OTM Credit Spread Update

by Jay Pestrichelli on June 27th, 2012

Its that time of month again where we discuss the entry details of what we call the NDX trade. This trade uses deep out-of-the-money (OTM) vertical spreads to generate small monthly credits with a high probability of success. We’ve written about this trade on a regular basis so feel free to search the blog for other posts if you’re looking to get familiar with this strategy.

As a reminder this position is hedged, but not with an absolute hedge. Meaning that there is no floor to the losses if the trade is left unattended. This trade requires vigilance and constant monitoring for exit criteria. Hence we would consider this to be more of a trade than an investment.

Last week on 6/21 we entered into the following position:

• Short NDX July 2300 put @ $5.73
• Long NDX July 2250 put @ $3.83
• Net Credit of $1.90
• Probability of success 96.5%

As mentioned above, knowing when to exit is the most important means of managing risk. The rule of thumb with this trade is when the spread premium doubles, its time to exit. In this example, if the spread reaches $3.80 (2x$1.90) the trade should be closed and an OTM Credit Call Spread should be written to help offset the loss. This second spread switches the trade bias from bull to bear.

Because option premiums are based on multiple factors, it’s not always easy to predict at what price of the NDX should the trade be closed. Premium is impacted by the price movement of the NDX, the volatility of NDX options, and days until expiration. 

While its difficult to graphically show all of these moving factors on a single chart, here is an estimate, based on normal market volatility conditions, that we are projecting for the price of the NDX where an exit will trigger.
You’ll notice that the trigger price moves every day. This is because as time goes by there is a greater and greater probability that the trade pays. If there are dramatic downward movements in the beginning of the trade period, the premium will accelerate against the trade and probability of failure increases.  The trigger price is also non-linear. This is due to the accelerating decrease in premium values as time decays (and that’s a good thing for option sellers).

As of the close on Tuesday, the probability of success of the trade was 97% and the premium had declined to 1.27% or a gain of 33% (1.90 to 1.27).

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