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Tom Loge's Dual Credit Spread Program This mini course tackles a wonderful strategy with a long list of benefits and advantages. The credit spread has long been a favored strategy of locals and floor mavens but, not generally known to retail traders ... until now. Follow along with R.Thomas Loge', CTA, as he sets the stage with the concepts and reasoning behind this strategy and then takes you through the steps of creating an actual trade. The "DUAL CREDIT SPREAD" is his favorite strategy and we think it will become one of yours as well. "Welcome to 'THE DUAL CREDIT SPREAD' Course. Few strategies move so many advantages to the traders' side of the table and provide such a consistent, relaxed way to take money out of the markets. The strategy is quite simple to learn. Many of the folks trading this program with me are Doctors, Lawyers, senior corporate executives and business owners. People with huge demands on their time that preclude them sitting, watching the screen for hours at a time. This program is perfect for them. It also allows us to play markets with rather lofty margin requirements for very modest amounts of capital." "My hope is you will understand and embrace 'THE DUAL CREDIT SPREAD' after completing this course. It has been my most consistent strategy and understandably I view it with great affection ... I hope you will as well." Tom THE ELEMENTS A Zero Sum Game Option trading is a "zero sum game". Whenever there is a winner, there must be a loser; and the opposite: Whenever there is a loser, there must simultaneously be a winner. Someone is making a bad decisions while someone else is making the right decisions. |
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Profitable ones! This is the essence of option trading. So, what is the trader’s first priority in option trading? Making as many right choices as possible. We want to be right more frequently than we are wrong. How is this to be achieved? It begins with understanding the rules, or elements, of the game! There are 3 predominant elements that affect the value of any option. Time Value, Probability and Implied Volatility. Time Value An option can either be purchased or it can be sold. This becomes the trader’s first decision. When an option is purchased, a strike price is selected. The price paid for the purchased option is called the premium. This premium establishes the value of the option. Most options purchased are "at or out-of-the-money", meaning that the premium paid is for an object without real value. In trading parlance there is no intrinsic (real) value to the option. Yet, the buyer paid a premium, so there must be some actual worth. There is value, and that value is time. Most purchasers of options buy time only which by its very nature, of course, is a depreciating asset. Time runs out! Remember that the trader wants to make as many "right decisions" as possible. Buying a depreciating asset (time) is generally not a good way to be on the "right side" of the trading decision. Time is going to run out upon the option’s expiration, and if it does so before the market reaches the strike price purchased, the option becomes absolutely worthless. The option buyer loses the purchase value (premium) of the option plus the fees and commissions paid, while the person selling (granting) the option keeps the premium from the sale. For every option purchased there must be a seller to write (grant) the option. There is someone making the "right" decision and someone else making a "bad" decision. Probability There is a mathematical formula by which we can calculate the probability of a market price reaching any option's strike price at the expiration of the option’s contract. This Probability Analysis is calculated employing a formula created by Black and Shoales (Nobel Prize winners in Economics). The formula indicates (in terms of percentage) the probability of any market moving from its present price, point "A" to another price, Point "B" within a defined period of time. In other words, we can mathematically calculate the probability of any strike price being reached prior to or at expiration of the purchased option. It must be pointed out that when "at-the-money", the chances are 50% that a market will go up, and consequently, a 50% chance that it will go down. So, any out-of-the-money option that is purchased must have less than a 50% chance of being reached. The farther away the option is "out-of-the-money", the lower the probability of its being reached within a certain time period. So let’s assume an option (with 2 months until expiration) is purchased 3-strike prices "away-from-the-money". The option has perhaps a 25% probability of being reached within the 2 months remaining before expiration. Two points to remember: 1) Someone is buying the option and someone else is selling the option;and 2) The buyer has a 25% chance of being right, so the seller (under the "zero sum" theory) must have a 75% chance of being right. Our goal is to make more "right decisions" than wrong decisions. It is logical and the likelihood far greater that the 75% probable position is a better play than the 25% probable position on a long-term basis. Implied Volatility The driving force in the Probability Analysis formula is Implied Volatility. IV is the measure of the emotion or excitement factor present in a market. It is more likely that a strike price will be reached, within a defined time period, if the market has the characteristics of excitement and emotion. A market that is placid and emotionless has little mobility. This