100% Success in 112 Strategy in 2024

So far…

Occasionally, it’s good to look back and see how a strategy is performing. A lot of traders reach out with questions about the 112 strategy, so it seems like a good time to share some good news. When things are going well, it can be good to review details and see what insights can be gained. It’s also a time to consider what could go wrong in the future. For six months this trade has made money every single time I’ve traded it. That doesn’t happen often with any strategy, so it’s worth taking time to discuss.

I’ve been trading the 112 strategy for quite awhile. I’ve written about it here. That page goes through all the mechanics of the trade, so I won’t repeat that in this post. Instead, we’ll dig into some real world examples and talk about how I chose to manage the trade in a few different scenarios, and answer some questions that I’ve been asked in other forums about worst case scenarios.

A Brief Review of the 112 Strategy

While I won’t repeat the page on the 112 strategy, let’s do a brief overview of what this option strategy involves. Typically, I trade this using /ES futures options on the S&P 500, but I know lots of traders who trade it with other underlyings. I open the trade between 55 and 120 days before option expiration. The three digits of 1, 1, and 2 represent three different put option positions being traded in a ratio of 1:1:2. The 1-1 parts of the trade are buying a 50 point wide put debit spread that costs about $10 to open, and then selling 2 puts that are selling for about $10 each. The net result is that the opening of the trade is around $10 credit. How do I find the right strikes? Just do a little trial and error in the option table to find strikes 50 points apart that are $10 difference in premium. You’ll notice in my results that I actually try to collect slightly more than a net of $10, by picking a put debit spread that is slightly under $10 and selling puts with a premium of slightly more than $10. I usually end up somewhere between $11 and $13 net credit to start. Since I am trading /ES, there is a 50x multiplier, so the actual dollar credit to the account is $550 to $650 with that level of premium.

Most of the time, this is a slow boring trade that slowly decays. If the market goes up, I can usually close the trade for about 20% of what I paid and keep 70-80% of the premium I collected. Often, I only buy back the 2 far out of the money puts, and keep the 1:1 put debit spread in place as cheap insurance. I almost always close the 2 far out short puts early before expiration, usually between half and 2/3 of the way to expiration from when I entered.

Occasionally, the market drops and as long as the drop is not super quick, I can often close the trade for a credit. This happens when the 1:1 put debit spread goes into the money, but the 2 short far out puts have not increased that much. This can get a little nerve-wracking, but this is where big money comes in and why it makes sense to trade the 112 vs just selling one put for $10 out of the money.

On rare occasions, which hasn’t happened this year so far, the market will drop quickly, and 112 positions that are new and haven’t had time to decay will lose money. The 2 short puts will jump in value faster and more than the 1:1 put debit spread increases. If the 2 short puts were ever to get in the money, the losses really explode to catastrophic levels. A trader never wants that to happen. This is what people constantly ask about, and rightfully so- what can I do to prevent my account from blowing up in this situation?

The Results

Here’s a table of trades opened in 2024 that were closed by early July. It seemed like a good time to show this concept. There’s nothing special about the sheet- I just made columns for things I thought were important so I could look back later and see what I could learn. Others may track in different ways.

Most of the trades I chose were the 112 strategy, but you can see I sprinkled in a few 111s. The 111 trades were typically entered when the market was a little down and IV was up, giving me a little cushion on entry. You can also see that I varied the DTE entry, with many trades in the 50-65 DTE range to open, and others well over 100 DTE. Longer duration trades use less SPAN margin on futures and allow the far out puts with much lower strikes, but also a bit slower decay.

You can see that most trades were closed between 50 and 75% of the initial duration. In most cases, well over half the premium was kept. I’ve shown the initial premium collected and then the debit that was paid to close, or in several cases, there are negative numbers that mean I actually collected a credit to close, double-dipping with a credit to open and a credit to close.

From the data, you can see three different types of outcomes as mentioned earlier. When the market was on a sustained up move from opening, the trades were usually closed with about 70-80% of the initial credit kept. The trades could have been held to expiration, but closing them or just closing the far out put freed up capital to start new trades. Often, the put debit spread, the 1-1 of the 112 strategy was kept as insurance as there was usually very little value left in those two strikes.

