In this issue of TraderSavvy:
The Monthly Cash Machine explains how to generate monthly cash-flows using a special options strategy.
Earn $2,000 Each Month with a Conservative Options Strategy.
Watch live traders enter trades in their own accounts.
Customize Your Own Futures Portfolio.
First-ever Futures Trading Summit for active traders!
Gold – How High Can it Go? FREE Gold Trading Kit!



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Trader Savvy Newsletter


September 19, 2006

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First-ever
Futures Trading Summit
for active traders!

How to Generate Monthly Cash-Flows Using
an Options Strategy Closely Guarded by the Pros
Author: The Monthly Cash Machine

Learn More About Today's Author
 
How to Generate Monthly Cash-Flows Using
an Options Strategy Closely Guarded by the Pros

Forget about Predicting the Market

Fellow traders, I am going to tell you something I have learned through years of research in the stock market.  Nobody, and I mean NOBODY, can predict which direction stock prices will move with any reliability.  Of course, there are always short-term trends and every day you witness "event-driven" rallies and sell-offs in specific issues, but correctly forecasting the market's activity on a regular basis is an impossible task.

What we can predict, however, is the probability that a stock will trade in a defined range or above a specific price for a given period of time.  (This calculation is based on comprehensive analysis of the historic share value of the stock -- more on that subject later.)  The idea that one can statistically establish a defined region, rather than a specific direction, for the future price of a stock is important because in that case, a unique option-trading strategy becomes very effective as a trading tool. This lesser-known "spreading" technique profits if the issue remains in a predetermined range and it also has lots of margin for error if the underlying stock (or the market in general) encounters unexpected volatility.

Spread Trading -- A Conservative Approach to Option Trading

There are a number of ways to trade options but the primary strategies among professionals are speculating and portfolio hedging.  Both of these practices involve the management of risk with each method striving to leverage gains and limit the potential for loss in a different manner.

Another popular approach, spread (or combination) trading, seeks to produce option positions with less risk than the speculative strategies.  The majority of spreads involve buying and selling simultaneous but opposing positions in different option series on the same underlying instrument.

Traders who attempt to forecast the future direction of specific issues generally use price spreads.  These positions consist of a long (bought) option and a short (sold) option, where both options are of the same type (calls or puts) and expire at the same time. The benefit of this technique is that it is aptly suited to situations where the underlying issue's trend is relatively well established and option pricing concerns are of secondary importance.

As you can see, spreads and combinations are an important part of every trader's arsenal.  By its very character, this type of trading limits potential loss.  However, there is another, more conservative method that offers consistent profits while maintaining an acceptable amount of risk.

The Credit Spread: A Simple Explanation

Spreads are combination positions where a trader buys one option and sells another.  One side of the spread generally acts as a hedge, lowering the price of the overall position or limiting potential loss in the event of an unexpected move in the underlying issue.  In the case of a credit spread, the long option establishes the maximum downside while the short option generates the premium or “credit” in the position.

A credit spread can be bullish or bearish but since the characteristics of the position are the same, I’ll talk about the bullish version – it’s called a bull-put spread.  As the title suggests, this position utilizes put options and is generally initiated when the price of the (underlying) stock or index is expected to move upwards in the near term.

A bull-put spread is a very simple combination: a lower strike put is purchased and a higher strike put is sold.  Since the higher strike put is worth more money, initiating the spread yields a credit. 

For example, a trader who is bullish on Yahoo! (NASDAQ:YHOO), which, at the time, is trading near $35, might purchase ten (10) DEC-$25 puts and sell ten (10) DEC-$30 puts for a credit of $500.  The bid and ask prices of the individual options are irrelevant – what is important is the “net” credit from the transaction.  In this case, a $500 profit is earned immediately against a maximum risk of $4500.  If you are wondering how the potential risk is determined, that’s simple – it’s the difference or “spread” in the strike prices, minus any credit received in the opening transaction.

YHOO “Bull-Put” Credit Spread

YHOO @ $35.10
Buy (10) DEC-$25 puts for $0.25 each = $250.00
Sell (10) DEC-$30 puts for $0.75 each = $750.00
Overall “net” credit = $0.50 (X 100) X 10 contracts = $500.00
Spread difference = $30.00 - $25.00 = $5.00
Potential risk = $5.00 (X 100) X 10 contracts = $5000.00 - $500.00 = $4500.00
Return On Investment = $500.00 / $4500.00 = 11%

In laymen’s terms: When this position is opened, you will receive a credit of $500.  It will be placed directly into your brokerage account with no regard to the eventual outcome of the spread. At the same time, you must have at least $4500 of collateral (cash or equity) in the account to “cover” the potential obligation of the short put options.  If the stock price is above the sold strike price ($30) when the options expire, both sides of the spread become worthless and the positions, long and short, are removed from your account.

