Tag Archives | credit spreads

How Should a Beginner Approach Option Trading?

The following question seems rather tame, but it addresses a very important issue:

Is there a correct syllabus for new option traders?

Hello Mark,

I’ve just starting to read your Rookie’s Guide book, bought from Amazon. I also read several other options books, while doing my paper trading with OptionXpress with thinkorswim platform.

I also have joined an options course and what they teach are very basic, which is just Buy To Open (Call / Put) and Sell To Close (Call / Put) and pay attention to the candlestick chart for entry point. So making profit from that simple strategy. What do you think of that strategy? They didn’t teach any strategies mentioned on many options books.

Candlestick Charting

Candlestick Charting

But after reading couple of books on options, they all teach the Covered Calls as basic strategy, which from my understanding that one investor has to have real stocks in order to make the options trading. Do I need to buy real stocks? Is that true?

How about if we only open an options account, and didn’t have a real stocks to trade in that Covered Calls strategy? And why I can’t trade the Covered Calls in optionsXpress? Please help me.

Thanks in advance,
Aldo Omar

Paper trading is an excellent idea. It teaches you how to handle your broker’s platform and it gives you experience learning to make critical decisions — entering and exiting positions.

However, this course is a disgrace, in opinion. I do not care how respectable the course giver is, but these lessons are almost guaranteed to see their students go broke when using options. Unless they explain that the course is designed only to teach you something about options and that “buying to open and then selling to close” is NOT a strategy that you ever want to adopt, they are doing you a great disservice. I hope this course is free because it is not worth even that much.

  • First; A trader, and especially a new trader, cannot be expected to know how to use Candlestick charts. It is extremely difficult to “pay attention to” charts and come away with useful information. Think of this way: Candlestick charting is well-known and used my millions of traders around the world. Despite that, the data is clear: The average individual investor does worse than the S&P 500 index. The average mutual fund manager — someone who ears big bucks to pick winning stocks and beat the market averages — cannot beat the averages. Do not get trapped into believing that you can read one or two books on charting and know how to sue the charts. My conclusion is that it is far more difficult to pick entry points than your course teachers suggest.
  • Second; You are learning the simplest of all strategies, and that is a good thing because one should begin with the most basic concepts of options. However, it should have been mentioned as often as possible that buying to open and then selling to close is a death wish. Unless you (A. O.) have a proven track record of predicting which stocks will rise and fall, then you must not — for your financial well being — believe that you can suddenly start trading options and become a successful stock picker. Life does not work that way and using Candlesticks will not turn you into a successful stock picker. The professionals cannot predict stock direction on any consistent basis, and neither can you
  • Third; Even if you work diligently and learn to read the charts successfully, there is more to “buy to open” than simply picking a stock and correctly forecasting the direction of the stock price. Did they teach you that buying out-of-the-money options is not a viable strategy? Did they teach you to pay attention to the implied volatility of the options? In fact, did you learn anything at all about volatility and how crucial it is to an option trader? I assure you of this: If you but out-of-the money options and if you buy them when their prices are relatively high, you will ruin your trading account, even when you get the stock direction right. My advice: If you are going to play the “buy to open” game, at least stick with options that are already several points in the money when you buy them.
  • Fourth; I know that advanced strategies cannot be dumped into the lap of a beginner. Building a sound foundation in option basics comes first. But that is no reason to teach a strategy where the vast majority are guaranteed to fail.
  • Fifth; Yes, covered call writing is a sound basic strategy and yes, it does involve the purchase of stock (in multiples of 100 shares). However, it is still a bullish strategy and the covered call writer can still lose a lot of money if the market takes a dive. Obviously you lack the cash to buy stock. That is okay because there are other ways to use options to generate exactly the same profit/loss profile as writing covered calls. You will get to that in Chapters 13 and 14 in the book that you are reading (The Rookie’s Guide to Options; 2nd edition).
  • Last; The whole idea about using options is to hedge (reduce) risk and still give yourself a good probability of earning a profit on any given trade. Buying options based on Candlestick chart reading is not one of the paths to success. Sure some people can do it, but you don’t want to count on being one of them. Covered call writing is “better” for the new trader – but only when he can afford the downside risk. However, there are other strategies that I would recommend for you. At the top of the list is “credit spreads.” But please have patience. Don’t jump to the chapters on this and related strategies. Go through the lessons at your own pace and if possible, resist the temptation to trade until you feel comfortable.

I hate that course and the sad fact is that this is popular stuff taught by many people.

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Advice for the new options trader

I ‘borrowed’ (and modified) the following question from the EliteTrader Forum.

I have been studying, paper trading, and real trading – using mixed options strategies with mixed results. I mainly sold call & put spreads and did ok – until I got hammered on one trade. I’ve tried weekly & monthly expiration because I was attracted to these trades and their high probability of profit.

I have a $5k account and pay $1.50/contract flat rate commissions. At the moment, I am being lured into iron condors.

I am not dependent on my account but I want to grow it. I prefer strategies that require low monitoring/maintenance, but I am open to suggestions. What strategies should I try to incorporate and why?

