Response:  Here are a few things to think about as you trade options or learn how to trade options, and ponder the interrelations of the underlying index, implied volatility and strike price placement when you trade options on credit spreads and iron condors – for  these option trading strategies:

1)    Implied volatility of the underlying index is one of the values used to calculate the price and probability of an options leg expiring ITM (in the money) or OTM (out of the money)

2)    Implied volatility for the RUT (Russell 2000 index) is RVX, and as of this writing it’s around 36

3)    Implied volatility for the SPY (and ETF that tracks at 1/10^th the value of the S&P 500 Index – SPX) is the VIX and it’s around 26

4)    Because the implied volatility for the RUT is higher, the RUT moves a larger % on a daily basis as compared to the avg % daily move of the SPY, so this is why we can get a larger % distance between our short calls and puts on the RUT when opening an iron condor – this option strategy

5)    The return on a RUT credit spread is calculated as follows, using the example of having $1000:  Let’s say we bring in 70 cents credit on the RUT Dec 640/650 bull put spread; this is a 10 point wide spread where each spread requires $1000 of maintenance; thus we are able to open qty 1 of this spread, and we bring in $70 of premium; our risk capital is $1000 – $70 = $930; our potential return on this trade is 70/930 = 7.5%;

6)    The return on a SPY credit spread is calculated as follows, using the example of having $1000:  Let’s say we bring in 13 cents credit on the SPY Dec 115/117 bull put spread; this is a 2 point wide spread, where each spread requires $200 of maintenance; thus we are able to open qty 5 of this spread, and we bring in $13 x 5 = $65 of premium; our risk capital is $1000 – $65 = $935; our potential return on this trade is 65/935 = 6.9%

7)    In general, the risk/reward nature of the majority of our credit spreads is the same, whether it’s a 10 point wide spread on the RUT (Russell 2000 Index), a 5 point wide spread on the MNX (NASDAQ 100 index) or a 2 point wide spread on the SPY (S&P 500 index) where each has an 87% to 91% probability of expiring OTM and profitable, the bottom bull put spreads bring in about 5% to 8% in 30 days or less, and the top bear call spreads bring in about 3.5% to 5.5% in 30 days or less.  As a result, when the bottom and top credit spreads are combined to create an iron condor, the overall potential ROI is about 8.5% to 13.5% in 30 days or less.

Answer:  Any time prior to Thursday, Feb 17^th when the RUT ceases to trade after the close of the market, if the RUT climbs over 840 the short 840 Call has gone ITM, and we never want to get to this point.  We would adjust the RUT Feb 840/850 bear call spread when the RUT touches 837 or so.  

Specifically answering your question, if the RUT settles at 839 on Friday, your short 840 call expired OTM and you keep 100% of the premium that you collected when you first opened the RUT Feb 840/850 bear call spread.  If the RUT settles at 843 on expiration Friday, your short 840 call expired $3 ITM and $300 per spread that you are holding would be debited from of your account.  If the RUT settles at 847 on expiration Friday, your short 840 call expired $7 ITM and $700 per spread that you are holding would be debited from of your account.  Using a final example, if the RUT settles at 856 on expiration Friday, your short 840 call expired $16 ITM, but only $1000 per spread that you are holding would be debited from of your account because the long 850 Call helped to limit your loss to $1000.  The settlement value is different from the “opening value of the RUT” on Friday morning of expiration.  It’s important to understand how the settlement value is calculated.  For more on the settlement process please visit the FAQ page at http://www.monthlycashthruoptions.com/FAQ.htm and read entries #24 and #25.

Answer:  We rarely open a complete iron condor at the same time as it’s best to open one side at a time, based on what the underlying is doing.   When we have a strong UP day, it’s best to focus on the top bear call spreads and “sell calls” to the bullish speculators because they are getting excited that the market is rallying, they’ve been thinking that the market is ready to rally, and they are willing to pay more for the Calls.  Since we are a seller of the Calls, we will be able to bring in more premium on the UP days.   It also allows us to select strike prices that are farther out-of-the-money (OTM) and safer where we can still bring in a reasonable level of credit.

On the other hand, when we have a strong DOWN day, it’s good to only focus on the bottom bull put spreads;  the bearish speculators are getting excited, they’ve been thinking that the market is ready to correct so they buy more Puts, and they are willing to pay more for them since the market is DOWN that day.   Since we are the sellers of these Puts, we’ll be able to click farther down in strike price to a safer level, and still be able to bring in a reasonable premium.

