Money Management Considerations When Selling Option Credit Spreads for Income
Dan Gibby, Chief Options Strategist, MasterTrader.com
Before trading, read below and watch the below videos. This will show you how to approach trading credit spreads like a Master Trader.
Money Management, Trade Management and understanding the use of Contingent Orders is of vital importance to your success.
Many overlook these and most options trading services ignore the use of stop-loss orders. Rather, they “roll” or extend losing trades into the future in “hope mode.”
We rarely do this unless the chart pattern supports the adjustment.
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Master Trader specializes in selling credit spreads around compelling patterns as Income Trades because we literally get paid for determining where a stock or ETF is not going in a short amount of time.
The time decay (which is a “drag” to option buyers) favors selling them to the novices – particularly at extreme moves of fear and greed where volatility spikes.
These trades are for those wanting to generate weekly income from high probability short-term option selling, including news, gaps, earnings, and volatility trades around compelling chart patterns.
Whatever the broader markets are doing – trending, whippy, or choppy – we find compelling credit spread opportunities around the charts for generating monthly income.
Although we have an impressive 85% success rate in trading these short credit spreads, proper money and trade management is critical to success since you don’t want a few losses to disproportionally wipe out your gains.
In this Video, Money Management Considerations When Selling Option Credit Spreads for Income, we will discuss:
- General Money Management Considerations
- Calculating Proper Contract Size per Your Trading Plan
- A Word on Probabilities and Max Loss
- Managing Short Credit Spread Positions
- Taking Stop Losses on Short Credit Spreads Based on Various Stops
Money Management Considerations When Selling Option Credit Spreads for Income
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Master Trader wants you to succeed at selling credit spreads using the Master Trader Method (MTM).
This information will help you do that with proper money management — and not suffer large unexpected losses towards your journey to trading mastery.
If you want to master this high-probability option-income strategy to regularly sell credit spreads around the charts for weekly and monthly income, you need to take our Mastering Advanced Credit Spreads course now. Course Descriptions and Order at: https://mastertrader.com/SpreadTrader
The Video called Estimating Stop Out Amount on Credit Spreads will discuss an easy way to estimate the stop out amount if your stop is hit and how to calculate the proper number of contracts based on your pre-determined Max Loss.
Estimating Stop Out Amount on Credit Spreads
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We encourage you to watch both videos to gain a better understanding of risk management in shorting credit spreads for income.
Now that you’ have watched the Video, let’s discuss possible contract size using a hypothetical $100,000 account. Divide all these numbers by 10 if you have a $10,000 account.
- If you sold the Put Spread for $.80/share, the estimated amount to close it if SPY hit your $3 stop at $277 was $1.25/share, which would be a $.45/share loss.
- If your Trading Plan says you can risk one-half of 1% of account size per credit spread, then you could trade 11 contracts ($500/.45 = 1,111 shares, round down to 1,100, and divide by 100 since 1 contract represents 100 shares of the underlying).
- Conservative traders using the lower number of contracts based on this estimate or 3x Credit Received could trade 3 contracts ($500/(2x .80/share credit received) = 312 shares). Note: When we say if you want to use the larger loss estimate or 3x Credit Received in this example, that means you would be closing it at 3x $.80/share received = $2.40/share to close; however, you already received $.80/share, so your net loss is still only 2x of credit received, or $1.60/share.
Since one (1) contract is the smallest option contract you can trade, if your account size does Not permit you to place the trade per your Trading Plan, don’t trade it. But always feel free to paper trade any trade to increase your level of understanding and learning.
Next, watch this Video, Placing Contingent Option Orders on TOS – MasterTrader.com.
It will show you how to place a contingent order on ThinkorSwim (TOS) to close out a credit spread based on a stop being triggered on the underlying stock or ETF, which is the methodology taught and used by Master Trader.
The TOS platform is not required to trade credit spreads successfully and any “Good” trading platform will have a contingent order function.
Placing Contingent Option Orders on TOS – MasterTrader.com
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Guidelines on Selling Options
We sell options to generate income on high-probability chart setups. We prefer selling them when volatility is high since we receive more premium for the risk assumed. The premium received is 100% profit if the option expires out-of-the-money (OTM). For example, if we sold 10 contracts of the Apr $12 puts on FCX at $.25/share (generating $250), and it closed at $12.50 on Expiration, then the options expired worthless and the $250 received is 100% profit.
When you are short options, you have a contractual obligation to Buy Stock if you are short Puts, or obligation to Sell Stock if you are short Calls. Therefore, you have exposure/risk while the options are still open and not expired. This is why it is important to define risk of each and to manage this risk during the life of the trade.
We recommend closing at least half of the position if you get a rapid 50% gain. This is measured by the Max Gain which you would realize if you closed the position.
This could happen from the Stock moving in the intended direction or from volatility contraction (i.e., Theta and Vega gains).
Example #1. Assume you sold a 10-lot of Facebook $100/95 put spread for $500, with 8 DTE (Days to Expiration). Two days later you can close the position for $250. We recommend closing half for $250 gain (50% of Max Profit) and then moving your stop to break even. Note that there is nothing wrong either with closing the entire position for a nice $500 gain to eliminate the remaining 6 days of risk. It is a personal choice and should be addressed in one’s Trading Plan.
