I buy a 1 DTE straddle on indexes for two reasons. 1, It has a positive expectancy over time. 2. It is a hedge against short option positions
I’ve started buying 1 DTE straddles on the S&P 500 for two reasons. First, this straddle trade has a positive expectancy- over time it has made more than it has lost. Second, and perhaps more importantly, the straddle is a great hedge against my many short option positions further out in time. How I came to these observations and how I manage this trade are the topics of this discussion.
A straddle is buying a call and a put at the same strike price and same expiration. When traded at the money, it roughly represents the expected move of the underlying for that time period. So, buying a 1 DTE straddle for $30 would mean that the market expects the SPX index to move around $30 plus or minus the next day. Buying a straddle means the buyer is hoping the market will move more than expected, and the seller is hoping the market will move less than expected.
Normally, I only sell options or spreads for a net credit and wait for the value to decay away for a profit. I mostly sell options with expiration dates weeks or even months out and a decent distance out of the money. Those trades have a high probability of profit. However, they also carry the risk that an extended big move in the market could result in a big loss.
Profiting from the trade outright
With 2022 being a bear market year, I have studied more about ways to manage positions in downturns. One interesting book on the topic is “The Second Leg Down: Strategies for Profitting after a Market Sell-Off” by Hari P. Krishnan. One observation in the book is that options under 7 DTE tend to be undervalued and have good potential to make money or protect a portfolio in the midst of a downturn. The book has numerous interesting strategies to help navigate downturns. I’ve toyed with a few of these, but I couldn’t find a trade strategy that achieved the type of positive outcome I was looking for.
As I’ve noted elsewhere, I’m a big fan of the TastyLive.com broadcast site. Just before Christmas at the end of 2022, Jermal Chandler interviewed Dr. Russell Rhoads on his Engineering the Trade show. The topic was short duration options that are now quite prevalent. One key point is how very short duration at the money (ATM) straddles on SPX (S&P 500 Index) and NDX (Nasdaq 100 Index) are actually underpriced. If you buy a 1 DTE straddle at the end of the day and hold to expiration the next, it has averaged a positive return in the past year, which says these options are actually undervalued, counter to what we would normally expect.
I’ve added the presentation, which is broad ranging on the topic here: (Press the red play button to watch)
Starting at about 8:00 into this video, the discussion starts on how 1 DTE premium has been underpriced for the past year.
I decided to try buying these as a one lot and so far I’m seeing this work out with a positive return. And this has been during a few mild weeks with little movement. The straddle never expires worthless as one side is always in the money- it’s just a matter of how much. I have generally closed these early, selling the side that is in the money when I can for more than I paid for the straddle. So far, this has worked better than holding to expiration because we have been range-bound. When we get into a trending market one way or the other, it will likely make more sense to hold.
The hedging benefit
However, I found a second benefit that may be much bigger. I decided to switch over and buy a 1 DTE /ES (S&P 500 mini futures) option straddle in an account with a lot of short futures options for a 1 DTE straddle- not sure why I even decided to other than the size is half as much. Anyway, I noticed that buying one straddle greatly increased my buying power by over $27K, which didn’t make sense initially because I was paying a debit and I thought that would reduce buying power by what I paid-about $1500 ($30 x 50 multiplier).
It turns out that the futures SPAN margin saw this as a big risk reduction. (For more on futures options and margin, see the webpage on different option underlyings.) Buying the /ES straddle gives me 500 equivalent shares of SPY notional in either direction of price movement. This will counter several short options out in time and out of the money. So essentially it is a shock absorber for my futures positions.
Many traders are nervous about the overnight risk of holding short options, due the possibility of a big gap in price overnight. Having a hedge like this can help mitigate that risk.
The biggest question is how big of a position is appropriate? Well, keep in mind that if the market doesn’t move at all and closes very close to the strikes of the straddle, the straddle will be nearly a complete loss. So the size of the trade should be a very small portion of a portfolio, as this trade will be very volatile, going from losing nearly 100% some days to returning several multiples of the initial value others. Think of it as a volatile side trade that can reduce volatility of a much larger set of positions. Kind of a contradiction.
Futures make this obvious, but the same logic applies to any portfolio full of short option premium. The S&P 500 and Nasdaq 100 indexes have a variety of options underlyings at different costs to allow traders of virtually all account sizes to utilize this kind of trading strategy.
So, I think there are a number of angles to pursue this from a trading and portfolio management tool. I thought it might make a good topic to discuss with this group- the gamma of this trade provides a lot of protection at a low cost, essentially free over time, although likely to have periods of loss.
Essentially, I look at it as a great hedge that can still make money on its own. If I have out of the money longer-dated short options in a portfolio, they will make money on calm days, and the 1 DTE straddle will make money on turbulent days. And if I manage each correctly, each should make money over time.
Managing the Straddle
I tend to buy these straddles right at the close the day before expiration. On Fridays, I buy Monday’s expiration, which surprisingly often is about the same price as other days. I’ve tried buying two days out and laddering, but that gets to be a lot to keep track of if I try to manage early, so I prefer to buy at the money at the close for just one day.
Big moves by the end of the day can be very profitable for a 1 DTE straddle, so so can smaller moves overnight or early in the day that allow a trader to manage the trade or take some risk off the table.
Like all option trades, there’s always a management choice of hold, fold, or roll. This trade has all those elements to choose from.
As mentioned earlier, probably the simplest choice is to just hold to expiration. The odds are that over time, the trade will win more than lose. However, this may mean that we have a day where a trade is profitable at some point in the day, but then moves back toward the strike price and loses money. Finding a way to beat simple holding takes a lot of effort and since we know the worst case scenario is losing all the premium we paid, we may want to just let it ride. On days where the market is on the move, this can be very lucrative, as the max move may be at the close of the day. Think of holding as the default way to manage the long straddle.
I’ve found that calm days in a range-bound environment are ones where prices explore support and resistance levels before returning to a point closer the strike price. As the day goes on and price stays constrained, I look for a chance to sell one side of the straddle for a price more than I paid for the total. Earlier in the day, I feel like I can be greedy and wait for a big profit, but as the day goes on, I’m happy to get out for any profit. So, I’ll fold one side of the straddle for a profit when it doesn’t look like we are going to close at an extreme move. Occasionally, I might get to sell the other side if there is a late move in price to the other side of the strike price.
So, that’s hold and fold. How/why would I roll? Let’s say the market has moved a significant amount from the strike price, and I’d like to take a profit but still have the possibility of taking advantage of additional movement. I can roll my in the money option toward the current price for most of the distance rolled. For example, let’s say the price of SPX is down 40 points midway through the day and I’m worried it might come back up, but want to also benefit if it keeps going down. I could roll down my put 20 points and maybe collect $18, locking in 90% of the move. If the price keeps moving, I could keep rolling. The downside of this is that I don’t get 100% of the move, and I’m paying commissions on each roll, and these trades will be pattern day trades if I close the new position before the end of the day. I also will have a hard time locking into a profit that is beyond my purchase price, unless I have a really big move. But rolling is a choice to consider for some traders and some accounts.
Conclusion
So, there you have it. A volatile option buying strategy one day before expiration that averages a profit and can hedge other positions in a portfolio. I have found expiration trades stressful in the past, but this one has been much less stressful to me despite the volatile nature of it.
I’ve noticed some put spread rolls collect more credit than others. This study shows that there is an ideal Delta for rolling put spreads
After trading put spreads for several years, I’ve noticed that some rolls collect a lot of premium credit, and others are a struggle to collect any credit at all. I decided to study this to see if I could find if there is a “sweet spot” for rolling put spreads based on Delta values. I’m happy to report that there is.
It’s no secret that if a put spread gets fully in the money, it is impossible to roll to the same strikes in a later expiration for a credit. But when a spread is out of the money, I’ve seen a wide variation in credit when I roll, and I’ve often thought that there must be a best place to make a roll to get the most credit. If there is, I could devise a strategy to take advantage. So, I copied some option tables into Excel and pivoted the data a few different ways to figure out how premium from rolls vary.
Before jumping into the study, let’s discuss what rolling option spreads involves and why we might do it when a spread is out of the money. Rolling is one three ways to manage an exisitng trade- I covered the three ways in the page on managing by holding, folding, or rolling. One of my common management techniques is to continuously roll a position- I let the short spread decay in value, then roll it out in time to get more premium, and then let it decay all over again. Just repeat over and over. For those not familiar with the roll concept, rolling means executing a trade where an existing position is closed and a new position is opened all at once in one trade. The new options may be at the same strikes, which would be rolling “out,” or the strikes may be higher, which would be rolling “up and out,” or we could also roll “down and out.” Rolling a credit put spread that is out of the money out to the same strikes, will almost certainly generate a credit, which is the goal of this strategy. I’ve discussed this -approach in detail in other pages of this website, including roll for 6 percent a week, goals for rolling Iron Condors, the power of rolling Iron Condors, and rolling losing positions.
Rolling Spreads in the Study
I looked at a lot of different combinations of rolls, different durations, different times between durations, and I saw similar results. In the interest of keeping this write-up from getting lengthy, I’m choosing to just show a few examples.
7-10 DTE Roll
While I don’t trade a lot of options with durations of a week or less, I thought it would be good to look at this timeframe as the lower end of timeframes where we get outside of current week expirations. The following chart shows all the available combinations of 40 wide 7 days to expiration (DTE) SPX credit spreads rolling to the same strikes at 10 DTE.
Rolling out from 7 DTE to 10 DTE has the best credit when the 7 DTE short strike is between 10 and 20 Delta. Note that the Theta peaks at a slightly higher Delta.
I’ve shown the net credit for each roll combination, as well as the raw Theta difference for each existing 7 DTE 40 point wide spread. The x-axis is the Delta of each 7 DTE spread. The roll credit is shown on the left axis, and the net Theta is shown on the right axis. Looking at a peak value of approximately $1.20 per roll, we would collect 3% of the 40 wide spread. Meanwhile, the peak Theta of around $0.45 per day would equate to 1.1% of the width. So, holding might get a similar daily return, but with increasing risk as expiration approaches, but a roll would allow us to collect 3% and still collect additional Theta over again. Actually, that’s double counting. The Theta would just be the decay of the premium we are collecting. Just a few ways to think about the transaction. We can also look at actual strike prices and look at a few other values.
This graph shows roll credit plus Delta and Theta values for the positions
On this next chart, I’ve shown the x-axis as the strike price of the short put of the credit put spread. I’ve also added the Delta values of each of the puts for the 7 DTE spread as well as the Delta of spread position. In addition to the net Theta of the 7 DTE spread, I added the net Theta of the 10 DTE spread that we would roll to. So, each strike price on the x-axis is tied to six different pieces of data for a potential spread roll. While the roll premium and net Theta of the 7 DTE spread is the same information as the previous graph, the additional data can add more context.
Note that the Theta values of the longer duration spreads are generally lower than shorter. That should be expected. More time means slower decay. But the new spread will have a slightly higher Delta, which moves the peak of the Theta curve down in strike prices, because as we have seen in our study on maximizing Theta for a put spread, Theta tends to max out at short Deltas around 20, which will be further down after a roll. So, note from the chart that the maximum roll premium lines up for the most part with the maximum Theta of the spread we are rolling to.
The take-away from the Delta information on the chart is that as we get closer to the current price and have higher Deltas, the net Delta goes up, and the value of rolls goes down. Also, if Delta gets too low, there isn’t as much premium available in a roll to the same strike prices. I picked out the Delta values of the spread with the highest roll value, and it is approximately 14 Delta on the short strike and 8 Delta on the long strike.
So, the ideal scenario is to start with Deltas of around 20/13 and see the positions decay and Deltas to decline to 14/8, and then roll out to new strikes with Deltas of 20/13. If only the market would cooperate with our plan and let us do this all the time. Obviously, the market isn’t that consistent, so we have to manage in other ways.
