High Probability Credit Spreads 12-26-12

Posted on December 26th, 2012

On Monday the 24th a new option expiration month began, and as a matter of our usual investing process, it was time to look at selling deep out-of-the-money credit spreads. As it has been a few months since we’ve written about this topic, here’s a reminder of how this strategy works.

We look to sell deep OTM spreads on a index like the SPX, NDX, RUT, etc. each month for a small percentage ranging from 1 to 4%. These spreads are written at a strike level that is far away from the current market price and have a high likelihood of expiring worthless. Spreads can be calls or puts depending on what bias you have. Put selling is bullish and call selling is bearish, but the strategy is still considered neutral by most standards as it pays off when the market moves only +/- 5% over the month.

As we enter the trade determining the size of the spread, the premium of the spread, the return if successful, how far away from the market we want to be, and the probability it will expire worthless. The combination of all these factors are what go into creating our entry with the target of trying to get a risk / reward ration that works to our favor. In other words, the return of the trade pays off more than the risk we took.

Here is an example of what an entry trade would look like based on today’s mid-day pricing with RUT (Russell 2000 Index):

- Sell Jan13 740 Put / Buy Jan13 730 Put for a net credit of 0.30 per contract with a 97.4% probability of expiring worthless.

This trade has a probability of losing money of 2.6% (100%-97.4%) and has a payoff of 3.1% {0.30 / (10-.30)}. When we have that kind of ratio of taking a 2.6% risk and getting a reward of 3.1% we consider it to be an advantage to the investor.

The probability of expiring worthless is calculated off of the strike that is closer to the market. In this case that is the short leg at the 740 strike with the market currently quoting the index around 840. This about 11% OTM and the probability is a data point that most option platforms will provide. However if you don’t have one, there are plenty of free ones out there for you to use.

Here’s a link to one on OptionsStrategist.com

http://www.optionstrategist.com/calculators/probability

You will need to know the volatility of the index for this calculator and for the RUT the volatility is quoted as RVX. This is just like the VIX, but is the volatility on the Russell 2000, currently at 22.11

Calculating the reward is as simple as just dividing the premium by the maintenance. In this case, the premium of the spread is $0.30 and the maintenance is the size of the spread, 10, minus the premium or $9.70.

On Friday we’ll outline the criteria used to sell or let the trade expire in a post titled: Exiting High Probability Credit Spreads.

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