Answer:   In a very rare occasion that we get stuck with ITM credit spreads, we will usually roll them and keep them alive….and eventually get 50% to 70% of our money back.   Unfortunately, and fortunately, I’ve become an expert on rolling because some of my spreads went ITM during the Oct 2008 crash, and after rolling them I got back 65% of my maintenance.   Not bad for a total melt-down.  (Just as a side note, most credit spread traders, including editor-in–chief’s from other credit spread newsletters don’t have experience in rolling because most just throw in the towel and let their subscribers take a total loss.  I personally hate to lose money and will fight to the end to get back at least some of my money) 

Answering your question specifically, if some of our spreads went ITM and we didn’t want to roll them but just let them expire, the credit spread on the RUT and SPX (classified as broad based indexes) are cash settled, so cash would be withdrawn from our account.   If the spread went completely ITM and we let it expire, we would lose all of our risk capital, which is the required maintenance less the premium collected.

Per options on the SPY and IWM (which are ETFs that track at 1/10^th the value of the S&P 500 and Russell 2000 indexes, respectively) the ETF shares would be PUT to us where we have to buy the shares at the strike price and the shares would be deposited into our account.

Again, in general with this situation, and this is only for the emergency case where the stock market crashes 12% or more in just a few days and we get stuck with ITM bull put spreads, we will roll our spreads month to month and there is a very good chance we’ll get back at least half of our money, and more like 60% to 70%.

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.

By Brad Reinard, Editor-in-Chief, monthlycashthruoptions.com

Here are the assumptions we use when making our calculations:
1) Commission = $1/options contract or $2/spread. (we show additional commission rates in the spread sheet summary below)
2) $5000 of cash is available to open the spreads
3) Per technical analysis, the trade stays out-of-the-money (OTM) and profitable, and we let the spread expire worthless, which is 100% profitable for us, the seller.  Thus, we only pay commission to open the spreads and we call this “one-way” commissions. (in contrast to round-trip commissions where we pay to open and close the trades)
4) All spreads have 31 days until expiration
5) We simplify the number of spreads that we can open by dividing the available $5000 of cash by the required maintenance.

Below is the SPY Aug 89/90 bull put spread which has the following characteristics:

1) It’s a 1 point spread (i.e. 1 point between the sell leg and the buy leg)
2) Required maintenance by the broker is $100 per spread (1 point spread * $100/point)
3) 50 spreads can be opened ($5000/$100 of required maintenance per spread)
4) Premium collected is $15 credit x 50 spreads = $750
5) Risk capital is $5000 in maintenance – $750 of premium collected = $4250
6) One-way commission at $1/contract is 50 spreads x $2/spread = $100.
7) Commission as a % of premium collected is 100/750 = 13.3%
8) ROI after one-way commission is (750-100)/4250 = 15.3%

Below is the SPY Aug 88/90 bull put spread which has the following characteristics:

1) It’s a 2 point spread (i.e. 2 points between the sell leg and the buy leg)
2) Required maintenance by the broker is $200 per spread (2 point spread * $100/point)
3) 25 spreads can be opened ($5000/$200 required maintenance per spread)
4) Premium collected is $25 credit x 25 spreads = $625
5) Risk capital is $5000 in maintenance – $625 of premium collected = $4375
6) One-way commission at $1/contract is 25 spreads x $2/spread = $50.
7) One-way Commission as a % of premium collected is 50/625 = 8%
8) Return after one-way commission is (625-50)/4375 = 13.1%

Below is the SPY Aug 87/90 bull put spread which has the following characteristics:

1) It’s a 3 point spread
2) Required maintenance by the broker is $300 per spread
3) 16 spreads can be opened ($5000/$300)
4) Premium collected is $35 credit x 16 spreads = $560
5) Risk capital is $5000 in maintenance – $560 of premium collected = $4440
6) One-way commission is 16 spreads x $2/spread = $32.
7) One-way commission as a % of premium collected is 32/560 = 5.7%
8) Return after one-way commission is (560 – 32)/4440 = 11.8%

Below is the SPY Aug 86/90 bull put spread which has the following characteristics:

1) It’s a 4 point spread
2) Required maintenance by the broker is $400 per spread
3) 12 spreads can be opened ($5000/$400)
4) Premium collected is $44 credit x 12 spreads = $528
5) Risk capital is $5000 in maintenance – $528 of premium collected = $4472
6) One-way commission is 12 spreads x $2/spread = $24.
7) One-way commission as a % of premium collected is 24/528 = 4.5%
8) Return after one-way commission is (528 – 24)/4472 = 11.2%

