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At the end of each email, I asked you to submit any topics you want to learn more about.
The response has been AMAZING!
Reading through your feedback, I discovered just how many of you are interested in learning more about options.
That’s why today, I want to cover a special topic that has come up in multiple emails: options spread management.
Folks want to know how to establish a position, where and when to take profits, and how to avoid losses when possible.
The good news is that I have those answers. So, let’s start at the beginning.
The Optimal Time Until ExpirationEach option has an expiration cycle that can be weekly, monthly, quarterly, or annually.
We want to focus on the monthly expiration cycles for highly liquid stocks like Apple (AAPL), IBM (IBM), and so on.
If you pull up an options chain for a symbol and you only see monthly options, chances are the stock isn’t liquid enough.
Ideally, we want to create trades that are between 30 and 60 days until expiration, with the optimal length of time being 45 days until expiration.
Selling option credit spreads in that range creates the ideal balance of time decay and directional risk.
This is the options chain for Tesla (TSLA):
As one of the most widely traded stocks, TSLA has weekly and monthly options.
So, how do I choose an expiration cycle? I look for the best balance of directional risk and time decay. In this case, I’d choose the expiration cycle 52 days out, or the April 14, 2022, expiration. I also want to consider when a company reports earnings.
Tesla last reported earnings on Jan. 26. The next earnings release is estimated to happen between April 25 and May 3.
That’s outside of the monthly expiration, which is what I want to see.
I don’t want to take on the directional risk from an earnings announcement that can send a stock moving in one direction or another.
By the way, a benefit of using options with exchange-traded funds (ETFs) is that you never have to worry about earnings. While you do have to take dividend payments into account, as you would with any stock, they tend not to have a material impact unless you are at expiration and at the money.
Managing Your Trade to 50% of Max ProfitIf you don’t know them, TastyTrade is the content arm of TastyWorks, an options-focused broker based out of Chicago. Over the last decade, they’ve compiled a wealth of data and information they provide to the public for free.
Over the years, I’ve watched their programming and reviewed the data and analysis they provide.
In many cases, as with the strategies below, I’ve come to the same conclusions as they have. However, we don’t always agree on everything.
Ideally, you want to close the trade at 50% of your maximum potential profit. Why? Because it increases our win rate and returns our capital back to us faster to be redeployed for another trade.
What’s really cool is you can do this right after you initiate the trade.
Let’s use Tesla again for our example.
Assume I put on a call credit spread selling the $870 strike and buying the $875 strike.
That would result in the following:
- $73.65 – $70.16 = $3.49 credit and my maximum potential profit
- $875 – $870 – $3.49 = $1.51 is my maximum potential loss
Here’s how that would work:
- I sell to open the $870/$875 call spread for a $3.49 credit.
- The order of the option strikes doesn’t matter when you write it out for another trader. All that matters is you identify it as a call credit spread or that you received a credit. The other trader will automatically know that if it’s a credit spread or you received a credit, you sold the lower strike and bought the upper strike.
- I immediately create a good ’til canceled order to buy to close the $870/$875 call spread for $1.75.
By placing the closing trade immediately after I initiate the position, I simplify my trade management.
Managing Your Trade at 21 Days Until ExpirationThis is another area where TastyTrade and I agree.
Not every trade works out the way we want it to.
Sometimes we don’t hit that 50% of maximum profit, or our trade moves against us.
At 21 days until expiration, we hit an inflection point. That’s the time where the balance tilts in favor of directional risk and away from time decay.
So, here’s what you can do.
At 21 days until expiration:
- If your credit spread is at breakeven or a profit, close out the trade and move on.
- If your credit spread is at a loss, and you can roll the trade to the next monthly expiration cycle for a credit, as long as the implied volatility rank is over 30.
- If your credit spread is at a loss, and the implied volatility rank is below 30 or you cannot roll the trade for a credit, let it ride until you can take it off at breakeven or just before expiration.
The Nature of Option Credit SpreadsSince credit spreads are defined-risk trades, they become mechanical without much need for management.
Most of the time they either work or they don’t. It’s the little things we do, like selling credit spreads when implied volatility is high and managing our winners at 50%, that give us an edge.
This is quite different from naked options strategies like strangles and straddles, where traders need to aggressively manage their positions.
That’s why I like option credit spreads. They’re easy to understand, implement, and manage.
Now that you’ve learned a bit about option spreads, what stocks and sectors do you think are great places to try option credit spreads and why? Email me and let me know. While I can’t respond to everyone individually, I promise to read every message.