As a great options trader once told me - professional options traders are a different breed. We take a statistical, mathematical, rational approach to the marketplace. We add another layer of probability and risk management that is not possible with stocks alone.
We make investments on things like volatility and don't always care which way a stock or ETF moves. Everything we do is at least partially hedged, which reduces the need for Maalox, Prozac and heavy drinking, which many of my stock-trading buddies rely on almost daily.
Fear is certainly in the market. Look no further than the Volatility Index, or the VIX (otherwise known as the investor's fear gauge) to see that the fear is palpable. However, opportunities are plentiful with the VIX trading at 35 - especially those of us who use credit spreads for income.
In short, a credit spread is a type of options trade that creates income by selling options.
And in this type of atmosphere, fear makes the volatility index rise. . And, with increased volatility brings higher options premium. And higher options premium, means that options traders who sell options can bring in more income on a monthly basis.
So, I'm selling credit spreads. And I'm make more money than I was say, just a few weeks ago, when the VIX was half what it is today.
Over the past month or so I have explained how I use credit spreads to bring in income on a monthly basis.
Now I want to tell you about another trade that I am eyeing as we enter the week.
As we all know the market fell sharply last week and now the small cap ETF, iShares Russell 2000 (NYSE:IWM) is roughly 18 percent below its high a month ago.
So how can credit spreads allow me to take advantage of a market, and specifically an ETF, that has declined this sharply over the past few weeks?
Well, knowing that the volatility has increased dramatically over the past few weeks causing options premiums to go up, I should be able to create a trade that allows me to have the same profit range of 10-15 percent while creating larger buffer than normal to be wrong.
Sure, I could swing for the fences and go for an even bigger pay-day, but I prefer to use volatility to increase my margin of safety instead of my income.
Basically, IWM can move 9.8 percent higher and the trade would still be profitable. This margin is the true power of options
So, let's take a look at a potential trade using IWM, which is currently trading at $70.86:
- Sell IWM Sep11 78 call
- Buy IWM Sep11 80 call for a total net credit of $0.24
It's a great strategy, because a highly liquid and large ETF like IWM almost never makes big moves and even if it does, increased volatility allows me to create a larger than normal cushion just in case I am wrong about the direction of the trade. So, selling and buying these two calls essentially gives you a high probability of success - because you're betting that IWM will not rise over 10 percent over the next 32 days.
Again, my space is limited here so I will go into greater detail next week. The questions have been rolling in and please keep them coming . Email me at Andy.Crowder@WyattResearch.com.
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- Volatility Index