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.

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.

Answer:   Periodically, we’ll have a short term spike or sell-off in the underlying index in the last two weeks of trade before expiration giving us a final chance to open some additional spreads.  So in the last few weeks of trade, I continue to show the currently recommended strike prices and price ranges, even though there is a low probability that we’ll have another opportunity to open more spreads.  In general, when we are down to the last 2 weeks of trade before expiration, premium usually dries up and we won’t have the opportunity to open additional credit spreads.  (especially for the top spreads)    We do monitor the recommended strike prices and credit price range daily and we’ll move them up or down, or remove them completely when the risk/reward characteristics of the trade no longer make sense.    

Per opening credit spreads that are 5 weeks in duration, yes, it usually works and you can bring in excellent levels of premium.  However, just due to how the market has been behaving in the last 4 months, I’ve shied away from 5 week trades and have focused on 2 to 4 week trades to reduce the time exposure risk.  We are also able to open shorter duration, 2 to 4 week credit spreads because volatility, VIX, is elevated making them more expensive and allowing us to bring in higher levels of premium.

Answer:   As long as the recommended spread is filling for between 45 and 70 cents, we open the recommended spreads using the price that it’s currently filling at on that particular day, and we use about 20% of the available cash for that day.  We then pause and wait for the next day when it’s filling again betwen 45 and 70 cents.  (i.e. we collect premium over time, which helps reduce risk)    If at any time it starts to fill for 71 cents or more, the spread no longer has a 90% probability of expiring OTM and profitable, but it has an 83% (just a guess…but probably close)  probability of expiring profitable.   Because we have the goal of opening 90% probability credit spread options, we then would move our strike prices away from the underlying index ”one-click” so we can bring the probability back to the 90% level.

Per our RUT Sep 620/630 bear call spreads options and our SPY Sep 108/111 bear call spread options, they are still safe, even though the market is continuing to trend upward, and most likely we’ll be ok through expiration.   We’ll keep you posted if we decide to close them out early.

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.