Good news for this trader

This rookie trader is seeking advice, has experimented with several trade ideas, has a good attitude (does not expect instant riches), and incurred a loss from which he has learned a lesson. He appears to be patient and is seeking new ideas to consider.

This person has a nice edge: He has a flat rate commission per contract. That allows him to trade small size (yes, even one-lots) without having to be concerned that the ‘per ticket’ charge will consume too much of any profit. This was an intelligent item to negotiate and I strongly recommend this idea for all traders who trade small size. The savings can be significant – if you can get them.

The not so good part of the story

He is being ‘lured’ into a new strategy, but he should only adopt this play if he feels comfortable using it. In truth, it’s merely a combination of the strategies he has already been using – and in my opinion, anyone who understands the risks associated with selling vertical spreads is ready to consider trading iron condors.

The other problem is the size of the trading account. I understand that brokers allow customers to trade with even less capital, but it is a difficult task. It is simply too easy to lose the entire account when it is small.


As a young person with a job, he is in position to make a deposit into this account every time he receives a paycheck. That’s an outstanding method for increasing wealth over time. However, with this advantage comes the responsibility of carefully managing risk.

Learning to do this well takes time. The best recommendation I have is to be very careful with trade size because that is the simplest and most efficient method for managing risk for any trader. Smaller is better. Less risk and less profit potential is better – especially when the trader is first getting started. There is plenty of time to increase size as experience and confidence grow.

Patience is necessary because some strategies (such as selling credit spreads) may take some time to perform as hoped. [It’s true that selling a put spread can become very profitable quickly when the stock rises, but in a neutral market, iron condors require patience and good risk management.] Experience does not come quickly.

I also offer this advice for our rookie trader:

  • Rapid time decay may look great on paper, but (as you already learned) it comes with explosive negative gamma, making these trades riskier than they appear
  • Longer-term options come with higher premium and more protection against unwanted market moves. They also lose time value more slowly
    • Trading involves trade-offs. Less risk requires accepting a smaller profit target.
    • Your problem is to find the trade-off that feels ‘just’ right.’ Not a simple task – but it gets easier with experience
  • Choosing a good strategy is important. You want to feel that you understand how to use it effectively
  • However, risk management is more important and will have the greatest effect on your overall performance
  • Which strategies?

    The list is long. Options are very versatile and provide many alternatives. If you are comfortable with credit spreads, they make an excellent choice because losses are limited, margin requirement is small – allowing you to diversify, and they are easy to understand.

    Then there is something you may not yet recognize: Selling the put spread is equivalent to the very conservative collar strategy. More than that, selling put spreads is the same as buying call spreads (same stock, strike, and expiration date), and selling call spreads is the same as buying put spreads (same stock, strike, and expiration date).

    That means you are already using a much wider variety of strategies than you realize.

    I believe you are on the right track. Don’t get greedy. Increase position size one contract at a time, and don’t do that too frequently. Keep asking questions and don’t accept all replies as ‘correct.’ Use your own judgment.

    Excellent reviews for first live discussion session at Options for Rookies Premium. Become a Gold Member and get invited to future sessions
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    Limited Portfolio Protection; an Introduction

    When discussing methods for protecting a portfolio from large losses, I've mentioned that I prefer a trade that allows me to own extra options – with the condition that those extra options are NOT father out of the money than my 'at risk' options.  Those extra options offer the possibility of earning a good-sized profit if and when a truly unexpected major market move occurs.

    The problem with buying extras is that the cost is high.  When buying insurance, or adjusting a portfolio, one of the most difficult decisions is: How much should I pay? It's not the same situation as insuring a house against a destructive fire.  If you cannot afford to replace that house from petty cash (as most people cannot), then insurance is needed, and the cost is not the primary concern. [We all know that we pay too much for insurance, or else the insurance companies would not be profitable]

    When we trade with negative gamma (credit spreads, covered calls, iron condors, etc), at some point we may be called upon to make a risk management decision, and that decision will often cost cash.  [Yes, we can always find a way to shift or roll a position for zero out of pocket cost, but that often increases risk, is not a good strategy for general use and is outside the scope of today's post].  There must be a spending limit when making a position safer to own.  At some point, the investment becomes too large, profit potential too small, and it's best to exit the trade – accepting the loss.

    Spending less

    Instead of buying extra options, an alternative is to buy spreads.  These are far less costly than individual options, and they offer limited protection.  I find that this is a winning trade-off under many market scenarios.  Consider this method and decide whether it has merit for your trading. 

    When you buy a 10-point spread and pay $2, there is $8 worth of upside potential – if the market continues to move against your original position. That's a substantial amount of insurance at a very reasonable cost.

    The problem is that these spreads are not available for $2.  By the time the market has moved far enough to convince you that risk must be reduced, these spreads may cost $5 or more.  In my opinion, paying half the maximum value of the spread is just too much to pay.

