I remember talking to my good friend Brian last July, a few months before the “Great Crash of 2008″.  Brian was (and I emphasize was) a “traditional” investor.  He had a diversified “portfolio” of stocks, managed by a professional “investment advisor”.  I, on the other hand, was then and still am a humble trader in options, with no long term holdings, who uses an online broker.

Anyway, Brian related to me that he was having a dispute with his “investment advisor”.  He felt the market was getting a bit turbulent, and he wanted to sell all of his positions and go to cash.  His broker disagreed.  She felt that it was still a good time to hold a diversified group of high quality stocks, particularly those that would not be affected by the brewing crisis with the banks.

Brian is big (or maybe, was big) on trusting his professional advisors, so he let her have her way.  Four months later, his portfolio was decimated, and he went to cash with what was left of it.  That’s where he sits as I write this article – the bleeding is stopped but the blood loss is severe, and there’s no apparent way to replenish the “blood”.  His retirement hopes have pretty much been dashed.

A Formulaic Approach to Trading

I’ve just never been much of a believer in “playing the market“.  Maybe the reason for that is I never figured out how to make it work.  Actually, perhaps I did, although what I’m about to say is meant to be “tongue in cheek”:  If you want to make money watching me trade stocks, just watch what I do, and do the opposite.  If I buy XYZ stock, you should short it.  If I short it, you should buy it.  Looking at my history in traditional stock investing, a person could have really done well following that strategy!

However, I’ve long been absolutely fascinated with options.  The fascination was, at first, with the notion that you can buy an option for a few pennies, and a few weeks later it’s worth many dollars.  That actually happened quite a bit during the “dotcom” era.  These days, it’s mostly fantasy.

But what really fascinated me was the idea that there must be a way to, somehow, mathematically “beat the system”.  I mean, options have all those “Greeks”; they have spreads that vary widely with market conditions and the number of a particular option that is traded; and you can do all of those crazy combinations of buying and selling, long and short, one against the other.  With stocks, you buy or sell, long or short, and that’s it.  With options, the combinations are limitless.  Surely there’s a way.

And, in fact, there are a number of “systems” you can use to make your fortune.  Just go to a search engine and type in “option trading strategy” and most of them will appear before your eyes.  I’ve subscribed to many of these systems, and I’ve taught the strategies.  And, under the right circumstances, some of them can work well.  Problem is, circumstances change, and what works well one month, or one year, can wipe you out the next while you’re not looking.

However, from my first “covered call” back in the dotcom days, I’ve never given up on my quest for an options strategy that is formulaic in nature, and can be used consistently with minimal adjustments to market conditions, for generation of significant and steady income.  And you’ll never guess where I found it…

N.I.M.B.Y. (Not In My Back Yard)

Well, yes, that’s where.  In 2006, I was turned on to credit spreads and iron condors.  If you know what they are, stay with me – I’m going to give you a twist.  If you don’t know what they are, stay with me – they are elegantly simple.

An option credit spread is a “new and improved” version of shorting an option.  If you know anything about options, you know that it’s considered exceptionally risky to “short” options, and index options in particular.  Your potential risk is, for all intents and purposes, unlimited.  Brokers don’t like that exposure, and they make it pretty much cost prohibitive to short options.

But supposing you had a formula for shorting options that:

• limits the potential risk to a specific (and not too large) amount
• dramatically lowers the likelihood of any loss at all

Then, you would have a credit spread (at least, my kind of credit spread).  And then, your broker would be happy with you again, and would make it cost effective to do this trade.  He may not show you how to do it, or how to manage it, but he’d let you do it.

Here’s an example of my kind of credit spread in its simplest form.

Say the Standard and Poors 500 Index (SPX) is trading at 770, as it is at this writing.  If we were to short the 610 put for the next expiration month, we would collect about $4.45, or $445 for each contract.  However, depending on the arrangements with our broker, the “maintenance” (cash they get to hold to protect against losses) can be pretty high.  In this case, a standard calculation would require the premium you took in, plus $6,600 per contract; plus typically a minimum account size of $100,000.  And that’s just for starters – if the market crashes overnight and the cost to buy back the short option goes way up, so does your maintenance requirement.

With the credit spread, we do one simple adjustment.  In addition to shorting the 610 put, we simultaneously buy the 600 put with the same expiration.  Remember the 610 put we could sell for about $4.45?  Well, the 600 call would cost us about $4.20 to buy.  So our net credit (money which goes into our account) is $25 per contract.  Our total maintenance requirement, though, goes down to only $1,000 per contract.  You see, no matter how badly the market tanks, we could never possibly lose more than $1,000, including our $25 that we took in.  (If you have a “portfolio margin account”, it gets even better – the initial maintenance is only a portion of the $1,000.)

But wait, there’s more!  If you know how to negotiate, you can get something closer to about $.65, rather than $.25 when you do this as a package deal – trade the two options simultaneously.  Quite an improvement, huh?  You ought to see what it does to your Return on Investment.  By the way, they call it a “credit spread” because the net effect of the trade is a “credit” (money in our account), and there is a spread, in this case 10 points between the two options, which quantifies our risk.

Complex?  I hope not.  Let’s say we do 10 of these, with a month left until expiration.  So our maintenance is $9,350, plus the $650 we took in (which isn’t ours yet), for a total of $10,000.  It’s our money, in our account, earning our interest – it’s just restricted until expiration.

Now, remember, the SPX index is at 770.  Anything can happen, but we did this trade knowing there was only a 7% likelihood that SPX would expire in March at 610 or below.  We know this by looking at the “delta” of the 610 option, which any good options broker will give you.  I like those odds.

