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.

Answer:   You could if you wish, but I don’t recommend it.  In order to buy back the short leg it will be really expensive.  And, I’m not convinced that the market will climb any more.  On the other hand, if I thought the market was going to continue to rally for the next week, this would be a good strategy.  Let’s look at the numbers as of March 11, 2010:

 To close out the RUT Mar 680/690 bear call spread it would cost a debit of $2.55

To BTC the 680 leg it would cost a debit of $3.85

To STC the 690 leg we would collect $1.30 credit

3.85-1.30=$2.55

 You can see that if we just hold onto the long 690 call, it will cost us $1.30 and the RUT would need to continue to rally in order for this long 690 call to pay off.

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.

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%.

Buy to open RUT May 560 call 

Sell to open RUT May 550 call  -   For a credit of 40 to 65 cents.

Then it goes on to say:   If the market continues to climb, and if this spread is now filling for 68 cents, for example, we would suspend fills on this spread, per the directions in the advisory above, and we would ”click-up” to the RUT May 560/570 bear call spread and repeat the process of “collecting” premium on the days where it’s filling for at least 40 cents, but no more than 65 cents.   But are you not then overlapping this new spread with the previous one and thus opening up a 20 point spread of May 550 / May 570 ? The May 560s will cancel each other out.  Would this then require trading in 2 separate accounts ?

Response:    Yes, when trading 10 point wide spreads, like what we do with the RUT, we need two accounts.  That is, we need two accounts if we want to be nimble and click-up and click-down our strike prices as the underlying index moves, which ultimately reduces our risk.  Some credit spread traders/newsletters don’t click-up/down during the month, which is rather unfortunate because this increases risk, and you wouldn’t need two accounts.  Per how we do it at MCTO, we do recommend for our subscribers to have two accounts. 

One way of eliminating the need for two accounts is to mix RUT credit spreads with IWM credit spreads.   The IWM is an ETF that tracks at 1/10^thof the RUT.   For example, if we recommend the RUT 570/580 bear call spread (which is a 10 point wide spread…i.e. 10 points between the buy and sell legs), the IWM 57/59 bear call spread (which is a 2 point wide spread) has almost the same risk/reward profile.  So for example, let’s say we first open the RUT 570/580 bear call spread.  One week later the RUT rallies and we decide that we need to click-up to move further away from the underlying index.  Because we want to do our best to maintain 10 point wide spreads in our account, we shouldn’t put the RUT 580/590 into the same account that already has the RUT 570/580 since this would create a RUT 570/590 bear call spread, which is 20 points wide.  So an option is to put the IWM 58/60 bear call spread into the account.  Then if the RUT continues to rally and we decide to click-up again, we go back to the RUT and put the RUT 590/600 in the account…..etc.  We also call this “layering” our spreads.  The disadvantage, however, of opening 2 point wide spreads is that higher commissions eat into our returns, so it’s best to use low cost options brokers, like eOption or TradeKing.

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.

Response:   Absolutely.  I think we should pick up some premium within 2 hours from when the unemployment numbers are released this Friday.   If the market rallies, let’s open some bear call spreads, and  if the market sells off, let’s open some bull put spreads.  Once the market moves, it’s my guess that the market will stabilize rather quickly as investors/traders/money mangers await Q4 earnings that start to come out next week.   I’ll send out an advisory tomorrow, Thursday, with my thoughts on strike price placement.

Response:   I think I’m going to wait for the unemployment number to come out on Friday.  I believe there is a reasonable chance the number will be good, possibly showing the first positive jobs growth in 23 months, and the market could have a strong UP day giving us one last opportunity to bring in some premium on the top spread.   I’m hesitating to bring in more RUT 670/680s and would prefer to click-up and bring in some 680/690s.

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.