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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!

On April 30th, 2008 I wrote a Fast Break article entitled "Sell Credit Spreads in this High volatility Environment" . In the article I explained how out of the money premiums in S&P500 options have increased significantly over the past 12 months due in large part to the dramatic increase in volatility we have seen since the beginning of the subprime crisis in early 2007. I went on to explain the volatility index (VIX) and how it serves as a gauge of investor fear.

Most importantly, I went on to recommend selling specific call and put credit spreads for the June contract. In this follow up article I will take you through the progress of that successful trade and go on to recommend a similar trade for the summer.

In italics I have reprinted the trade recommendation from April 30th.

The following are the spreads that I would recommend selling today. All prices and margins are based on the close of business on April 25, 2008.

Sell June 1230/1270 put spreads
Premium: 3.80 points x $250 = $950
Margin Requirement: $2,400
Expiration Date: June 20, 2008

Sell June 1490/1520 call spreads
Premium 3.85 points x $250 = $962.50
Margin Requirement: $2,850
Expiration Date: June 20, 2008

Sell 2 call spreads and 3 put spreads
Premium: 19.1 points x $250 = $4,775
Margin Requirement: $6,350

On April 25th the June S&P500 contract closed at 1397. Over the ensuing 3 weeks the market moved steadily higher before topping out at 1441 on May 19th. On that day the market actually closed at 1430 which was the highest close since early January. Despite the move higher, the two June 1490/1520 call spreads were never in jeopardy. Over the month since reaching the high the market has sold off to a recent low of around 1330. Despite the recent market weakness the put spreads were also never in jeopardy. The short strike price for the put spreads of 1270 is still 60 points below the recent low in the market.

If you cannot view the S&P chart, go here.

This trade has worked perfectly since the market traded back and forth in a range and never threatened either the out of the money put or call spreads. The spreads actually expire on the morning of Friday June 20th based on the settlement price for the June contract. One could decide to hold the spreads to expiration and retain the entire premium, but for this particular trade I would suggest a different course of action. Due to time decay and the fact that the spreads have remained deep out of the money, most of the premium in the options has evaporated. One could easily have closed out both the put and the call spreads a few weeks ago and have retained 90% or more of the potential return. There are two reasons one should close out the trades early. First, these are trades with a limited profit potential and it is smart to close them out when most of that profit potential has been achieved. If you collect over $4,500 for a two-month trade and can close the trade by paying only $400 two weeks before it expires then don't be greedy, close the trade and take the risk off the table. Second, even though the trade is doing very well the margin requirements are still there. Why tie up your money for the last two weeks of a trade with very little to gain. Close the trade and free up the margin.

If you cannot view the VIX chart, go here.

Ready for another trade? The VIX is approximately 10% higher now than when I recommended the previous trade in April. (22.24 based on the close of business on June 18th). With relatively high volatility, premiums still remain high. The following are the spreads I would sell today. All prices and margins are based on the close of business on June 18th, 2008.

Sell August 1160/1200 put spreads
Premium: 4.20 points x $250 = $1,050
Margin Requirement: $2,150
Expiration Date: August 15, 2008

Sell August 1450/1480 call spreads
Premium: 3.25 points x $250 = $812.5
Margin requirement: $2,550
Expiration Date: August 15,2008

Sell 1 call spread and 1 put spread
Premium: 7.45 points x $250 = $1,862.50
Combined Margin requirement: $2,100

Mr. Jonathan Lubow graduated from Dartmouth College in 1989 with a BA in History. He has had uninterrupted registration with the National Futures Association since 1990. Prior to co-forming Trader's Edge in 1998, he was the number one broker for his firm for five straight years. At Trader's Edge, a commodity brokerage firm in New Jersey, he maintains the position of vice-president while still trading and servicing customer accounts. Jon is also a contributor to the OptionsScholar web site.

Mr. Lubow is married with two daughters and resides in Morris County, New Jersey.

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!