The markets will remain irrational a lot longer than you'll be solvent.

- Gene Ratti

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COMPLIMENTARY Booklet: Smart Trading Techniques

Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now!

I'm thinking if you're a regular Fast Break reader you probably know what an option credit spread is. I'm also thinking, that if you take a position in a call credit spread, and a put credit spread, and make a strangle out of it, you know that's referred to as an iron condor, which is a term you hear quite a lot of lately. When I started as an options trader almost 14 years ago these were somewhat esoteric strategies and it seemed reserved only for the ivory tower traders. Thanks to the availability of better information via the internet, and better trading services available from brokers, this strategy has become a regular diet of what I believe to be, the greatest all around options trading strategy, for the most successful option traders. It certainly kept me around as a professional working at the same firm for 14 years.

For those not baptized by fire yet, let's describe an option credit spread and the implied strategy behind it. First off let's start with an underlier. I'll use the Dow Jones Index as an example because it's a market everyone understands, at least to the point of at what price level it's trading. In March of 2008 the Dow Jones Industrial Average was 10500 and very volatile. At this time we think the Dow will trade in a range for a specified amount of time, let's say 60 to 70 days, and we would like to take advantage of walking away with some collected premium by selling a call spread and a put spread simultaneously. The end result is that we want the option value to decrease with time decay and either buy the option spread back at a lower price than the premium collected or let it expire worthless. What's nice about this strategy is that you don't have to be absolutely right about the market's direction to win. This is called non-directional trading, another phrase that wasn't in the main stream a few years back. In my opinion, before non-directional trading became a main street strategy, the human propensity to believe that markets always go up was etched in stone, a mentality that's human in nature but comes with many shortfalls (pun intended). With non-directional short trading comes another huge benefit called time decay. Unfortunately everybody on the option-buying planet knows what that is. In an option writing strategy this "monkey on your back" is actually your friend. As time advances and all things remain the same the value of the option premium diminishes until it becomes worthless on expiration day.

To take advantage of this and to keep us in a delta neutral or non-directional position we will enter into an iron condor position. On March 25, 2008 the Dow opened at 12,540 and closed at 12,515.

Looking at the 36 week highest high at 14,270 and the lowest low at 11,610, with very strong support in the 11,800 area and resistance at around 13,000 I decided to do the following. On March 25, I bought a June 08 140 call / 110 put strangle and paid $2200.00, and sold a 135 call / 115 put strangle collecting $3800.00 for a total credit of $1600.00 before any fees and commissions. As you can see we are 1000 Dow points out of the money on both sides or 8%. During the time in this trade we saw the Dow reach a high of 13140 on 5/19 and a low of 11815 on settlement day 6/20. Not a bad ride. All of the options expired worthless and if you stayed to the end you would have collected $1600.00 per spread before fees and commissions. The margin on this trade was roughly $1000.00. A $1600 profit on $1000 margin is easy to take.

Our objective was made without much of a fight, relatively easy, but what happens when the waters get a little rougher. One might have this type of trade on and unknowingly encounters one of the worst times in stock market history or maybe some type of event similar to September of 2001. On July 17, 2008 I sold a September 08 120 call bought the 125 call for $700.00. To make it an Iron Condor I sold the 105 put and bought the 100 put for another $700. Now mind you, those long options, the 125 call and the 100 put are riding shotgun, they're expendable insurance policies. But these are the guys that are going to help us reach the Promised Land. Again our research indicated that these short strikes should be deep enough out of the money and expire worthless by the cash settlement date of 9/19. Hopefully this will happen and we will keep the entire premium.

As it turned out this time our trade was cruising along until close to the very end, only a few days remained before expiration. We choose to stay in the trade because of the channel the market was staying in as you can see by looking at a chart. Then the short put option started taking some heat because of rumblings in the investment industry and this was after news of the Fannie and Freddie bailout. Unexpectedly came a cavalcade of hierarchical boneheads and their toxic offerings from the investment banking industry, retail banking industry and one really big insurance company. This type of risk, event risk, is a blind-sided sucker punch that you don't see coming. Earlier we could have bought the options back keeping the lion's share of the premium, but because the market was behaving predictably we decided to hang out until expiration. Had they been naked options or some configuration of a ratio spread with unlimited exposure we would have had margin issues. On expiration day with the market reaching a low of 10465 before closing at 10982 we were able to stay in the trade because of our delta neutral position. Such pandemonium would have caused most other non-directional risk strategies to be adjusted. We did nothing because the risk of loss was originally calculated into the short options strategy. Our margin might increase but only to the amount of our calculated loss. By being able to hang out we were capable of riding the spread to worthless at expiration. On settlement day, Sept 19 the options expired worthless with the market at 10715.

To me, using limited risk short option strategies is the best way to trade this market right now. For the option writer this strategy is particularly appropriate and can be used in most markets where volatility is supporting some generous overvalued premium.

Currently if you're selling options in today's market with the VIX trading up in the nose bleed section it would behoove you to be working with some type of limited risk strategy. If you have credit spreads on and predetermined risk you will be capable of waiting for hopefully some favorable market movement as long as you can withstand the risk. If the market comes back favorably the options could expire worthless or you could buy them back early. If not you're only on the hook for what you initially risked. History shows most options expire worthless. The key is being there to take advantage of this and the benefit of time decay and predetermined risk helps allow you to hang with credit spreads.

COMPLIMENTARY Booklet: Smart Trading Techniques

Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now!