Example #2. Assume you sold a 10-lot of Facebook $100/95 put spread for $1,000, with 30 DTE. Four days later you can close the position for $500/share. In this case, we recommend closing the entire position for a nice $1,000 gain to eliminate the remaining 26 days of risk.
Let’s review some further metrics of the math on Example #2. You received $1,000 on a 5-point wide spread (i.e., the difference between the put sold and put purchased for protection). Your Max Gain is the $1,000 premium received, 25% ROI ($1,000 Premium divided by Max Loss) which you earn if Facebook closes over $100 (Short Strike) by Expiration.
Your Max Loss is $4,000 (Strike Width less Premium received). Your Cost Basis (if assigned because it closes below $100 at Expiration) is $99/share (i.e., you had to buy 1,000 shares of Facebook at $100/share since you were short $100 strike Puts, but you already received $1,000 for that obligation, which reduces your Cost Basis).
Closing four days later for $500 generates $500 total Gain (11.1% ROI ) and eliminates 26 days of risk to Expiry!
Here’s another way of looking at the math, although you never have to be “this exact.” Receiving $1,000 for a 30 DTE short put generates $33.33 Time Decay profit per day ($1,000/30). But in this example, you made $500 in four days versus the expected $133.33 if Facebook just chopped sideways (and ignoring the other Greeks). This was $366.67 more than expected using straight pro rata allocation per day (275% more here). So prudent risk management says BOOK THE QUICK GAINS and move on to the next trade!
Rule on Premium Received on Selling Options
Often, we suggest premium selling trades when the stock trades over/under a specific amount. We give the “current mid-point credit” at the time of posting the trade; however, it will likely be less than the Credit because the directional move in the intended direction decreased the Credit (as well as time decay and volatility contraction). Additionally, a significant gap can reduce the desired Credit.
As such, here is our Guideline: If the mid-point credit that you can open the trade (always try mid-point) when it triggers is less than 75% of the price posted when the trade was recommended, then cancel the trade. When we sell premium, that is our Max Gain, so anything less than that changes the reward-risk characteristics.
Note on Option Spreads
Do not trade options with wide spreads. You want to trade liquid options, which are those with high trading volume and open interest. You want tight bid-ask spreads (e.g., QQQ typically only 1-cent). Option spreads will typically also be greater with more expensive stocks. Ideally, it is best if they are not more than $.10.
We have created a List of Master Trader Liquid Options which you should try to stick with. We find compelling patterns on many stocks that are not on this list. However, we believe the reward-risk of the pattern and strategy makes them reasonable (or we might just trade the stock).
There are two permissible exceptions where it is acceptable to trade options with wider spreads. The first is if you are playing “Market Maker,” meaning you get filled at near the bid (for buying), or at or near the offer (for selling).
The other exception is if you are selling put options and get filled at a strike price where you are happy to be assigned the stock at the calculated Cost Basis. For example, with Facebook trading at $103, you sell a 10-lot of Facebook $100 puts (with 2 months to Expiry) for $1,500. Your Cost Basis if assigned (i.e., if closes below $100 at Expiration) is $98.5/share. If you are happy to own 1,000 shares of Facebook at a reduced cost of $98.5/share (4.4% below $103), then there is nothing wrong with shorting these puts since you either make $1,500 as profit or own Facebook at a cheaper price.
Also note that spreads will be wider at market open, so it is good as a general rule not to trade options (unless very liquid) in the first 10 minutes of trading. This will give time for the spreads to naturally tighten as volume picks up. Additionally, note that spreads will also widen when volatility rises (e.g., VIX rising, market selloffs, or into known stock or market news events where big moves are expected).
If you want to master this high-probability option-income strategy to regularly sell credit spreads around the charts for weekly and monthly income, you need to take our Mastering Advanced Credit Spreads course now.
Access Mastering Advanced Credit Spreads course, it’s the best $597 investment spent to get up to speed fast, click HERE.
Course Descriptions and Order at: https://mastertrader.com/SpreadTrader
These are just a sampling of the numerous positive comments we have received from graduates of our Mastering Credit Spread Course:
- Wow! You did a phenomenal job putting that together. Very fine job indeed. There is so much great information in there, I am so pleased with your course. Dave E.
- Best investment of my life so far. Thanks for teaching me to fish. Made a few trades on my own after the course and all are profitable. A bear call spread I did on ROKU on Friday (Jan 5 weekly 57/62) already at 85% gain in one day. Thanks again for an excellent course and your guidance. Sajjad E.
- ALL I CAN SAY IS… these guys know what they’re doing! If you are selling options, you should ABSOLUTELY take Dan’s Mastery course and subscribe to the Weekly Options Trader. You will make your investment back in a week. Outstanding! Very pleased. Carl M.
- Your Mastery course offering which combines your technical expertise with great options advice is dead on! My first 2 weeks easily paid for my annual fee. Thank you for all of your hard work. David R.
Master Trader and You Building Your Financial Future Together
Happy trading! If you have any questions or comments, please e-mail Dan Gibby at Dan@mastertrader.com or Greg Capra at Greg@mastertrader.com.
All the best,
Dan Gibby
Chief Options Strategist
Greg Capra
Managing Director of Master Trader
Trading the Pristine Method — Origin and End