    Here's an example:

    You sold some call credit spreads: INDX Jan 920/930 when INDX was 840. 

    figure 1

    Now that INDX has moved to 890, the position is uncomfortable to hold (if it's not uncomfortable for you, at least assume it is for the basis of this discussion) and the experienced trader wants protection.

    When buying debit spreads, the objective is to own spreads that are less far OTM than your current shorts because you must earn some good money from that 'protection' to partially offset the original position, which continues to lose money.  I don't know how long you would hold out before buying protection, but let's assume that no one would want to stay in this trade when the short strike (920) is breached.

    Figure 2, shows an adjustment: we bought 2 INDX Jan 900/910 call spreads @ $4 each.


    figure 2

    The $800 paid for the trade comes right off the bottom line, if the market reverses direction. [Of course the trader always has the choice of selling out that protection when he/she feels it is no longer needed]

    The $400 debit allows a gain of $600 for each spread, so the upside disaster is reduced by $1,200.

    The good and bad news about buying call debit spreads for upside protection is that the expiration profit zone is much improved (red line vs blue line).  It's good news because there is a nice area of significant profits.  The bad news is that the trader may elect to hold this trade into settlement (Market opening for each stock in the index, on the 3rd Friday of the month), and that's a very risky situation.  With the market in the best possible spot (between 910 and 920) at the close of business on Thursday, the trader is set up to take a big hit if the market opens somewhat higher on settlement Friday.  A 10-point move is not that big for an index priced above 900 (it's a 1% move).

    The protection looks good, but holding to expiration provides the same high theta (good) and large negative gamma (bad) threat – as always.



    It's less expensive to buy the call spread with the highest strikes that are not already in your position (900/910 in this example).  The advantage to that play is that you can buy more spreads for the same money as buying fewer, more costly spreads.  I vote for the 900/910. 

    One variation is to buy more (or fewer) such spreads.

    However, it's reasonable to buy an 890/900 or an 890/910 call spread instead. 

    Another choice is to pay even less and buy the 910/920 spread.  In genral, traders shy away from this trade because it involves selling more of the option they are already short. There is no reason not to make this trade, unless it's difficult for you to examine your position and figure out exactly what you own.  I recognize that this trade adds complexity to the position for less experienced traders.  Note:  I have no objection to this adjustment, but if you find it too strange to manage, then stay away.  You can decide whether this specific adjustment type appeals to you once you gain more experience.

    The last variation to consider is buying the 920/930 spread.  Because that's the position sold earlier, this 'adjustment' is merely reducing position size.  This truly is an overlooked trade.  Those who refuse to take a loss, and feel they must adjust to allow an opportunity to escape a risky trade with a profit would never consider this trade.  In my opinion, a trader should buy the call spread that seems to best serve his/her purposes.  If that happens to be the trade sold earlier, then so be it.  Don't let that stand in your way.



    The idea of picking up some positve delta (or negative delta, when trading puts) in the form of debit spreads works as a good compromise when making adjustments for negative gamma positions.  My philosophy remains the same on one important issue:  Do not buy farther OTM options.  When short the 920 call, as in our example, the adjustment (single option or spread) should involve purchasing a call with a strike of 920 or lower.

    NOTE:  A trader may choose to buy some very far OTM extras as ultimate protection.  These are NOT satisfactory to protect a position such as a troubled iron condor, credit spread, or covered call.  Recognize that this is a waste of money most of the time.  But when the payoff comes, it's a dandy.  Owning these options is not for everyone, but Nassim Taleb claims that it worked wonders for him.



    Ideal Christmas gift for your friend who wants to learn about options

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    Selling Naked Index Options


    Thanks for the ongoing education.You run a great blog and I enjoyed your 'Rookies' book enormously.

    For the past 2 years, I've been selling naked options (mainly puts, a few calls) to generate monthly income.

    I sell WAY out of the money RUT puts in the front 2 months using an initial margin limit of about 35-40% in my portfolio margin (PM) account at Interactive Brokers.

    I keep the account about 65% invested in dividend paying ETFs and stocks, 35% cash.

    As an example, With RUT around 740, I'm currently short the following options:

    RUT Dec 540 P
    RUT Dec 580 P
    RUT Dec 590 P
    RUT Dec 810 C
    RUT Jan 480 P
    RUT Jan 500 P
    RUT Jan 540 P
    RUT Jan 850 C

    I normally sell puts with a premium around $1.00; calls around $0.40.

    My position returns just over 1% per month on average on the total account value, which is more than sufficient for our needs.

    Over the past 24 months I've had just 2 losing months, in each case losing about one month's average income.

    I wonder if you could comment on this strategy? I like to think this is quite conservative, but a catastrophic drop in the market wouldn't be nice…

    Should I consider selling credit spreads instead? I assume I would need to operate closer to the money to generate similar returns and spend more time adjusting my positions.




    Hello Steve,

    1) NOTE about Portfolio Margin: $100,000 minimum balance is required for a PM account.  In addition, margin is calculated more leniently than for Reg T margin accounts.  That means you can sell many more options than a non PM customer.  Another way to look at that is you can sell far more options than are good for you.

