Income Through Vertical Spreads

[Hester]

Quote from spindr0:

1) The odds may seem with you but they are not. Say you can improve that win/loss ratio from 75/25 to 90/10 using your technical analysis. This would be extremely difficult but lets say hypothetically you could do it. Say you would still win the $.45 90% of the time and lose $4.50 10% of the time. You would still lose money. If you were to do a hundred trades winning 45 cents 90% of the time and losing $4.5 10% then you would lose $4.50.

This would be true if all of the spreads went to the maximum gain/loss but they're not going to. As the OP indicated, "I can close out a position well before I would hit my max loss of $4.50". Other than the unusual gap up, he's going to have plenty of warning before the underlying goes ITM and that will be long before the maximum loss is reached.


2) You could not thwart this with stops. Some of your winning trades will turn into losers by the miracle of time decay and whipsaws. You could just as easily want to cut winners short before they reach $.45.

The OP is writing OTM credit verticals. Time decay is his friend.


3) Bottom line is vertical spreads are no way to produce income. It is an option strategy that should be combined with others in your investing or trading strategy.

What option strategies are for producing income?

1. Well, it hasn't been discussed where he will cut his losses. If he does it too soon then he will miss out on trades that may eventually become winners. If he cuts losses too late he may not be saving much money. It is a tricky thing to do and is not a science.

2. Time decay is his friend until the spread becomes in the money. Then what? If you set your stop so tight that your spreads never become ITM then his win/loss percentage will suffer. If he uses a looser stop or none at all then many positions may become ITM and then time decay is his enemy.

3. First of all, all you had to do was read the very first post of this thread from the op to answer that question. He specifically asked if he could do these spreads to produce monthly income. That was what I was addressing. The subject was brought up in many additional posts by others in this thread as well.

Second of all, there are several option strategies for producing income. It depends how you use them. Covered calls are used by many folks as a sort of second dividend on a stock they own. Writing puts can be viewed as collecting income (via premium recieved) on stocks you would like to own at a lower price. You could do a credit collar as income. It really just depends how you want to use options, how you view the profit on some strategies, and how creative you are willing to be.

 

[TheoHornsby]

Quote from erol:

In the end, I preferred to be long verticals. Ironically it's less stressful for me, and I just feel like I had more control. The potential gain is larger as well.

Not being subject to assignment is good but there's no extra gain to be had with a long vertical over the equivalant short vertical.

 

[erol]

I guess psychologically, I was more comfortable being long.

It's irrational I suppose, but I guess if I end up making better decisions, then it (hopefully) works out in the long run.

 

[TheoHornsby]

Quote from Hester:

1. Well, it hasn't been discussed where he will cut his losses. If he does it too soon then he will miss out on trades that may eventually become winners. If he cuts losses too late he may not be saving much money. It is a tricky thing to do and is not a science.

2. Time decay is his friend until the spread becomes in the money. Then what? If you set your stop so tight that your spreads never become ITM then his win/loss percentage will suffer. If he uses a looser stop or none at all then many positions may become ITM and then time decay is his enemy.

I think your missing the point of several posters. If the OP writes Out of money vertical for 50 ct credit on a $5 spread difference, it's going to be 5-10 or more pts out of money. The probability of making that 45 cts is very high and there will be a lot of room to adjust or close before the spread gets ITM. A $4.50 loss or anything close to it should be a very rare event. And time decay is always your friend when you sell an option. It doesn't matter whether the option is in or out of the money. every day that passes is decay in your pocket. You're confusing intrinsic gain with time decay.

 

[TheoHornsby]

Quote from erol:

I guess psychologically, I was more comfortable being long.

It's irrational I suppose, but I guess if I end up making better decisions, then it (hopefully) works out in the long run.

It's not irrational. If your more comfortable that way then it's the right thing to do.

 

[uptickk]

There is a ton of great information here. It’s amazing how much I have learned from these comments.

Quote from steveplace:

3. You're neglecting the volatility component here. If you don't have an edge in vol you should be trading common not options. So if you're selling verticals that are OTM you are expecting that price will not move as fast as what the options are pricing in-- you're shorting volatility. If that's you're goal, fine. But when vol upticks you lose money on the vega as well as any fast move.

You are right about the volatility component. I recently have been reading through my “Options as a Strategic Investment” and I will try to incorporate selling the spreads during times of high IV. I would love to benefit from the time decay as well as decrease in volatility.

