Option strategies that limit your risk: Sell Double Credit Spreads

The Sell A Double Vertical Spread strategy offers an alternative to traders who are not comfortable with the unlimited risk associated with selling a straddle/strangle. Selling a straddle/strangle strategy consists of selling an out-of-the-money call and put. The Sell A Double Vertical Spread strategy does this and also purchases a further out-of-the-money call and put. The advantage is that this allows a trader to profit from time decay while eliminating the threat of unlimited risk. The disadvantage is that the profit potential is reduced by the amount paid to purchase the further out-of- the-money options. This strategy will be used primarily when:

1. A. You feel confident that the underlying stock or futures contract will remain in a particular range,
   
2. B. Volatility is high enough to justify selling premium,
   
3. C. You are not comfortable selling naked options and want to limit your risk.
   

To set up a double credit spread, the trader would do the following:

If XYZ is trading at 100

Sell 10 Aug 95 Puts @ 5

Sell 10 Aug 105 Calls @ 6

Buy 10 Aug 90 Puts @ 4

Buy 10 Aug 110 Calls @ 5

By selling the 95/105 spread, the trader is essentially selling a strangle and exposing himself to unlimited risk on both sides of the trade. To protect himself from unlimited risk, the trader then purchases further out of the money puts and calls which still results in a net credit.



When To Exit Double Vertical Spreads

Choice 1:

• Establish the trade so that your maximum risk on this particular trade is below your maximum allowable risk level for any given trade and then simply hold trade until expiration.
  

Choice 2:

• Exit trade when 80-90% of maximum profit is obtained. This will involve paying 4 more commissions when trading stock options.
  

Option strategies that limit your risk: Sell a Covered Call

The Write a Covered Call strategy is probably the most frequently misused option trading strategy. Proponents of covered call writing imply that writing a covered call is tantamount to picking up "free money", since it allows you to generate additional income by simply selling an out-of-the-money call option against a stock or futures contract that you already hold. They also trumpet the idea that this strategy provides downside protection. And to some extent, both of these assertions are true. However, most traders who employ this strategy have no idea that writing a covered call actually limits their upside profit potential and provides only a limited amount of downside protection.

For example, if you own 100 shares of IBM and the stock is trading at 126, you might be able to sell a 130 call option with 21 days until expiration for 2 points, which means you will receive $200 from the option buyer. This $200 is yours to keep. Over the next 21 days one of several things will happen:

1. For each point IBM rises above 130, you will make $100 per point on the stock and lose $100 per point on the option you sold. In other words, your maximum profit potential is capped if the stock rises above $130.
   
2. Selling the call at a price of 2, gives you 2 points of downside protection. Thus, if IBM falls to 122 at option expiration, the two points you made by selling the option will offset the two points you lose on the stock. If IBM falls below 122, the covered call offers no additional downside protection.
   

Because covered call writing limits your upside potential and offers only limited downside protection, it is important that the Write A Covered Call strategy be employed only at the most advantageous times. Covered calls should only be written under the following circumstances:

1. The volatility for the options is very high (to maximize the amount of premium received).
   
2. Write only out-of the-money options (this strategy is not a market timing strategy. It is simply an attempt to generate additional income by selling out- of-the-money options and letting time decay work in your favor).
   
3. The best time to write a covered call is after the stock or futures contract you are holding has already experienced an advance in price. If the stock then enters a consolidation period, you can generate income by writing a covered call and watching it expire worthless.
   

When To Exit Covered Calls

Before entering trade, decide what you will do if underlying security rises sharply while you are short a covered call. Your choices are:

1. Buy back call option (probably at a loss) only.
   
2. Buy back call option (probably at a loss) and sell another further out-of-the- money-call.
   
3. Let stock be called away.
   

Exiting at a Loss

1. If the stock price falls:
   
2. If you have a stop-loss price for the underlying security and that price is hit (thus prompting you to sell your stock), buy back the call option at that time.
   