Below is the SPY Aug 85/90 bull put spread with the following characteristics:
1) It’s a 5 point spread
2) Required maintenance by the broker is $500 per spread
3) 10 spreads can be opened
4) Premium collected is $50 credit x 10 spreads = $500
5) Risk capital is $5000 in maintenance – $500 of premium collected = $4500
6) One-way commission is 10 spreads x $2/spread = $20
7) One-way commission as a % of premium collected is 20/500 = 4%
8) Return after one-way commission is (500 – 20)/4500 = 10.6%

Below is the SPY Aug 83/90 bull put spread with the following characteristics:
1) It’s a 7 point spread
2) Required maintenance by the broker is $700 per spread
3) 7 spreads can be opened ($5000/$700 required maintenance per spread)
4) Premium collected is $58 credit x 7 spreads = $406
5) Risk capital is $5000 in maintenance – $406 of premium collected = $4594
6) One-way commission is 7 spreads x $2/spread = $14
7) One-way commission as a % of premium collected is 14/406 = 3.4%
8) Return after commission is (406 – 14)/4594 = 8.5%

Below is the SPY Aug 80/90 bull put spread with the following characteristics:
1) It’s a 10 point spread
2) Required maintenance by the broker is $1000 per spread
3) 5 spreads can be opened
4) Premium collected is $65 credit x 5 spreads = $325
5) Risk capital is $5000 in maintenance – $325 of premium collected = $4675
6) One-way commission is 5 spreads x $2/spread = $10
7) One-way commission as a % of premium collected is 10/325 = 3%
8) Return after one-way commission is (325 – 10)/4675 = 6.7%

Below is a grid that summarizes our analysis.   For a larger view of this grid please visit the Monthly Cash Thru Options Learning Center at http://www.monthlycashthruoptions.com/LearningCenter.htm and read the entry “Why we usually open 3 point credit spreads on the SPY”.    If you would like access to this spreadsheet, please contact us at support@monthlycashthruoptions and we’ll forward it to you.

Conclusion:   From the analysis above, we like the 3 point spread where it gives us an excellent return, minimizes the commission hit, gives us flexibility to make adjustments when needed if it “gets under pressure”, and the required maintenance is low enough to allow investors with different account sizes to participate in the trade.  When we say that we need “flexibility” to make adjustments, when the spread gets under pressure from a fast moving underlying index (the SPY in this case) we implement the “stay ahead of the wave” strategy by “clicking-down” our strike price to move further away from the underlying index and we open more spreads to bring in more premium. If we use the 3 point spread we have the flexibility to “click-down” 3 times if needed. (in this case we are talking about the bottom, bull put spread) For example, let’s say we have a SPY 90/93 bull put spread and 10 days after we open this spread the SPY sells-off putting our 90/93 bull put spread “under pressure”. In this situation, we would not yet close-out the SPY 90/93 spread but we would watch it closely, and in parallel we would “stay ahead of the wave” and click-down a strike to the SPY 89/92 bull put spread (in the same month) and open some to continue to bring in premium. And if we need to click-down again, we have the flexibility to click-down one more time to the SPY 88/91 bull put spread to allow us to keep bringing in premium. If we need to click down even further, we won’t be able to open the SPY 87/90 bull put spread until we close-out the original SPY 90/93 bull put spread because the 90 strike overlaps and will cancel each other out; however, this is ok because if the underlying SPY is dropping this fast, and just by the fact that we’ve already clicked down 3 times, we probably will need to close out the original SPY 90/93 anyway to cut our losses and to minimize any further downside. With this said, and especially for bull put spreads, we would not engage in the “stay ahead of the wave” strategy unless the “market timing” indicators were giving us the green light that the economy and the market are “healthy” and therefore it’s ok to keep clicking down and bringing in premium.   For more on how we Market Time, please go to http://www.monthlycashthruoptions.com/WhyMarketTiming.htm.   For more on the “staying ahead of the wave strategy”, please read the entries “what if the market surges, how do we protect ourselves”? and “what if the market crashes, how do we protect ourselves?” in this Learning Center.

About The Author
Brad Reinard is Editor-in-Chief of Monthly Cash Thru Options LLC, a leading index credit spread & iron condor options advisory newsletter, which has the following track record:   69% YTD 2009 (thru Aug); 33% 2008; 63% 2007; 42% 2006; 50% 2005.  For more information on the technical analysis that we perform on the S&P 500 and Russell 2000 (RUT) indexes, along with how to trade trading tips on iron condors and credit spreads please visit www.monthlycashthruoptions.com or call Brad directly toll-free at 877-248-7455.  Monthly Cash Thru Options LLC is located in San Jose, California, the heart of Silicon Valley.