    2) This is not a conservative strategy.  Not even close.  It is a high probability play, with many profitable months.  I cannot imagine a strategy in which I earn a profit month after month for several years.  Yet this strategy could provide those results.  The question is: how much is at risk?  That is very difficult to answer.  More on that later.

    3) Your last sentence explains the dilemma.  Yes, you would have to sell closer to the money options if you chose to sell credit spreads instead of naked options.  Yes, you would spend more time making adjustments.

    The question is:  Which is a better situation for you and your money: your current strategy or the alternative of selling credit spreads.  And it's a good question with no simple answer.

    To me, this is a no-brainer.  I prefer to be in the situation of making adjustments, knowing that my losses are limited and that I cannot go broke overnight.

    So far, you have come out well.  You had two losing months and I'm anxious to learn how you handled them:  Did you adjust to reduce risk, or did you hold to the bitter end (expiration)?  And when you say 'losing months' does that refer only to the naked option selling, or dos that take into account your significant position in ETFs.


    I will never again sell naked index options.

    4) I am NOT telling you what to do, but you have not been through what I have.  You have not seen how quickly money can vanish from your account.  I understand your situation.  No matter what anyone tells you about risk, you just know that either nothing terrible is going to happen, or if it does happen that you will react in plenty of time.  I know I thought just those thoughts.  The people who managed risk for a living were just being silly when they told me that I have more risk that any other market maker in the clearing firm (and it was First Options, a very large clearing firm).

    I thought that I could handle it.  Even after having been hammered more than once, I made the same mistake again. All I can do is relate the story, issue a warning, and allow you to make your own decisions.

    Let me assure you that in Oct 1987, puts were not buyable at any price that you would have been willing to pay.  Incredible as it may seem, in many stocks, the bid/ask spread for options was 10 points wide and the asking price for some puts was more than the strike price.  Imagine being asked to pay $32 to buy the Nov 30 put – an option that could never be worth more than $30.  But when customers were  told they had to cover short positions and they had to buy their options at the market price – and do it right now, they paid whatever they ahd to pay. I have no idea whether anyone had to pay above the strike price for puts, but that was a common asking price.

    Next, consider the poor customer who was short calls.  When IV explodes, far out of the money calls do not sell for tiny fractions. The premium expands.  Those who lost tons of money by being short puts were forced to cover their short calls as well.  No consolation there because they had to pay obscene prices for puts.  Obscene.  And this was not the market makers taking advantage of customers.  The prices were high because maraket makers had to buy calls to protect themselves.  They were selling lots of puts and also shorting stock, when there was an uptick.  The only way to protect the upside was to buy calls.  So call prices were bid higher.


    Back to you Steve

    You did live through the winter of 2008, but if you have truly been doing this for 24 months, you began at the right time. You missed out on the excitement of Sep and Oct of that year.

    Have you considered what would have happened had you begun in August 2008, instead of 3 or 4 months later?  If you have access to TradeStation (or if your broker offers back-testing – I believe thinkorswim does), go back to August expiration, choose options to sell for the Sep and Oct expirations and then follow the trades.

    I don't know how much risk you are willing to take, but your note warns me of the danger.  You claim to earn $1,000 per month per $100k in your account.  You also say that's enough money for your needs, so I'll just guess that this is a half million dollar account and that you pull out $5,000 every month, on average.

    You have 65% of your available margin invested in ETFs.  If the market crashes, dividends or no dividends, this is not going to be pretty.  I assume that you look at risk from the vantage point of those short put options but I don't believe you are considering how much worse it will be because of these ETFs.

    If you believe you know what fear is – you have no idea.  Imagine a catasrophe in which the market is plunging, IV is exploding, bid ask spreads are getting wider, half of your account is already gone, you want to buy puts but don't know where to begin, and your broker is blowing our your positions (by paying the ask price) to cover your now sky-high margin requirments.  Whenever you enter a bid, the ask price just mves higher.   That's fear. 

    I believe you need to do something better with your money.  I want you to know that I NEVER suggest how anyone should trade or how anyone should invest.  But in your case, all I am trying to do is to be CERTAIN that you understand risk.

    Consider this:  How much will you lose if the market opens 20% lower one day, RUT IV (RVX) moves to 90 or 100, and the option markets get very wide?  You must have this number in the back of your mind.  You must have some idea of 'just how bad this can get.'

    If you can live with that loss, then you are ok in my book.  This strategy may wowrk for you, after all.


    Reasonable Compromise

    The fact that you ask about selling spreads instead of naked option tells me that risk is a consideration for you. 

    To trade credit spreads, you would buy one option for each option sold.  If you still like the idea of being naked short options, rather than short credit spreads, try this compromise:

    Continue to sell options as you do.

    But do not hold to expiration.  in fact, cut your holding period considerably.  If you sell at $1.00, then buy them back.  Choose a price.  Maybe 40 cents.  Maybe 25 cents.  It does not matter how far OTM they are.  Buy them back.

    I note you are short several different stike prices.  A different compromise is to be short far fewer options.  When you sell a new put, cover the old put.

