Income Through Vertical Spreads

Discussion in 'Options' started by uptickk, Oct 14, 2009.

  1. uptickk


    Hello All,

    I am pretty new to options trading, 3 months of paper trading and this will be my 2nd month of real trading. I learned a lot in those first 3 months of paper trading. Basically, I started selling covered calls and have since moved to a mix of covered calls and bear call spreads. I write my bear call spreads less with less than 4 or 5 weeks until expiration and out of the money and the same timing with my covered calls but they are in the money to keep things a bit more on the conservative side. Additionally, I only enter into trades where there is approx. a 75% of obtaining the maximum profit. I have several other things I look for but I don’t want to bore anyone.

    I guess I have three questions

    1) Are selling vertical spreads a viable way to produce monthly income over the long term? I generally look for 8-10% return a month but am happy with anything over 5%. Basically, I am selling time decay. I have been successful but I want to ensure it’s not a fluke.

    2) Do most people who sell the spreads close them out before expiration? For the first time my short call is getting closer to being in the money then in my past. If you do, is there a rule of thumb you use (i.e. sell them the week before expiration?)

    3) Is there an industry average risk to return ratio for the spreads? I know everyone trades differently but if I am collecting 0.45 on a 5 point spread, I stand to loose a good amount. But I also only will enter the trade if there is a 75% chance that the short call will not end in the money.

    Any help would be greatly appreciated.

  2. Hester


    1. No, selling vertical spreads is not a viable way to produce monthly income of any amount, much less 5-10%. If you could produce an 8-10 or even 5 percent return a MONTH using vertical spreads over the long term, then you'd easily be the richest person ever to live in a couple of decades. Vertical spreads are not investing vehicles that are designed to produce income. They are bets on the direction of an underlying security. If you try to do this every month, you may have a series of wins that makes the strategy look great, but once a major event happens, you will quickly lose a ton of money, if not everything. You are playing with matches in a pool of gasoline.

    2. You close the spread whenever you want. There is no rule of thumb, its just based on your opinion of the future direction and volatility of the stock.

    3. Some people who stick to a disciplined trading strategy rely on a certain risk/reward ratio, but not me. It completely just depends on the situation. Sometimes it pays to take a shot. If you do your due diligence and think that for whatever reason, a stock could make a big move, then its not a bad idea to enter a trade that has a lower probability of ending in the money, providing that you do not risk a lot of capital, have a strong conviction, and will have a lot of reward if a big move does happen. This is one of the things that makes options so great, you can take a very small portion of your portfolio and turn it into a small fortune if you are willing to take some risks.
  3. erol


    I am still in your shoes so to speak, and I read a lot of great advice here.

    Just a warning, unless you have nerves of steel, real trading involves emotions that I personally don't feel paper trading. It's a different game, so just be aware. You also may not get the fills you want (the prices you want). This is a gentle warning, not meant for discouragement.

    Best of luck and keep us posted!

    edit: i'm a dolt, didn't read that you are real trading for 2 months, sorry.
  4. 1) You win 50 cents 75% of the time

    2) You can lose up to $4.50, 25% of the time.

    Does this sound like a good deal to you?

    It shouldn't. It's a horrible deal.

    Yes, you must cover some positions early. You are not going to win over the longer-term if you hope each position expires worthless. You can expect to lose on 25% of your positions, as you described them.

  5. coffee898


    Good question uptickk
    I have been trading this strategy, with positive results, for a number of years now. I have a system over at Collective 2 under the name index spreads - also a website The most important part of this strategy, any strategy in my opinion is having a solid plan and sticking with it. Also you need to be realistic in your expectations of returns. I believe 30% annual return, give or take a bit, with this strategy is realistic. So it can and is being done. It is a long-term strategy and frankly pretty boring (which is a good thing in my opinion) but just keep your eye on the yearly return not month-to-month.
  6. wayneL


    Of course it can work, but it is not as easy as a lot of the literature makes out. There are numerous caveats.

    I did some videos on this topic after reading a breathless article on how to get rich quick with credit spreads.

    Check them out.

    Part 1

    Part 2

    Part 3
  7. uptickk


    Thank you everyone for your input. I really appreciate it being new to the game and there are some great take aways. One comment to make sure I am thinking straight. . .

    If I were to only base my trades off of being 75% profitable and never made any adjustments then I would agree with the above, however, I have the ability to use technical analysis (moving average, resistance, support, etc.) (got to be worth something right?) for direction, additionally I can close out a position well before I would hit my max loss of $4.50. If this is all true then I would think that I would be able to move the expected return in my favor. Am I thinking logically here or have I just convinced myself that my strategy will work?

    I guess what I am getting at here is that I know my risk/reward ratio isn’t anywhere near the yahoo screeners show but if my trades have a higher probably on their own and then I add in stops and technical analysis, am I not improving the probably more so.

    Thanks once again
  8. u21c3f6


    My concern is that your thought process is being based on a small amount of time where the market has been moving in a direction that is favorable to your strategy.

    I don't think you can really gauge whether you have an "edge" until you have many more trades in all kinds of market conditions.

    The hardest thing for me to learn was how to take a loss. There was this urge to do "something" to turn a losing trade into a winning one. Part of your thought process is to limit losses which is good, but until you actually face many trades that have gone south on you, you may not actually do what you think you would and worse you may not recognize it when you should.

    My suggestion is to be concservative until you have enough experience under very different market conditions to determine if this truly is a "workable" strategy. Good luck.

  9. Back in the summer of '07 I started selling vertical spreads and condors by following a newsletter that had a really good track record for doing such. Within a few months I had lost about 1/3 of my account due to the expansion in volatility and because the newsletter I was following kept making "adjustments" to positions that I later figured out were just adjustments to keep from saying they closed the position in order to make their track record look better than it really was.

    Although losing 1/3 of my account sucked, it taught me at least one truth: you are either trading a direction or you're trading volatility (another form of direction). So wake up! The market gives away nothing for free, and there is no inherent edge in any position, period. Once you realize you are trading directionally, you've got to be smarter or luckier than all the other contestants in picking the right direction. What is it about you or your strategy that makes you smarter or luckier? If you can't answer that question honestly, then you are about to become a statistic.

    I'll give you three clues on your journey:

    1. Learn more about yourself. What kind of pain do you detest the least? The market provides everyone with pain, but your strategy dictates the way in which you suffer it.
    2. Learn more about price action. There is no substitutue for experience. There are no setups or option strats that inherently give you an edge. Which setups do you take when? Experience will teach you. It is the only edge I know of.
    3. Brace yourself. You will fail at this game for much longer and lose much more than you ever thought possible. If you're in it for the money you will give up due to the pain. Only the love of the game will keep you engaged until you turn the corner of profitability.
  10. Before you make more trades please consider the dynamics of options.

    Let's say that you enter a position and have stop losses. Because options contain time decay what it means is that you might end up getting stopped out even though at the end your trade would have won.

    To do this strategy reasonably you will need to understanding option pricing and where the price could go. And then you need nerves of steel!

    I am a contrarian by nature. I like to catch falling knifes because I manage my money in my account. Managing your money and your risk is not taught very well, but is absolutely crucial in this strategy.

    If you are not a contrarian and are not somebody who is willing to stand up in the crowd and say, "hey you all are stupid, I am right" then stay away from this strategy.
    #10     Oct 15, 2009