I have had a few people ask me recently about 2 of the option trading strategies that I use – Credit Spreads and Iron Condors, so I thought I would post this options trading tutorial for anyone interested.
Credit Spreads and Iron Condors are very similar. Basically an Iron Condor is TWO credit spreads. A Bear Call Spread and a Bull Put Spread. So, if you can get your head around credit spreads then you can easily master Iron Condors.
Credit spreads are something I have only mastered in the last couple of years. Prior to that, I never really understood the attraction as the potential losses can far outweigh the small gains. But since trading them I understand that the keys are:
1) Adjusting the trade if it gets into trouble
2) Placing the spread far enough out of the money that it hopefully won’t need adjusting.
The great thing about credit spreads is that you can be completely wrong in your analysis of where the market is going and STILL make money!! I will try to give you a couple of examples.
On Jan 19th, RUT had a pretty big selloff and finished the day at $785. It looked to me like the market was headed for further selling so I sold a Bear Call Spread above the market. Here are the details of the trade:
RUT Price on Jan 19th: $785
Trade: Sell RUT Feb 19th 845 call @2.08, Buy RUT Feb 19th 850 call @ 1.63
Premium received: $0.45 (or $45 per contract). I sold 5 contracts so I received $225
Total Capital at Risk: Difference between the strike prices LESS the premium received. 850-845-0.45 = $4.55 or $455 per contract. (with 5 contacts my total CAR was $2275). This is also the amount of your maximum loss and therefore the amount of margin your broker will require you to put up.
Max Return: $255 / $2275 = 9.89%
Break Even Price: $845 + $0.45 = $845.45. This means RUT has to stay below $845.45 for me to keep the entire options premium and achieve my maximum return
RUT % Return Before Entering Loss Territory: $845.45 / 785 – 1 = +7.70%
Time To Expiry: 31 days
This all seems pretty simple on paper, and it is when things go well. The key is managing the trade and having a good plan for when things go bad. Looking at this trade, RUT would have to rise by 7.70% before I lost money. If you look at the chart of RUT, it sold off for a couple more days and then rallied solidly into the Feb expiry, which was not what I wanted. The option premium had increased and I was sitting on unrealized losses part way through the month, but the option premium had not risen enough to hit my stop loss, so I stuck with the trade. Eventually RUT topped out at $838 on Feb 18th which was the day before my options expired. I was very tempted to adjust the trade on the 18th because if they market had a huge up day I could have been hit with some pretty big losses. I was ready to adjust or close my trade the next morning if the market continued to rally, but instead the market sold off 2.5% and my position expired with the maximum profit.
This is an instance of my market analysis being COMPLETELY wrong, yet I still made money on this trade. I thought the market would keep heading south, but instead it rallied about 6.70% and yet I STILL made money!
At the moment I have a Bull Put Spread on RUT for the May expiry, here are the details:
RUT Current Price: $821.51
Trade: Sell RUT May 19th 700 put @1.26, Buy RUT May 19th 690 put @ 1.03
Premium received: $0.23 (or $23 per contract). I sold 34 contracts so I received $782
Total Capital at Risk: Difference between the strike prices LESS the premium received. 700-690-0.23 = $9.77 or $977 per contract. (with 34 contacts my total CAR is $33,218). This is also the amount of my maximum loss and therefore the amount of margin my broker requires.
Max Return: $782 / $33,218 = 2.35%
Break Even Price: $700 – $0.23 = $699.77. This means RUT has to stay above $699.77 for me to keep the entire options premium and achieve my maximum return
% Return Before Entering Loss Territory: $699.77 / 821.51 – 1 = -14.82%
Time To Expiry: 30 days
With this trade my maximum return is lower, but the % movement that RUT needs to make is MUCH greater at 14.82% rather than 7.70% in the previous example. However the market tends to fall much faster than it rises so you sometimes need that extra margin for error with put spreads. Also you need to monitor the trade closely and get out of the position if it starts to go against you in a bad way. For a trade like this, I set my stop loss at 200% of the premium received. I received $0.23, so I will close out the trade if the premium on the spread reaches $0.69. If this happens my loss will be -$1,564.
If I wanted I little bit of extra protection on this trade, I could sell a Bear Call Spread above the market, thus creating an Iron Condor position.
Credit spreads have the potential to be more risky than other option strategies as the maximum loss is quite large. You really need to know what you’re doing with these trades before you attempt them. If you decide you want to try them out, you should paper trade them first to get an understanding of how they work, then when you go live with your trading, make sure you keep your position size small to start with until you are more experienced.
Anyway, I hope this helps, please let me know if you have any questions.
