
- Define your risk when entering a trade.
- Manage winners mechanically, not emotionally.
I'll explain all that as we move on.
How You Sell Option Premium With Defined Risk
The idea is to sell options to people who are willing to pay a premium for them. When an option expires OTM (Out of The Money) it is worthless. When that happens with an option you sold, you keep all the money (the premium) you received for the sale.
Buying stocks has only a 50/50 chance of a profit. Additionally, when you buy a stock, you are risking all your money. But you can sell options with a defined-risk strategy.
You define the risk by buying an option further out of the money for much less than the premium received.
An analogy will make this clear:
You sell an option to someone who wants to buy it for one of two reasons:
- They think it will move in their direction by a certain amount within a specific time. That is pure gambling. But you are on the other side of the trade, and it’s always in favor of the house. And YOU are the house.
- They buy a PUT option as insurance against loss on a stock they own. Or they buy a CALL option as insurance to be able to buy a stock at a particular price.
Either way, you are selling insurance, and you keep the premium if things don't favor the buyer.
How to Stay in the Game Even When You Are Wrong!
A mistake some traders make with selling options is thinking they get to keep all the money when the option expires worthless. That works only until the day that they bet wrong and get a margin call from your broker.
However, entering a spread trade by buying a low-cost option as protection to define your risk allows you to stay in the game even when you are wrong. I'll explain that in detail in a moment.
You can never get a margin call because you have established how much you risk when you enter the trade. It can’t ever get worse, no matter how wrong you are.
So, staying in the game offers a great opportunity. When you are wrong, you can roll a losing trade forward another month, sometimes with a credit. That credit reduces your cost-basis.
How to Profit More Than 68% of the Time
When you enter a trade with the strict rules that I'll explain below, it will be profitable 68% of the time.
- You need to look for a stock that has options trading with an Implied Volatility Percentile higher than the average for that stock.
- Consider options that will expire in roughly 20 to 50 days. That is the best period to realize a profit from theta decay. Theta is one of the Option Greeks that help with doing things right. A good online broker should have an option to display the Greeks.
- You need to sell an option more than one standard deviation away from the current stock price. That will have a delta of 20 or less. (Delta is another of the Option Greeks.
- You need to define your risk by buying insurance. How? By purchasing a similar option further out of the money. That's known as a spread trade. It's the spread between the option you're selling and the protective option you're buying. It does reduce the premium you receive, but it locks in (or defines) a maximum risk.
- You need to take a credit of at least 1/3 of the spread. Remember that you’re selling, not buying. So you get a credit for the trade.
Example: If the spread is $10 between the option you sell and the option you purchase for insurance, then you want a credit of $3.33. That’s 1/3 the spread. So you risk $10 to make $3.33.
After commissions, let’s make it an even $3. So if you want to make a $300 profit, you risk $1000. (When can you make $300 on a $1000 stock investment in one month?)
How to Manage Your Profit
You can do two things to manage your success rate and increase profits beyond a 68% Probability of Profit (POP).
- Rather than sell premium one standard deviation from the strike price, go out two standard deviations (a delta of 5). That raises your probability of profit to 95% because there is only a 5% chance the stock will move that much within the particular timeframe.
- Rather than waiting for a trade to expire so that you keep 100% of the premium received, take profits when you have a 50% gain or higher.
If you wait for a home run, it can turn against you due to volatility. Besides, closing a trade sooner frees up the risk so that you can enter new trade when you find another good opportunity.
Someone once said, “I never lost money by closing a trade too soon.”
How to Close a Spread Trade Position
When you entered a trade to sell premium with defined risk, you sold a credit spread. That means you sold an option to get premium and bought another further out of the money at a lower price to protect yourself and lock in a maximum possibility for a loss.
You received a credit because the option you sold was more expensive than the one you bought.
You'll have a profit when the value of the short option (the one you sold) loses value. The long option will lose value too, but it doesn't have much left to lose anyway, which is why you have a better than 50/50 probably of profit—even 68% to 90% POP if you adjusted your spread well.
To close the spread trade position, you buy back the short option and sell the long one. The cost of closing the position should be less than the credit you received, leaving you with a profit.
If the trade went against you, you would be paying more to close it. But another way you can handle that is to roll the trade forward to the next month, usually with a credit. That would buy you more time.
Remember, option premium erodes over time, so you eventually should have a profit buying back at a lower price as long as the underlying stock doesn't have an extreme move.
Five Rules for a Better Experience
1. Pay Attention to the Open Interest
If you find a seemingly good trade with a high Probability of Profit (POP), first check the open interest at the strike price where you plan to trade. Most options brokers display the open interest.
If few people are interested in it, then the bid/ask spreads are too wide, and it's best to stay away from those trades. No matter how good it looks, it's useless if nobody is buying or selling.
2. Stay Small With Your Trades
You need to limit yourself to small trades so you can stay in the game until the trade comes to you. It's rare to enter at the right time.
Most likely, a trade will initially go against you. But if you keep it small, you'll be able to wait for it to come back. Selling premium has a better chance for that to happen since premium erodes with time.
3. Learn From Your Mistakes
When you have losses, examine how you entered the losing trade.
When I do that, I see what I did wrong, and I avoid repeating the same mistake.
A safe method is entering trades two standard deviations from the strike price, as I explained earlier. If you're greedy and sell within one standard deviation just to make more money, you have a likely chance of getting burnt. I've made that mistake.
But even in that case, you can buy more time by rolling forward until you get back to break-even. Eventually, you might get your money back even when you're wrong. However, the better plan is to avoid those trades that have a lesser POP and not be greedy.
You will make mistakes, but keep track of when you win and when you fail. Then you'll have something to look back on to see why you have specific patterns.
4. Admit When You're Wrong
When you have a bad trade that's going way against you, consider rolling forward at break-even or a with small credit.
You could be right and just have the timing wrong. So buying more time gives you a second chance. And usually, you can roll at a credit because there is more premium another month out.
There is no cost of buying more time. You're just holding your risk for another month. The main thing is that you need to admit you are wrong in the short term, and you need to make adjustments.
5.The Most Important Rule: Wait for the Right Opportunity
If you can’t enter a trade with all the parameters I mentioned earlier, move on.
Many people try to squeeze out a bad trade out of greed. Or they simply don’t pay attention to all the rules. I'll admit I've made those mistakes. Try to be better than that.
If you can't enter a trade with all the correct parameters, just wait for another opportunity. There will always be another chance for a trade that works.
When you stick to making good trades, you will be in the 68% category. Sure, you will lose 32% of the time. But I like those odds.
I never sell premium on options less than a delta of 10, which has a 90% chance of POP. I make less money, but only 10% of my trades are losses.
Let's review the crucial points that make money safely with options possible.
- People who buy options usually lose money because options lose their premium as they approach expiration. You take advantage of that fact by selling options to others. When they lose, you keep their money.
- The only way they can win is if they are right with the direction of the underlying stock—and the timeframe for that to happen. To protect yourself from such a situation by limiting your risk with a credit spread—selling a high-premium option and buying a lower-cost option to cover you in case of an extreme move by the underlying stock.
- When you buy an option that's farther out-of-the-money, you are effectively defining your risk, and it costs much less than the premium you received, so the difference is the amount you can potentially profit.
- The defined risk is the spread between the option you bought and the option you sold. That locks you into a maximum loss that can't get any worse if you're wrong.
- And remember that you can be slightly wrong and still come away with a profit because the options you sell to buyers erode in value over time.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2013 Glenn Stok