    This is not anywhere near an ideal situation because you will still be short naked options.  However, you will hold each short for less time, ad that cuts risk.  You will hold fewer short options at any one time, and that cuts risk.  you will earn less cash, and the one thing that you must not do is increase size to compensate.

    I don't like your strategy, but if you understand what can happen – and how difficult it will be to put out the fire – and if you are willing to accept that, then that's your well-reasoned decision.  But if you just don't get how bad it can get, then you are taking on more risk than you understand.

    Whatever you do, I wish you the best.  Just be careful out there.


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    The Rising Stock Market

    I've discovered how difficult it is to maintain a blog when driving around the country.  It's much easier when I'm comfortably ensconced in my home office.

    Enjoyed the car trip to North Carolina, but happy to be home.


    Strategy of choice

    Trading iron condors was especially successful as recently as a few months ago when the markets calmly traded within a range.  More recently, a rising market has made this strategy less effective.  This is as it should be.  No single strategy works all the time and a trader must have more than one strategy in his/her trade arsenal.

    While iron condor traders (along with sellers of call credit spreads) may be having a difficult time, covered call writers, sellers of naked puts and put credit spreads should be enjoying the rising market.

    One of the personality traits that makes for a successful trader is understanding that varying market conditions require different appproaches.  The bottom line is understanding that stubbornness is not the trait of a winning trader.

    The future

    The problem is that we trade for the future, and for most traders, the future is unknowable. [I do understand that technical analysts claim the ability to forsee the future of the stock market – often enough to wager on their expectations]

    For example:  I don't know why the market is advancing so strongly.  Perhaps solid earnings gains – when compared with last year – are all that matters.  Perhaps the banks will eventually lend money and businesses will once again hire workers.

    From my perspective, all I see is the gloom of high unemployment, coupled with companies being satisfied with higher productivity, and thus, no plans to hire. Maybe yesterday's election will have some positive or negative influence on the market.  What I know is that I don't know.

    I see falling housing prices.  I'm concerned about the inevitable class-action lawsuits over home foreclosures that were not processed according to law. 

    I see money being concentrated into the hands of fewer and fewer people and don't know how the consumer can spend money to support the economy, even if he/she wants to do so.  This is not a political statement.  It's merely me, wondering who is going to provide revenue to all these companies whose stock prices continue to rise.


    However the market has been rising and I am not going to fight it.   That translates into not opening new iron condor positions blindly.  I may not  understand the rally, but I also know that it's foolish to fight market trends.  Th whole idea behind market neutral trading is to avoid trading with a bias.

    I've learned that 'the market' is much smarter than I am.  I'm doing what I can to stay ahead of the market rise, adjusting sooner than usual, and refusing to open bearish positions. I also kept cash in reserve if adjustments were necessary.  And they have become necessary for my specific positions. For now that's my plan.

    It's not necessary to aggressively seek profits when the market is telling you that your preferred approach (strategy) is not working.  I can wait patiently, holding less aggressive positions.  That translates into reduced profit expectations with less risk than my 'normal' portfolio.  This is just one more aspect of successful risk management.


    The Obvious?

    I don't want to wager on this thought, but it occurs to me that if I am refusing to consider taking bearish plays (when I am bearish) and was seriously considering (for a short time) taking bullish positions to profit from a further rally, then perhaps that's a sign of capitulation.  In other words, if this non-believer in the current bull market wants to get long, then maybe it's a signal that others may be capitulating.

    In other words: I should go short for the sole reason that I don't want to go short.  That's not viable in my world.  Is it in yours?

    A note on the ad below (not visible to RSS subscribers): Several ads appear on a rotating basis and I never know which one is visible.



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    Stock Picker’s Market?


    I think I may be missing something as it relates to trading options. I've read The Rookies Guide and one thing that I don't understand is how do I pick the options to trade?

    Do I need a background in stock picking?



    Stock-picking history

    A background in stock picking is not nearly good enough.  You must have a proven track record of earning money when picking stocks. 

    However, If willing to adopt a less aggressive approach and try to find some stocks that will not fall significantly, then the selection task is much easier. Being forced to pick stocks that move higher is the norm for investors, and most cannot do it.  Picking stocks that either mover higher, remain essentially unchanged, or decline by a small amount – that's much easier. 

    It's not foolproof.  Nor is it guaranteed to return big profits.  But your chances of earning money are much higher.  In return for that 'good stuff' profits are limited and there are no killings to be made.  The goal is to earn steady money.  As I said, it's not guaranteed, but you have a better chance to succeed that the person whose stock picks must move higher to earn a profit.

    Part of your question may be how to pick the specific options to trade.  I recommend the credit spread strategy (Chapter 18) with one warning.  Understand that losing is part of the story, and you must practice good discipline and not sell too many spreads at one time.  Risk management is essential when you adopt this method.

    When choosing specific options, you will have choices.  If it's difficult to decide, open practice trades and see how they feel.  Are you comfortable with risk and reward?  Option trading involves a constant trade-off between risk and potential reward and a bit of experience goes a long way in helping you find the right choice.

