March OTM Credit Spreads

by Jay Pestrichelli on February 22nd, 2012

If you’ve read the chapter on vertical spreads in our book, Buy and Hedge, you understand that regular income can be generated by writing out-of-the-money spreads on a monthly basis. Typically we’ll use the index options on the S&P500, S&P100, or the Nasdaq100 as the vehicles for this strategy due to their liquidity, lower volatility, and beneficial tax treatment. The symbols for these 3 indexes are OEX, SPX, and NDX, although that may vary by the broker you use.

As a review, what we look for in this trade is for a risk rate that is mapped to an equal or greater return rate. Since all the capital that is allocated to this trade is at risk, we suggest using probabilities on the strike closer to the market to assess the chance of success. For instance, as of Tuesday’s close, the probability that the SPX closes at or above 1250 by March expiration was 96.4%. This means that there is a 3.6% that this trade will not work so we want to make sure we’re making at least 3.6% on the reward side of the equation.

Regarding probabilities, many brokers offer the ability to determine probability values and it’s typically found with the options tools. The two interfaces I’m familiar with are through ThinkorSwim from TD Ameritrade and OptionsHouse.

The March options markets are giving us an interesting signal, but one familiar to the OTM credit spread writer, and that is stay bullish. The bullish OTM credit spread is a credit put spread and means that a strike closer to the market price of the index is sold and the one farther away is purchased. The net of these two option legs is a credit to the account and max loss of the trade is held in maintenance against your buying power.

We say that this is giving us a bullish signal because there is no value can be written on the calls that generates the right amount of income for the risk we would take. For example, a vertical put spread on the NDX (Nasdaq100) at the 2300/2275 can be written for 0.50, and as of Tuesday’s close there was a 98.8% chance that the index stayed above 2300. The return on this 25 point spread is about 2% (0.50 / 24.50). We would consider this a beneficial ratio; earn 2% while taking a 1.2% risk of failure.

However, there are no OTM call spreads that give us this kind ratio for any of the indexes. If you wanted to take the same percentage of success you would need to go to the 2900 strike price. Right now there is a 98.5% that the NDX closes below 2900. However, the spread can only be written against the 3000 strike because there just aren’t any options trading in that range at this time. Not to mention, the 2900/3000 OTM call spread will only generate 0.10. This is a measly 0.1% return. With a chance of failure at 1.5% returning 0.1% it hardly justifies the trade. If you wanted to get even close to the same returns, you would have to do an OTM call credit spread at the 2775/2800 strikes generating 0.35 in income. This trade returns 1.4% in gains, but the probability of success is only 91%. While that is still a pretty good chance of working, you’re not getting paid enough to take the 9% risk.

Bottom line, take what the market is giving you and as of right now in this month’s expiration period, it looks like its OTM put spreads will provide the best chance of a favorable risk/reward ratio.

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