The Benefits of Credit Spreads…Gangnam Style Continued

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Fifteen minutes before the close Wednesdayit looked like the bulls were about to claim victory for the third straight day. But, to the bulls' dismay, the bears made a last minute appearance. The push lower took the S&P 500 (SPY) from $144.90 down to $144.00, which is where it sits after the close.

The move doesn’t seem like much, but the S&P was higher almost 1.0% Wednesday, before eventually closing the day down roughly 0.75%. If the bears are serious a move below $142.50 would have to occur before they are taken seriously.

Even after the move lower Wednesday, there are still several key ETFs that are in a short-term overbought state. I am watching FAS closely and EWY, the South Korean ETF.  A push lower in FAS would certainly be a sign that the market in general is headed lower which would be wonderful for my SPY bear call spread. However, I am a but more interested in EWY.

The state of EWY is intriguing.The ETF has been in an extreme short-term overbought state for ten straight days. During that time the ETF has moved from $60.13 to where it stands now at $62.38. The push higher while sitting in an overbought state is why I prefer to use credit spreads, more specifically out-of-the-money credit spreads over any other options strategy. OTM credit spreads allow me a margin for error just in case the trend continues, which has the case in EWY.

On the 10th, I mentioned how I would apply a bear call spread using EWY as my underlying of choice. At the time the ETF was trading for $60.90.

I proposed the following:

Here is a good example of what I look for in a high-probability trade for my options strategies.

First, I have to decide how much risk I want to take.

By using a bear call spread I can define my risk by choosing my probability of success. In this case, I prefer 80+%, although others might choose a lower probability to bring in a bit more premium.

But I am okay with going out 38 days and selling the 64/66 vertical call spread for approximately $0.23 for a 13.0% gain. As you can see from the chart above the probability of success is 80.52% and my margin for error on the trade about 5%. Not bad, given the index has already gained 9.0% in just 15 days.

Some might say the risk associated with the trade is too high…well, that is the nature of a high-probability trade.  I can tell you firsthand that most of the skeptics have never traded high-probability credit spreads, so most don’t understand the ins and outs of the trade. One being that to take a max loss the underlying would actually have to move through the 66 strike. The likelihood of that happening – 7.5%. Moreover, the move would have to be swift for me to take a max loss, because I can always adjust. Although, if I keep my position-size small I allow the probabilities work themselves out without making rash decisions.

While the probabilities are high noting is full-proof. For instance, how many times would you bet on the 15th seed beating the 2nd seed in the NCAA tourney. It only happen once every 15 to 20 times, so you are not going to make much money speculating on the higher seed. Same goes for the high-probability trade. Remember, we are basically selling the speculator the ability to bet on the 15th seed, knowing that he will occasionally win, but also knowing that more often than not we are going to come away the winner.

Slow and steady, that’s the name of the game. No heroes here.

Now, eight days after the trade the spread is worth $.20. So, even though I have been completely wrong in my directional assumption, the credit spread is profitable. Albeit, not by much, but given the extreme overbought state a push lower will most likely suck out much of the premium. And with only 30 days left a push back to the 64 level seems like a tough endeavor, especially given the fact the recent extended move in EWY.

I could go on and on about the benefits of credit spreads and the EWY trade, but I am going to save it for another day. For now, my plan is to go outside and hike up the mountain where I live. Ski season is here and I am not about to let it slip me by. See all of you tomorrow.

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