Sometimes, we may want to roll down and out. Let’s look at the premium for 40 wide spreads and see what is possible if we want to collect a credit.
Looking at the premium differences, we can see opportunity to roll down at some strikes more than others.
On the above chart, I have plotted the premium value of 40 wide put spreads at 7 and 10 DTE, along with the premium collected to roll out to the same strikes. I’ve also highlighted possible rolls down and out. The highest strike where it is possible to roll down a strike and collect a credit is to go from 3920/3880 at 7 DTE to 3915/3875 for a 10 cent credit. When a spread is being tested, every bit helps, but clearly this roll doesn’t give the position much more breathing room. On the other hand, if we had the 3800/3760 spread, we could roll down 25 points to 3775/3735 for no cost. So, again it pays to stay away from being tested. But at this short of timeframe, it doesn’t take much of a move to get a spread in trouble, so let’s look at how a little longer duration would fare.
21-42 DTE
Let’s look at an example that generally matches up with the common strategy often associated with TastyLive.com. Interestingly, values peak out at about the same place based on Delta.
This example shows rolling from 21 DTE to 42 DTE, essentially doubling the time until expiration.
Again, the best premium for a roll is in the mid to low teen values of the Delta value of the short strike of the 21 DTE spread. Here we are collecting just over $6.00 to roll our 100-wide put spread out to 42 DTE. In that case, we would be collecting an additional 6% of the width of the spread. The 21 DTE spread would be decaying about $0.30 per day, so the roll allows us to collect around 21 days of decay in cash.
Notice that the observations we made on the 7-10 DTE roll hold almost exactly the same on the 21-42 DTE roll, even though we have much higher time to expiration, wider spreads, and proportionally longer rolls. One difference to note is that amount of premium and Theta are much less on a daily basis, but that should be expected as daily decay for similar Deltas gets higher as expiration approaches.
This graph shows the premium levels of 100 point wide spreads at 21 and 42 DTE, as well as the premium collected to roll out at the same strikes.
Another key difference is the distance that our strikes can be from the current price, giving the position more wiggle room for price changes. The above chart shows the premium of the various spreads available at 21 and 42 DTE. Notice that the lower strikes approach zero value while the spreads at higher strikes approach 100, which is the width of the spread and would be maximum loss for a credit spread at expiration. With spreads, the closer expiration gets the more of an S-shape we get when charting the premium. Since we are selling the spread, we’d like to see the value decay, either by staying out of the money as time goes by, or seeing the price go up, which would shift all the lines to the right on the chart.
What if we want to roll down to lower strikes when rolling out from 21 to 42 days? Let’s look at what would be available by zooming in a bit to the chart above to the area where there is credit available to roll out.
In this chart, we can see that the further we are out of the money, the more we can roll down for a credit. Once a spread is in the money, the opportunity to collect a credit is gone.
With plenty of time to expiration, we can roll out for nice credit or roll down quite a ways for some credit. For example, in the chart above, the 3700/3600 spread could be rolled down 150 points to 3550/3450 for 20 cents credit or rolled to the same strikes for $7.50 credit. The closer our strikes are to the money, the less credit we get to roll and the less we can roll down for a credit. And as we’ve seen, if our strikes are in the money, we would have to pay a debit to roll out. Having more time allows us to sell spreads that are much further away from the money and be able to roll out and away much easier than spreads that are closer to expiration.
42-49 DTE
One last example for contrast, we will roll out a relatively short amount of time from a 42 DTE put spread.
Again, we compare rolls at different Delta values, along with the net Theta of our current position.
So, this roll is from 6 weeks to 7 weeks until duration. However, our previous observations generally hold. The peak premium is at a bit higher Delta, in the high teens. This makes sense if we consider that we are only rolling out for about 16% more time, so our new spreads will have peak Theta much closer to our old spreads. This would point to the idea that the best roll is the roll that gets us to a new spread with a short strike Delta of around 20.
Again, our max roll amount equates roughly to the daily Theta multiplied by the number of days we are rolling out.
How to Use This Information
Readers may wonder, what good is this? A trader can’t really control where prices move to, so the Delta value is not really controllable by a trader. This is somewhat true, but prices do move up and down all the time, and so if I’m looking to roll out to get to a timeframe that has less volatility, I might be able to enter a limit order that seeks to collect close to the maximum roll credit possible. Often, I’m not in a big hurry to roll, so I can check out where the maximum should be and set up an order for 90% of that amount and go about my business. If it doesn’t execute after a day or maybe even a week depending on the timeframe of the position, I could change the order to something less lucrative.
Another way to look at this data is to realize that if my position has both strikes down in the single digits of Delta, I’ll likely want to roll up my strikes when I roll out to get to optimal Theta. On the other hand, if my position has strikes with Deltas in the twenties or thirties, I may want to try to roll down and out, and hopefully still collect a credit.
If my position has gotten even closer to the money or even into the money, I’m going to have trouble rolling for a credit, and I have some tough decisions to make. I need to consider all my choices: holding, folding, or rolling. If I’m deep in the money I might consider taking desperate measures. It all comes down to risk appetite and an overall plan of action. It’s best to have a plan for all possibilities ahead of time, and not try to figure it out when times get tough.
Final Take-aways on rolling put spreads
My thought process for looking into this was to find optimal credits for rolling spreads, so I could devise strategies to improve my results. After studying this, I was excited to find an answer that makes sense. Deltas in the teens for the short strike of the spread are ideal for rolling. The further out in time the roll is as a ratio of current DTE to future DTE, the lower the delta of the current spread for best credit from the roll.
A good starting point for estimating the best credit is to take current Theta of the spread and multiply by the number of days that are being rolled out. So, if Theta is 20 cents and the roll is going out 5 days beyond the existing spread, the best credit will be around $1.00.
Finally, realize that this study was for put spreads, not call spreads, iron condors, or naked options. Spreads have unique characteristics compared to naked positions, and their behavior does not translate over. So, I only apply this information to rolling put spreads.
I am studying how naked puts best roll as well and plan to do a write up in the future on the topic.
This post lists recent additions and changes to the website. For frequent users, this change log might be helpful to see what has changed from past visits.
The following is a listing of recent additions and changes to the site. For frequent users, this change log might be helpful to see what has been added new or changed.
October 2024: Lots of new comments from readers and responses on various pages of the site. Keep those questions and ideas coming!
August 24, 2014: Added an update to the page about 100% success in the 112 trade to highlight the issues with the August 5 volatility debacle that did wiped out many 112 traders.
July 23, 2024: Added a new post sharing results from the 112 trade in the first half of 2024. 100% success.
July 2,2024: I added a new page contrasting debit vs credit option trading strategies. It’s one of a few considerations traders should consider when picking strategies that work best for their style of trading.
May-June 2024: Lots of new comments and replies came in from readers. Always good to hear from folks with their questions and comments.
December 30, 2023: I added a couple more books to the Resources page. I also updated Tasty links for their new TastyLive.com URL.
December 20, 2023: Made a number of changes and additions to the home page of the site. With all the new content, it seemed like it was time to highlight some of the content that isn’t as obvious.
November 22, 2023: Added a duplicate post on the 1-1-2 Put Ratio Trade. I did this to capture the search engine traffic from the numbers of traders looking for information. So, whether it’s 112 or 1-1-2, there’s a write-up. Just read one or the other- they are the same.
November 14, 2023: Added a page on the 112 Put Ratio Trade. While I mentioned it a bit in the post on the 1112 Put Ratio Trade, I decided the naked option version deserved a write-up of its own.
September 19, 2023: Added a page on Covered Calls. Yes, I know I just wrote a post on the same subject. (Secret note: the write-ups are exactly the same. This is actually a test to see if pages do better than posts in getting search engine connections. Universally, my most read articles are always pages, but maybe that’s just a coincidence. Most readers would never recognize the difference between a page and a post, but posts are supposed to be part of an ongoing blog, while pages are more “permanent.” I’ve used them interchangeably, and I want to make a data-driven decision on what the impact of that choice is.)
September 18, 2023: Added a post on 5 Bullish Call Trades. This is the culmination of a series of trades that I felt like I had overlooked regarding data driven ways to utilize calls in a bull market without absorbing too much time decay. With the market in what appears to be a bull market, it was time to focus in on this topic. 4 of 5 of these trades have recent extensive write-ups that were completed in the past 3 months.
August 4, 2023: Added a post on Buying Out of the Money Call Spreads. This is a strategy that would appear to most option traders who mostly sell options to be a sure loser, but back-testing shows it to be quite profitable over time.
July 26, 2023: Added a post on the Poor Man’s Covered Call, a low cost variation of a Covered Call, based on selling a call against an in the money long call that acts as a replacement for stock. So, a bit of a cross combination of the two most recent previous write-ups.
July 25, 2023: Added a post on Covered Calls. Not sure why I never wrote one before, but given it is one of the most popular option trades around, I thought it was time to weigh in on it with a level of detail that isn’t available many places.
July 5, 2023: Added a post on Replacing Stock with a Call Option. When markets are going up and IV is low, buying calls can be a good way to get in at a low cost. This post goes into more detail.
June 19, 2023: Added a post on Underlying Security vs Risk Permission. There are a lot of factors to picking the type of security to buy or sell options for a specific type of trade. This post digs into what to consider and why some approaches may be better than others.
May 24, 2023: Added a post on Trading Options while working a Full Time Job. I went back to work this year and changed my trading routine. I know many readers can relate, even if they just want to make better use of their time.
May 20, 2023: Added a chart to the 1 DTE Straddle post to show profit and loss at various times of the day.
May 17, 2023: Added a post on Covered Strangles, a conservative options trade that reduces volatility with higher probability of profit than owning an equivalent amount of stock outright. It’s my first deep dive into Level 0 option trades, something I’ve had a number of requests to address.
February 27, 2023: Added a new Phone Stock Charts page with stock price charts formatted for a smart phone, and potentially screen-cast onto a monitor or TV. Not for everybody, but if this is something you are looking for, like I was, you’ve found it.
February 27, 2023: Updated the Current Prices page with more interactive charts, replacing those from a previous provider that had security flaws.
February 26, 2023: Added a post on the topic of 0 DTE trades.
January 16, 2023: Provided responses to a couple of great reader comments and questions regarding the 1-1-2-2 trade.
January 13, 2023: Added a new post on my 2022 learnings.
December 23, 2022: Added a post regarding the best Delta for ROLLING put spreads. This is a new topic that I had curiosity about from years of observing that some rolls do better than others, and I couldn’t figure out why.
November 28, 2022: Accepted an extended comment to the page Rolling Iron Condors and added a response. Comments are always welcome and appreciated. Note that comments from first time commenters must be reviewed and accepted to keep those crazy spammers from ruining the site.
November 9, 2022: Response added to a comment about how to roll a back ratio call spread up or down to get back to Delta neutral.
November 3, 2022: Added a new page on Options Margin Usage. In this page, I compare different types of margin available for option traders and the benefits and risk of each.
October 15, 2022: Worked with the ad provider to reduce the number of ads on the site and make them less obnoxious. Should be no more pop up adds when changing pages, and less ads per page.
September 30, 2020: Added a new page explaining how brokers permit different levels of risk in option trading.
Understanding and charting expected moves based on implied volatility and option pricing can be a helpful tool for option traders.
The expected move is a concept that is important for option traders to understand and use. It took a while for me to grasp this when I started trading options, but now it is something I consider in trading on a regular basis. Expected move allows a trader to put into context what implied volatility and option prices are predicting for the future. While expected move isn’t a Greek, I’m including it in the group of Greeks because it is derived value from option prices and is closely related to some of the Greeks and the ways they are calculated.
Option prices increase and decrease with changes in implied volatility. Actually, since implied volatility is just an “implied” concept, Implied Volatility is the explanation of why option prices go and down after taking into account the other key pricing factors of time and price movement. Implied volatility is a percentage that represents the standard deviation of price movement for the next year, as implied by an option’s price. In any normally distributed data set, approximately 68% of the data will be within one standard deviation of the mean of the data. Stock prices aren’t typically normally distributed (they won’t perfectly fit in a bell curve), but for simplicity most people make the assumption that they are and understand the differences in outcomes to consider. I won’t dig any deeper down this hole, because for most purposes the statistics work pretty well for stocks and options, despite the simplifying assumptions that most traders make.
