Andy (and Phil, provided that he is open minded enough to listen): There really is no advantage in credit spreads, but if you like to sell options and want to do so with predetermined risk, they will do fine. One warning: you better be ready to lose all of the margin you put down. Statistically it will happen. How do I KNOW this? If the options you sold had NO STATISTICAL CHANCE of going itm at or past the strike of the protective option bought, you would never have been able to obtain premium in the first place. Put it another way, why would a market maker, or anybody for that matter, buy something that had no chance whatsoever of having value? Remember, when you (or Phil, or whoever) sells the options, someone else is buying them. Why would someone buy something worth nothing? They wouldn't.
Some would say that historically there have been few gaps and few sharp moves, so therefore the risk is practically nil with credit spreads. This is a poor argument. First, past has nothing to do with the present. The markets are open systems, and closed. This is not roulette, the odds of which can easily be determined according to the rules of the game. What would have been a three sig move past upon X past data might ended up being a mere two (or, gasp, one) sig move based upon the same number of data encompassing a period that includes right now. A gap move would seriously deplete one's margin, but even a period of sharply rising vega could be just as painful. There have plenty of such movements, and there will more in the future. When? No one knows, but that is the point. It is axiomatic that when one buys or writes a trading system, one should expect that future drawdowns will be double (or more--they could and often are much, much higher). Systems or strategies that work great in one period fall apart in other periods.
That said, I would recommend credit spreads, but only under the following guidelines. First, margin should be 20-25% of the total capital reserved for the strategy, and returns for the strategy should be based on total capital (the 20-25% plus the 75-80% reserved). In other words, with a total capital base of 100K, I would commit only 20-25 to the margin. Assuming a handle of 10 and $100 a point, that would mean only 20-25 spreads (or 40-50, if one does both sides). Why so conservative? If the strategy is done indefinitely, one WILL lose the entire margin, either by adjusting several times, taking several small losses, or by one big unforeseen move of either vol or the underlying. Just because it has not happened lately does not mean that it won't. Remember, one cannot game the future. If it happens once, it can and will happen again. Ask yourself: What would I do if this happened TWICE in a short amount of time. If one happens to lose the entire margin twice in a short period, the account will experience something close to a 40-50% drawdown. Painful, sure, but not fatal. The 75-80% in reserves should not be used to write other options of the similar instruments. Buy T-bills, or a long-term bond fund, or something else. If one HAS to write options, then pick something entirely different. Gold options? Maybe. 10-year notes? Maybe.
If you STILL think I am being too conservative, consider this: I know of one professional option seller/hedge fund manager who writes stock index futures options with only four percent of the capital in the fund. For an account of 100K, he will write only 4K in options. I should note that he often (but not always) writes them naked. Despite being so conservative, he has suffered several drawdowns in excess of 10%, and some approximating 20%. And he is one of the best.
Second, make sure that what you are getting full value for the risk you are taking. I used to trade the SPX options, when I did not know better. I would do what Phil does: put a limit order near the middle, and then shave off a point. I became frustrated with the poor fills, and especially with the waiting for even a poor fill. In fact, I stopped trading stock index options for a while after having had so many bad experiences. Alas. the SPX was my first love, but I dumped her. In this case, love hurt.:-( I trade the ES options now, since they have become much, much better to trade than they used to. They are easy to hedge, too. The spreads are much, much better. They are not perfect, but they are better than the SPX (at least the SPX I remember).
A low-risk approach to credit spreads would generate a return around 10-12% a year. Some years more, some years, much, much less. That might not sound like much. Everyone wants 2-3% a month, but that amount is unrealistic. It is possible, of course, but not without unacceptable levels of risk.
Smil--can you give me an example of unacceptable level of risk? I think 2% a month should be realistic: if you are not using size booking less than that wouldn't even pay the bills... ...especially if spreadtrading is your only strategy
Ryan: Great link, thanks for posting it. I've been looking for this kind of data. Is there a similar chart for gaps upwards in the SPX? Thanks.
There is no free lunch. A steady 2% a month is possible, but unless one is working with an already built-in advantage (selling expensive options and buying cheap options acc to skew), extremely risky. If one just puts on credit spreads without any regard for market timing, the long-term return would not even be close to 2% a month: breakeven minus commissions minus spread. If one IS an able market timer (sells bull put spreads at bottoms and sells bear call spreads at tops), then, yes, positive returns are possible. 2% a month, even. Very difficult. High returns come with higher risk. 2% a month compounded is close to 30% a year, a VERY high return. Think about it this way: if putting on credit spreads were a way to an steady 2%, or even 1%, a month, banks would be all over it. They would be fools to loan money at 7 or 8% to customers to speculate on sometimes risky real estate or business ventures if they could get much higher returns doing credit spreads. For me, credit spreads are OK (sometimes, they work out great) but not the best in terms of risk/reward.