August High Probability Credit Spread

by Jay Pestrichelli on July 23rd, 2013

Sometimes sticking to your discipline means missing out on some profits. It’s unfortunate to say, but it happens. That is going to be the theme of this month’s note about our High Probability Credit Spread (HPCS) Strategy.
It’s been a while since our last post, so here's a reminder of how the strategy works. Vertical spreads on indexes are established for a net credit. That means one option is sold and one is bought where the net cost generates some premium. The one sold was more than the one bought, hence the credit and this is what is kept for profit if the options stay out of the money.
For Puts that means the market has to stay above the short leg of the spread and for calls, it means the market has to stay below the short leg. The short legs (the ones sold for the credit) are the ones we want to make sure don’t go in the money. That is when this trade will lose at expiration. So we choose strikes that have a high probability of success of staying OTM.  
One of the primary rules of this strategy is to ensure that the return received for the trade (credit/requirement) is a greater percentage than the probability of the short leg going ITM
You can see some previous posts as to how the trades work:

*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 31 months, don’t put any money into it that you can’t risk.
Back to the theme of the day…Trade when you can and don’t when you can’t. Seem obvious, but so often in the face of some other strategy making money, we see investors deviate from their entry and exit parameters.
Right now (before Apple’s earnings) there really hasn’t been any good entry points on the SPX, RUT or NDX. All of them have very low volatility components and the premium we would generate is anemic. This means that today, at these levels, the trades would generate maybe 2% returns. We don’t really consider that worth it considering what we’re putting at risk regardless of the probability.
The result is an emotional reaction to not participating in these new highs. Don’t worry. Volatility always seems to give us a window to jump in at some point in the month. You just have to be patient and prepared.

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