Options have the unique ability to express how the market in general expects prices to vary between the current time and option expiration. This is possible because the market of buyers and sellers settle on prices that balance risk and reward for future outcomes based on all currently available information. The result is that we can determine how much the market is expected to move in any timeframe, based on option prices. It is kind of like sports gamblers betting on the over/under of a game score- the betting line is determined by the cumulative expectations of those wagering based on what is known about the scoring and defensive ability of each team.
Ways to measure the expected move
One very quick way to determine how far the market is expecting the market to move by a given expiration is to add together the put and call premium of the option strike closest to the money. As I write this, the S&P 500 index (SPX) sits at 4108.54. The closest option strike is 4110. Looking 40 days out, the midpoint value of the 4110 call is 125.60, and the 4110 put is 123.15. Adding these together, we get 248.85. Why is this significant? Let’s say one trader buys these two options (a straddle) and another sells the two options. The break even is a move of plus or minus 248.85. Both the buyer and seller would feel like this is a fair trade. The market of buyers are hoping that the market moves more than expected, and the sellers are hoping it moves less. As a balance, it is a measure of the expected move.
Studies by TastyTrade.com show that this at the money straddle pricing often over estimates actual future moves slightly. For their TastyWorks.com trading platform, they use a modified formula that takes the at the money straddle and the first two out of the money strangle prices in a weighted average to calculate an expected move that historically is closer to the moves that actually end up happening. For the same timeframe, Tastyworks has an expected move of +/-263.83, so for some reason at the moment their calculation is slightly higher than the at the money straddle. Only a few trading platforms actually show an expected move calculation, and it is done differently at different brokers as there is no default standard.
How does this relate to implied volatility? Well, as it turns out the implied volatility multiplied times the price of the underlying stock can match fairly close to expected moves calculated by at the money straddles. The straddle or similar TastyWorks method come out to approximately a one standard deviation move. So a very quick calculation is to take implied volatility multiplied by underlying price multiplied by the square root of the fraction of a year until expiration. The square root part is a little much to begin with, but it is based in statistics and math. So, for our previous example, we will use the current VIX value for volatility of the S&P 500, which is currently 24.79. We have 40/365 of a year for 40 day move, and the square root of that fraction is 0.33. With the current SPX price still at 4108.54, we multiply by 24.79%, then by 0.33, and get 336.10. This would imply that the market is expecting something less than a one standard deviation move in the next 40 days. However, the calculated one standard deviation move is just 27% more than the TastyWorks expected move. For something that is “implied” from option prices and calculated in a couple of different ways, that actually is fairly close- close enough for us to have a ballpark estimate of what the market is likely to do in the future.
So, what is the best way to determine an expected move? Well, there is no right answer because no one really knows what the future holds. But, we know that more often than not, options are overpriced for the moves that eventually happen, so implied volatility will typically be more than realized volatility, so methods that show smaller expected moves will likely be closer over time. But to use the straddle method, a trader must have access to option tables for every expiration of interest and do calculation after calculation to see how the move evolves with time. Using the calculation of volatility and the square root of time allows a quick way to estimate moves over a broad range of time. For option sellers looking to “play it safe,” this calculation may encourage the choice of wider short strikes.
Charting Expected Moves
Once a trader understands the concept of the expected move, it often helps to see how this works out on a chart over time. Let’s look at a chart for early 2022 for SPX.
At the beginning of April 2022, we can see the expected moves for the next few months.
After a week we can see that the moves stayed inside the expected move. With another week of information, we can update our expected move chart.
As time passes, the expected move changes as well with new pricing information.
As it turned out, this period of time included a fairly strong bear move down that was outside the expected move for a while, but then returned inside.
Using the original expected move, we can see how the realized move played out.
This example illustrates a point worth noting. The longer the time duration, the more likely that the realized move will stay within the expected move. Time allows probabilities to play out more.
Another factor with expected moves to consider is that implied volatility can vary significantly over time and those variations can dramatically impact expected moves of the future. Consider that an expected move when VIX is 30 will be twice as large as when VIX is 15. When implied volatility is high, the market is expecting big moves in the future. When IV is low, the market is expecting calm in the future. When the market gets volatile, it tends to take a lot of time to calm down. On the other hand, when markets are very calm, sudden changes can cause sudden spikes in implied volatility and future expected moves. It is far from an exact science, but it is the best real time future indicator of movement we have.
Regardless of how we calculate the expected move, it gives us a good idea of what the market currently collectively thinks the future movement of pricing will be. For planning option strategies, this can be very helpful.
In the bear market of early 2022, I re-discovered a strategy that I had mostly discarded during the bull market of the preceding years, the Iron Condor. The Iron Condor is primarily a neutral trade that when managed with aggressive rolls can provide good returns in choppy, down-trending markets. My goal is to maintain a position that can tolerate fairly big market moves up or down, while benefiting from time decay.
I had discarded the Iron Condor trade because I found I was always losing on the call side of the Iron Condor. Initially, I liked the idea of making money on both sides, but I found in a constant up market, I often lost more money from calls than I made from puts. So, I switched to mainly put spreads and other short put strategies, which did great. But then 2022 came along, and it was clear that the market was no longer going up, and that we were heading for a bear market. I started adding credit call spreads to my credit put spreads to balance risk and have a neutral strategy. Over time I saw that some of my set ups and management strategies were working better than others, so I investigated and came up with a process that now works well in the current bear market environment.
The basic setup of an Iron Condor
Selling Iron Condors is an extremely common option trading strategy. The strategy is a combination of two calls and two puts, four separate options working together. Usually, an out of the money put and out of the money call are sold, and then a further out of the money put and call are purchased to define the risk and reduce cost. The trade wins at expiration if the price ends up between the short strikes, and hits max loss if the price moves beyond one of the long strikes. However, I rarely if ever hold to expiration and roll my position way before expiration is a concern.
Here is an actual California Condor with a profit curve of an Iron Condor option trade drawn over it.
An Iron Condor is named after the shape of the profit curve at expiration, which kind of looks like a condor with a bit of imagination, kind of like how star constellations are named. The iron part of the name designates that it is made up of a combination of puts and calls, as opposed to a put condor, or call condor which has four legs of the same type of contract. An example of a put condor is the broken wing put condor strategy I have described in a separate post.
To build on the condor metaphor, the difference in option strikes are often referred to as the body and wings of the combination trade. The body is the difference between the short put strike and the short call strike. The wings are difference between the call strikes or between the put strikes. The wings on the puts may be equal in width to the wings on the call, or they may be different. Wings that are different widths might be call unbalanced, or broken wings, as the profit profile will no longer be equal levels each end of the price ranges of the trade.
My preferred Iron Condor setup
What I have determined works best for my management strategy is to use the S&P 500 index options (SPX), targeting a starting point 28-35 days from expiration, with option Delta values of 30 for the short strikes and around 20 for the long strikes. I like equal width for the put side and call side, so the Delta values for calls will be a bit wider than the put side, and the net Delta of the Iron Condor will be slightly negative. With implied volatility between 20 and 30%, I generally target 100 wide wings, with the body between the short put and short call of around 15o points on SPX.
Here is the setup of an actual trade from early 2022 on SPX using the criteria from this post. In this example 30% of the wing width was collected, and a little lower deltas were used.For the above example trade, the goal is to keep in the profit zone for the first several days of the trade- the positive area under the 21 DTE curve.
I use SPX because it is the least likely underlying to have outsized moves. It is also very liquid to trade, has tax advantages in taxable accounts, and has expirations multiple times per week in the timeframes I trade. Depending on account size or type, other option products for the S&P 500 may be appropriate and can be used instead with essentially the same strategy. Other indexes or even individual stocks can be used, but managing can tougher with bigger moves, less expirations, and less liquidity.
I use 28-35 days to expiration (DTE) because my position can tolerate most reasonable moves while still having decent decay. I’ve used timeframes as low as 7 DTE, but find that many one day moves can push a position out of the profit zone, and I find myself fighting a losing battle too often. Longer durations of up to up to or over 100 DTE can work, but decay is slower, and there are very few expiration choices to roll to for the way I like to manage. All that said, my plan can vary to different timeframes, with the goal that I will only hold the position for somewhere between 1/10 and 1/5 of the time left to expiration- for example, a 30 DTE would be held 3-6 days before rolling, while a 100 DTE position would be held 10-20 days.
I choose 30 delta for short strikes and 20 delta for long strikes because they are the most forgiving in a move, while still offering reasonable decay as a spread. Higher deltas allow for more premium to be collected, and price movement will often be well tolerated as the long strike of the tested side will increase and the short strike of the untested side will decrease in value, compensating for much of the increase in value of the tested short strike. The goal of my management strategy is to keep this relationship intact, so that price movement has little impact on my option position value. I think of the area where deltas of the four options balance each other out as the profit zone. Staying in the profit zone allows Theta, or time decay, to do its work and deliver profits. I have used strikes with a bit higher delta values, but if too high, the two sides will get tested more often and then require more management. In the past, I often used lower delta spreads for safety and better percentage decay. However, I have discovered that low delta positions don’t actually tolerate price movement well because the untested side of an Iron Condor quickly runs out of premium to offset any of the movement of tested side. This observation has been a game changer for my use of Iron Condors.
I use equal width wings on the Iron Condor for a couple of reasons. Equal width seems to tolerate price movement, both up and down. Equal width also leads to a net negative Delta position, decreasing the total position profit when prices go up and increasing profit when prices go down, which is good in a bear market where downturns are frequent. Negative delta actually is somewhat neutral if the value is only slightly negative- Iron condors also have negative Vega, or decrease profit when implied volatility goes up. So, typically when prices go down, implied volatility goes up, and impacts of the negative Delta and negative Vega cancel each other out.
My Iron Condors are opening somewhere around 50% of the width of the wings. For example, if I have 100 wide wings, I would expect to collect $50 premium. I initially resisted this, thinking that the probabilities would be too low. However, since the time in the trade is so short, and I plan to actively manage moves against my position, I find that the risk reward ratio becomes favorable. However, the example trade that I’ve used is a little wider body and collected only 30% of the width.
This chart shows previous market movement at the time of entering a trade, along with the expected move based on implied volatility and boxes to illustrate the strikes of the Iron Condor. The dates are the opening date, the expiration date, and the planned target date to close. This trade used long strikes that were at the expected move at expiration.
I have devised a graphic that may help to visualize this setup in regards to the expected move and time frame of the trade. The graph has several components- a historic rendering of what the index has done for the past several weeks, a curve showing the expected move for the next several weeks based on current implied volatility, and two boxes to represent the put and call strikes shown from the time of opening until expiration, and the target date to take action. My point with this chart is to show that while the strikes chosen are within the expected move at expiration, they are outside the expected move through the time I expect to be in the trade before I manage it. Said another way, if the position were held to expiration, it is very likely it would be breached on one side, but because the plan is to manage early, a breach is not likely- it would take an outsized move beyond the one standard deviation expected move.
Managing the trade with rolls
I manage my Iron Condor with what I think is a fairly unique rolling strategy. I roll my positions out in time and change all strikes in the direction that price has moved. If price goes up, I roll all the strikes up. If price goes down, I roll all the strikes down. I just roll whichever way the market goes. Here’s the interesting part- if I keep in the “profit zone,” I can roll up or down for a net credit with each roll, and my existing position will have a net profit. Usually, one side will be sitting with a profit and one side with a loss. The losing side is being tested- its strikes have higher deltas than when the trade started. The profitable side will have lower deltas than when the trade started. My profitable side should have a bigger profit than the loss of losing side. When I roll, I will likely have to pay a debit to get my losing tested side back to a good set of strikes at the new expiration. However, I should be able to collect a bigger credit on the profitable untested side than my tested side cost. Ideally, every roll is closing a profitable trade and collecting a net credit to open its replacement. All of this sounds great, too good to be true, but there are a number of details to unpack.