means Volatility stretches the "pricing array" of a market. The greater the Volatility, the more premium will be there in "out of the money" options. Why is this important? When purchasing options, we want to buy before this price array becomes expanded. If selling, we want to do so after prices have become inflated. This of course is not fool-proof, but it certainly is advantageous in an attempt to be on the right side of the option trading decision! A further application of Volatility is that it serves as a measuring device to determine whether an option is over or under-valued. This valuation is done through comparing various Historical Volatility readings. Using these comparisons, it is possible to determine whether an option is over or under-valued. Why is this important? It is obviously better to buy something under-valued and sell something over-valued. Again, we want to make as many good trading decisions as possible. Selling an over-valued option is better than buying something that is over-valued. Volatility measurements give us an excellent evaluation tool. THE REASONING By putting these basic elements together, we hope to increase the chances of being on the winning side of the trade decision. We can see that "at-the-money" and "out-of-the-money" options are merely a purchase of time value, and time, once purchased, is a depreciating asset. So, one would more frequently prefer to be the seller of option premium than to be the buyer of premium. We also know that the farther "out-of-the-money" an option is, the less likely that the strike price will be reached within the expiration period (the lower the Probability). Therefore, selling an "out-of-the-money" option offers greater probability of being successful than does buying the same "out-of-the-money" options. Traders can continuously evaluate options to determine if they are over or under-valued. This affords the ongoing advantage of knowing whether it is timely to buy or sell the option. If one finds an over-valued option, they can sell it to collect the premium. Hopefully, this is done with options that are tremendously "far-out-of-the-money". When achieved, the Probability of that "far-out-of-money" strike price being reached before expiration becomes improbable. So, what is improbable? 30% probability, or 20% or even as low as 5% and 10% probabilities often exist, depending on how "far out-of-the-money" one goes. If a market has just heated up emotionally (Volatility has increased), there exists a great chance to find options far "away-from-the-money" where the Probabilities of that strike price being reached are very low. By waiting for these situations, the seller gains a definite advantage. This sort of selectivity in selling options gives the trader both the high probability of being right plus the added advantage of selling something that is over-valued. To this impressive combination of selling advantages, we add the omnipresent time decay factor of the option also being on the seller’s side, and a compelling argument develops for SELLING OPTIONS as a logical way to approach trading. Note: It is not that selling options is the only approach to Option Trading. There are certainly many buying opportunities as well, but they are not as apparent and require a number of factors being properly in place. Always included should be a desire to lower one’s exposure to loss. This is necessary as the odds are always going to be under 50% of being right when purchasing "out-of-the-money" options. Because of the overwhelming logical reasons that favor option selling to option buying, it could be concluded that to improve our chances of making a correct trading decision, the trader should seek selling opportunities. OPTION SELLING STRATEGIES SHORT STRANGLES or NEUTRAL OPTIONS POSITION STRATEGIES (NOPS) The traditional strategy to take advantage of all the favorable elements offered by selling options is embodied in the Short Strangle or Neutral Option Trading Strategy. This option trading strategy sells options (far-out-of-the-money) on both sides of the market that are over-valued. In other words, sell Puts to the Put buyer who thinks the market is going down, while at the same time, sell Calls to the Call buyer who thinks the market is going up. The required and consistent common denominators of successful Neutral Option Trading are: 1. The options must be "far-out-of-the-money" (far enough away to offer a low Probability of being reached before expiration); 2. The Puts and the Calls must be sold at the same time to achieve balance in the position, because if one side of the trade fails, the other side is gaining. (Delta Neutrality). 3. There must be enough premium to collect to make taking the risk of selling naked options worthwhile. This requirement means that it becomes tempting to sell options that are too "close-to-the-money" (for safety considerations) just in order to gain enough premium. 