Thursday, February 24, 2011

Credit Spreads - Profiting From Time Decay With Short Dated Options

All option values are made up of two components; time value and intrinsic value. Intrinsic value is the in-the-money portion of option premium, and the left over portion represents time value. Options lose two-thirds of their time value in the last one-third of their life. As option traders, we can profit from this time decay by selling credit spreads.

Options lose the most time decay the closer they move to expiration. Therefore, it makes sense to be a seller of options with only a few weeks left to expiry. Selling "naked" options involves the risk of unlimited loss, but credit spreads will cap your maximum loss at the difference between strike prices less the option premium received. A credit spread trade means we are selling one option and buying another at a lower strike price (in the case of a put spread, higher for a call spread). A put credit spread is a bullish strategy and a call credit spread is a bearish strategy. The great advantage of credit spreads, is that we don't have to be 100% correct. We can have a margin for error.

Let's assume that we are slightly bearish on the current market. With the SPY trading at 129.39, we could sell a February call credit spread. Picking strike prices would depend on how much of a margin for error you desired, how bearish you are and how much profit would like to make. We could sell the February 18, $134 calls for $0.37 and buy the February 18, $136 calls for $0.14 This would give us a net credit of $0.23, so $23 is the maximum profit per contract. Our maximum loss would be $177 per contract (13600 - 13400 - 23). That's a 12.99% return on capital at risk in 4 weeks. The margin required for this trade by most brokers is equal to the maximum loss.

At expiration, SPY could finish at $134.23 before we start to experience losses and $136.23 before we hit our maximum loss. That's a 4.50% and 6.06% margin for error.

You should note that with this trading strategy, you are looking to make minor monthly gains while trying to avoid significant losses. As the maximum loss is 7.7 times greater than the maximum gain, you would need to have 7.7 winning trades for every 1 losing trade with this options trading strategy. That's not a great ratio to have. For this reason it is especially important to set stop losses. Each person should choose their own stop loss levels and trading rules based on their risk tolerance. Some options sellers use a 200% rule, meaning that if the sold spread rises in value by 200%, they are stopped out. In this example, that would be if the spread increased from $0.23 to $0.69. The investor would be stopped out with a loss of $46 per spread which is much less than the maximum potential loss of $177. By using this stop loss level you would decrease your required winning trade ratio from 7.7 to 2. You can use this options trading tutorial as a great way to develop you trading strategies.

Gavin McMaster
Options Trading IQ

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