April High Probability Credit Spread

Posted on March 26th, 2013

As we start the 2nd week of the April expiration period (I know it’s still March, but option months don’t match the calendar) we’re looking at putting on our monthly credit spread. This is a trade we talk about from time to time and we refer to it as our “High Probability Credit Spread”.  The tactic, as readers of our blog know, sells a deep out-of-the-money vertical spread for small amounts of income, typically 2-4%, and has a high probability of success.  The trade benefits from the natural depreciation of options.
 
*Risk reminder: As we always do, we want investors to know that what you put into a fully allocated spread like this is at risk. That means in the unlikely event that the market moves to the point that both your strikes are in-the-money, the position losses 100%.  So despite how well this strategy has worked for us over the last 28 months, don’t put any money into it that you can’t risk.
 
Let’s focus on probability data this month. As of yesterday’s close, the RUT (Russell 2000) still looked like the best index to use. We like indexes because they have very liquid options markets and they are less volatile by nature. Speaking of less volatility, we’re seeing the index maintain its low levels via symbol: RVX (RUT’s volatility index) that is hovering around 17.  Comparably to the VIX ranging from 11 to 14, this seems high, but historically, it’s never been lower.  This means that our premium is going to be lower and we’ll have to get closer to the current market to get it. Volatility is one of the primary drivers of option probability calculations. 
 
One of our rules of thumb for RUT is to be at least 7% away from the market. That means that at 945, where it closed yesterday, we have to have our short leg higher than 1012 or below 879. From a probability perspective, market data tells us that the lower strikes have a lesser chance of occurring by April’s expiration. Our data shows that the chance of hitting 879 with 25 days till expiration is 5.1% compared to a 6.1% chance of closing above 1012. This helps guide us to take a bullish position where the probability is lower for failure. 
 
If your platform doesn’t do this for you, you can use the free tool at Option Strategist.

Probabilities can be looked at in two ways. The first is picking a level and a date and seeing what the probability is that it will get there. The second way is to pick a probability level and look at it over time compared to the change in index price. The best tool we use for that is known as a probability cone. Here’s snap shot from ThinkorSwim’s platform for a 92% probability cone on the RUT:
What this tells us is that based on the data as of yesterday’s close there is a 92% chance that on any given date the RUT index will be inside the cone (looks more like a parabola to me). If 92% is in the cone, that means 8% is outside the cone; and you can estimate that 4% is above and 4% below.
 
While this looks pretty on a chart, the real benefit is knowing what market conditions will trigger an exit. For example, if the market was to trade below the purple curve, we know that we’ve moved to a level that only had a 4% of occurring. Improbable moves like that would spur us to consider an exit.  When using probabilities, keep this curve in mind and use it as an alert in your tools.
 
In past blog posts we’ve given you the ways to calculate return, so we won’t rehash it here. But if you need a refresher see our March High Probability Credit Spread post from February 14th.
 
This month, here are 3 examples of trades, based on yesterday’s data that meet our criteria of having a greater return than a chance of failing by going in-the-money.
If you need a little translation, let’s look at the bottom trade. This is a vertical credit put spread at strikes of 850 and 860 that generates 0.25 in premium. If successful, the entire premium is kept and the spread expires worthless. This happens when the RUT closes above the short leg or above 860. The probability (or risk) that it closes below 860 or 9.0% lower than where it was on 3/25 is 1.90%. The return for this trade is 2.6%. 

If you're looking for a little more return and willing to take a little higher chance that your spread will to ITM, then you can pick one of the others. Our golden rule is that we're always looking to earn more than the probability that the short leg goes ITM. Therefore, any of these trades have the kind  ratio we like at Buy and Hedge.


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