February High Probability Credit Spread

Posted on January 29th, 2013

Usually by now we would have put out our thoughts on the High Probability Credit Spread trade for February, but so far, there’s been nothing to report.  That is because selling options for income right now is unusually tough.  Not because the market won’t execute trades, but because the lack of the premium we’re willing to accept for the risk. As a reminder, the core ideology of this trade is to make sure the rate of return generated from the sale of the spread outweighs the probability of the short leg going in-the-money.
And why is premium so low? The answer is volatility; low volatility; really low volatility.  Actually, it’s the lowest volatility in more than 7 years.  I realize this isn’t news to anyone, but speculation drives the price of options and options reflect the implied volatility within their prices; and THAT is what we sell with credit spreads. Typically we execute these deep out-of-the-money trades against the NDX which represents the NASDAQ 100 Index. This index has its own volatility index with the symbol VXN. We’ve all heard of the VIX; well this is the VIX for the NDX. As an additional bit of info, the Russell 2000 also has an index future, RUT, and the volatility index for RUT is RVX. 
Most months our trade that has a risk and reward rate of 4%. Said another way, it will typically work out that a 4% return means we have better than a 96% probability of success. This meets our core requirement of taking less risk than the rate of return. To get that, the VXN or volatility level of the NDX options has ranged from 16 to 20. However right now we’re looking at levels of 14 and on Friday hit a low not seen since Dec 2005.
The result is our reward to risk ratios don’t really level out until the 2% mark. In other words, to meet our #1 rule we have to accept a 2% profit with a 98% probability of success.  98% is a great number, but to only make 2% is much lower than what we’re used to especially if we have to wait for 4 weeks to get it. Sure you could pick levels that would return 4%, but the risk of going in-the-money jumps to more than 6%.
Staying disciplined is important to the success of this strategy and avoiding unwanted accelerated losses. There’s nothing wrong taking 2%. Compound that monthly and you can have a pretty good year. However, 2% is a trade that is going to be there whether there are 4 weeks to expiration or just 2 weeks. Yes, the levels will be different, but avoiding 2 weeks of market exposure helps your survival rate by avoiding a sell off.  So why not wait? However, the time will come this week as to whether we decide to trade or not. Because with less than two weeks till expiration, our ratios really start to become challenging.   
Here’s another way to think about all this. The strategy sells volatility and it does it by selling options to speculators willing to pay a premium for a big market move. When options are as cheap as they are right now, it’s like selling at the low. Markets-101 (if there was such a class) reminds us that selling low isn’t a good strategy for making money.  Waiting for the right trade can be emotionally draining, and can even mean skipping a month. Last year the strategy skipped the January expiration trade and the strategy still turned in a 42% annual gain for 2012.
If you want to participate in some of this run up via OTM Credit Spreads, consider doing a partial position, say 33 or 50%.  It leaves you the opportunity to add if the market moves against you.  You can always add with a different position as you get to the 2 week mark.
Waiting for volatility to return to the market is like waiting for the rain to come. It’s going to happen, no doubt about it, but when is tough to tell…usually it’s when you plan a big picnic or outdoor party.  A client said to me today, “I’m not worried. The market will provide volatility…it always does” and I couldn’t agree with him more. Being patient is the hardest part. 

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