Posted on February 14th, 2013

With February’s option expiration occurring this Saturday, it’s time to start looking how the March credit spreads are shaping up. With so many of our clients adopting this trade as part of their allocation, we’ll outline the criteria we’re reviewing for next week’s entry.

As always, we start with understanding our risk.  By definition, credit spreads have a max loss of the difference between the strikes minus the premium generated. As an example, let's evaulate the selling a RUT (Russell 200 Index) 850/840 Credit Put spread for \$0.40. That means sell the 850 put and buy the 840 put for a net difference of 0.40..  The max loss on the trade would be \$960 per contract. That is calculated as follows: ((850-840) - .040)*100). This is also going to be the maintenance necessary to create the position. So what you put up for the trade is what you can lose.

Now that we have that out of the way, we remind you that this is what we call a “high probability” trade. So let’s look at the probability that our RUT trade from above will lose money. RUT is currently trading around 923 and the max loss will occur if at expiration it is below our long strike of 840. However, it will start losing money at levels below the 849.60 level (850 – 0.40). So to keep things simple (I know this isn’t simple) we watch for the probability that the 850 strike goes in-the-money. Said another way, we evaluate the probability that the RUT will drop 7.9% and end below 850 at expiration.

As of this afternoon, the probability that RUT will close below 850 is 1.5%. We get this from a probability calculator we use, but there are plenty of free ones online you can use. Here’s a link we’ve referenced before on Option Strategist. You’ll need the volatility for the index when using the calculator, which is 15.3 and that is symbol RVX (CBOE Russell 200 Volatility Index).  We now know our risk of losing money has a probability of only 1.5%. Said another way, this trade has a 98.5% probability of success. That is why we label these as high probability.

Now that we know our risk, it’s time to evaluate our return.  This is simply calculated as the premium generated divided by the maintenance. If this 850/840  spread can be sold for 0.40 per contract and held successfully to expiration, it would pay \$40 (0.40 *100). And since we already know our maintenance is \$960 from above, the return percentage is 4.16% (40/960).

Based on these two data points, 4.16% return and 1.5% risk, we should feel comfortable following our rule of getting a higher return than the risk taken.   From here you can decide to take more or less risk to improve returns.  Try looking into different strikes and find the trade that best works for you.

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