    Talking heads

    Talking heads on TV tell viewers that 'it's a stock picker's market,'  suggesting that investors cannot just buy index funds.  Instead, they are to seek out the best stocks and buy only those.  The missing piece of the puzzle is how to pick the best stocks.

    The same problem exists when trading options with a directional bias., bullish or bearish. The truth is that most investors and professional money managers cannot beat the market averages.  There is no reason to believe you can do any better.  In my opinion, it is very difficult to generate profits consistently by adopting simple strategies, such as buying options.

    I believe it's easier to find market neutral trades, but even then, picking stocks that are not going to undergo significant rallies or declines is not as easy as it may appear.


    Indexes: less risky for premium sellers

    If you lack confidence as a stock picker, then one alternative is to play the broader market by trading options on an ETF (such as SPY or IWM or QQQQ) or an index, such as SPX, NDX, RUT.

    For the premium-selling, market neutral trader, index trading avoids the need to be concerned with the performance of a single stock. 

    Practice and practice some more

    Take another look at the chapters on credit spreads.  If you are new to this type of trade, and especially if you are new to options, begin by paper trading.  Have patience.  Be certain that you understand how these positions make/lose money.  Determine how well you manage risk.   Why does your position profit one day, or lose money on another day?  Follow the trades using your broker's risk management tools.  The purpose of this exercise is to understand why option prices change and to get some experience making trade decisions. 


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    Low Premium Iron Condors


    mentioned that collecting a 0.25 credit is a horrible trade for many
    reasons [MDW: I was discussing 10-point iron condors].

    I have been following various options trading services, and
    there are 2 that I have come across that actually use this exact
    strategy (xxxxxx xxxxxx and xxxxxxxxxxxx).  They recommend very small
    credit spreads on indexes that are far out of the money. It seems they
    have been pretty successful using this strategy but they also have
    certain months where they don't issue a trade recommendation because of
    excessive volatility.

    Is the reason that you don't like collecting low credits for far out
    of the money spreads because of the bad risk:reward ratio? It would
    seem that with this strategy, there can be 10, 20, or 30 months in a row
    where the spreads never come under pressure. The key is to have a risk
    management plan so you know what to do when the market eventually does
    make one of these sigma 3+ events.

    Obviously you also couldn't close
    the spreads early when you are bringing in such a low initial credit.
    You would generally have to let them expire worthless to gain the full
    credit. During options expiration week, you can usually close out
    spreads that are far out of the money for .05 to .10, however this still takes a fairly large bite out of the very meager credit that you
    initially took in.

    Are there other negatives that I'm missing?



    Thanks for the question Tom,

    It's far more than the risk/reward ratio.  But first let me explain that when I offer a strong opinion, it is just that.  An opinion and not a fact. 

    I believe that those who sell low-premium spreads eventually blow up their trading accounts. 

    I agree that there are ways to manage risk, but there is often a psychological barrier.  Too many traders think in terms of the cash collected when opening the trade and cannot allow themselves to pay $1 or $2 to exit a position when the original premium collected was a mere twenty-five cents.  These are the traders who will hold to the bitter end.  And that means the occasional $975 (+ commissions) loss.

    That would not be an insurmountable problem if traders held positions of appropriate size.  But Tom, as I'm sure you know, success brings confidence, over-confidence, and cockiness.  Eventually position size is too large and that inevitable loss is often enough to destroy the trader.  Very sad.

    Thus, the primary reason I dislike these trades is that the wrong traders use this method.  In my opinion, this is not a great trade for anyone, but I'm sure there are experienced people who make decent money doing this.  But I feel a responsibility to do whatever I can to discourage this very risky strategy.

    I would never consider it myself, and am comfortable recommending that everyone stay away form these low reward plays.

    Plan ahead

    I agree that having a plan in place is important for the trader who adopts low-premium, high probability trades.  I just feel that the inexperienced trader will find any number of reasons for not following the plan.  And that's even more true when the first time an adjustment is made – it turns out that the adjustment was unnecessary.

    Although I'm a big fan of exiting such trades early, there is not much incentive to do so when the original credit is so small.  Holding to the end is probably part of the trade plan.

    I don't think you are missing anything.  This strategy, as any other, is appropriate for the right trader.  But it requires enormous discipline – just to keep size at an appropriate level – and then more discipline to lock in a loss to exit – even when the probability of success is still on your side (the short options are not yet ATM).  I believe that someone who has the experience to be certain he/she has that much discipline would choose a different strategy.


    Trade King Webinar

    August 10, 2010; 5PM ET

    Mark D Wolfinger

    Adjusting Iron Condors.  Part I

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    Zero Risk with Iron Condors: Can I Have my Cake and Eat it Too?

    The following question is slightly edited.  The original question is elsewhere.

    To provide a meaningful reply, I
    requested more information.  Norm has been trading iron condors (with
    real money) for five months.

