Selling Premium Spread

Discussion in 'Options' started by sondermark, Feb 26, 2011.

  1. Hi,

    As a paper trader I am working on different systems and was wondering if you guys mind commenting on this idea:

    It is clear that close-to-the-money options trade at higher premiums than further away options. Therefore I was wondering if it would make sense to trade the premium spread. I would like to have the major part of the time decay to work in my favor and collect as much of the premium spread as possible.

    Example GE April 2011 options:
    Share price: $20.82

    Option #1:
    Strike: 20
    Price: 1.33
    Intrinsic Value: 0.82
    Premium: 0.51

    Option #2:
    Strike: 19
    Price: 2.13
    Intrinsic Value: 1.82
    Premium: 0.31

    I would be buying #2 and selling #1 and watch the share price as a hawk.

    Scenario 1: Share price increases:
    If the shares rise in value the intrinsic value of both #1 and #2 would increase equally but the premium of #1 would decrease the most, resulting in a profit. Time decay would hit #1 harder due to the higher premium.

    Scenario 2: Share price decrease:
    Intrinsic value of both #1 and #2 would decrease equally, the premium of #1 would increase the most resulting in a loss. System will need to liquidate the spread when share price hits $20 to avoid loss of intrinsic value. Time decay works in my favor.

    Scenario 3: Share price stays the same:
    Time decay eats away the premiums resulting in a 20 cent profit.

    Scenario 4: Share price opens sharply down, and stays low until expire:
    No time to act, might lose the entire spread of 80 cents. (Looking for a way to hedge this risk).

    Basically in this system the key is to find an option with the highest possible premium while not too close to intrinsic value. If a mispricing (to the high side) could be identified on the sold option the down side would be limited further. Also, as a general rule I would like the time decay to work in my favor.

    While there are probably still much improvement needed for the “system” to be consistent profitable, I guess my questions to the experienced traders are: Are my scenario assumptions correct and do you have ideas to improvements/hedging of risk?
  2. Forgot to mention that I use call options in the example.

    Kind regards,
  3. There are thousands of sites that describe the scenarios you suggest regarding vertical spreads. I'd start my search on "credit spreads" as they are very popular these days. In point of fact, I currently earn my living trading credit spreads. After you have read some of the publicly available material, I can try to answer trading questions. BTW, I only trade index options credit spreads. Then I don't have to work about individual company news that is unexpected.
  4. Hi HowardCohodas,

    Thank you for your reply. I will indeed read up on this but is unsure if this is a clasic credit spread.

    If you do not mind me asking; where do you see the edge in the CS strategy you deploy? Is is time decay capturing, risk management or something else?

    Appreciate your time!

    Kind regards,
  5. Time decay is the mechanism, management is the edge. There are two sides to management. One is taking advantage of opportunities and the other is minimizing exposure to jeopardy. The first is a profit enhancement technique, the latter is a loss limiting technique. Each makes a contribution to your P/L. Since a credit spread caps both profit and loss with the capped loss being 8 to 10 times the capped profit, every additional profit improves you position. Even though the capped loss is 8 to 10 times the capped gain, no one suggests that loss limits not be put in place.

    This week we experienced an increase in volatility and it was painful for credit spread traders. I resemble that remark. Nonetheless, February is slated to be my best month since I began in Aug 2010. My average month on month return is 11.4%, up from 10.6% as of last month.

    Trade2Win interviewed me about my trading methods. That may give you some additional insight. Howard's Interview.
  6. spindr0


  7. ++1, to success in long term, you need edge and the edge for retail will nail down to two primary - right in direction or volatility.

    The bad news to retail is that you immediately in the disadvanced situation when you setup a position due to slippage and commision. It is like playing red/black in roulette in casino, you don't have green in your choice and you are not as rich as the oener of the casino

    Obviously. prof firm have more choice in term of edge.
  9. spindr0


    I meant to mention in my earlier reply that if you're buying ITM verticals (for ex, the 80 ct cost for your $1 spread), your R/R is skewed toward the risk side. IOW, you have the potential to make 20 cts when right and lose 80 cts when wrong. If you have no edge and hypothetically, everything goes up or down a lot, you're going to lose 4:1. Not good. Even if an identified "mispricing" is discovered, you're still toast.

    Volatility is a factor but IMHO, it's secondary to getting direction right.