3. If you are simply holding a stock for the long-term, then let call option expire worthless.
   

Exiting at a Profit
Maximum Profit (MP):
MP = (Strike Price of option sold + premium received) - Stock Price
If 80% of MP is achieved, you may consider buying back the covered call and selling a further-out-of-the-money call.

Remember that using the Sell A Covered Call using a stock on which you have a large unrealized profit can cause you to realize the profit for tax purposes if the stock is called away.

Option strategies that limit your risk: Sell a Vertical Spread

The Sell a Vertical Spread strategy offers traders a number of advantages. First and foremost, it allows traders to take advantage of time decay by selling out-of- the-money options. It also allows them to take advantage of disparities in volatilities between different options. This strategy also allows option sellers to enter a trade with limited risk, rather than exposing themselves to the unlimited risk associated with selling naked options. Finally, it allows a trader to profit from a market timing forecast if Relative Volatility is extremely high. Remember that most traders generate a market timing forecast and then buy a call or put to try to profit from that market movement without regard to whether volatility is high or low. If volatility is extremely high, the probability of making money is extremely low for the option buyer. So instead, a trader who is bullish on a stock with a high Relative Volatility (6 or higher) might sell a vertical put spread rather than buying a call option.

By selling an out-of-the-money put and buying a further out-of-the-money put he can profit if the underlying stock or futures market goes up, sideways or even down slightly.
The primary disadvantage to selling Vertical Spreads is that profit potential is limited to the difference between the premium received for the option sold and the premium paid for the option bought. In most cases, the profit potential is less than the maximum risk. As a result, traders should only employ the Sell A Vertical Spread strategy if they are confident that they will be able to pull the trigger and cut their loss if the need arises.

An investor creating a call vertical spread will buy the call with the higher strike price and write the call with the lower strike price. The call purchased will have a lower premium that the call written. The result will be a net credit. The trader using this strategy is bearish on the underlying security. A decrease in the underlying stock will cause the call premiums to decrease and the spread to narrow resulting in a profit.


Example:

Buy 10 ABC May 90 Calls @ 5
Sell 10 ABC May 80 Calls @ 9

The spread is executed for a net credit of $4,000. The breakeven point for this trade is 84. If ABC drops below 84, the spread becomes profitable. If ABC is below 80, both options expire worthless and the trader keeps the entire premium sold. If ABC rises above 84, the trade becomes unprofitable with a maximum loss of $6,000 at 90 or more.



A trader creating a put vertical spread will buy the put with the lower strike price and write the put with the higher strike price. The result will be a net credit. An trader using this strategy is bullish. As the underlying stock increases, the put premiums decrease. This causes the spread between the premiums to narrow.

Example:

Buy 10 ABC May 55 Puts @ 1
Sell 10 ABC May 65 Puts @ 8

This spread is executed for a net credit of $7,000 and the trader will benefit if the spread increases. The breakeven point for this trade is 58. If ABC rises above 58, the spread becomes profitable. If ABC is above 65, both options expire worthless and the trader keeps the entire premium sold. If ABC falls below 58, the trade becomes unprofitable with a maximum loss of $3,000 at 55 or less.



When To Exit Short Vertical Spreads

Exiting at a Loss

Determine maximum downside risk and select some percentage of that amount as your stop out point. If that amount is reached or exceeded then exit the entire position. Maximum stop-loss permissible MUST be no greater than maximum profit potential for this trade. For example, say you enter a short vertical spread with a profit potential of $500 and a maximum risk of $1500. You should exit the trade if a loss of $500 is incurred anywhere along the way. Because short vertical spreads generally have greater dollar risk than potential reward, you MUST be prepared to cut losses when necessary.

Exiting at a Profit

Maximum Profit (MP) = (price of option sold � price of option bought)

Trade Period (TP) = Time until expiration.

Exit Rules:

1. During first half of TP, exit trade if 90% of MP is obtained.
   
2. During second half of TP, exit trade if 80% of MP is obtained.
   
3. Exit trade if price of option sold declines to .125 or is worth less than $100.