    Hi Mark,

    "I am trying to come up with a strategy that involves zero risk of a
    sudden downswing in the market because of a terrorist act or other
    negative developments. You mention in previous blogs that one strategy
    is to reduce your overall iron condor position size, but this would
    still leave me with the possibility of losing the maximum for outstanding trades."

    Hello Norm,

    I'm sure you
    understand that risk and reward go together.  If you truly want zero
    risk for a specific market event, the best play is not to have any
    position that loses in the unlikely event that your scenario comes to
    pass. This means you will be out of the market (or part of the market)
    with no potential losses, but that comes with zero reward potential.  Thus, this is not an easy decision – but
    apparently you have made yours.

    "Insurance for the downside is, as you have pointed out, too expensive
    now, and it creates the risk of having to close a position at
    unfavorable prices when the insurance expires."

    Every trade you make has the possibility
    of your being forced (prudently) to cover at unfavorable prices.

    There are
    trades that profit on a market collapse – the event you fear.  Those
    plays are not iron condors, nor are they plays in which you have theta
    (time decay) on your side.  As mentioned, IV is relatively high right
    now, although it has been falling in recent days.

    I don't know whether insurance is too expensive right now.  It's more than I want to pay, but my current positions are much less risky that they have been at other times.  For me, and the fact that I do not need insurance, I can state that it's too costly.

    However, you are much more worried than I and perhaps insurance would be cheap with your mindset.  Let me clarify: I believe there is a realistic chance that the market may fall from its own weight.  It's the terrorist attack that I am forced to ignore.  Otherwise I would be unable to trade.

    The very best play to
    protect your portfolio is to buy some out of the money puts (yes, at what appears
    to be exorbitant prices).

    The most likely outcome is that the puts will
    expire worthless (as does most insurance).  However, by investing
    whatever amount of cash you are willing to place at risk, you can
    prosper on a huge decline.  Is it worth it?  That's a personal decision.  Do you believe you can afford to own some puts and still earn a reasonable return?  If yes, go for it.  But it will be difficult, and you don't have enough of a track record to begin to make a reasonable (or otherwise) guess as to how well you would do.

    "Consequently, I am considering limiting my trades to call credit spreads
    which would have a bearish basis. My concern here is that if I try to
    limit my losses to 1.5 times my average monthly earnings, this limit
    could be reached fairly quickly with an upswing in the market because I
    would not have the put spread income initially offsetting some of the
    loss on the call spreads."

    Also, my not having received the premium from
    both the call and put side of the iron condor could limit my ability to
    make a kite adjustment." 

    Here is my
    major problem with your questions/comments:  You jump form one example to another with no consistency.  You are worried about everything that occurs to you.  I understand that you want to be certain that major risk is covered, and you don't want to be trading in the blind.  Truly, the best way to cover your bases is to trade small while you are learning.  I understand that you do not want to trade small and that you want to earn money.  However, there are three truths that must be faced:

    • Trading with little risk is an excellent investing choice.  But accept the fact that it goes hand in hand with modest (at best) profits
    • You are moving too quickly.  You can learn and I can reply to questions.  However, there is just so much information that cannot be put into simple answers.  You want some experience trading and making decisions.  And that takes time.
    • You are trying to accumulate a large amount of data – and then base future trade decisions on those data. You must keep a detailed journal/diary of your trades, your thoughts, your decisions (even when the decision is to 'do nothing'), and the results.  Reread those journal entries often and see if they speak to you.  See if you can get some nuggets out of the data

    I acknowledge that the more you can
    understand the better trader you will be.  However, there is a limit as
    to how quickly you can gain meaningful experience, but five months is not enough.  Not even close. Why? 

    You must experience all kinds of trading decisions before you can know how well you handle them.  It's easy to trade an iron condor and then cover at a big profit.  It's easy to make a minor adjustment when a trade makes you slightly uncomfortable.  It's more difficult to see a big move in one direction – make a trade to account for that, and then have the market make another good-sized move.  That second move can be in either direction.  How well will you handle that?  Or are you willing to take your chances and make the discovery at the time it happens?

    You write of average monthly earnings.  You have no idea what your average monthly earnings are going to look like over the longer term.  You don't yet know whether you can earn anything as an iron condor trader.  I am NOT being negative.  I am telling you that you are worrying about minute details when the big picture is an untouched canvas. 

    Keep in mind that you plan to sell call credit spreads.  It may be similar, but it is not trading iron condors.  Thus, you have ZERO months of earnings from which to determine your 'average.'

    Data from a
    few months is worse than meaningless.  Yes, worse.  You have not
    experienced enough different market types to know what that average is. 
    Have you made enough adjustment/hold/exit decisions to have a good feel
    for how skillful you are going to be in that area?

    Norm – you are at the beginner stage
    and no
    amount of data that has been collected to date is any more than a hint
    of what you can do.  You do not have any 'useful' average monthly

    If you want to
    establish a maximum monthly loss – and you should do so – then base it
    on the size of your bankroll and the probability (as best you can guess
    it) of taking the loss.  Don't base it on how much you earned when
    trading iron condors – especially when you now plan to trade half iron condors.  the entire strategy is different – similar, yes – but
    it's different.  You have different rules in place.  Rallies with
    shrinking IV are less frightening than declines with expanding IV.  You
    will have to use a different adjustment plan.  The point is your average
    IC earnings are meaningless.