4. The options sold must be overvalued (high Implied Volatility) to the underlying asset. When these requirements are met, the Short Strangle or Neutral Option Trade can be a thing of "theoretical beauty". But it is only beautiful in theory because the strategy has one overwhelming flaw. It always has an undefined (unlimited) risk attached to it. Thus, the theoretical perfection can easily be shattered by any sudden dramatic market move in a market where both sides have been sold. Such a move usually causes great discomfort to both the undercapitalized and novice trader. Note: It takes both the experience, (a cool head under pressure) plus ample trading capital to successfully trade Neutral Option Positions. If one possesses these two characteristics, Neutral Option Trading is certainly a viable strategy, but it must be managed properly. In fact, I run a parallel trading program devoted strictly to Short strangles or Neutral Option Trading. It requires a minimum account of $100,000. A VIABLE ALTERNATIVE THE DUAL CREDIT SPREAD It is possible to take advantage of the market by selling over-valued, "far-out-of-the-money" options on both sides of the market at strike prices that have a low probability of being reached, and to do so in a consistent manner without incurring "unlimited" risk. This can all be accomplished quite easily using Credit Spreads on both sides of the market, thus gaining all of the advantages of selling options plus one critical additional advantage ... defined risk! The Credit Spread is an Option Strategy whereby an over-valued, "out-of-the-money" option is sold (taking in premium), while at the same time, a "farther-out-of-the-money" option (one or two strike prices removed from the option that was sold) is simultaneously purchased. This purchase of the "removed" strike price option gives the sold option "coverage", thus eliminating the undefined risk aspect of selling. What a concept! The result is that it becomes possible to sell "out-of-the-money" options, giving the trader a significant advantage in 1. A high percentage probability of success, 2. Selling over-valued options, and 3. Putting time-decay on the trader’s side, while 4. Being able to constantly define the risk. Remember that the risk can never be greater than the difference between the strike price sold and the strike price purchased. This gives the trade a risk definition, and allows the trader to sleep at night.For example: The difference in S & P strike prices is 10 Basis Points. Each Basis Point is worth $250, so the difference between the 1200-strike price and the 1210-strike price is 10 basis points, $2,500. If the 1200 Call were sold for premium of $1000 and the 1210 Call was purchased (as protection) for $500, the spread would yield the trader a credit of $500. The risk would be the difference in the two strike prices, $2,500, less the $500 credit received or $2000 total risk. The exchange recognizes our spread and only requires us to post about $2500 or less in margin. What makes the Credit Spread so interesting is that we can initiate the trades on both sides of the market. In other words, we can do a Credit Spread with Puts as well as with Calls. This is very significant because by incorporating both sides of the market, it is possible to increase the premium collected, while also allowing the trader to enjoy "balance" in their position. As with the NOPS (previously explained), selling both sides of the market only enhances one’s chance for success. Clearly, the market can only be biased in one direction or another. This means that either the Put or the Call side is vulnerable to a dramatic market move (rendering it unprofitable), while the opposite side will be profitable, thereby lessening the overall prospect of loss. This holds true with Dual Credit Spreads as well. When collecting premium from both sides of the market, the total risk becomes greatly reduced. It’s logical. If a market can only move in one direction at a time, the total risk is always limited to the maximum exposure only on one side. (In the S&P scenario, this risk was the difference between the strike price sold and the one purchased or $2,500. By collecting the additional premium, another $500, the total risk is reduced by the amount of premium collected. So, if the risk is $2,500 on one side and we collect $500 premium on that side with a Credit Spread, the net risk exposure is only $2,000. But, if we initiate a Credit Spread on the opposite side of the market as well and collect another $500 in premium, the net exposure then goes to $1,500. We reduce the overall risk, while increasing the premium collected by initiating a Credit Spread twice ... one in puts, one in calls. Now catch this! They let us do this for the SAME MARGIN! By iniating credit spreads on both sides we REDUCE risk, INCREASE potential profit AND THEY LET US DO IT FOR THE SAME MARTGIN ... What a country! The one great advantage of the Dual Credit Spread over the Neutral Options Position Strategy is that the risk is always defined. Not defined by the insertion of a stop loss or some other often arbitrary means of managing the position. It is there via the structure of the trade. The loss can never be greater than the difference in the strike price sold and the strike price purchased. Once that loss is defined and accepted by the trader as being the maximum, some additional advantages appear. One such advantage is that it is not necessary to adjust one’s position should a market move dramatically in one direction or another. If one sells without defined risk (naked options), as in NOPS trading, there would be legitimate concern and possibly a need to adjust the positions. This process is painful both emotionally and financially. With the Dual Credit Spread, it is possible to allow the position to remain in place hoping that the market will reverse itself (as it so frequently does), and end up back inside the original Dual Credit Spread range. Once the maximum loss is accepted, there is no need to go through an expensive adjustment of the position (locking-in losses) because of the legitimate fear of "unlimited risk". Another outstanding advantage of defined risk allows the trader another significant edge, that being the ability to "leg" into the trades. This means initiating