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Before getting into this week's article, I want to tell you about a special free event I'm participating in on Monday. I'm holding a LIVE options webinar on February 6, and I'd like to give you first dibs to sign up. We have limited number of seats available for this webinar and, as a valued reader, I want you to be able to take part.
During this live event, I'll discuss my two basic strategies for producing income – and I'll field questions from the audience.
If you've ever had any questions about options and option strategies or would like to talk with me personally, next week is your best opportunity.
Click here to get signed up before we run out of room.
Okay, on to the topic of today's issue.
What would you buy now?
It's a question that we, as self-directed investors should have to answer. Yet the question is asked everyday in almost every financial media outlet. And most of the answers lack depth and sound reasoning. Moreover, the probability of choosing a successful stock is always 50/50. Why do you think monkeys throwing darts at The Wall Street Journal stock section performed almost as well as the professionals?
This concept underlines the success of my strategy: most of the time, we probably shouldn't be buying or selling anything. Most of the time, the odds are stacked against us. That's why we have to be so focused on patience – to wait for the times when the odds are stacked in our favor.
That's my strategy.
As an example of how I use this strategy in actual practice, let's look at a bear call spread.
A bear call spread is a credit spread composed of a short call at a lower strike and a long call at a higher strike. The nature of call pricing structure tells us that the higher strike call we are buying will cost less than the money collected from the sale of a lower strike call. It is for this reason that this spread involves a cash inflow or credit to the trader/investor.
The ideal condition is for the spread to expire worthless, thus allowing you to keep the premium collected at the time of the sale of the spread. In order for this to happen, the underlying will have to close below the lower strike call option that you are short.
In essence, a bull-put spread is an options strategy that lets me choose my own probability of success based on my risk tolerance. Yes, that's right. I can choose my own probability of success.
Let me explain, using options on the SPDR S&P 500 ETF (NYSEAMEX:SPY). The chart below is a partial listing of some SPY call options that expire in March.
With SPY trading at $131.83, I want to choose a strike that meets my risk/return objectives.
I prefer to put a little more on the table to gain a higher probability of success, because ultimately you want a winning trade. Yes, I could bring more money in by selling a strike that is closer to the current price of SPY. But this lowers my probability of success. Don't forget, the ultimate goal is to increase your probability of success while at the same time taking on risk that allows for a return that is suitable for your income goals.
Again, this is how one important way that I trade in the Options Advantage portfolio.
For my trading with this strategy, I prefer a win rate/probability of success in the 70%-90% range. As such, I like the 138/140 bear call spread or the 139/141 bear call spread.
Both have a high-probability of success (100 – 17.52 = 82.5%) (100-13.70 = 86.3%).
I like to give myself a decent margin for error, which obviously increases my probability of success. For example, the 139 strike allows for a 5.4% cushion to the upside. So SPY would have to move above 139 for the trade to start losing value. As long as SPY stays below 139 through March options expiration the trade is successful.
Credit spreads are my favorite way to trade options, particularly selling verticals. It's an extremely simple strategy to learn and arguably the most powerful strategy in the professional options traders' tool belt.
As always, if you have questions, feel free to drop me a line at [email protected].
Or, click here to get signed up for my webinar event, and you can ask me your question live next week.
Good investing,
Andy Crowder
Editor and Chief Options Strategist
Options Advantage and The Strike Price