Profit & Probability – Part 3

Getting into the Hall of Fame is all about consistency and longevity. How to stack the odds in your favor for a high probability of success using income generating credit spreads.

In the first part of this series we looked out how to properly measure risk and return for before even stepping in the batter’s box. In the second part walked through the value creating the right risk/reward to make sure you’re swinging at fat pitches. In this installment, to further torture the analogy, I show how taking a “walk” to get on base is a crucial part of the game.

That is, there are some positions in which you don’t need to do much of anything, except exhibit patience, and you still get to first base.

I’m talking about positions in which are options are sold for a credit. If the value of the options declines a profit can be realized. The profited is limited to the sale price or premium collected. The maximum profit would be realized if the option expires worthless.

Typically credit positions involve puts, calls or a combination of both that have strikes that are out-of-the-money. Meaning the options have no intrinsic value; their value is entirely comprised of premium. In this sense the seller, or “writer” of options is acting like an insurance company; you collect the premium but you also assume the often risk of making a large payout or loss if there an adverse event.

To offset this inherently asymmetrical risk/reward profile we need to create a situation that not only has a high probability of success but also make sure we are collecting enough premium for the risk we are assuming.

The first and foremost way we limit and manage our risk is to never sell or short options naked. That, is always use some form of a spread. A typically credit spread involves selling a put or call and then buying a further out-of-the money put or call for a lower price.

An example of a basic credit put spread in Apple (AAPL) would be with shares trading $127 one could sell the March $125 put for $3.00 a contract and buy the $120 put for $1.40 a contract.

This is a $1.60 net credit. If Apple shares are above $125 on the March 20th expiration all options expire worthless and the $1.60 maximum profit would be realized. On the other hand if shares sink below $120 the maximum loss of $3.40 would be incurred.

So why would someone put on a position that can only make $1.60 but lose $3.60? Because even if you were moderately wrong about your bullish outlook and even Apple shares declined by up to $2 or 1.5% you could still realize the maximum profit. In fact shares could drop by as much as $3.5 or 2.7% to $123.50 and a small profit could still be realized.

Compare this to buying a call option with the $125 which would currently cost $4.50 a contract. In this case you need shares of Apple to rise an additional $2.50 or be at $129.50 at expiration just to break even.

Obviously the credit spread position has a much higher probability of achieving a profit. To go back to the baseball analogy, credit spreads allow you to be the batter to the market’s pitcher, forcing it to do all the work by throwing strike after strike.

Tailwinds of Time & Volatility

Credit positions benefit primarily from time decay and a decline in implied volatility. This makes them best suited for sideways or range bound markets, ones that exhibits a reliably steady trend or situations in which volatility levels have elevated to levels that are unlikely to persist.

To set up a position with a high probability of profitability and acceptable risk/reward profile I use to basic parameters.

I want at least 75% probability of a profit; that means choosing the inside or short strikes that have less than 25% probability of expiring in-the-money.   While many option chains will provide probabilities of expiration a basic rule of thumb is to look at delta. I’m using strikes with a 0.20 delta, meaning they have only 20% chance of being in-the-money on expiration.

I also want to achieve a 20% return on my risk capital.  That means there must be enough premium to generate sufficient income while marinating the limited risk of a spread.

Maybe the best thing is to look at two positions I recently recommended, both are iron condors and both are still live.

The first is in the SPDR 500 Trust (SPY) which I established on January 20th. I sold the February 186/190-209/213 iron condor for a $1.15 net credit. At the time the SPY appeared range bound between $198 and $205 but had been posting up and down days in excess of 1% causing implied volatility to move to a two month high. I calculated there was an 80% chance of achieving profitability and 60% chance of realizing the maximum profit. The $1.15 credit would represent a 40% return on the $2.85 risk. Not bad for the one month holding period.

Now, with one week until expiration the SPY has moved to $209 and the iron condor is trading at $1.20, or a small paper loss, but still a good probability of realizing a profit. Time decay and a decline in implied volatility have offset the adverse price move.  I’ll get to how I’d further manage risk in a second.

But first let’s look at the iron condor I established in the United States Oil Fund (USO) on February 4th.   At the time USO had been just bounced some 20% to a high of $20 in a matter of days. This had come following its six month long 50% decline. It appeared a momentary bottom with the low in USO at $16.40. On February 4th USO retreated 7% to $18.50 so it appeared we had an intermediate term high and now a defined range. Due recent crash and violent bounce caused implied volatility was at 7 year high.   I was able to set up the March 13/15-24/26 iron condor for a $0.35 net credit. I calculated this has an 88% probability of delivering a 21% return on $1.65 at risk.

USO

USO is currently trading at $19 and the iron condor’s value is down to $0.28. If it remains range bound implied volatility will drift lower and soon time decay will begin to accelerate.

The 75% Solution

While I have the probability of profit in my favor I want to further manage risk. I use basic rule of thumb to close positions once either 75% of profit has been realized or a 75% loss has incurred.

For instance, in the original Apple example above, f shares quickly rallied above $130 the value of the put spread might decline to 40c way before the March expiration. At this point I would look to close the position for a profit.

Conversely, in adverse move, such as we are experiencing in the SPY condor, if the value of the iron condor climbs to $2.02 I would close the position.

You can create a sliding scale along a time frame. Such as if a 50% profit could be realized within a matter of days it may make sense to close the position. If you’re suddenly facing a 50% loss clearly something in your thesis of range bound or declining volatility environment was wrong and it may be best to just vacate.

But no matter the time frame, if an option you’ve sold short has declined to less than $0.10 a contract, then buy it back and cover yourself. At that point, the risk/reward becomes too asymmetrical. Don’t try to squeezing out the last dime of premium, it would cost you multiple dollars.

To sum up this series on profit and profitability; it’s important to understand how risk is measured, knowing how to identify the fat pitches but also having in your arsenal the skill set and patience to occasionally take a walk.

— Steve Smith

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About the Author: Steve Smith