The first challenge is to stay in the profit zone. My general rule is that if I keep my untested short strike must never drop to a Delta value below 15. The reason is that when the Delta of the untested side gets below this point, it quickly stops being able to meaningfully contribute to offsetting price movement in the tested direction. For example, if the price drops, the short call will get further out of the money and drop in value, while the puts will go up in value. For a while the Deltas will mostly balance each other out, but as the Delta of the short call drops below 15, the put spread will start increasing much faster and the calls decreasing less. If this happens, it is time to act and roll all the puts and all the calls down to where there is again premium on both the put and call side. If price has gone up too much, it’s time to roll up all the puts and calls.
Actually, I try not to wait until the untested side gets to 15. I think of my position of having three possible states, green, yellow, or red. Green is when both short strike’s Deltas are above 20- everything is great and there is nothing to do. Yellow is caution, one of the short strikes are between 20 and 15, and probably will need to roll soon. Red is stop and take action, one of the short strikes is 15 or below, so it is time to roll immediately. So, my choice is clear for Green or Red, but I need to use some judgement in the Yellow state. If the day starts in the Yellow, I am more likely to let it ride for a while and watch to see if it recovers or gets worse. If the market has trended throughout the day and moved into the Yellow, I am likely to roll before the end of trading so I don’t end up deep in the Red overnight. If there is a strong trend pulling the position quickly toward Red, that may also be a good indication to act. Yellow is a judgement call.
I find that it is harder to have a profitable, credit roll when tested on a quick up movement. As mentioned earlier, equal width wings means that there will be a negative delta overall, and while volatility reduction can help, big up moves can be hard to stay on top of. That’s why this strategy works best in a bear environment, when the market is trending down.
Don’t over manage. Markets bounce around a lot, and it can be tempting to want to act on each little trend that happens. If I have the right strikes- the right body width and wing width for the market conditions, my position should be able to tolerate price movement. If I’m trading at 30 DTE, I want to wait 3-6 days between rolls, so I need to be choiceful about not rolling too often. If the market moves a huge amount in a couple of days, I may need to roll early, but then I’ll want to try to go longer before the next roll. The other thing to consider is that often the markets overshoot in one direction or the other, so I try not to move too far to chase moves that go on for days, and stay patient that the market will counter the trend.
If a position isn’t winning regularly and isn’t holding its premium in control, that’s a sign that the strikes aren’t right for the market and the duration. For a while I was trading 7 DTE Iron Condors on SPX with around 100 wide bodies and 50 wide wings. I would adjust nearly every day, but I couldn’t keep the position in the profit zone, and I often took losses. There wasn’t enough space in the body and the wings weren’t helping enough. By widening out the body and wings and adding more time, I found the position much easier to manage, and more likely to be profitable, and much less likely to take a big loss.
One way I can tell if I have a forgiving position is to compare my premium to the premium of the same position a few strikes higher or lower. For example, with Schwab StreetSmart Edge, I can pick Iron Condor as a strategy, pick an expiration date, pick a body width and a wing width. The application will then give me a list of strike combinations and premiums for those parameters. If all the choices around my preferred strikes have similar premium, then I know that price movement will have minimal impact on my chosen position. If there is a rapid change in premium for other strikes above or below my choice, it means my Iron Condor parameters are not very forgiving, and I should adjust time or widths or both. Other brokers will have similar ways to compare prices by shifting up or down all the strikes.
I have updated the earlier graphic to illustrate how a change in price over time will dictate the choice of a new position to roll to. The new price now dictates a new expected move, and new ideal strikes and expirations. Hopefully, this chart will help those that are fond of graphical illustrations.
After 7 days of mostly down moves, I decided to roll down my positions and roll out to a later expiration. In this image, the old position and expected move are there along with an updated expected move and new strikes.
Eight legs in the Roll
Since an Iron Condor has four legs, rolling involves closing four legs and opening four new ones. I don’t think any broker or exchange allows a eight-legged trade, so at a minimum this will take two trades to complete the roll. My preference is to roll the puts as a trade, and roll the calls as a trade. I usually start with the side that is being tested and might need a debit to roll to a new expiration and strikes. Then I do the other side, usually moving the same amount and keeping the same width, expecting to collect more to roll the untested side than I pay to roll the tested side.
At times, I may have a situation where I don’t have enough buying power to roll one side while the other side remains in place. If that happens, I’m probably using more of my buying power than I should, or the position is just too big for my account. It isn’t that big of a deal to manage the situation, however, I just close the untested side out and roll the tested side, then open a new position on the untested side. Worst case scenario, I can close the whole Iron Condor at once- freeing up its buying power, and then open a new one with the same buying power. As long as the wing widths are the same and the new Iron Condor collects more to open than the old Iron Condor cost to close, there should be a net gain in buying power. But again, any time buying power restricts a trade, it is probably time to pare down some positions in the account.
How Iron Condors tolerate price movement
Probably the best way to explain how an Iron Condor tolerates price movement is with an example. Earlier in this post I showed an opening trade from April 1, 2022. Let’s look at it again and look at how it fared after 7 days.
Here is the setup of an actual trade from early 2022 on SPX using the criteria from this post.
Notice that the premium collected is approximately $15 each on the put side and the call side.
After a week, price has dropped to 4500, but the premium has dropped for a profit.
The premium on the put side has gone up to around 16.50, while the call side has dropped to just under $6.
After 7 days the premium increased on the put side but decreased on the call side, as illustrated by the larger and smaller strike position arrows, and the result is a net profit.
So, after 7 days, the trade made about $800 on $10,000 risk, an 8% return. But, that’s just the start- the plan is to roll, and so the closing trade above was combined with the following opening trade:
On April 7, this trade was opened while closing the old position for a net credit and strikes that are back at the edge of the expiration expected move.
The combination of closing the old trade and opening the new trade is a net credit of just under $14 premium. This is the result we are looking for- a profit on the trade being closed, and a credit to move out in time and get to better strikes for the latest situation.
And just to finish the example trade, let’s look out another week and see what happened to the market and the trade that was rolled to.
After rolling down, the market kept going down, but stayed within the new strikes with plenty of space to spare.
By April 13, the market had dropped even further, approaching where the puts from the original position had been. However, the roll down gave the new position plenty of space and the trade was sitting at a profit, and ready to roll again.
After 6 days, the rolled position had decayed even after a market move. Again, puts lost money, but the calls made the position profitable.
This trade made $1430 in 6 days, a 14% return on capital. Since the market went down, the put side of this trade lost money, although not that much since the price didn’t end up that close to the put strikes since our new strikes were lower than the old ones. Time decay helped counter the price movement against the puts. The money was made on the call side through both price movement and time decay. In the end time decay, represented by Theta, eats away premium as long as price doesn’t get too close to the strikes.
These are examples of trades I did during the Spring of 2022 in the face of a bear market. Not every trade faired this well. Some market moves were too fast and too far for me to be able to roll before the position went too far to one side. But more often than not, this rolling methodology has kept me from having positions blown out, and keeps day to day portfolio value from varying out of control.
You may notice that the example trades shown here don’t exactly follow all the mechanics I’ve described. Since those trades I’ve become a little more likely to intervene early, although it’s a balance with avoiding over-adjusting.
Finally, I don’t always get my rolled positions re-centered, like I did in the example I presented here. Often, I’m happy to just move in the direction of the market and make sure my new strikes are a bit out of the money on the tested side. In this crazy bouncy market, we get lots of reversals, so I let my positions stay a little off when the market has moved a long way and technical indicators suggest the last several days move may be about finished. However, these choices come down to individual trader preference and market outlook. No one knows what is happening tomorrow or next week, so we each have to decide what trade is best based on the information available. For a real life example of this type of decision making in action, see my post on the Goals of Rolling an Iron Condor.
the S&P 500 index is very appealing but most traders don’t know there are at least 7 different great choices for options tied to the index
For many new options traders, trading the S&P 500 index is very appealing for a number of reasons. But most new traders are not aware that there are at least 7 different great choices for options tied to the index. Most have multiple expirations each week and are very liquid. Each choice has unique differences from the others that may make it appealing in certain circumstances. For a long time I was only aware of one way, and when I now tell others about these additional choices for options, it’s usually a pleasant surprise.
Background
The S&P 500 index is the most quoted benchmark of the stock market for good reason. It is made up of the 500 largest US publicly traded companies. The index is weighted by market capitalization of each firm, so the largest companies have more impact on the index than smaller ones. In fact, as of this writing, the seven largest firms are responsible for 30% of weight of the index. While the news media often leads market reports by sharing the Dow Jones Industrial Average, most traders and asset managers pay little to no attention to the Dow because it only includes 30 stocks and has a bizarre price weighted averaging system that gives the most weight to companies with the highest price per share.
If a trader can choose only one investment to own, some form of the S&P 500 index would be the most logical choice. When selling options, unexpected moves outside of expectations can lead to large losses. Many studies have shown that the S&P 500 index is much less likely to have an outsized move than individual stocks or even other indexes. TastyTrade has done numerous studies on this that are free to review. So options on the S&P 500 index can be a large part of a trader’s strategy. Understanding the variety of choices for trading options on the S&P 500 can be very helpful for traders of all experience levels.
Mutual Funds?
Almost every employee retirement account offers a mutual fund that mimics the S&P 500 index. While mutual funds are great for retirement accounts that rarely change holdings, they aren’t that useful for trading in general, and specifically not for options. There are literally dozens of mutual funds based on the S&P 500, but they share the same trading issues- they only trade at the closing price of the day which isn’t known until after a trade is submitted, and there aren’t options on any of them. Active traders want to be able to buy and sell at any point in the trading day and have options for hedging or amplifying returns, so mutual funds just won’t cut it.
Exchange Traded Funds
In recent years, exchange traded funds (ETFs) have grown in popularity. These funds are structured to match the holdings of underlying indexes or other trading strategies. The funds actually hold shares in the index that they are matching performance with. By far the largest ETF is the SPDR S&P 500 ETF Trust, which goes by ticker symbol SPY, and follows the S&P 500 index. It is priced at approximately 1/10 the price of the index per share. So, if the S&P 500 index is priced at 4500, the SPY ETF will be priced around 450. The SPY price isn’t exactly 1/10 of the S&P 500 index price, but slightly less by varying amounts. The variations are due to fees that come out of the ETF, and the impact of dividend payouts. SPY pays dividends once a quarter, and the price of SPY gets closer to 1/10 of the S&P 500 index as the dividend payment approaches and then drops after the dividend is allocated. Generally, the variation is less than one dollar in SPY, so if the S&P 500 index is trading 4500, SPY is likely to actually trade at somewhere between 449 and 449.50. For most traders, this difference isn’t a big deal, but just a minor factor to be aware of when comparing SPY to the S&P 500 index. Because of its name and ticker, SPY is often referred to as the “Spiders.”
SPY option contracts are based on 100 shares of SPY. If an option is exercised or assigned, the option seller will either be forced to buy or sell 100 shares of the SPY ETF. Because SPY pays a quarterly dividend, traders who sell calls on SPY need to be aware of the risk of having the call option exercised on dividend day. If a trader has a call near expiration that is at the money or in the money, it will likely be exercised because the dividend can be captured by the owner of the stock. If the call seller doesn’t have shares to be called away, and the option is executed, not only will the seller be short shares of SPY, but the seller will have to pay the dividend to the broker that they are borrowing the shares from. Only call sellers have to worry about this, but it is a real consideration four times a year.
