Here is another example of how I use credit spreads to bring in income on a monthly and
sometimes weekly basis. This time I am using a bear call credit spread.
Fear is 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.
Why? Remember, a credit spread is a type of options trade that creates income by selling options.
And in a bearish 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 sell credit spreads. As we all know
the market fell sharply in the beginning of August 2011 and the small cap ETF, iShares Russell
2000 (IWM) traded roughly 18 percent below its high one month prior.
So how can a bear call allow me to take advantage of this type of market, and specifically an ETF,
that has declined this sharply?
Well, knowing that the volatility had increased dramatically 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, but I prefer to use volatility
to increase my margin of safety instead of my income.
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. Never extend yourself. Keep it simple and small and you will grow your portfolio reliably.
Back to the trade…
Basically, IWM could have moved 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 the trade I suggested using IWM. IWM was trading for $70.86:
Sell IWM Sep11 78 call
Buy IWM Sep11 80 call for a total net credit of $0.24
The trade allowed IWM to move lower, sideways or even 9.8 percent higher over the next 32 days
(September 16 was options expiration). As long as IWM closed below $78 at or before options
expiration the trade would make approximately 12.0 percent.
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 allowed 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 gave me a high probability of success - because I am betting that IWM would not rise
over 10 percent over the next 32 days.
However, I did not have to wait. IWM collapsed further and helped the trade to reap 10 percent of
the 12 percent max return on the trade. With only 2 percent left of value in the trade it was time to
lock in the 10 percent profit and move on to another trade.
I am always looking to lock in a profit and to take unneeded risk off the table especially if better
opportunities are available. I bought back the credit spread by doing the following:
Buy to close IWM Sep11 78 call
Sell to close IWM Sep11 80 call for a limit price of $0.04
I was able to lock in 20 cents in profit on every $2 invested for a 10% gain in less than 5 days. Not
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