May High Probability Credit Spread

Posted on April 26th, 2013

Despite the fears of a “Sell in May and go away” repeat this year, we are staying disciplined to our monthly tactic of selling deep out-of-the-money spreads to generate income.  For Buy and Hedge readers, you know that this tactic looks to sell same month vertical credit spreads that have a high probability of success.  Here are links to the last few months posts for a deeper description: 
 
April HPCS Post
March HPCS Post
February HPCS Post

In February we detail how tough it has been to sell in this low volatility environment. That continues to be the case for every month this year. Staying true to our rules of taking less risk than the return on the trade has forced us to be overly conservative. We’ll continue to do that this month as well. 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.
 
*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 29 months, don’t put any money into it that you can’t risk.
 
Last month I received some feedback that the spreads we used as examples were too similar in exposure. So this month we’ll give a wider range of trades that fit within the rules. Using the Russell 2000 Index (RUT), here is how the trade is shaping up for this month As of yesterday’s closing prices with the RUT @ 940
In all of these examples, the risk is lower than the rate of return, so they meet our core guideline. However, as a trader, you will need to assess the way a protective exit looks very carefully. Obviously the probability of exiting the aggressive trade is more likely than the moderate or conservative ones, but the return is also greater. As a rule of thumb we like to enter positions that have a 7% distance out of the money for a 4 week period. So since we’ve only got 3 weeks left, it meets that criteria as well.
 
The aggressive trade is a little to close to the money for our taste, but if you’re going to be disciplined to your exit rules if the market turns lower, than it may be very profitable for you over the long run.


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