Both SPY and options on SPY are extremely liquid with bid-ask spreads normally at one penny. I’ve found option trades that include four legs, can usually be filled immediately for two cents away from the mid price of the combined bid-ask spreads of all the legs. Options are priced in increments of one cent, so pricing can be fairly precise. SPY options have 3 expirations per week, with contracts for every Monday, Wednesday, and Friday. Adjustments are made for holidays when markets are closed. Every expiration has dozens of strikes, going several expected moves above and below the current price of SPY.
While SPY isn’t the only ETF to track the S&P 500 index, it is the predominant one, and really the only ETF to really consider for trying to match the performance of the actual index. There are a couple of other ETFs to consider that are designed to magnify or reverse the performance of the S&P 500 index. For some strategies, these might be helpful.
UPRO is an ETF from ProShares that is leveraged to deliver 3x the performance of the S&P 500 index. Officially, it is called the ProShares UltraPro S&P 500 ETF. So, if the S&P 500 index goes up 1% in a day, UPRO will go up 3%. However, the reverse is also true- if the S&P 500 index goes down 1% in a day, UPRO will go down 3%. To keep this relationship working, the holding in the ETF are adjusted each night, so over time the ETF won’t exactly keep pace at 3x the performance. The ETF relationship is more precise day by day than longer term, but will be relatively close to 3x. UPRO has options expiring every Friday and is somewhat liquid with wider bid-ask spreads than SPY. Because of large swings in price, the ETF has occasional splits to keep the share price reasonable, and the daily adjustment of holdings can alter the precision of the leverage factor, so the share price isn’t consistently convertible to a multiple of the S&P 500 index.
The opposite effect is achieved from the SDS, or Proshares Ultrashort S&P 500 ETF. SDS is set up to delivery -2x the performance of the S&P 500 index. So, if SPY goes up 1%, SDS goes down 2%. Over time the price of SDS tends to get lower and lower, and a reverse split is needed to get the price up to a reasonable level. Options on SDS also expire weekly. Both SDS and UPRO options are based on 100 shares of the corresponding ETF.
Options on leveraged ETFs are much more volatile than on non-leveraged ETFs. Because traders of these options know that there is multiple times price movement, options are priced accordingly. Because of this, strategies with options can perform very differently than with options based on the non-overaged SPY. The switch from SPY options to UPRO or SDS options is not as simple as it might appear, so research thoroughly before jumping in to these unique options.
There are other ETFs that follow the S&P 500 index as well as others that leverage the S&P 500, but they don’t trade with as much volume, and their options trade less frequently. Why trade a product that is less liquid, with fewer options, and much lower option volume when a better choice is available? I see no reason to use anything but SPY, UPRO, and SDS.
There are also ETFs that represent sectors or portions of the S&P 5oo, or weight the 500 stocks of the index equally. So, for value vs. growth, or Finance stocks or Utilities, there’s are ETFs with options of every flavor. But none of those represent trading the full S&P 500 index, so we won’t dig in any further into those products, because the point of this discussion is ways to trade the benchmark index.
For most traders, SPY options are the only options on the S&P 500 index they use, and many traders aren’t aware of any other choices for trading options on the index. But, we’ve only just begun.
Index Options
Why trade options on an ETF based on an index when you can simply trade options on the actual index? Index options remove the ETF from the mix and link options directly to the index. For the S&P 500, there are two index options available, SPX and XSP. SPX is literally the S&P 500 Index, and XSP is the Mini S&P 500 Index.
Traders are often not aware of these ticker symbols or the fact that options are available for these two indexes. There are a couple of reasons for this. There is no way to actually buy or sell the actual S&P 500 index directly, a trader can’t buy or sell shares of SPX. Additionally, since SPX is an index and not a stock or ETF, many brokerages don’t show it as SPX. For example, Schwab lists it as $SPX. Other sites may show it as ^SPX or .SPX. The point is that you have to know what you are looking for to even find it. Since SPX is literally the S&P 500 Index, it is priced at the full price of the index. So, if the S&P 500 Index is at 4500, SPX is at 4500. They are exactly the same.
Okay, SPX is the S&P 500 index. But, what is the Mini S&P 500 index, you may ask? XSP, or the Mini S&P 500 is simply an index that is 1/10 of the S&P 500. However, unlike SPY, which is approximately 1/10 of the S&P 500 index, XSP is exactly 1/10 of the S&P 500 index. Why do we need an index that is 1/10 of another index? It’s all because of options and sizing of positions.
Options on SPX don’t represent 100 shares in SPX because SPX doesn’t have shares. Instead, SPX options represent a value of 100 times the value of SPX. Think of it as if SPX had shares and the options represented 100 shares, even though there aren’t any shares. XSP options represent 100 times the value of the XSP. So, in both cases we still have a multiplier of 100 as we do with ETF options. This is where the similarity in options end.
One difference is that dividends are not part of the S&P 500 index. Many of the 500 stocks in the index pay dividends at various times throughout each quarter, and those payments have an impact on the individual stock price, which will then impact the price of the index. But the index has no mechanism to pay dividends because it is just an average of the prices of the 500 stocks it tracks and isn’t tradable itself. So, option buyers and sellers of SPX and XSP don’t have to consider dividends as an event, like traders in the SPY ETF.
Since index options can’t be settled in shares, they settle in cash when they expire. In many ways, this can be a lot easier. If an option expires $5 in the money, a call buyer will receive $500 from the account of the call seller at expiration because of the 100 multiplier. If an option expires out of the money, it is worthless and there is nothing to settle.
Cash settlement can be a bit confusing at first, so just realize that there is nothing to actually buy or sell from assignment- a put seller that is assigned doesn’t have to buy 100 shares, they just have to pay the difference in the current price at expiration from the strike price of the option. If the trader sold a put on a stock or ETF, they would be assigned shares that they would buy for more than the current price, which they could turn around and sell at a loss. Index options eliminate the step of buying and selling shares, and just settles the difference in price with cash.
Index options use European style option assignment, while stock and ETF options use American style options. American style options can be executed at any time by the option buyer, and this becomes a consideration for option sellers that have positions in the money before expiration. However, European style options can only be executed at expiration. So, sellers of index options don’t have to worry about having an early assignment before expiration, and buyers don’t have that option. And since index options are cash settled, there really isn’t an “option” at all. In the money index options are simply “settled” at expiration.
SPX options have lots of different expirations. Originally, these options only had expirations once a month on the third Friday of the month. Later, month end and quarter end expirations were added. Then weekly expirations every Friday were added. And now there are Monday and Wednesday expirations. Soon, maybe by the time you read this, there will be options expiring every trading weekday when Tuesday and Thursday are added.
One holdover from the original monthly expiration is that monthly index option expirations are different than all the other expirations in a couple of ways. First, and most importantly, monthly index options expire in the morning (AM) of expiration, while all other expirations expire at the close (PM) of trading. For SPX, there are actually two option expirations on the third Friday of the month, the monthly AM expiration, and the Friday PM weekly expiration. The settlement price for AM expirations of SPX is based on the opening trade price of each of the 500 stocks of the S&P 500 index. After each of the 500 stocks has traded on expiration morning, the prices are calculated to determine a settlement price for expiration. However, trading on the expiring option is stopped at the close of trading the day before. So, SPX option sellers and buyers are stuck with their positions from Thursday afternoon until Friday morning not knowing what the index price will be for settlement until the market actually opens and sets the price. For PM expirations, it is simpler, when the market closes, option trading stops and expiration settlement is based on the price of each of the 500 stocks in their last trade of the day. If you watch the price at the closing bell, you will see it change slightly by several cents after the close as all the different orders that execute at the market close get accounted for. The second way that AM and PM expirations vary with index options is that when the option contract is listed, monthly contracts use the ticker symbol SPX, while all other expirations use SPXW. The W is for weekly, even though the expirations may be quarterly, monthly, Monday, or Wednesday, and soon Tuesday or Thursday. So for S&P 500 Index options, just know that SPX listed options expire in the morning (AM) and SPXW listed options expire in the afternoon (PM). Either way, when you are searching for option listings, most brokers list SPX and SPXW options together under SPX.
XSP options are a more recent creation, and only have PM expirations. There aren’t different naming conventions either. Settlement works the same, with prices set by the final trade of each of the 500 stocks of the index when the market closes.
Another difference between SPX and SPY options is that SPX options are traded in increments of 5 cents. Since SPX is 10 times the price of SPY or XSP, trading increments or tick size is actually more precise on a percentage basis for SPX. XSP trades in increments of one cent like SPY. SPX options are also very liquid and orders can usually be filled 5 cents away from the mid price, even in multi-leg orders. There is a little difference based on trade volume of different expirations. Monthly expirations typically have the most volume, followed by Friday PM expirations and month-end expirations. Monday and Wednesday expirations have the least volume and can sometimes be slightly harder to fill, especially for strikes away from the money with more than a week until expiration.
XSP have a lot less volume than SPX or even SPY options, so they can be a little less liquid. Because of their pricing, they trade very similar to SPY, but with a little less liquidity. Since XSP is an index option, there is no worry of assignment, and dividends are not a consideration.
Some brokers don’t allow trading of index options in their accounts, and some strategies are not allowed with index options in certain types of accounts. Some brokers charge higher commissions and fees for index options than for stock and ETF options, so watch out!
Finally, index options get a different tax treatment and have a different accounting treatment at the end of the calendar year. Index options fall under Section 1256 of the tax code which allows a trader to classify 60% of the gains from trading index options as long term, while only 40% are short term. For taxable accounts of traders in mid to high tax brackets, this can be a significant advantage! It doesn’t matter if the option was held for a minute or six months, the 60/40 tax assignment applies. The other part of 1256 treatment is that index option positions are “marked to market” at the end of the year, meaning that a trader considers the option to be a profit or a loss at the end of the year even if the position is still open based on the price at the end of the year of open positions. In stocks and stock options, only positions that have been closed are evaluated for a profit or loss. Using mark to market can be a bit confusing the first time around, but most brokers do all the calculations and provide them in a year end tax statement.
The CBOE has announced another index option on the S&P 500 index to start trading very soon, call Nano options. This index will be 1/1000 of the SPX, or 1/100 of XSP, to allow very small option trades on the S&P 500. Supposedly the ticker symbol will be NANOS. Stay tuned for more details.
Futures Options
There are two futures contracts on the S&P 500 index that offer options. The primary one is called the E-Mini S&P 500 Futures, which uses the symbol /ES at most brokers. In listings of futures contracts and futures options the symbol will be followed by a letter to designate the month the future expires and a number for the year of expiration- for example /ESH2 represents the future contract expiring in April of 2022. The other futures contract is called Micro E-Mini S&P 500 Futures, and uses the symbol /MES. Some brokers may use other characters to designate futures instead of the forward slash, and some may require approval of futures to even see the ticker symbols. Consult with each broker for details.
Futures are tradable contracts based on the price of the underlying index at the expiration of the contract. Futures contracts in general expire at a variety of times in the month with /ES and /MES expiring on Wednesday mornings and settling to opening prices of the S&P 500 index. Since the futures contract is based on what the market expects the price to be at expiration, the price of the future is usually a little less or sometimes a little more than the current value of the S&P 500 index. However, it generally doesn’t vary that much because the current price is one of the best indicators of what the future price might be and futures buyers and sellers won’t let the prices to diverge that much because it presents an opportunity for arbitrage between the different values, knowing that at expiration they will converge. At any given time, there are many different contract expirations available to trade, going months out in time. The contract month closest to expiration is called the front month. Buying a front month futures contract is as close to directly owning the S&P 500 index as you can get. The value of the futures contract goes up and down with the index.
A single /ES contract is valued at 50 times the S&P 500 index. One might think of it as owning 50 shares of the S&P 500 index if the index price were the price of a share. A single /MES contract is valued at 5 times the S&P 500 index. These values are known as the notional value. However, futures contracts are priced at prices similar to the actual S&P 500 index, regardless of the notional multiplier.
