When people first get interested in options-income selling strategies they usually start by learning how to sell credit spreads or iron condors. Let’s discuss these two strategies and why they might be attractive to options traders.
If you have traded stocks or even simply invested in stocks, you know that you make money only if the stock goes up, assuming you are long the stock. If it goes nowhere you make nothing and if it goes down you lose money. So in only one out of the three scenarios you earn money.
But what if you learned how to make money in all three scenarios? Sounds great, right?
Well, in fact you can (but there is always risk). By selling an option or selling an option credit spread you can make money in all three situations and here’s how.
Credit Spread Strategy
Assume that you think that IBM is going to move higher from its current price of $200. You believe it is going to happen in the next 30 days.
Let’s examine the three potential scenarios to profit:
• We are going to sell an out-of-the-money put credit spread.
• To initiate the trade we will sell the 30-day 190/185 put spread for $1.00.
What this means is that we are selling the 190 put option and buying the 185 put to create what is called a put spread. Since the option we are selling is more expensive than the one we are buying this spread is commonly called a credit spread.
Now, here is how we earn money: As long as IBM closes above 190 the day the options expire, we get to keep the $100 we collected ($1 x 100 for the 100 shares that each options spread controls). With IBM trading at 200 when we put this trade on, if IBM goes up, we win!
If IBM stays at 200 we win, and if IBM falls but stays above 190, we win, all the way down to 189 which is our breakeven point in the trade.
But if IBM falls below 189 you will start to lose money. The total risk in the trade is $500 (the economic difference between the premium we received for selling the put option and the cost of buying the put option) minus $100 (credit received), or $400. While your risk is larger than your reward (1:4), the number of winning scenarios has gone from one to three—for many options traders this seems like a worthwhile trade-off.
Now, let’s look at an Iron Condor
An iron condor is made up of two credit spreads, a put spread and a call spread. Many credit spread traders move on to Iron Condors because your broker knows that if you hold your position until expiration, at worst only one side can lose. So you get to bring in additional credit and lower the total dollar risk in the trade without any change in your gross margin and a reduction in your total risk, because of the extra credit you will receive for the call side credit spread.
So instead of bringing in $100 credit with the put spread, you sell the 210/215 call spread for an additional $1 and now your trade-reward potential is $200—and your risk is down to $300 or 1:1.5! So as long as IBM stays between 190 and 210 you get to keep your entire $200.
It is important to understand that while you lowered your total dollar risk, you did add additional risk to the trade because you limited how far up IBM can go! In the first trade IBM could go up forever and it does not affect your profits. But by taking in the additional credit with the call spread, you now put a bracket around IBM prices for you to make your money. If it moves outside of that bracket, you will lose some or all of your risk in the trade.
As with all income options trades, or options spread trades as they are correctly called, having a robust adjustment plan for an iron condor is critical to long term success—because the market doesn’t always cooperate with the range of your iron condor. Those adjustment plans separate the “men from the boys” in the world of options-income trading.
Seth Freudberg,
Director, SMB Options Training Program
No Relevant Positions