SEPTEMBER 10, 2008

ROBERT RUBIN

Credit SpreadsEarn Income from Options with Limited Risk

What Are Options?

Options give you the right to buy or sell a stock at a set price within a set time The set price is the strike price The set time ends on the expiration date The option becomes worthless if not exercised by expiration

Calls give you the right to buy stock at the strike price If a call’s strike price is below the market price, the call is worth the difference, plus the

value of remaining time If a call’s strike price is above the market price, the call is worth the value of remaining time

Puts give you the right to sell stock at the strike price If a put’s strike price is above the market price, the put is worth the difference, plus the

value of remaining time If a put’s strike price is below the market price, the put is worth the value of remaining time

Options are traded Option price affected by underlying stock price, time remaining to expiration, volatility, etc.

You can “write” your own options Sell others the right to buy from you or sell to you

Credit Spreads

Two calls or two puts Same expiration, different strikes

Write one (short), buy the other (long) Short strike closer to the underlying stock – so higher premium Hedged option sale – the opposite of a naked sale

Always starts with a credit Short premium you receive, less the long premium you spend You get the credit immediately This credit is your maximum possible profit Maximum possible loss is the difference between the two strikes, less

the credit Brokers require this much cash kept in your account as margin You should never lose this much, with a good exit strategy

If the options expire, you keep the whole credit If close before expiration, get original spread less closing spread

Bullish, Bearish, and Neutral Spreads

Bull Put Spread is two puts Expect neutral or rising price for underlying stock, so sell puts

Bear Call Spread is two calls Expect neutral or falling price for underlying stock, so sell calls

Iron Condor is a Bull Put Spread and a Bear Call Spread, both at the same time Expect neutral price trend for underlying stock, so sell puts

below and calls above If short puts and short calls both expire, you keep the full double credit

Best Options for Credit Spreads

Adjacent strikes reduce risk Smaller credit, but bigger hedge

Expiration in 2-6 weeks Exploit time decay of options, fastest in last month The spread shrinks as expiration nears, if all else unchanged Just need short option to stay out of the money

Out of the Money options, as far out as possible Then the trade works whether the underlying stock trends

neutral or in the direction you expect – you can be wrong and still win

With In the Money options, the underlying stock must move in the direction you expect – bigger credits, much bigger risk

Best Options for Credit Spreads - 2

Credit should be at least 10% of the Spread Good reward/risk Return on Investment is at least 10% for 2-6 weeks!

Options on indexes or broad high-volume ETFs Unlikely to move much because a single stock blows up Avoid risk of price gaps sinking the trade

Options with high Implied Volatility IV measures the variability of prices IV more sensitive to falling prices than rising prices Short option with high IV more likely to fall in price – “volatility

squeeze” Get IV from your broker’s site, or from the CBOE -

http://cboe.com/TradTool/IVolMain.aspx then click on IV Index

Implied Volatility at CBOE

Trend of the Underlying Stock

Bullish, Bearish, or Neutral for 2-6 weeks? Leave yourself room to be wrong by picking the best options

Short options with strikes past key support or resistance prices Reduce chance of going In the Money Use Technical Analysis to find support/resistance and trend EMA, MACD, Volumes, RSI, DMI, Price Channels, etc.

Identify economic and business issues driving prices Use Fundamental Analysis

Credit Spread Calculators

Confirm profitability of a potential Credit SpreadMany free on Internet –

http://www.incometrader.com/csc.htm http://avasaram.com/strategy/screener/verticalSpreadCalc.jsp http://www.20method.com/tools.html

Credit Spread Calculator

Probability of Success

Estimate probable outcomes in advance of trade!Look for about 80% minimum probability of successUse a Monte Carlo Probability Calculator

http://www.volatilitytrading.net/monte_carlo_option_calculator.htm

Others can be bought Assumes an unskewed normal distribution of prices Risk greatest early in trade, before time decay works for you

Find the probability of hitting the short strike or key support/resistance prices

Monte Carlo Probability Calculator

Exit Strategies

Choose your risk level Close the position when –

Options expire You get an early profit

Give back part of your credit, but nail the win For example, a sure 5% return after 2 weeks might be better than risking a 6 week

wait to get 10% Consider keeping the long option for more profits

Loss equals credit (break even) Net loss equals credit The short option reaches its strike price (avoid assignment)

Use stops on the short option If the trade looks like it might go bad, you can also –

“Roll up or down” by closing the position and opening a new position farther out, with a bigger credit

Open a spread in the opposite direction – Iron Condor

Options Analysis Software

Powerful toolChart likely trade results by date, IV, stock price, etc.Get OptionsOracle

Free! Such software usually costs thousands Download from http://www.samoasky.com/index.html

Include User Guide