Let’s take an example. Let’s say that the S&P 500 index is currently at 5010, and front month futures contracts for both /ES and /MES are trading at 5000 as they are slightly less. The /ES contract would have a notional value of $250,000, and the /MES would have a notional value of $25,000. If the market went up 100 points on the S&P 500, and both /ES and /MES went up to 5100, the owner of one contract of /ES would make $5000, and the owner of /MES would make $500. For most people $250,000 for one contract is too expensive, but futures contract owners aren’t required to have the full amount in their account, but just a fraction due to the assumption that the price will only move within a small percentage of the index price. If the price moves more than expected against a contract owner or seller, additional capital will be required. This practice is called span margining, and can be very helpful to allow traders to leverage a position, but also very dangerous if over-used and the market moves against a position. For example, if a trader buys an /ES contract priced at 5000 and has $50,000 in their account, a 20% decline in the market to 4000 would wipe out the account. While /MES is one tenth the size, the problem can be the same for a trader with a smaller account.
So far we’ve talked just about the futures contracts themselves. The topic of this post is trading options on the S&P 500 index, not trading futures on the S&P 500 index. So, let’s talk about how options on futures work. In particular let’s look at options on /ES and /MES. One key difference from other options we’ve looked at is that /ES and /MES options don’t use a 100 multiplier, like stocks or index options. Instead, futures options are an option to buy or sell one single futures contract. Which futures contract is the option associated with? Typically, it is the futures contract that is next to expire after the option expires. So, an option on /MES expiring on the first Friday in March is tied to the March futures contract, which will still have time remaining when the option expires.
So, buying an /ES call gives the buyer the option to buy one /ES futures contract at option expiration, and buying a /MES put gives the buyer the option to sell one /MES futures contract at option expiration. So, settlement of the option at expiration doesn’t settle in stock or in cash, but in a futures contract. The price paid for the futures contract is the strike price of the option. For example, if a trader buys a call option for /ES with a strike price of 5000, they would get to buy an /ES futures contract at options expiration for $5000, multiplied times the /ES futures multiplier of 50, or a total of $250,000, assuming that /ES is trading above 5000, making the option in the money. On the other hand if the price of /ES is below the strike price of the call option, the option would expire worthless. Similarly, if a /MES 5000 put expired in the money, the settlement would be to sell a /MES futures contract for $5000 multiplied times the futures multiplier of 5, for a total of $25,000.
There are futures options for /ES and /MES that expire every Monday, Wednesday, and Friday, so there are plenty of expirations to choose from. And futures and futures options trade virtually around the clock, from Sunday afternoon until Friday afternoon. In fact, the price of /ES in the overnight hours moves around quite a bit based on news and as the opening of the market approaches, it is a fairly accurate indicator of where the market will open. Meanwhile the S&P 500 index stays the same during the overnight, because it is based on a calculation from the trading of the 500 stocks in the index, which don’t broadly trade at night.
The span margining ability to trade using the buying power associated only with a calculated expected move applies to futures options as well as futures contracts. As a result, traders can put on highly leveraged trades without consuming a lot of buying power. With this capability comes significant risk. Traders have to be very aware at all times of the true total risk that comes with trades in futures options. With futures options, the buying power used is not a good indicator of the capital at risk in the case of a very large move of the market up or down. Some brokers allow selling of naked futures options for very little buying power, where selling the same notional value of SPX or SPY could easily require ten times more capital even though the true risk is the same. Many trading strategies with futures options may seem very safe because they are high probability trades- perhaps they win 90% of the time- the problem is when the losing 10% happens and the trader is not prepared for the damage that occurs to the account. Risk management is critical in all options trades, but particularly in futures options using span margin. Stops and hedges become the difference between staying solvent and going broke.
Like index options, futures and futures options also use section 1256 tax treatment with 60% long term gains and 40% short term gains, and are marked to market at the end of the year. There are no dividend risk issues.
One final unique advantage to futures options is that they are exempt from the Pattern Day Trade rule. For accounts under $25,000 where trades are opened and closed the same day, a trader can have severe limitations placed on an account. Generally, the limit is five day trades in a rolling seven day week. This can be stocks or options. Futures and futures options are governed by different regulations, so many day traders favor futures.
Many brokers have significant approval processes to be allowed to trade futures or futures options. Some limit them only to standard taxable margin accounts. Other brokers don’t allow them at all. Go to the office of your broker and see if anyone there has any experience trading futures or futures options- it is likely no one there has a clue and they will tell you not to do it. If you have friends that trade in the market, chances are that almost none have ever traded a future or futures option, so you are likely on your own. Your best source for help will be specialist from your broker’s headquarters, specialized training materials, or online resources from your trading community as I discussed in an earlier post.
If trading futures options is so complex, hard to understand, and risky, why do it? For many strategies, futures options can fill in gaps at a low capital requirement. Some hedging strategies can be too expensive with stock or index options, but more affordable with index options. Because of the unique multipliers, futures options for the S&P 500 index may be just the right size for a particular need. And finally, because the futures prices move and trade all night, futures and futures options allow trading on that information at some brokers.
Review of choices
After a lot of discussion and explanation, we have come up with seven choices for trading options on the S&P 500 index. Five of these are directly correlated to the index, and two are leveraged. Remember that the UPRO ETF moves up and down with the S&P 500 index, but three times as much each day. SDS, the UltraShort ETF not only moves the opposite direction of the S&P 500 index, but twice as much in the opposite direction on a percentage basis each day. Because of this leverage, the options on these two ETFs behave in unique ways which can be helpful for some strategies. However, most traders are more likely to want options that are based on underlying entities that move on a 1:1 basis with the S&P 500 index. So let’s review those choices.
Ticker
Type
Index vs Strikes
# of Shares or Multiplier
Notional Value @ SPX = 4000
Settle as
Tax Treatment
SPX
index
1 : 1
100
$400,000
cash
60/40
/ES
futures
1 : 1
50
$200,000
one contract
60/40
SPY
ETF
1/10
100
$40,000
100 shares
short term
XSP
index
1/10
100
$40,000
cash
60/40
/MES
futures
1 : 1
5
$20,000
one contract
60/40
This table lists key differences in the five main choices for options on the S&P 500 index, listed in order of notional size. In this table notional value refers to the amount of capital controlled by a single option with a strike tied to the S&P 500 index being at 4000 (SPY and XSP would have strikes at 400, while SPX, /ES, and /MES would have strikes at 4000).
While SPY is the simplest choice because it is most readily available, there are reasons to consider each of the other listed choices to best meet the needs of a specific account or strategy. From biggest to smallest, SPX controls 20 times as much capital as /MES, and the other choices provide increments in between. I was personally reluctant to trade futures options at first, but for no good reason other than I wasn’t familiar with their nuance. As I write this, I currently have at least one contract of each of these five choices open amongst the various accounts I manage.
For all of our choices, we currently have the ability to select expirations three days a week, and potentially five days a week in the near future. Each choice has an extensive selection of strikes available at each expiration, although one can expect Friday expirations and month end expirations to have more choices and more trading volume than Mondays and Wednesdays. We expect third Friday (monthly expirations) to have more choices and trading volume than any other expiration in the month.
My personal preference in most situations is SPX due to its large size. Even though commissions and fees are more on a per contract basis, the fact that SPX is 10 times bigger than SPY or XSP makes commissions and fees almost negligible in most trades of SPX, where they can be a substantial consideration with SPY and XSP in some strategies that deliver narrow profits. For futures, I like /ES over /MES for the same reasons. However, when I’m trying out a new strategy or working with a small account, I often have no choice but to use SPY, XSP, or /MES. For most new traders, SPY is the first and easiest choice, but eventually there may be a need to use another choice. For example, if you start trading 10 option contracts at a time, it might make sense to use SPX. If SPY is too big, you may want to get approval to trade futures and trade options on /MES. If you have a taxable account and are in a higher tax bracket, XSP may be a good alternative to SPY to reduce short term capital gains. So, learn the differences and make the choice that makes the most sense for the situation.
If you want to investigate strategies for trading options on the S&P 500 index, take a look at some of my favorite strategies. You may also want to read my page on how different option strategies have very different risk profiles.
Traders need access to other traders to share, learn, and teach each other. Online social media groups can provide that type of community.
Let’s face it. Trading options can be a lonely task. It’s just a trader and the computer screen. Whom can a trader turn to with questions, for encouragement, or to share success and failure? Virtually every person who I dare to tell that I trade options as a primary activity either have no idea what I’m talking about, think I’m crazy, or both. Most people who do a lot of their own investing don’t even know what a put or call is. Traders need a community of other traders to keep their sanity and keep moving forward.
When I stop and think about it, I personally know seven option traders that I have met in person. Only seven. Four of them I met through one of the others. And only a few of them regularly do the same kinds of trades as me. And I feel lucky to know that many. So, personal connections can only help so much.
There are lots of online services that traders can pay a small fortune to join to help learn to trade options. Some are follow the leader- buy or sell what the guru says and exit when the guru says. I tried a few of those and found it hard to time it right and even then I didn’t get the results that were promised. So, I’m not a big fan of spending a lot to watch others trade.
If you do a Google search about any topic concerning options, you’ll be bombarded with ads for paid services, but then below them will be lots of YouTube.com videos, and other sites, maybe even this one. There are lots of quality YouTube videos on options, but many that are dubious at best. I first discovered TastyTrade.com through watching some of their YouTube videos. Tastytrade has their own channel on YouTube, and I’d encourage subscribing. One TastyTrader that I enjoy watching is “Sweet Bobby” Gaines. He has a “Sweet Bobby” channel on YouTube. Look around and search YouTube for option trading, and find your own favorites to follow.
But even watching others still doesn’t give you community. There’s nothing like interacting with others. This is where social media actually can be a help. A feature on Facebook.com that you may not be aware of is “Groups.” Just click on the Groups icon and either use the “Discover” icon or the search magnifying glass to look for groups that specialize in option trading. Some are more active than others. Most are private and require you to apply for membership- this is generally to keep out spammers and robots who will ruin the experience. I’ve joined a number of groups- some I’m active in and others not so much. For groups that don’t have members doing strategies I have in interest in, I simply drop my membership. I now have a number of virtual friends from these groups. Some of them message with me on an almost daily basis. I’ve discovered numerous trading strategies to try from posts in these groups, and the banter from members gives the members a wide variety of opinions about different trading scenarios, positive, negative, pointing out risk, ways to manage, and success stories.
Another social site that gained a lot of traction in early 2021 was Reddit.com. Reddit became an overnight sensation for traders when a little-known group on the site called “Wall Street Bets” essentially cornered the market on the stock of GameStop, an almost bankrupt video game store chain. By realizing that there was a huge amount of short interest in the stock and a small float of tradable shares, the group started buying up cheap shares of stock, and bigger buyers followed, driving up the price. Many short sellers, including some large hedge funds were caught flat-footed and had to buy back their short positions at huge losses, further driving up stock prices, a classic short squeeze. Call option buyers joined in as well and market makers hedged by buying increasing numbers of shares also driving up prices. By the time the craziness ended the stock was up over 100 times the price when the buying started. This crazy action drew attention to Reddit and the “Wall Street Bets” group. Like many, I joined both for the first time to see what the fuss was all about. The group membership ballooned to an enormous number and the content turned to mush- just a lot of nonsense posts slamming each other and promoting hundreds of other crazy schemes. I dropped my Wall Street Bets membership after less than a week.
However, Reddit has a feature that suggests posts from other groups that it thinks a reader might like. I found some other groups that I started commenting on that were more serious and in line with my view of trading. Again, I met a number of new virtual friends and engaged in both public and private dialogs about trading strategies. Groups on Reddit are public to read and join, so there can be a lot of spamming behavior and many users delight in being very foul-mouthed in their responses. Rudeness is tolerated a bit much, in my opinion. However, I’ve found that if I stay on the high road in my posts and stay factual and data focused, people generally engage back with me in a respectful way. It’s kind of a what goes around, comes around. In fact, the site has a measure called karma that is based on how well your posts are received by others. People who are mean and overly negative end up with negative karma and many of their comments get deleted by moderators.
