How to Generate Income Trading Credit Spreads – 1/19/13

Lately my mind has been whirring with the idea of doing more credit spreads to generate income in my portfolio every month. Kind of like a part time job; that requires minimum work. I think the one day session with OptionsANIMAL and Emilu and Jon had something to do with it. I have taken options classes quite a few years back with Optionetics and understand the concepts quite well. I have also traded credit spreads – but not in a planned strategic manner.

The basic idea in credit spreads is to sell a Bear Call spread in the near month, when the market is expected to be neutral or go down or sell a Bull Put spread when we have a positive or neutral bias in the markets. The income generated from the trade, immediately goes into your account. This is certainly not a method for a beginner although the risk many say is limited. Firstly it is a little misleading to say the risk is limited.

How would we like to make $900 in a trade with a 90% chance of winning? Great, right? Now what if I told you the risk of losing is 10% but the loss could be $9,000 that is not much fun. If you had a $10,000 account, the first trade, if it went bad, could almost annihilate the account. Not so good… but years back I was excited with this method and picked up Don Fishback’s method with ODDS. It is a little fuzzy to me now but essentially the method used options on an index like the S&P and sold spreads on both sides of the index at about a 90% chance of winning. During one Superbowl game, I sat down and while watching the game, back tested the strategy by working month after month of transactions on paper to see how it would go. At first the account grew with win after win. As the markets climbed, the volatility shrunk and the credits received grew smaller and smaller and with the difference in bid and ask, it was smaller wins. In fact the temptation was to increase the number of positions. Finally a couple of bad trades hit the account and months of profits disappeared “poof” in a flash. That is the part most companies selling you “how to trade credit spreads” don’t tell you. I will get back to that later now that I have warned the readers and myself. Clearly there is a need to control the loss and conduct a "Repair". Such a “Credit Spread Repair Strategy” would reduce the impact of the large losses and  contain it. Here is how it would go.

EXAMPLE OF CREDIT SPREAD:
Step 1. In a bearish trend, you have sold a call credit spread. ABC stock is at $100.
SOLD ABC July 120/125 Call Spread@ 0.80. Net Credit $80

Typically you would sell the near month expiration or less than 30 days to expiration. That would enable you to take maximum advantage of time decay on the Greek theta.

If the stock moved sideways or went down, or even went up slightly and ended the time period below 120, you collect the $80. If you traded 10 spreads, that was a cool $800 income in your account. Not bad.

Let us consider a credit repair strategy…

Step 2. The trend reverses, and the stock hits $120 rather quickly because Helicopter Ben flew in and printed more money and the markets loved it. Trade a repair as follows:
BUY ABC July 120/125 Call Spread@1.50. Net Debit $150
Sell XYZ July 135/140 Call Spread@0.80 Net Credit $80
RESULT: Total Credit (from both trades) = $160; Total Debit (from buy back)=$150. Total Net = $10

More details can be found at the website I used this example from 

http://www.swing-trading-options.com/trades.html

Using a timing tool would be nice to increase my edge to be on the right side of the trend.

I will trade this strategy with my QQQ system that I have written about previously as well as with CAT. Attaching a simple chart of CAT with my swing trade timing signals. If I had a down signal, I would sell a Bearish Call spread. If after a few days I got an up signal, I would buy back the spread, close it and sell a Bull Put spread. I will also avoid ex-dividend dates and earnings dates. Best to keep a calendar with those dates marked.

Attaching a chart of CAT dated 1/18/13 as an example. For some reason the blogger does not allow me to upload a current chart on Internet Explorer. Guess I have to use Google Chrome...