When the market dipped in April, the opportunity came to close several 112 strategy positions for a credit. As price dropped to approach or even go below the upper strikes of the put debit spread, and the far out puts that had decayed already stayed at a low value, the net result was put debit spreads that were worth more than the 2 far out of the money puts combined. I generally watched the Delta values along with Theta to decide when to exit. I didn’t want to let the market get too close to my 2 far-out puts, and I also didn’t want the market to go up past my put debit spread before I closed the trade. You can see several trades that closed in that time frame with a credit, some close to the credit that was collected to start. One trade actually had a bigger credit to close than was received to open. I didn’t try to hold any of these trades to expiration and pin a maximum credit of $2500 per contract- the value of a $50 spread with the multiplier of 50 from /ES, it just never seemed like a position was going to settle there. In hindsight, I don’t think any of them would have- the market came back up not long after I closed the winning credit 112 positions.

There were two trades that are highlighted that were closed for less than 50% of the credit received. These were trades where the market dropped almost right away after the trade was entered. In these cases, when the put debit spread was breached, the 2 far-out puts were also gaining considerable premium. I decided to get out while the trade had a profit and not chance a further decline that could quickly explode to the downside. On one of these positions, I closed the put debit spread, and rolled out the 2 far-out puts to 151 days at a much lower strike, collecting $20 premium and buying a $10 put debit spread for an unconventional trade that closed three months later for a nice profit. So even the “bad” 112 strategy trades turned out okay.

What if…?

Clearly, it could have been worse, and the market could have fallen much faster, leading to big losses. I’m often asked, how can someone manage those kinds of really bad situations with this trade. I have three ways that are very different and each appeal to a different type of trading style.

1. Set a stop loss, either mentally or with your broker. Many traders I know will set a stop loss at 1x the maximum gain, which for 1 /ES contract of the 112 strategy is typically around $3000. Given that the average gain per contract was around $400, a trader needs at least 7-8 wins for every stop loss just to break even. But considering that it is possible to go a year or more without a loss, that isn’t bad odds. Just know that when the losses come, they are likely to come in numbers, so seller beware.
2. Define the risk by buying a protective put way below at the opening. This is the whole point of the 1122 and 1111 trades. Losses could be much larger than the stop loss tactic above, but losses are limited to the width between the double credit spread created way out of the money. Some traders add an additional put to make the strategy 1-1-2-3, with the idea that a very, very bad market drop could make the three cheap puts end up worth more than the two short puts- a reality if the market drops 30% within a few months. Besides still having a big maximum loss, adding long puts reduces Theta, so overall decay is slower. But for the once a decade event that crashes the market, this could save a disaster.
3. Get creative and roll the short put that is being tested way out and down for a credit. Bet that the market will turn around and give back all the losses that were taken. If possible, buy a new 50 wide put spread above the new strikes for $10, creating a new 112 strategy. This is the tactic I used on April 22. It worked out, but I wouldn’t recommend it. Most traders take their losses and move on, and consider this type of loss rolling irresponsible.

So there you have it. A variety of 112 strategy trades from the first half of 2024. Plus a reminder of things that might be done when the market has its eventual down move that is much worse than the little spring dip of this year. Happy trading everyone!

Follow-up note: As with many things, timing is important in trading. Within a few weeks of publishing this post, the market had the fastest spike in Implied Volatility ever recorded, and anyone with significant holdings in naked options, and especially the 112, likely took significant, if not catastrophic losses. In August 5, 2024 pre-market trading, VIX spiked to 65, although the market was only down a moderate amount. Stock traders shrugged, but option traders, especially short in futures options saw premiums explode to extreme levels. Short traders saw margin requirements explode and marked positions move to 10, 20, 0r even 30 times the initial amount collected in losses they couldn’t escape in illiquid markets.

Many seasoned traders I know saw their accounts reduced by 30-50% overnight with their brokers liquidating positions to satisfy margin requirements. In short, the debit side of this trade didn’t provide the promised protection during this event. Many traders, including me, saw big losses even though the debit spread didn’t even go in the money and the short puts were still well out of the money. It was the implied volatility that did the positions in, not the actual underlying market indexes.

I’ll be writing a separate longer analysis of this situation and the take-aways that all option traders should take from this. While this event was unprecedented, due to the amount of trading now done in options, I suspect that there will be similar, if not worse, events on occasion in the future.