one side of the Credit Spread at a time. This is an advantage because one can wait for the market to move up, place the Call side of the Dual Credit Spread, and then wait for a reversal down to place the Put side. This allows the trader to increase the premium collected. The advantages to that are obvious. It’s always better to take in additional income, not to mention lessening the cost of the trade and lowering the risk. This "legging-in" is possible because it is not imperative that both sides be in place at once. The worst thing that can happen is that one side of the Dual Credit Spread is in place and the market goes strongly in that direction (causing a loss) and does not reverse itself. This results in the maximum defined loss $2,500, in the case of the S&P, less the premium collected on one side of the strategy. ($2,500-$500 $2,000 maximum loss). This is the absolute worst case scenario. The advantages of legging-in are many. The choice is there for the trader to make. You can take the available credit on both sides of the market, thus reducing the defined risk by receiving two credits. Further, you may be more adventurous by trying to improve the profitability of the trade through "legging-in". You do, however, run the risk of missing the second side premium should the market run away against the position in place. There is no right or wrong answer. This is "The Art of the Trade", and is probably best executed by employing competent brokers who understand the nuances of Dual Credit Spreads and the markets in which they are appropriately placed. THE TRADING RULES The Markets The Dual Credit Spreads depend on markets that offer enough Premium between the strike prices to make the "sell" and the "buy" a worthwhile transaction. Also, the markets should have enough Volatility on both the Call and the Put side to allow the Credit Spreads to be initiated at a distance "out-of-harms-way" on both sides. Also, the Volatility should be on the high side of the last 2-year Volatility range to make both the safety and the Premium adequate to fully maximize the opportunity. It is ideal if the market has, as its normal course, pricing spikes that allow the trader to "leg-in" and out of positions. The two best markets for Dual Credit Spreads presently are the S&P and US 30-Year Bonds. Both of these markets meet all of the qualifications. Other markets that are candidates for Dual Credit Spread Trading are the Currencies and the Metals (when Volatility is high), as well as Crude Oil. Trade Standards The trade should bring in a minimum Premium before it can be taken seriously as a Dual Credit Spread candidate. For the S&P, this minimum would be 2.00 S&P points ($500) on each side of the market, or a total of 4.00 S&P points ($1000). The maximum risk of a Dual Credit Spread in the S&P (buying the next strike price removed from the sold option) is $2,500. If the maximum income is $1000, the Return on Capital Employed (ROCE) is 40%. If realized in 30 days, the 40% would be annualized at 480%. The trades considered allow a maximum of 35 days until expiration (plus or minus 5 days). There will be occasions to expand this window of opportunity with a more aggressive approach. Bonds generally require 60 days in order to collect enough premium to make the trade worthwhile. When trading Bonds we ideally look for a total credit of $1,000, while risking $2,000 (The difference in 2 Bond Strike Price points). Trades can either be held to expiration or a Profit-Taking Plan can be installed to take profits when they occur at some point short of their maximum. Our trades will all employ a Profit-Taking Plan. It is up to the trader to decide if the Plan is to their liking. The first embellishment to the Dual Credit Spread is to aggressively not wait for the 30-day period. Rather, one seeks a trade that is 45 to 60 days from expiration and establishes a Dual Credit Spread. This lengthening of the time frame allows either 1. more premium to be taken in by selling the same strike prices as with a 30-day expiration position, or 2. selling positions farther out of the money so that even greater safety is achievable. It would most likely be our choice to opt for the safer position, when given this choice. This is an embellishment of the straight 30 days to expiration plan. If a market remains emotional (Volatility is high), it is possible to find Dual Credit Spreads on both sides of the market with very little time until expiration (10 -20 days remaining). This would be a second or third position using the Dual Credit Spread Strategy in the same market. The first Dual Credit Spread position may be taken 45 to 60 days from expiration. The second position would be 30 days from expiration, while the third spread would be in the 10 to 20 day period before expiration. Using these approaches, the same market is sold at three different positions, giving the trader some strike price diversification, while collecting substantially more premium than if just one position was in play. Remember there are 3 trades, so there are 3 different maximum losses. If the scenario is that each position has a maximum risk of $1,500 and there are 3 positions, the maximum loss in case of a "runaway market" would be $4,500 plus commissions and fees. This expanded effort is not for either the smaller equity accounts (It takes a minimum of $10,000 of available capital to be able to apply just 1 set of Triple Dual Credit Spreads. THE BROKER It is important to Dual Credit Spread trading that the technicians be adept. This process begins by selecting the ideal markets and strike prices with which to