Our goal each month is to ultimately complete the iron condor, but we are opening one side at a time.

Answer:   Trading credit spreads on the SPX, the S&P 500 index, is like the Roach Hotel….you can check in, but you can’t check out.  Opening credit spreads on the SPX seems to be just fine and it feels great to bring in a solid 9% premium on a 90% probability spread that has less than 30 days to expiration.   However, even though there is a lot of liquidity on the SPX options, it doesn’t act like it where if our trade gets into trouble, it will cost 20% to 30% of our risk capital to make an adjustment, such as rolling it into the same month or rolling it into the following month.   In other words, we won’t have many chances to roll our spread if it gets into trouble and we’ll pretty much be taking a 50% to 60% loss after rolling it just 2 times, which is not good.  When trading credit spreads on the RUT, for example, if our spreads unexpectedly go in-the-money, it’s quite possible to roll it for 6 to 9 months, if required, and we can still get back at least 50% of our maintenance, and sometimes as high as 70% of the original maintenance.   One possible reason that it’s difficult and expensive to make adjustments on SPX credit spreads is that it’s only traded on one exchange, the CBOE, and not on the other 7 exchanges.   In contrast, options on the RUT are traded on 6 exchanges, and options on the SPY are traded on all 8 exchanges.  It seems that the more exchanges the options are traded on, the more competition there is and thus the cheaper it is to make adjustments on the trade if necessary.

Answer:   Yes, the risk reward for the credit spread is the same whether the spread is 10 points wide or 20 points wide.  However, we recommend that our subscribers have two accounts when trading 10 point wide credit spreads on the RUT because we want to maintain maximum flexibility to allow us to open the other side of the spread to complete the iron condor.   In order to complete an iron condor where maintenance is only held for one of the spreads, both the top bear call spread and the bottom bull put spread need to have the same point width between the sell leg and the buy leg.  (i.e. if we have a 10 point wide bull put spread, we have to open a 10 point wide bear call spread to complete the iron condor)    It is true that if we end up creating a 20 point wide spread on the bottom we can easily open a 20 point wide spread on the top to complete the iron condor…and this will work.  However, for most months it’s not that simple and we are alternating between opening the top spreads and the bottom spreads, and we are moving our strike prices around as the underlying index is moving, so it’s better to keep all of our spreads 10 points wide giving us maximum flexibility and the best chance to complete the iron condors on all of our trades.

Answer:   The RUT provides the best strike price placement, usually above past resistance levels and below past support levels, while paying a nice premium when opening a bear call or bull put credit spread options.  It also has good liquidity, i.e. a high number of options contracts are traded daily on the RUT, which allows us to easily get into and out of our trades. 

The next best underlying index to trade credit spread and iron condor options is the SPY, (and ETF that tracks at 1/10th of the value of the  S&P 500 index – SPX) but in order to get the best return we need to open 2 point wide spreads, which has a drawback.  (a 2 point wide spread has two points between the leg that we sell and the leg that we buy)  The negative of a 2 point wide spread, as compared to a 10 point wide spread that we would open on the RUT, is that we have to open 5x the number of spreads to allocate the same amount of cash and this has higher commissions.  Also, the liquidity is very high on the SPY….i.e. a million or more options contracts change hands every day – and this is both good and bad.   The good part is that we can easily get in and out of trades….even during volatile times when the market is moving a lot.   The bad is that when the market is bouncing…and let’s say we need to make an adjustment or roll the spread, because there is so much liquidity we have to pay what the market is asking (between the bid and ask prices)  and we rarely can get a special low price that is outside the bidask price range.   On the other hand, if the market is moving a lot and we need to make an adjustment on the RUT, many times we’ll be able to get a cheap price that is outside of the bid/ask prices.

For a case study that compares and contrasts 2, 3, 4, 5 , 7 and 10 point wide credit spreads on the SPY please go to the Learning Center at http://www.monthlycashthruoptions.com/LearningCenter.htm  and read entry #6 – “why we usually open 2 and 3 point wide spreads on the SPY and IWM”.  

Regarding the SPX, you have to be super careful in trading credit spreads and iron condors on this underlying index.  I liken it to Hotel California….it’s really easy and everyone is friendly when you check in, but when things get ugly and you need to get out of your trade, you’ll usually get your head handed to you. (i.e. it will cost a lot to close out your spread and you’ll probably take at least a 25% loss)    Overall, do your best to avoid trading credit spreads on the SPX.