Another social site that I’ve found helpful is Discord.com. Discord was started as a way for gamers to chat with each other in private rooms, and have discussions in groups on a private “server.” Once you join Discord, you can set up your own server, or join public servers set up by others. As it applies to traders, individuals will set up and organize a server and invite others to join. Many people have private servers by invitation only. Some of my local friends set up a server like this and invited me- I like the familiarity of the small group and we get along well with each other. I’m also a member of a number of other groups. A nice feature is that anytime someone posts a response to a server, I can have a notification pop up on my phone, or I can choose not to- the choice can vary from server to server. So, I have notifications on for some servers and off for others. The idea is that like-minded people can have an ongoing private dialog about their trading. Some conversations are based on users posting each of their trades for comparison and comment. So, a group of 0 DTE traders might each post their opening and closing trades, and then discuss what went right and what went wrong, critiquing themselves and other members on strategy. A Discord server can be very busy, or not busy at all- it depends on the number of users and how active they all want to be.
Twitter.com can be another source for information on trading. There are lots of famous and not so famous traders and information sources that tweet out information on a regular basis. I personally don’t have the bandwidth for it at the moment and don’t use it much. However, I know lots of traders love it. TastyTrade has a daily show, the Liz and Jenny show, where much of their discussion is based whatever Twitter posts use the hashtag #LizJny, which has fostered a community feel. Other shows on trading networks and CNBC have similar features and hashtags. Many high profile traders will respond to personal tweets or tweets that use an @ reference for them. However, the format really doesn’t lend itself to in-depth discussions. Often, it just allows tweeters to refer followers to content that the tweeter thinks is interesting.
I used to be a big fan of LinkedIn.com and its groups. Now, I think other social media resources have taken the lead in being sources of interaction with like-minded traders. I joined a few trading groups, and I have to say that I’ve been disappointed so far. Maybe new groups will emerge that will be better for the trading community, but I’m still waiting.
I know TikTok.com is gaining ground in this space as well. Similar to YouTube, TikTok offers videos, generally short in duration, and based on your reaction, the site steers you to similar content that might be appealing. As I write this, it seems a bit of an immature community currently, but by the time you read this in the future, TikTok could be the greatest resource available. We’ll see.
This is just a start. Feel free to leave your favorite way to get involved in the trading community in the comments below. New forums and sites are emerging all the time and providing new opportunities to connect with other traders. I’ll refrain from naming any specific groups on any particular site, because if you are reading this years from now because I haven’t updated it, there will likely be many new groups and sites to join and find community.
From my website Analytics, I can see that over half the hits to my site come from people clicking on a link to this site from a post someone referenced on a social media site. It used to be just me that did that on occasion, but lately others are finding this site and sharing it with their groups and trading friends. I really appreciate it when readers of this site find it helpful enough to copy a link from this site and share it with others. People seem to like the pages I have on my favorite trading strategies. I hope that you find some community here as well and find content worth sharing. Your comments are always appreciated, even it is a pain to leave them. It’s a challenge to have a site like this that doesn’t get nailed by spammers and hackers, so I have to put up some hurdles to allow comments.
Remember, the whole point of this post is to give you ideas about connecting with other people who understand the kinds of struggles you face as a trader, and give you a chance to give back to newer traders. Discussing trades on social media is the only place where I can discuss the merits of 20 delta short strike on a wide put spread, and know that most of the people reading will not only understand, but have an opinion to share back with me. That won’t happen at the next neighborhood block party. You aren’t crazy. There are people out there that get what you are trying to do and will be happy to have a discussion about it. You just have to know where to look. That’s the power of community, even when your community is spread around the world.
I hit a milestone trading the broken wing butterfly strategy, passing 500% return in one year.
In June I hit a milestone trading the broken wing butterfly strategy, passing 500% return in one year. I learned the basic concept from Nick Batista and Mike Butler of TastyTrade.com. I was so pleased that I wrote the following note to Nick and Mike:
BWBF Success 500% in a year
Nick Batista/Mike Butler-
I’m writing to thank you for introducing me to trading broken wing butterflies.
A few years ago, you guys turned me on to the concept of Broken Wing Butterflies. I played around with the concept and settled into a trade that I was able to repeat over and over. Last June I set up an account with $9,000 trading only butterflies. Earlier this year I added Broken Heart Butterflies to the mix, because my strategy was a little susceptible to big drops. Not really sure why I have kept a single strategy in this account, but I’ve just kept going with it. After a year, I’m now at $54,000, which is 500% above where I started. I’m “only” up 119% this calendar year as I’m carrying around 50% cash most of the time to have for fighting downturns.
I played with this trade for over six months until I settled on this strategy in early 2020. I realized that butterflies hold value until expiration is close, so I adjusted this to a 21-day trade. I also wanted to make the trade worth my time, so I collect a lot up front. And I realized that hitting the high profit butterfly butterfly was close to impossible, so I just hold to get my premium collapse, which is much faster than a simple spread with the same risk.
typical setup of a broken wing butterfly trade (negative premium = credit to open)
My butterfly strategy is to sell two of the 25 delta puts and buy one a strike or two above, and buy the one twice as far below. I sell these 17 to 21 days before expiration and collect 12-18% of the width of the narrow spread or max risk. I close when this gets to 2%, by converting to a free butterfly. This works around 90% of the time. I was doing this in several accounts last year and had over 100 wins in a row at one point, making 10% in two weeks, over and over again. Eventually, I had some tests where I sell the debit side and roll the credit side, often for a debit. As long as I have cash to fight, I can hold out. I then wait them out for recovery.
Adding the Broken Wing Condor
I noticed that my tests were more likely when the market was going crazy up, hitting new highs every day and then a correction occurs. So, I was attracted to the broken heart butterfly in those situations for a little more probability, but less benefit. I think it is actually a broken wing condor, but whatever. For that trade I buy a 40 delta put and sell the one a strike or two below, then sell a spread three times as wide centered around 20 delta. I try to collect 6-8% of 2/3 the width of the wide spread (max risk). I open this up 14 days to expiration. Because of how this setup decays faster on the credit side, I target to collect 1-2% on the close. So I collect about 7% to open and collect another 1% to close. I can make a little more if I’m on the verge of being tested with 2-3 days left to expiration. Worst case, I sell the debit spread and roll the credit. I think I’ve only had one or two of these need to be rolled. I’m all about return on capital, so I look to make at least 10% a month on any short option strategy I do, while keeping probabilities very high.
All in all, I’m happy with how this is going and continue to watch Tasty for new tidbits every day. I especially like your show, because you are all about trade mechanics- what works and why. You also seem to venture out from standard Tasty style trades and look for creative ways to think about opportunities. Your discussions on leveraging skew and other unique situations are very insightful. Anyway, I just wanted to let you know that what you do is really helpful and that your approach to trading has given me tools to keep experimenting and try new things that have ended up being very successful for me financially.
Thanks so much-
(I received a nice note back from Nick)
If you want to see how I set up broken wing butterflies and how they work, go to the page I wrote on it here.
The basic 7 DTE trade is that I sell a 40-50 wide spread one week out at 10-12 delta for the short strike. I usually collect over $1.50 in premium, and I try to buy it back 2-3 days later as part of a roll for something under $1.00, usually by collecting around a dollar in a roll. For the most part, I roll the position every Monday, Wednesday, and Friday.
Since early January 2021, I have been trading a continuously rolling 7 DTE put spread on SPX. I finally took time to separate the data for this trade from my other trades to show how well it has worked. I’m averaging greater than 6% per week return on capital. The basic 7 DTE trade is that I sell a 40-50 wide spread one week out at 10-12 Delta for the short strike. I usually collect over $1.50 in premium, and I try to buy it back 2-3 days later as part of a roll for something under $1.00, usually by collecting around a dollar. For the most part, I roll the position every Monday, Wednesday, and Friday. No matter what happens, I roll and try to collect additional credit.
Said another way, I’m in a trade for a couple of days and collect about 2% on average for the effort. For example, a 50 wide spread collecting a net $1 on a roll has collected 2%. The profit comes mostly from time decay (Theta) and somewhat from upward price drift.
What is a roll?
For those not familiar with rolling, it is a trade where one position is closed while a similar trade with better profit probabilities is opened all in the same trade. In this case, I might buy back a position with 5 days left to expire for $0.75 and sell a similar position with 7 days to expire for $1.75, a net credit of $1.00.
Managing when the market goes down
Most of the time (76%), the trade wins outright and I close for less than what I sold the spread for. When the market goes against my position, I roll down and out as much as possible while collecting more premium.
In the few events where I end up in the money, I use debit rolls to reposition out in time at lower strikes. In this situation, I may pay more to close my 5 DTE position than I receive for opening a new 7 DTE position. The idea is that SPX will eventually turn around and the roll won’t cost that much if I stay within a reasonable distance. I’ve used this technique on many put positions last year during the Covid crash and now on this trade. Since the trade should generate lots of credit most of the time, I’ll take the risk of a total blow-up, and use profits to protect the position however far is needed. Probably not everyone’s cup of tea, but it’s my plan- roll, roll, roll, no matter what. I don’t know where I would want to set a stop for this trade- it’s defined risk, and rolling gives me the possibility and probability of full recovery, eventually.
Historically, 98% of my rolls with this strategy are for net credit, and only 2% are a debit. That’s a lot more cash coming in than going out.
Why does this work?
The general concept is that this trade is selling a spread that starts with about a 90% chance of expiring worthless. Essentially, it would take two expected moves in the full time-frame of the trade to put the short strike in the money. It also decays quickly and approaches zero well before expiration in the majority of the time. So, my expectation is that most of the time I can get around 1/2 of the premium collected to decay in about 1/3 of the time to expiration, then get out and do it again. By always being in the trade, I take advantage of the fact that time is always passing, which is the only sure thing with options. Being two expected moves away to start allows the position to filter out a lot of noise and still make money without a lot of stress over where the market is going. When we get the expected move down, the position is still in good shape because that’s only half-way to the short strike. By rolling down and out, we can re-establish further away from the money and still collect a credit. Even several down days in a row can be absorbed, as this happens somewhat regularly. My experience is that defensive rolls work out back to a full win without getting in the money 80-90% of the time. To be really problematic, it takes a move of over 5% down in less than a week that doesn’t recover at all to move the position into the money. I’ve been in survival mode several times with this trade and recovered fully each time. I expect that there will someday be a scenario where I can’t roll enough to recover, but I have saved back cash reserves to allow starting over if that time ever comes.
On the other hand, this trade generates 4-6% return on capital per week most of the time, so it should double its value in about a five-month time frame if there is not a major drawdown and even with no compounding re-investment. I’m not sure how to calculate the probability of a winning week, but I’m pretty sure it is well above 90%. The probability of an in the money scenario is likely in the 2% range, and I expect this scenario a few times a year, with a position that drags out without recovering for over a month happening in the once every few years timeframe.
I’ve adjusted my mechanics a few times during the time I’ve been trading it. I started this the second week in January, at 100 wide and switched to 50 wide contracts when I realized that the extra width wasn’t gaining much, and was extra risk and extra buying power. I’m now trading 40 wide. I’ve gradually gotten more methodical in my approach, although I’m still not that rigid. Originally, I was selling 4-5 DTE and rolling 3-5 times a week. Since I switched to 7 DTE, I’ve found the trade much less time consuming with more premium and time cushion, but slightly less decay. However, the concept is the same- sell way out of the money put spreads and roll out every two days or more often to collect additional premium.
Why SPX?
I trade SPX only for this, and I think it is perfect because it has less price swings that almost any other underlying, and it is big enough that the commissions/fees are negligible. I tested RUT and NDX and found them to be too volatile for my taste. I’ve tried SPY, but I find it hard to get filled near the mid-price on my rolls, and commissions are a much higher percentage of the trade. I got the original idea from a post in a Facebook group last December, and tweaked it until it fit with my style. There are a lot of ways to vary this, but this strikes me as a nice way to trade fairly near to expiration options with a high probability of success without a lot of drama. I know several people who now also do their version of this trade, some using stops, some getting in and out based on the market, some using technical indicators to inform their decisions.