The Difference Between a Pro and an Amateur

And I use that heading with all due respect, because I’ve been both.  But the difference between a person who consistently gains using this strategy, and one who gains a lot and then gives a chunk back, it very simple – risk management.  Remember that “delta” of the short option?  Well, that’s a moving target.  The closer the market moves to that strike price, the higher the delta (risk) goes – except that each passing day pulls that delta back down a little. 

Now, we’ve done a credit spread that is WAY out of the money.  Our goal, very simply, is for the SPX to expire above that 610 short strike – even at 611.  If that happens, we keep the $650; the $9,350 is freed up to use for a new trade; and life is good.  And, this will happen 93% of the time based on this trade’s initial odds.  It’s that 7% that will kill us, because our $9,350 is then potentially at risk.  If the SPX closes at 609, we will lose the $650 we took in plus $350 or our own money.  But, if it closes further down, we lose more, or even all, of our $9,350.  Remember, our maximum loss is at SPX 600 – anything lower than that and we still only lose our maximum – but that amount is HUGE!

So, to manage our risk, we monitor that “delta” as time passes and the market fluctuates.  If the market goes way down, quickly, we’ll see that delta creep up to our limit of 25%.  At that time (which won’t happen often, but it WILL happen), we calmly take action.  We’re not suddenly at risk; we’ve just triggered our action mechanism.  We’ve got several choices – but it’s time to take one of them.  That’s a subject for another article – but essentially, we want to buy back our now “challenged” position, and possibly sell a new one with around a 7% delta to offset some of the cost of buying back the old one.  Wait.  Did we just suffer a loss?  Well, maybe.  If we only do one credit spread at a time, then yes, we’ll incur a loss on occasion.  I do several a month, using different indexes and different strike levels.  That way, I have a “bucket” of money taken in, that I can use a small amount of to offset a loss.

The Other Side of The Coin

Earlier, I mentioned Iron Condors.  If you know what they are, there’s still a twist.  If you don’t, it’s a pretty cool name, isn’t it?

Remember how we used puts for our SPX credit spread?  Well, you can use the same process to do a call credit spread too.  In the above example, with the SPX at 770, we did a put spread about 160 points out of the money, and took in about $.65.  However, we can also do a call with the same expiration.  To get the same probability of success, we might sell the March 930 call, and buy the March 940 call.  We won’t get $.65, but we might get about $.40.  And guess what?  No additional margin.  The SPX can expire in March either way up, or way down, but not both!  So now, on one contract, we will have taken in $105, and we have $935 at risk.  For the one month that we have our money at risk, that’s an 11% return.  And if we could sustain that return for a year, without compounding, our annual return would be 136% (more than doubling our money).  This ignores commissions and income taxes, both of which you have to pay.  But it gives you a great illustration of the potential.

Having the put spread and the call spread about equidistant from the market price, with the same expiration, is called an Iron Condor.  It gets its name from the risk profile graph that the two trades together create – at expiration, we make the same profit whether the SPX expires at 611 or 930 or anywhere in between.  But, beyond either of those points, the losses can rack up quickly (if we failed to take action).  The graph looks a bit like a condor, with it’s wide wing span.  That’s where the name comes from.

The Last Thing You Need to Know

Well, two things, actually.  First, I have referred to the SPX expiring at a certain level.  In fact, the “expiration” is actually a calculation that takes place on the third Friday of the expiration month.  It may be close to the opening price of the index that morning.  But it may be different from where it closed the day before, which is when trading of the option actually stops.  All the more reason for us to make our adjustments at that 25% delta level – if we simply hold on and hope we don’t expire in the money, we could face a surprise when the “settlement” is calculated.

But the real last thing you need to know is, what’s the catch?

This, I’ve learned the hard way, and I’ll share it with you for free.  I can envision two “catches”, and they both end badly.  First, a person follows this strategy for a while, and gets really good at it, which could happen quickly and last for a long time.  Then, as with gambling, they go crazy and go “all in”, by increasing the number of credit spread contracts they sell dramatically.  THAT, my friend, will be the month that the market chooses not to cooperate.  Even if they manage their risk and adjust their positions at the 25% delta, their loss for the month could be pretty large.  The other case, a distant cousin, occurs during suddenly volatile times – such as the Great Crash of 2008.  The trader has made a bundle of money, month after month, and doesn’t want to give even a nickel of it back this month.  So, as the market moves against him (either way down or way up), he just sits, watches, bites his nails, waits, and hopes.  After all, those spreads were initially WAY out of the money, and they can’t possibly move that far, can they?  Yes, they can.  And the closer the market moves to your spread, the more it costs to bail out.  Seems unfair – but you’ve been warned!  We make excellent money most months, and take a not-too-large loss on occasion.  It’s a cost of doing business – and the returns after factoring in the occasional poor month are still phenomenal.

Conclusion

Not to end on a sour note – this strategy can be consistently profitable, in good times and bad, if that “formulaic approach” is followed at all times.  Using our version of the formula, there will occasionally be a losing month; though the losses won’t be huge and the gains will more than offset them.  I found this strategy in my own back yard, so to speak – buried among the “get rich quick” systems I was paying other for – but now I use it pretty much exclusively.  It is boring and very predictable – but isn’t that the “holy grail” of a formulaic options strategy?  (Plus, at night I sleep like a baby…)

Kerry O’Hallaron is a teacher, student, and practitioner of options trading. He hosts the “Cash Flow Trading Center”, a members-only site, and a trading newsletter called “The Perfect Play”. Both can be found at http://www.cheatthestreet.com This article may be reprinted in full with no changes and full attribution, including this closing message.