Answer:  I’m not sure I agree that Iron condors are good for uptrending markets.  Iron condors have both a short put and a short call and we want the underlying stock or index to stay above the short Put and below the short Call through expiration.   In general, with the 90% probability type of credit spreads that we open, we can handle the underlying index moving around 9%, but that’s about it….so it could be trending UP or DOWN, up to 9%,  but after this we’ll have to make an adjustment.

Right now, we’re not feeling comfortable in opening the June bear call spread since the market recently corrected 15% and it could rally hard if some good news comes in.  We just don’t know, but when a market pulls back so hard, it could also rally hard.  This is where I’m using more of the volume based indicators to help me gauge the prevailing trend and to predict trend reversals.  I’m feeling more comfortable in opening the June bull put spreads right now on the Russell 2000 index, RUT, as long as they are down several strike prices below the 200 day SMA and below the Feb low.

Answering your questions specifically, when sentiment/fear makes a market correct, like it just did where it recently pulled-back 15%, this is when we make some of our best returns;  and we primarily focus on one side, the bottom bull put spread.  If the volume based indicators continue to show choppiness over the next week, where it’s not showing a “go long” signal, we might consider opening the top spread….but not sure yet.

Response:   I would wait a touch longer before jumping into the bear call spreads, if at all.   For the RUT, it would be wise to set our short call at 650 or higher, which is the Jan high.  It’s pretty easy to get burned on the top spreads…so we need to be careful. 

Question:  But it’s interesting to notice with today’s market that even though the DOW is up almost 200 points, NASDAQ 30+ point, and S&P 500 is up 16+, the Call options on these indexes aren’t moving up much.   Why isn’t there much premium on these call options?

Response:    A lot of it comes down to supply and demand and currently there are few speculators that want to buy calls on the major indexes, and rightly so since we might still be in a correction, so the premiums that they are willing to pay are low.   Premiums are low anyway for OTM calls, especially when we’re down to the last 10 days of trade or less before expiration.    We know that  it’s difficult to push a boulder uphill and if we ‘re able to move it, it will move slowly;  however, if we let go it will start to roll down the hill quickly and momentum will build as gravity takes over.   Because the stock market is similar to a boulder on a hill,  we can charge the speculators more for Puts because there is more potential to make money on them if the market has a correction, versus the lower premiums that we are able to charge for the Calls.

Response:   Regarding liquidity.…yes, if too many folks start trading index credit spreads, for example on the S&P 500 and Russell 2000 indexes and ETFs, the risk/reward characteristics of our credit spreads will become less attractive.  So far, however,  there seems to be plenty of  liquidity and the placement of the strike prices are still good.   Luckily, credit spreads are a lot harder than they look, so a certain % of participants get hit every month, scaring them and washing them out..…so it’s my guess that there will be plenty of liquidity for a long time to come.

Answer:    So far we’ve placed 4 options trades in the auto trade accounts for the January cycle.  Three, 2 point wide SPY credit spreads and one, 10 point wide SPX credit spread options.   We  send a maximum of 5 trade alerts each month that uses 100% of your cash, and so far we’ve sent four.  (at least our goal is to send 5 auto-trade trade alerts, but sometimes we’re not able to invest all of your cash for a particular month….like in the last 3 months due to how the market has been behaving)

The reason we’re focusing on the S&P 500 index this month is that we’re a little concerned that the RUT might spike-up to play “catch-up”….so we’re under weighting on the RUT and over weighting on the big-cap S&P 500 index this month.  Because the US dollar is strengthening, this also will put a little downward pressure on the big-cap stocks that reside in the S&P 500 index, which gives us a higher probability that our top January bear call spreads will expire profitable.

Per the topic of diversification, because these are indexes, they are already diversified since each is composed of hundreds, if not thousands of stocks.   The big cap index does move a little differently as compared to how the mid-cap and small-cap indexes move, so this does provide a small amount of diversification, but we don’t want to use all of these indexes just for the sake of trying to diversify.  We  look at each index as a independent trading vehicle and if the technicals, strike price placement and levels of premium look good offering us a decent risk/reward profile, we’ll open the trade.    In the process,  if we’re able to open credit spreads on multiple indexes giving us a little bit of added diversification, all the better.