Here’s a profit/loss diagram of the spread:

Notice how the maximum profit of $0.50 (per contract) is achieved as long as the stock price remains above $30.  That means the share value of YHOO can fall almost 15%, to $29.50, before the spread begins to lose money.  For stocks in a bullish trend, that is a lot of downside margin.
Of course, there is still considerable risk in the position because you have agreed, through the sale of the put options, to a possible (per contract) debit of up to $4.50.  Indeed, once the sold strike ($30) is breached, losses can become substantial -- when compared to the potential profit -- so it’s important to use strict money management techniques such as trading stops (based on the stock price) or “limit” orders on the sold options.
Again, the risk/reward calculations are:
Maximum profit = the initial (net) credit received
Maximum risk = the difference between the strike prices - the net credit received.
Break-even point = the sold (put) strike price - the net credit.
Return on investment = credit received / maximum risk Despite the unique risk/reward ratio, there are a number of advantages to this strategy.  First, a credit spread can be funded with the collateral value of a brokerage account. There is no upfront expense, but rather a commitment to "make good" on the obligation of the (short options in the) spread should it fail to perform as expected.  In addition, the "credit" is assumed upon the initial trade, so the incoming funds can be put to work immediately in other positions, further improving the potential return on investment.  Finally, a successful outcome occurs when the options expire, so there are no closing transactions -- the positions are simply removed from your account at the end of the option expiration period.

For the investor who is not familiar with spread and combination strategies, this type of approach also offers a great opportunity to learn the basics of derivatives trading in a low-risk environment.  The fundamental concepts are relatively easy to understand and once established, most positions can usually be managed with little difficulty.  The occasional adjustments also provide the necessary background for more advanced techniques and those who enjoy aggressive, directional trading can construct combination positions to fit their style as well.  Although the potential for upside gain is reduced, the limited downside exposure in price spreads provides a favorable profit/loss ratio for the majority of investors.

Implementing the System: Diversity + Risk Management = $$$

As with most trading strategies, the key to long-term success is limiting risk.  However, one of the biggest mistakes new spread traders make is to failing to completely understand the concept of risk versus reward. This lack of knowledge can lead to unsuitable positions, regardless of the technique being used or the quality or technical character of the underlying issue.

Most option-based strategies are geared towards achieving large gains on small capital investments, with the hope that one winner can pay for a number of losers.  The problem with this method is the few profitable plays rarely produce enough gains to overcome the draw-downs from multiple losing positions.  In fact, history suggests that retail traders who participate in option "buying" strategies rarely make money over the long-term because approximately 90% all options expire worthless.

In contrast, a portfolio of conservative credit spreads offers a high probability/low profit approach where consistent, small returns outpace any debits from occasional unsuccessful positions.  In those instances where unanticipated moves (in the underlying) occur, the spread is closed or adjusted -- in a timely and effective manner -- to minimize losses.  While this technique is not suitable for all investors, it is common among professional market players who know the odds are in their favor over the long run.

Since this style of option trading yields relatively small gains, it is crucial to limit losing positions and their impact on the portfolio.  Remember, there are never any "big" winners, so there simply can't be many "big" losers.   Experienced traders strive to achieve this outcome in a variety of ways but the most important methods are:

  • Prudent Play Selection
  • Broad Portfolio Diversity
  • Effective Position Management

Our selection process adheres to the first principle through an exhaustive analysis of stock and option prices.  Using a rigorous screening methodology, over 2,500 optionable issues are evaluated regularly with strict criterion for technical trend and character.  From those candidates, only the most favorable positions with regard to profitability and potential risk are published in the portfolio, thus guaranteeing a superior rate of success in all types of market conditions.

Another way our portfolio attempts to limit risk is through broad diversity in its positions.  Stated in simpler terms, "We don't put all our eggs in one basket."  Regardless of the strategy being employed, a diversified group of positions is one of the fundamental prerequisites to long-term success.  By spreading out across industry groups and market segments, one can avoid the agony of violent swings in a particular stock or sector, thus limiting losses when unexpected events occur. 

But, even when a portfolio is filled with diverse, technically favorable issues, unexpected moves can occur.  The best way to deal with these events is to follow a precise and well-developed trading plan that uses effective loss-limiting techniques.   

Exits & Adjustments -- Keep It Simple!