establish the spreads. The broker and client should work hand in hand to apply the Art-of-Trading working in tandem to design a plan specific to each individual. This certainly includes working the trades to achieve maximum positions, especially if the trade is being worked to "leg" in. If "legging-in" to improve the Premium derived from the trade, that Broker/Client team must be very competent. The result of their effort means the lowering of maximum risk, while improving the profit potential of the trade. ACCOUNT SIZE REQUIREMENTS These strategies can be employed successfully with minimum accounts of $5000 If you would like more information on the selling strategies discussed here I invite your call or email at 800.656.0443 or rtom816@att.net TRADE SELECTION Let's walk through the steps I take to arrive at my trading decision. You may wish to refer to the attached chart as a visual reference. I am predominately a resistance and support technician. I begin working with the daily and weekly charts about 50 days prior to option expiration each month. I will draw my first line of resistance across the chart at the contract high on the daily chart and the recent high (One year) on the weekly. Then do the same for lows. I then draw horizontal lines that touch either bottoms or tops of price bars that are at the same level. I will allow plus or minus one full point as the same. For instance, let's say I find 8 (days) price bars spread over 3 months that have tops and/or bottoms that are all in the 1176 to 1178 area. I would draw a horizontal line and label it 1178 resistance. resistance because this price level is above the current market price level. I find another point at 1075 that has a number of "hits" much the same in appearence as the 1178 level. I draw a horizontal line here and label it 1075 support. Support because it is below the current market price level. A resistance or support line will be drawn at each point of congestion that is identifiable. In the accompanying chart I have only shown the levels I have decided to use. Were I to mark all the R&S lines you'd have difficulty seeing the chart. I'm sure you can pretty much discern where I might have drawn additional R&S lines just by eyeballing the chart. When I have all my R&S lines drawn, I assign a 1-10 scale value to each line of R&S. I will sell calls above a minimum of 3 magnitude 7 lines of resistance and sell calls below a minimum of 3 magnitude 7 lines of support. Let's say in this example I land on the levels we used here. I will sell a call above 1178 and I will sell a put below 1075. I'm feeling comfortable with any strike price above 1180 (closest to 1175) and below 1075 (closest 1070). But I'm going to reach a little here beyond my comfort level to provide an additional measure of safety. So, I want to sell a 1200 call and a 1050 put. The next step is to decide which corresponding options I buy to create my coverage which defines the risk. This is a purely mechanical process. I would buy the 1040 put and the 1210 call. 10 points above and below the options sold. This gives me a positon with the desired defined risk of $2500. Next I consult the array of option prices to determine how much premium I can collect net by buying and selling the strike prices I've landed on. It will be rare to get a net 2.00 points on both sides simultaneously. So I will watch and track market movement over the next few days and the impact on option prices looking for the opportunity for the call credit spread or put credit spread to pass within my crosshairs. I stretched the range on the strike prices and may have to come back in closer to the actual R&S levels to get my trade done but, that's fine. I have confidence in my R&S numbers and wouldn't hesitate to sell at either level. I would prefer to do both sides at the same time but that rarely happens anymore. Some who do "DUAL CREDIT SPREADS" will put both sides on everytime. I prefer to rely on my R&S analysis and only do them above and below those levels never compromising. This means that I frequently "leg" into these trades. Occassionally I will only get only one side on in a given month. I have compared the results of my methodology to others who prefer to put them on simultaneously and have for the past 2 years outperformed them. Once the trade is on I review the postion daily, updating new R&S lines. I use this to constantly update the management plan for the trade. I update all clients participating in the trade with a once a week email report tracking the trade and giving my current management strategy. One of the great benefits of this strategy is that management can be as creative or conservative as each individual desires. The flexibilty is truly phenomenal. Some cautions. RULE #1 DO NOT EVER TAKE OFF THE BOUGHT OPTION AND LEAVE THE SOLD OPTION OPEN ... NOT EVER! Never leg into the one side of the trade. Meaning don't ever sell the put or call without simultaneously buying the companion option. I have but do not recommend buying the put or call and later selling the companion option. By there nature aa a spread they tend to have a lot of price integrity making them very easy to live with. Tamper with the structural beauty as little as possible and they will traet you exceedingly well. I hope I've imparted some useful information and encourage you to call upon me if I can clarify any issue or answer any questions you may have. Thank you for spending some of your precious time with me and my favorite strategy. Tom Loge can be contacted at Tom@Tradershelpingtraders.net |
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