    Yes, you can
    avoid selling put spreads and sell only calls.  That does what you
    seem to have established as your primary objective: No significant loss
    if the rare event occurs.  My question to you is:  Which of the
    following is going to produce more money in your account with an
    acceptable risk level?

    • Sell a reduced number of put spreads,
      presumably earning a small sum, on average, on a continuing basis – but ever fearful
    • Avoiding puts altogether – until
      after the disaster.  Earning less, but without worry

    This is a question, and you should take the time to figure out the answer: 
    If you are that afraid of the loss, have you considered how much that
    loss would be?  Have you taken an option calculator and determined the
    value of a typical spread that you would sell – if the market gapped lower by
    (perhaps) 25% one morning?  Assume IV triples, or make some other
    assumption.  What would that spread be worth?  How much real cash would
    you lose?

    Do the same for the calls spreads and remember to subtract these gains (if any) from the put losses.

    You may be surprised at just
    how little of your portfolio is at risk.  What I am asking is: 
    You are afraid of a specific scenario.  Do you know how much you would
    lose in that scenario?  If you don't – and you clearly do not – how can you fear the scenario?  How can you make intelligent trade decisions when you don't know how much is at risk?  Your assumption that you could not exit the put spreads at any meaningful discount from their maximum value is incorrect.

    Once you do the math (arithmetic), then if you decide that zero risk is the sweet spot
    for you, then it will be an informed decision.  Right now it is a decision based on fear.  Do not misunderstand:  Fear is a great reason for avoiding a trade.  But don't you want a realistic estimate of how much would be at risk?

    That brings us back to the question: Can you sell only call
    spreads, and the answer is yes.  But to do that, you should not be a
    bullish investor.  You don't want to wager against your
    anticipated direction for the market.  So, do you prefer to sell only
    call spreads?  The reply may be 'yes,' and if so, you are trading
    reasonably.  If the answer is 'no' but you feel forced into doing it, I'd suggest you find an alternative strategy.

    "Also, my not having received the
    premium from
    both the call and put side of the iron condor could limit my ability to
    make a kite adjustment."

    Regarding kite spreads;

    a) You don't have to use kites.  There is
    nothing magical about them.

    b) Nothing hinders your
    ability to use the kite strategy  If you want to use it, use it.  You
    seem to have convinced yourself that if the credit collected when
    opening your call spreads is too small, that kites are precluded. 
    Nonsense.  If you decide not to sell credit spreads and pay too much for
    insurance (any type), that's a decision.  It has nothing to do with
    using kites.

    Keep in mind
    that kites are not a simple slap in on and forget it strategy, although
    that's how it appears. 

    Perhaps with only a few months experience, and
    with IV remaining elevated, you ought to think about more useful
    techniques than kites.  I also believe that you have far more to worry
    about than kites.  You are new to this game.  Concentrate on learning
    things that are important to your profitability – and one strategy for
    managing risk is not at the top of that list (as long as you have some
    plan in mind for reducing risk – when necessary).

    "I realize that in the event of a sudden upswing
    in the market due to some government action I would still have the
    exposure of losing the maximum, but this scenario appears to be much less likely than a
    similar scenario on the downside.
    Given my concerns, is it reasonable for me to expect to be profitable if
    I limit my trades to call credit spreads?"

    Norm, I cannot answer this question.  Sure a meltup occurs less often and moves more slowly than a meltdown.  You want my opinion on how well you will do by trading short?   I don't know where the market is headed.  I don't know how far OTM you plan to sell the spreads.  I don't know how quickly (or slowly) you plan to adjust, nor do I know your adjustment plan.  I have absolutely no idea if it is reasonable to expect to make money based on what I know.

    If you are bearish, then it's a very viable trading plan.  Go for it. 

    If you are market neutral with a crash fear, it may be okay to trade this plan.  But I would not be happy camper if I were in your shoes and would choose to trade smaller size. 

    If you are bullish, it's a death wish.

    "Also, would it be too
    personal a question to ask how you made out with your iron condor trades
    during 911 and during the recent sudden drop in the market?"


    Yes, it is far too personal.  I don't remember 2001.  I was not trading iron condors at that time.  I did much
    better than average in 2008, with a small loss for the year and did
    worse than average during all of 2009. 

    The recent drop worked very well for me.  I had no problems for two reasons: My shorts were far enough OTM and I covered some put spreads on the rally.  Trading reduced size also made it easy.

    I believe you have too much on your mind.  You must go after the more important stuff at this stage of your career.  I appreciate your need to understand the details, if you have the time to work on them.  But spend your energy on finding a suitable strategy and figuring out how to deal with your market fears.  There are inexpensive ways to play for a crash.


    June 2010 Expiring Monthly.  Table of contents


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