Consider the previous example of a bullish put-credit spread on Yahoo!  The sold option strike price in the position is $30 with a $0.50 net credit, thus establishing a "break-even" of $29.50. If the issue begins to trend downward, there are a few ways to limit potential losses or even capitalize on a reversal (or transition) to a new bearish trend.

The first alternative is to simply close the position at a debit and register the loss. Obviously, this is the easiest exit strategy and it generally works best with low volatility stocks that are currently above the sold strike price.  Many traders establish an exit point based on the (technical) chart indications of the underlying issue while others use a pre-arranged loss limit based on the composite price of the spread. Be practical when utilizing the latter approach as a brief spike or "whip-saw" may force you out of a position too early, long before an exit is truly necessary.

If the stock or index is more active, you might consider a popular "covering" technique among day-traders; shorting the stock (to offset the obligation for the sold option) as the stock moves through the short strike. This is a great method for bailing-out on an issue in which the trend or technical character has changed significantly due to news or events, however you must be prepared to repurchase the stock in the event of a recovery.

Another strategy is to attempt a "roll-out" of the spread for a small profit or at least a break-even exit. To roll-out of a credit spread (in the current expiration period), place an order to close the short option when the stock trades, and preferably closes, below technical support or a well-established trend line or moving average on heavy volume.  After the sold (short) option is repurchased, wait for the new trend to lose momentum and sell the long position to close the entire play.  The key to success with this technique is using it at known support levels or after obvious reversal signals, otherwise you are simply speculating about the stock's next move.

Finally, there modified version of the "roll-out" that involves a transition to longer-term options.  This approach works best when the price of the underlying issue is approaching the sold option strike, but has not endured a significant change in (technical) character.  To initiate this strategy, the current spread is closed and a new spread is opened with lower strikes and/or a more-distant expiration, in the best possible combination that will achieve a credit in the trade.  The most optimum adjustment would use the same strikes in the closest available month, thus you would be selling the highest relative premium without committing to a long-term position.

Clearly, a trader has many different alternatives when the underlying issue moves beyond the sold strike price in a spread or combination position but in most cases, the appropriate action should be taken prior to that event, when the issue experiences a technical change in character (such as "breaking-out" of a trading range or closing above/below a moving average).  There are many indicators available to establish an acceptable exit point however the most important requirement is to exit the play when a violation of a pre-determined level occurs.  If you choose to "roll" into a new position, that adjustment should be made only after a thorough evaluation of the existing market, sector, and industry group conditions, as well as the current outlook for the underlying issue and the ratio of potential gain to additional risk.

Margin Requirements & Target Returns

Our goal with this strategy is to generate $2,000 in cash every month.  A margin-maintenance (collateral) amount of approximately $35,000 in equity is required to achieve this target.  The margin requirement is basically a deposit in your brokerage account designed to guarantee that you will cover any written options in the event they are exercised.  It can be held in cash or securities and although our margin/ROI calculations are based on the widely used regulations at the Chicago Board Options Exchange, higher collateral requirements may be imposed either generally or in individual cases by various brokerage firms.  We suggest that you discuss this strategy and the necessary adjustment techniques with your broker before entering any positions.

A portfolio of conservative credit spreads, when prudently selected and diligently managed, can easily achieve a 3-5% monthly (annualized) return.  However, most of the spreads will provide a slightly larger percentage profit in order to offset the few losing positions.  Using this approach, the portfolio can focus on "out-of-the-money" positions with a very high probability of success, sometimes as high as 90% -- which corresponds roughly to the 2nd standard deviation of a normal distribution.  (The market almost always trades within the 2nd standard deviation of a normal distribution).  Of course, it would be great if every portfolio position was a "winner" but since that isn't possible, the best course of action is to choose trades that offer a favorable balance between probability of profit and potential downside risk.  In those rare cases where things go awry, it's often possible to turn losing plays into winning ones with the effective use of stops and by "rolling" into new spreads.  Even when these methods fail, at least you have reduced your losses by leveraging against another position.

Conclusion

We invite you to follow along as we show you how you can generate $2,000 per month in cash as we execute this easy to follow strategy in real time.  Then you can sit back, and watch the cash start dropping into your brokerage account while you do nothing but smile. 

To Learn more about the Monthly Cash Machine, click here.

About Today's Author

The Monthly Cash Machine staff is dedicated to your performance as an individual investor using options to maximize personal wealth. For many years, the Monthly Cash Machine team has been successfully teaching traders just like yourself how to limit risk while using the flexibility of equity options to their greatest potential. They have extensive experience in technical analysis, statistics, and pricing theory, and readers appreciate their "no-nonsense" approach to option trading. In addition, a tireless work ethic and extreme attention to detail allows the research group to provide one of the absolute best investing values available on the Internet.

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