Thursday, April 16, 2009

Trading Lab Recap - Debit vs. Credit Spreads

Day Trading
Larger time Frame – Daily
Main Time Frame- 5 minute
The 5 minute chart is more appropriate for a day trader than the 1 minute chart (unless scalping).
1 minute charts can whipsaw you in & out of trades
1 minute support/resistance levels aren’t near as significant as support-resistance on higher time frames (like a 5 min)

If entering Bullish day trades:
Make sure the 5 min trend is up – Buy retracement or Breakouts above resistance
If entering Bearish day trades:
Make sure the 5 min trend is down – Sell retracements or breakdowns below support

April 1st – Bull Call Spread
Buy to Open April 40.00
Sell to Open April 42.50

What’s the advantage to using April (2 weeks till expiry) options vs. June (2 months to expiry)
1. The main advantage is if the stock moves through the spread we only have to wait 2 weeks to make our money. By entering 2 weeks out, we’re turning a bull call spread from a position trade to more of a short term swing trade.
2. The main disadvantage is if the stock moves the wrong way, you lose money quickly. With only 2 weeks until expiration, there isn’t much time to allow the stock to come back if it moves adversely.
Using April: More aggressive
Using June: More conservative

If at expiration, NFLX is above $42.50
40-42.50 bull call spread expires ITM, resulting in my max profit
Long 100 shares @ $40
Short 100 shares @ $42.50

SPY @ $85
MAY Iron Condor
73-71 put spread Credit = .17
95-97 call spread Credit = .16
Net Credit = $.33
Max Reward = $.33
Max Risk = $1.67
73 put delta is 10 (90% probability of success on bull put)
95 call delta is 10 (90% probability of success on bear call)
Probability of Profit on Iron Condor: 1 – delta of short call – delta of short put
1 -.10 - .10 = 80%

$33 isn’t much profit if we take into consideration that we’re buying back either spread when their worth $.05 or less. This brings our potential profit down to $23. Tack commissions onto that & we’re not really making much at all!

Adjustments that can be made to bring in more credit on a SPY Iron Condor:
1. Try a $4 or $5 spread instead of a $2 spread. For example: 95 -99 call spread & 73 – 69 put spread
Wider spreads have more risk, but the risk can be mitigated by entering less contracts. For example, (10) $4 spreads is the exact same as (20) $2 spreads.
2. Instead of entering 4 weeks to expiry, we could enter 5 or 6 weeks to expiration. There will be more time value in the options, resulting in more credit.
3. Use credit spreads closer to the money (sell calls/puts with a higher delta)

Credit vs. Debit Spread… What’s the diff?
Bear Call & Bull Put vs. Bear Put & Bull Call

Bear Call & Bear Put Spreads using the same strike prices are synthetics (exact same risk-reward characteristics). In addition, changes in time and Implied volatility affect both the same.
If stock XYZ @ $50 and we’re Bearish, we may consider the following bear spreads.
45-40 Bear Call Spread Reward = $3 Risk = $2
45-40 Bear Put Spread Reward = $3 Risk = $2

If credit & debit spreads using same strikes have the exact same risk-reward profiles, what causes one to choose one over the other?

When entering vertical spreads I generally don’t like to short ITM options due to the risk of early assignment. As a result, when choosing which vertical spread (credit or debit) to use, I choose whichever one results in being short an OTM option. For example, if stock XYZ is trading at $50 and I want to place a 50-45 bear spread, I would use a put spread. On the other hand, if I place a 55-60 bear spread, I would use a call spread. In other words, if I use strikes below $50, I will do a put spread (OTM). If I use strikes above $50, I will do a call spread (OTM)



KrengelFamily said...

I'll aplogize at first and hope this comment makes sense. I'll do my best to organzize. I have a few questions in relation to options spreads.

1. Based upon your Iron Condor example you have a 80% chance of gettting the full return of .33 and a 20% of taking a loss (1.67 or maybe a little less if you close out a piece prior to expiration.) I've been doing the math and I'm wondering how to make this profitable. By those numbers if you do this strategy 100 times you'll make 26.4 but lose 33.4. This means you're losing money in the long run.

2. In relation to question 1, I've been doing a lot of vertical spreads and am wondering how to make these profitable as well. I've been using delta's of .2 as a general rule of thumb, so the average spreads I've been running are about a 5pt spread with a .50 - .70 credit. This means (based upon a previous post of Delta meaning probablity of ITM at expiration) I have around a 80% of being profitable, but then over the long run (100 times) I'll make (80 X .60 = 48 may be less if I'm closing trades early) and a loss of (20 X 3 = 60 i'm using 3 as my average loss because i'd more than likely close trade out a bit early to avoid max loss and there is also a 5pt gap above my short option to achieve the max loss) In this example I'm once again losing money over the long run.

I'm wondering if I'm missing something or how do you make these trades profitable?

Tyler Craig said...


Thanks for the question and yeah it did make sense.
First off, most option spreads (that I've seen at least)will have a negative expected value right off the bat.
I'm assuming this if the formula you're using:
EV = (prob of success * reward)- (prob of loss * risk)

EV isn't really a variable I look at very often (if at all) when I'm trading.

1. EV assumes you're realizing the max risk when you're wrong. On Credit Spreads, or Iron Condors I NEVER realize even 1/2 of my max risk. If instead of entering 1.67 as the max risk, I use $.80 or $.90 as the max risk, the EV will come out positive. You used $3 instead of $4.40 as the risk in your example, but I would bet you don't let a $5 spread go $3 against you.

2. If I'm playing a directional credit spread, then it's usually b/c I believe there is a greater than 50% chance the stock is going to move the right way. Consequently, I don't care what EV says b/c I don't accept the 50/50 assumption.

Making credit spreads profitable is not a function of finding one with a positive expected value, rather it's a matter of proper trade management.