The Strategy that Profits in Any Market Environment

SmallCapInvestor.com


These days, income is king. People are absolutely parched and starved for any kind of yield. You can't get it from CDs, safe bonds or even very many stocks.

But for me, best way to bring in income hasn't changed. I've been collecting income from a reliable investment that most people don't even know exists.

I collect income on a regular basis by selling vertical call and put spreads.

Otherwise known as credit spreads.

Credit spreads are a unique options strategy that takes advantage of the fact that each options contract suffers from something called "time decay."

Since each contract is just a time-limited right to buy or sell shares of stock, then anytime you buy these contracts, you lose money as time goes by.

Credit spreads take advantage of time decay AND they do so without forcing you to choose a direction on the underlying stock. It's a great strategy when you aren't 100 percent confident in the mid-term direction of say, an ETF.

Vertical spreads are simple to apply and analyze. But the greatest asset of a vertical spread is that it allows you to choose your probability of success for each and every trade. And, in every instance vertical spreads have a limited risk, but also limited rewards.

My favorite aspect of selling vertical spreads is that I can be completely wrong on my assumption and still make a profit. Most people are unaware of this advantage that vertical spreads offer.

Stock traders can only take a long or short view on an underlying ETF, but options traders have much more flexibility in the way they invest and take on risk.

So what is a vertical credit spread anyway?

A vertical credit spread is the combination of selling an option and buying an option at different strikes which lasts roughly 10 - 40 days.

There are two types of vertical credit spreads, bull put credit spreads and bear call credit spreads.

Bear Call Credit Spread and Bull Put Credit Spread

Here is an example of how I use credit spreads to bring in income on a monthly and sometimes weekly basis.

As we all know the market has experienced a sharp rally over the past week. The small cap ETF, iShares Russell 2000 (NYSE:IWM - News) pushed roughly16 percent from its low established last Tuesday.

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The sharp rally resulted in IWM moving into a short-term overbought state and nearing strong overhead resistance and the top part of the 2 1/2 month trading range.

So how can I, as an investor, take advantage of the sharp rally?

Do I think the market will continue to move up after such a strong rally or do I think the market is going back down into the established trading range? With credit spreads it truly doesn't matter.

Knowing that the volatility has increased dramatically and remains historically high (causing options premiums to go up) I should be able to create a trade that allows me to have a profit range of 10-15 percent while creating a larger buffer than normal to be wrong.

Sure, I could swing for the fences and go for an even bigger pay-day by placing a directional bet, but I prefer to use volatility to increase my margin of safety instead of my income. This is the bread and butter trade of professional options traders.

Think about that. Most investors would go for the bigger piece of the pie, instead of going for the sure thing. But as they say, a bird in the hand is worth two in the bush. Take the sure thing every time. Don't extend yourself. Keep it simple and small and you'll grow rich reliably.

Back to the trade.

If after the latest rally I thought IWM is going to move lower I would employ a bear call strategy. A typical bear call trade that I might use would look like the following:

With IWM trading at $69.19 I would

     Sell IWM Nov11 77 call
     Buy IWM Nov11 79 call for a total net credit of $0.24

The trade allowed IWM to move lower, sideways or even 11.5 percent higher over the next 36 days (November 18 is options expiration). As long as IWM closes below $77 at or before options expiration the trade would make approximately 13.6 percent.

So what if I thought IWM was going to push even higher?

If I thought IWM is going to push by November expiration I would place a bull put spread.

A typical bear call trade that I might use would look like the following:

With IWM trading at $69.19 I would

Sell IWM Nov11 59 put
     Buy IWM Nov11 57 put for a total net credit of $0.24

The trade allowed IWM to move higher, sideways or even 14.4 percent lower over the next 36 days (November 18 is options expiration). As long as IWM closes above $59 at or before options expiration the trade would make approximately 13.6 percent.

It's a great strategy, because a highly liquid and large ETF like IWM almost never makes relatively big moves and even if it does, increased volatility allowed me to create a larger than normal cushion just in case I am wrong about the direction of the trade.

But, more importantly I can be substantially wrong in the direction I think the market is going to go over the next 36 days and still make 13.6%. Moreover, you could actually have both a bear call spread and bull put spread on (called an Iron Condor in the options world) and as long as IWM closed in a range of our short strikes ($77 - $59) you would make money on both sides of the trade.

Until Tomorrow,

Andrew Crowder
Chief Options Strategist

Wyatt Investment Research

Disclosure: None



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