We use a disciplined approach to our index “credit spread” option trade recommendations.  Our approach is designed to emphasize capital preservation (reduce risk), while striving for a consistent and attractive return on your capital (profits).  Unlike many “traditional” investment approaches which focus on the long-term fundamentals of the underlying investment, our index credit spread strategy is based primarily on the short-term technical indicators and analysis of a particular market segment or index. To learn more about index credit spread option strategies, see “Why options” and “What is a “credit spread” option strategy”.  In determining our index “credit spread” trade recommendations, we use a specific and disciplined methodology.  Our strategy and methodology is as follows:

1. Indexes – We only use market “indexes” or ETFs……why?
   With our credit spread strategy, we only use broad market “indexes” (such as SPX, RUT, OEX) and occasionally select Exchange Traded Funds (i.e. ETFs), never individual stocks!  Individual stocks are subject to much more volatility and risk than broad based market indexes.  To reduce volatility risk, we only use market indexes when entering into a “credit spread” position.  The specific index used in our recommendations often change from month to month.  Based on technical analysis and market conditions during each option cycle, we determine which specific credit spread position (type of credit spread, index and strike prices) offers the most opportunity, with the least amount of risk.
2. Short Term Positions – Typical “hold” periods are 20 – 45 days….why?
   Since longer term positions (investments) tend to involve more risk and uncertainty, we do not recommend holding any “credit spread” positions longer than 45 days (typical hold periods are 20 – 45 days maximum).  Generally, all options are due to expire at the end of the next option cycle expiration.  An option cycle is the third Friday of one month to the third Friday of the following month. In other words, we do not recommend any “long-term” hold periods with our credit spread strategy.  In the world of options (namely “writing” options), shorter “hold periods” typically means less risk.  So, unlike the “buy and hold for the long-term” wisdom which is often espoused regards stocks, one of the key ingredients to preserving capital (risk management) with credit spreads is SHORT TERM POSITIONS.  Perhaps a subtle clarification is in order – credit spread option investors can and should still be good “long-term” investors.  However, good “long-term” investors should not and does not necessarily translate into investor’s who always “buy and hold” for the “long-term”!
3. One Position – Only one “credit spread” position per option cycle…why?
   Our recommendations are based on entering into only one index “credit spread” option position during any given option cycle.  Actively trading “credit spreads” (or prematurely closing out the position prior to expiration) will always cost investors and reduce the maximum potential profit. In addition to the “profit erosion” and high trading costs (commissions) associated with opening and closing positions, multiple trades throughout the month can become very confusing and overwhelming.  Therefore, we keep our trade recommendations simple, methodical and consistent.There are occasions when a “credit spread” position must be “closed out”.  This occurs when the market index reaches the “closer-to-the-money” option exercise price.  In these instances, we ALWAYS recommend closing out the option positions to avoid further losses and possibly incurring a maximum potential loss scenario.  To safeguard our members, we always provide members with “contingent close orders” and instructions following a successfully executed trade (see #6).  Although we strive for conservative recommendations, investors can and do incur losses from time to time!
4. “Out of the Money” – Both “legs” are “Out-of-the-Money”…why?
   To further reduce risk, we use “out-of-the-money” (OTM) calls/puts for both “legs” of the credit spread position.  The further “OTM” the strike prices are from the underlying security’s current price, the less probability of incurring a loss (in addition to being short term). These options are priced based on their “extrinsic value”, or time value, and thus have no “intrinsic value”.  Because of the short duration to expiration, this “time value” premium erodes quickly and ultimately expires worthless if the index never reaches the “strike price” during the hold period (thus, the “net credit” collected is 100% profit).  In addition, placing positions that are considerably “out-of-the-money allow for a large degree of error – even if the market moves in the wrong direction!
5. Narrow “Legs” – Manage and limit risk!….why?
   To further reduce the risk to capital in the event the underlying security (market index) moves dramatically in the “opposite” direction of our “credit spread” position, we limit any potential loss by placing a “narrow” credit spread position (the difference between the two strike prices).  Again, every credit spread involves two option contracts.  The option further “out-of-the-money” is allows purchased and is intended to limit your potential losses.  Remember, with any credit spread position, your maximum profit and loss is definitive and can be calculated.
6. Contingent “Close” Orders – Safeguard our members!….why?
   In the event the underlying market index does move dramatically in the “wrong” direction of our “credit spread” position, we always recommend placing a “contingent trade” to close out the positions.  The “contingency” orders that we post would be “triggered” when and if the underlying index used in our credit spread position trades within 10-points of the lower option leg (the sold option) strike price. A contingent close order should always be entered after every successfully executed open order.  These orders are designed to close credit spread positions, in the worst case scenario, and limit a potential maximum loss scenario.

There are essentially two types of credit spread index option positions.  Let’s take a look at examples of the “Bear Call” Credit Spread and the “Bull Put” Credit Spread! (see “Index Credit Spread examples”).

To learn more about options and option strategies, visit CBOE or optionsXpress®.

* Although designed to reduce risk, our credit spread positions are still subject to and can incur losses. See our Disclaimer

Note: Option Empire reserves the right to change or modify our strategies, methodologies and recommendation practices and procedures at any time and without any prior notice to subscribers.