Yesterday, Monday May14th at about 10:35 ET I entered a SIMULATED OEX vertical spread on the weekly that expires this Friday. I just wanted to see it in action. Here is what I did: Bought 10 585 puts at 0.95 Sold 10 590 puts at 1.30 Bought 10 625 calls at 0.75 Sold 10 620 calls at 1.40 In total, received a credit of 1.00, which equals $1,000 minus $45.86 in commissions. My total credit, or profit would be $954.14. My max risk is $5,000 should either side expire in the money. For the week I am risking $5,000 to make $954.14? Is this risk justified? What do you folks think? Some sites say they have an 80% success rate. Which means if I made money eight times ($7,633.12) and lost money twice ($8,091.72) I would be in the hole for -$458.60 after 10 weeks? Isn't that a huge waste of time? Keep in mind that I entered this trade two days earlier than what most sites recommended. If I wait until tomorrow to enter, the premiums would be much lower and I would need to select strikes that are much closer to the money. And chances are I would not be able to collect 1.00 worth of total premium. I saw a post where someone said that they are risking 4.75/4.50 to make .25/.50 trading this way. I personally think its NUTS! Any thoughts?
Your numbers do not lie. If you have a risk/reward of 5/1 you need a probability ratio of 1/5 just to come out even. i.e. it must be 1/5th as probable to lose on the trade just to break even in the long run. This is not impossible but such trades do not fall in your lap. I run these trades all the time and indeed I try to make it so that a loss is very unlikely. e.g. say you have a 5 point spread where the win is $50 and the loss is $450. If the probability of a win is 75% and the probability of a loss is 25% (this assumes a binary outcome) the expected outcome is: Expectation = .75(50) - .25(450) = 37.50 - 112.5 = -$75. That's a really bad trade. If the probability of a win is 90% then: Expectation = .90(50) - .1(450) = 45 - 45 = 0 Thus you need a better than 90% probabiity to have an even chance of making a profit over the long run. http://en.wikipedia.org/wiki/Expected_value Most outcomes are not binary and thus you need to make an approximation of the expectation. I use a 3 point estimate of expectation which adds in the mid-point between complete failure and complete success. In screening for such trades I troll for situations where the probability is > 90% with return > 12%. i.e. .9 + .12 = 1.02 = a winner
Thanks. I get a lot of what your saying, and some of it I probably do intuitively. I come from a Chart Reading/Trend Trader background, so I tend to approach it more pictorially than mathematically. Diversify quite a bit, set the Max Loss of each Spread at 2% of Equity, and lessen that even more by getting out of the losers 45-30 days before Expiration. 2012 will be my first full year with this strategy, so we'll see how it goes. It's certainly being tested as of late, with all these drawdowns!
not my best idea selling those calls but still in the trade didn't panic this morning so I'm better than breakeven right now. You can see how jacked up those options were now, say you had bought those puts yesterday and the stock dropped 2 bucks and you were just at breakeven that would be agravating
In my short trading span my experience with credit spreads has been mixed. I've been burnt more by it than any other strategy. I prefer bleeding theta and having my guts squeezed out than just blow up a large chunk of my capital within minutes If you're new, stay away from credit spreads. I still do one or two here and there but its a small fraction of how i personally trade. Just my two cents as a newbie
You like the trade? So for you the risk is justified for such a small reward? I know the odds of success are in my favor but is betting $4,045.86 to win $954.14 good odds? Two full trading days have passed with three more days to go until expiration. OEX closed at 605.32 today which is 15 pts. away from the money on both sides.
If you prefer to bleed theta then may I suggest you look into ratio credit spreads using farther months. I have traded them on ES and ZC options. The options you buy as the hedge will provide you a cushion against some of your losses and it may even become a source of additional profits when the underlying moves against you enough and those options expire in the money.
hey thanks for getting back, i do see volatility collapsed - which saved your day. just highlights how hard it is to make money on the long side in options, as you imply in your post as well.... glad the position is working out for you, still I would have been interested in knowing how you would have handled a big gap-up in the option, say had it opened above $1? (again just for my education).
That ties up too much capital ... especially on index options... I doubt that's worth the time. Don't you think? I've thought about it but usually it's the convexity's ugly hand that screws you over between now and expiration that's the problem.