Quote from TheoHornsby:

I think your missing the point of several posters. If the OP writes Out of money vertical for 50 ct credit on a $5 spread difference, it's going to be 5-10 or more pts out of money. The probability of making that 45 cts is very high and there will be a lot of room to adjust or close before the spread gets ITM. A $4.50 loss or anything close to it should be a very rare event. And time decay is always your friend when you sell an option. It doesn't matter whether the option is in or out of the money. every day that passes is decay in your pocket. You're confusing intrinsic gain with time decay.

Right on as well with regards to writing the verticals OTM. On the 5 point spreads I usually shoot to write the vertical closer to 10%+ OTM which gives me plenty of notice in the event I get the direction wrong.

As far as setting my losses, I REALLY need to work in that area. I have only had one position go against me and that was while I was paper trading so I haven’t had much experience with this.

One additional question I have is at what time do options actually expire on Friday (technically Saturday). What I am getting at is do all options (Equity) stop trading at 3 EST or because after market trading is allowed can you technically get assigned if at 3:30 Friday there is a swing and you end up ITM?

 

[AAAintheBeltway]

A vertical is not a vol play. It is directional. In a credit spread you will actually be selling low IV and buying somewhat higher IV, due to the skew. In any event, any change in vol tends to be offset by the nature of the spread. If you want to trade vol, you need to look at straddles, strangles, ratios, etc.

A vertical is a low risk, low reward directional play. Your max profit and max loss are predefined. It is a conservative way to play a directional bias.

I would suggest reading Natenberg to better understand this.

 

[hidge]

Quote from AAAintheBeltway:

A vertical is not a vol play. It is directional. In a credit spread you will actually be selling low IV and buying somewhat higher IV, due to the skew. In any event, any change in vol tends to be offset by the nature of the spread. If you want to trade vol, you need to look at straddles, strangles, ratios, etc.

A vertical is a low risk, low reward directional play. Your max profit and max loss are predefined. It is a conservative way to play a directional bias.

I would suggest reading Natenberg to better understand this.

Hello AAA,
Although you right about the fact that volatility skew makes the options priced with higher IV the more distance they are from the underline price. Selling verticals with high probability (more than 50%) of profiting will produce a short Vega position as long as the underline price stays above or below the short option strike (above for bullish vertical & below for bearish vertical).
I agree that verticals are directional plays but paying attention to IV levels and understanding that you have a Vega exposure in your positions is part of the game and has to be factored before and during the trades.
For an example:
if you think that market conditions are over sold (don't ask me how can you know that I am an undirectional trader ļ ) and due to market recent bearish sentiment IV has increased it will make your bull vertical even more attractive for two reasons:
1 you will get a better price or higher distance for your vertical.
2 if the market will rise or even stay range bound you'll benefit from the IV decrease.

Have a great weekend,

Oded

 

[TheoHornsby]

Quote from uptickk:

You are right about the volatility component. I recently have been reading through my “Options as a Strategic Investment” and I will try to incorporate selling the spreads during times of high IV. I would love to benefit from the time decay as well as decrease in volatility.

Right on as well with regards to writing the verticals OTM. On the 5 point spreads I usually shoot to write the vertical closer to 10%+ OTM which gives me plenty of notice in the event I get the direction wrong.

I don't think that selling directional spreads during times of IV is anything special nor should it be your primary focus. If IV is high or low, the extra you pay is somewhat negated by the extra you receive. Direction should always be your primary concern. Getting volatilaty right might be pennies versus the dollars you'll get from getting direction right. Aslo, how many people have a clue if IV will increase or decrease outside of earnings and special news?

and options stop trading at 4 PM not 3 PM EST

 

[spindr0]

Quote from Hester:

Second of all, there are several option strategies for producing income. It depends how you use them. Covered calls are used by many folks as a sort of second dividend on a stock they own. Writing puts can be viewed as collecting income (via premium recieved) on stocks you would like to own at a lower price. You could do a credit collar as income. It really just depends how you want to use options, how you view the profit on some strategies, and how creative you are willing to be.

You've stated that "Selling vertical spreads is not a viable way to produce monthly income of any amount" and "Vertical spreads are no way to produce income." Yet covered calls, writing puts and credit collars are. Interesting premise.

Now what happens if someone substitutes a call for the stock in order to limit risk? That will provide a yield somewhat similar to the covered call and more often than not will have less risk. Yet it's a vertical. So one is not an income producer but the other is??

Better yet. You say that a collar is an income vehicle but a vertical is not. But in reality, a collar is a vertical so it's just another contradiction. I'd use that confused face but I'm not