Strategy

My option trading strategy is used to collect premiums over and over again. I prefer the slow and steady gains by using an extremely high probability trade. In this system, I trade high percentage winning credit spreads and Iron Condors month after month.

One advantage of credit spread trading is that in order to profit, we don’t need a directional move in the market. Instead, we profit from time decay. That’s the beauty of this system. We don’t need to rely strictly on picking directions and timing the market. Because we are placing our credit spreads on options that are out of the money, we are giving ourselves breathing room in case the market and ETF index moves against us.

What is a Credit Spread?

A vertical credit spread is constructed by buying one option and selling another option of the same type (call or put) in the same expiration month, where the option sold is more expensive than the option bought, resulting in a net credit to your trading account.  With a credit spread there is a margin requirement based on the difference in the strike prices and the number of contracts traded.

The market can even go against us and we still make the same amount of money. We profit from time decay. The rapid decay in option's value works in our favor. Time is on our side. We don't need to rely on market timing to profit. Because we give ourselves a cushion when we place the spread order, we can weather a downturn or upturn and still profit.

Our trades have a high probability of expiring worthless at expiration month-after-month. We usually do not have to make adjustments to the open trades. Instead, I prefer to enter the spread trade and then let them expire worthless. But when the market is moving in one direction I will exit (close) an open trade if I have realized 80%, or more, of the original profit. The best part of this trading strategy is that we collect all our profit upfront. The credit goes into our trading account when the spread order is filled.

The Iron Condor

The iron condor is a neutral strategy that is a combination of a bull put spread and a bear call spread. To setup an iron condor, the options trader sells a lower strike out-of-the-money put, buys an even lower strike out-of-the-money put, sells a higher strike out-of-the-money call and buys another even higher strike out-of-the-money call. This results in a net credit to put on the trade.

The key is choosing Put and Call options that are very FOTM (Far Out Of the Money) and safe. I trade options that I expect to be worthless at expiration. My strategy is very boring and good for those desiring a steady 8% monthly return with minimal risk. I only process one Iron Condor trade a month and normally start with Bull Put or Bear Call Credit Spreads earning 4% each. When I  complete an Iron Condor the return is doubled because margin is only required for one side of the trade.

Risk Management

In 2009 my risk management strategy will continue to deal with wild price swings and market surges. I want my cash flow to stay positive and I want to keep collecting credit premiums month after month. I am a risk manager first and an investor second. Sure there are other option trading strategies that can make more money. But nothing in life is free. Greater rewards means greater risks and greater risks is how you get wiped out. You will never last long taking on greater risks when trading. Trading is about stamina and consistency, not about how many homeruns you can hit.. The more you try to swing for the fences, the more you will strike out, except in trading a strike out means being WIPED out. Credit spreads provide us an automatic hedge since your loss is limited and the long options help offset adverse movements in the index. When a credit spread trade is filled I immediately focus on protecting this position and the premium I collected.

1. If the ETF index starts moving towards a short strike, and I usually have quite a cushion in front of it with OTM strikes. I like to add additional spreads to take advantage of the surge. This is normally the best time to enter a new credit spread position because credit premiums will also be rising with a market surge.

2. What usually happens is that by the time the fund index gets close to my short strikes, a significant amount of time has passed and time decay has worked its magic to counter some of the movement higher in the options.

3. When a fund index price does move against us we have a number of defensive strategies that we can use to help reduce or prevent a loss. One of them is to rollover a spread. In doing this, we simply close out the current month spread, and open a new credit spread in the next month. The advantages for doing this are:

- Helps prevent a significant loss
- Maintains the possibility of a profit in a rollover
- Allows us to move the strike prices up or down.

This gives us more breathing room in a spread. The main disadvantage of rolling spread trade is that it will tie up our funds for a longer period of time. Although I do not like to roll positions, sometimes it’s the best way to prevent or reduce a loss. I would rather lower the return in the spread and preserve our trading capital than to take large losses.  

Trading Capital

With this strategy your trading capital is only used to support margin requirements. Most option brokers  allow you to invest this capital elsewhere to be used as collateral for spread trading. These brokers do not require margin to be in cash so you can actually earn more than just the spread premiums. Trading capital can be invested in closed-end funds that pay dividends monthly and are diversified across munis, preferreds, REITs, corporate bonds, floating rate loans, convertible bonds and other fixed instruments. Between the dividend yield and capital appreciation you can earn 7%-10% annually. Most brokers allow you to margin 100% of cash amounts, 90-95% of t-bill amounts and 50% of the stock accounts like closed-end funds. The majority of option brokers permit the trading of credit spreads in an IRA account as long as the account balance is cash.