Results summary
The sheet at the end of this post shows each individual trade. At the first of the year, I showed trades that I rolled out that were losing by their cost basis to me. So, if I sold a spread for $1.50, bought it back for $2.10 and sold the new position for $2.50, I would show closing at 1.50 and opening the next trade at $1.90, my adjusted new cost basis. In June, I decided that this wasn’t very transparent, so I switched to showing the actual closing cost and opening sales price when I have to roll out on a tested position. Either way, these were my actual trades. I think that is easier to see how the trade works when the market is challenging. I’ve scaled up the number of contracts I trade, but for simplicity, I’m showing just one contract. The dates are the expiration date of the position- I don’t track which date I actually roll.
When I charted this out, I was surprised to see how consistent this trade has been in accumulating profits. Keep in mind that my results are just for the trade, and don’t take into account having cash on the sidelines to use for defense if the trade goes into the money. My goal in this trade is to consistently generate cash as time passes by, and for the most part that is what has happened.
My results for this trade are in line with these expectations so far. In over 8 months, I have made money every single week on this trade except three, which is amazing to me, considering that the market had a few weeks where it really trended down. In the first four months of this trade I doubled my money. While this is the most consistently profitable trade I regularly do, I only use a small portion of my capital with this trade due to the tail risk from a major crash.
I hope this explanation and the data attached helps you understand this trade a little better. As you all know, this is one of several trades I do. I thought this would be of particular interest, especially considering how well it has worked. I’m very aware that there is considerable risk in this trade, despite its high probability of success, and that even in the majority of times significant volatility to the position can be expected.
I’ve shared this trade in a number of other forums and received a lot of questions. Here are some common ones:
How does this compare to 0 DTE?
One reason I started this trade was that I wanted an alternative to the 0 DTE or expiration day trades that I see a lot of people doing. I tried my hand at these using stops, and I would have long strings of wins followed by a big loss that I couldn’t get out of in time. It was very stressful to me, and most importantly, I wasn’t making money for all my effort. When I came across this concept, I saw that I could use many of the same management techniques, namely rolling, that I use in longer duration trades, and avoid expiration day stress.
Where does 4-6% return on capital per week calculation come from?
A couple of ways to think about this. I’m making at least three trades a week with this strategy. Each trade has an average profit of around $0.80 per share, or $80 per contract. The capital at risk is the width of the spread, $40 per share, or $4000 per contract. Either way, that’s 2% profit for the capital at risk. With three trades a week, I total up to 6%. I could just as easily say 25% per month, or 100% per quarter, but that is less intuitive.
Why not use stops?
I know a lot of people are big fans of stops. They prevent losses from getting out of hand, which in many situations is an absolute necessity. Stops also eliminate the possibility of a position recovering. My view is that market movement is mostly random up and down, and my experience with stops is that I often get stopped out right before the market reverses, locking in a loss that would have been much less if I had stayed in the trade. As a result, I prefer to find ways to extend out the trade on positions where I have a reasonable expectation that the position will recover in a reasonable amount of time. With the S&P 500, this has been a very reasonable expectation, especially if I can re-position my strikes down while collecting more credits in the process.
Advantage of defined risk over naked puts
I know that many people are big proponents of selling naked puts because there is more premium per contract than with a spread. However, naked puts take more capital in most situations, and have undefined risk. Because a spread requires less capital, the return on capital can be much higher. Having defined risk through a spread, provides a floor for the trade that prevents the possibility of completely blowing up an account with an outsized black swan type loss event. For those reasons, I avoid selling naked puts, and instead sell credit spreads. One caveat is that if a naked put is sold cash secured, the risk is reduced to market risk and can never blow up an account- however, returns will be a small fraction of trading a spread. It’s all trade-offs and a matter of strategy preference.
Are these three trades at once or one?
I trade this with just one position, opened and closed three times a week or more with a roll. For example, each Monday I close the following Friday position 4 days out and open a position for the following Monday 7 days out. Then, on Wednesday I close the Monday position 5 days out and open a new position for the following Wednesday 7 days out. Then, on Friday I close the Wednesday position 5 days out and open a position the following Friday 7 days out. I just repeat over and over. If the market jumps up somewhere in between rolls, I may choose to roll to higher strikes in the same expiration for an extra credit.
Why not hold to expiration if the odds are so high?
The strikes I pick decay quickly, and I expect the position I roll into to decay more than if I had held the position I closed. This is why I can make $3 in a week with a position that sells for $1.50 to $2.00 to open on average. By rolling to a new position, I make better use of my capital. Also, rolling early gives more flexibility to manage compared to positions that are closer to expiration.
What time of day is best for the roll?
I’m still trying to determine when the most profitable time to roll is. I don’t believe time of day is as critical as the action of the market. Ideally, the IV of the strikes at 7 DTE are much higher than those at 5 DTE to maximize the difference in premium. But when is that most true? What triggers that situation? It appears to be a mix of variables that I haven’t yet been able to model or pin down. My tactic is to monitor the net credit available throughout the day and trade when I can get what seems high based on my previous experience. So, it is more art than science, which is never my preference. Alternatively, I just put in the trade when I have time, knowing that time decay generally works out so that no matter what credit I get to roll, it will average out in profits in the end. I’m not convinced this is optimal, and I may be leaving some return on the table. This is an area I continue to study.
What strike do you roll to? Always to 10-12 delta?
Ideally, I’d always roll to 10-12 delta strikes if the market were constantly grinding higher. However, the market varies and sometimes goes down and rolling to 10-12 delta would require paying a debit to achieve. My strategy is to collect a credit to roll whenever possible. So, if I can roll to an ideal short strike in the 10-12 delta range for a credit, then I do it. If I can’t, then I roll to the lowest strikes I can while still collecting a credit. This causes the delta value to drift when the market is in a downturn with an expectation that eventually the position will work its way back to the ideal delta values. Because we work from values so far away from the current price, we can afford to drift closer from time to time, knowing that the probabilities still favor the position decaying.
What about bear markets?
I don’t know when we will have a bear market. Obviously, if I did, I’d get out of this trade to avoid losses and get back in at the bottom. Lots of people predict crashes, and if you predict a crash enough times, you’ll eventually be correct. I’m not naïve, I know a bear market will come some time. But since I can’t predict it, I’ll deal with it when it or a significant correction comes. I’ll use the mechanics I’ve described for this trade, and fight to make a profit with defensive and survival rolls. Remember, in down markets the strategy is to aggressively roll down strikes, improving the probability that even a modest recovery will lead to a profit.
Is there a scenario where this trade could be a total loss?
Sure, this is a highly leverage trade, and as such a fairly small correction could put this position deep in the money and marked for a near total loss. Any number of events could trigger a sudden drop in the market- for example: a surprise Fed announcement, another unexpected financial crisis, a natural disaster, a military or terrorist action against the US or US interest, or another pandemic. Most situations would progress slowly enough to allow this trade to be adjusted and rolled out and down, but some could be so sudden that there would be no action that could be taken. After 9/11 the market was closed for several days, and opened way down when it did open. Is it possible that the market could be closed for the life of a contract? Absolutely. I’m sure there are numerous scenarios for total loss that I can’t anticipate with this strategy. The only thing I can do is be prepared that a total loss won’t ruin me financially because I keep cash on hand as an ultimate hedge.
How much do you scale up your position to compound profits?
This trade can provide a lot of cash. I see three ways to use the cash that is generated. One is to take it as income. Another is to save it as a buffer for when the market requires a survival roll for a debit, or even a total loss. And finally, cash profits can be plowed back in to increase the amount of contracts traded. So, how much to use for each purpose? It depends mostly on how much income you need from the position. I know that taking income distributions means that money can’t be used to build the size of the account. But, I take out what I need to. With what’s left over, I have a simple rule. I want as much cash available in the account as is required for the strategy. For example, in a $40,000 account, if I have $20,000 capital required for five 40-wide spreads, then I want to have $20,000 cash buying power available and not used. If the account grows to $48,000 balance, I can add another contract- that’s another $4,000 at risk and another $4,000 cash buying power sitting in the account. Effectively, this cuts my portfolio return in half, but with compounding from scaling up, the portfolio would theoretically
These returns seem unbelievably crazy. Are you making this up?
These results are actual trades I’ve done. I don’t know what will happen in the future, but this trade has worked well so far. There’s no guarantees, and past performance does not predict future results. This trade has substantial risk, and potential for big rewards.
Can I see a log of this trade over time?
Sure, here’s eight months of raw data:
2022 Update-
As we moved into 2022, the market changed dramatically. 2021 was a very calm year with no downturns in the S&P 500 of over 5%. However, with inflation growing and the Federal Reserve taking action to tackle inflation, the market became much more two-sided and essentially bearish.
So, for this trade, I have adjusted to sell both sides of the trade, puts and calls. Instead of a credit put spread, I now sell an Iron Condor. I aggressively adjust my strikes up and down with each roll now, using credits from moving the untested side rolling toward the current price to pay for debits if needed to roll the tested side away from the current price. This has reduced volatility of my positions and made the trade manageable in this near bearish environment.
The other change that I have made is taking advantage of Tuesday and Thursday expirations. With expirations every day, I can move my positions out to 7 DTE every day, allowing regular adjustment of my strikes while rolling out each day.
Combined, I feel like I have more control managing my 7 DTE positions in a volatile market. Results are looking positive with these changes and I will update when I have enough data to show. Once the Federal Reserve is done tightening the economy and switches back to stimulating, I will likely switch back to puts only or some hybrid that goes in and out of calls.
Generally, there is a way to roll any option position to a new more favorable position and even collect a credit, if more risk is taken on. This may mean converting a $10 wide spread to a $12 wide spread and collecting $0.05, but improving the the possibility of profit.
Every good option trading resource says that a trader needs to have a good management plan to avoid big losses. Usually this is followed with vague explanations of setting mental stops and adhering to them. I fully agree with this, except that I believe a trader shouldn’t have vague plans. When an option trader opens a trade, the trader should know what conditions, good or bad, will necessitate an exit. And a system like that will work great until it doesn’t, like maybe during a coronavirus outbreak.
Most of my option strategies involve selling defined risk credit spreads that I enter with many weeks until expiration. My plan is to exit every position 2-3 weeks before expiration, buying back the spread for less than I paid for it. For each strategy, I have a target profit to exit, and a loss limit that I use to get out.
But, sometimes a good plan just fails. What should I do if the market drops 5% overnight and my options strikes were 2% below yesterday’s close? I can wait for a bounce back, which once I’m underwater makes sense if I have time to wait. With my approach, I usually have time. But when a 5% drop becomes 15% or 25%, it’s pretty clear that the odds are I’m not going to see my spread get anywhere close to getting out of the money. This is one of several desperate scenarios I’ve found myself in, not just the past month, but other times as well.
So, what is there to do? Most professionals will say to take the loss and start fresh. If the position is a total loss and hopeless, just leave it until expiration and hope a miracle occurs. All the capital is gone. That’s probably sound advice, and if anyone asks what they should do, that’s what I’d say. But, that’s not always what I do.
Against all advice, and probably all probabilities, I will take a total loss and roll it into something else that has a better chance for success, but increases capital at risk. To repeat, I add even more capital at risk to try and salvage a bad situation, perhaps making a bad situation worse. If that just freaks you out to think about it, just stop reading and move along. Options involve risk, and these approaches might be called risk squared.
If you are nutty enough to still be with me, let me explain. More than most investments, options truly balance risk and reward. Or maybe it is more like a balance between probability of profit and potential reward. Most initial strategies I open have a high probability of profit, but a somewhat limited reward. Those strategies therefore have a dark side, the potential for big losses a small percentage of the time. More often than I should, when those losses happen, I choose to fight to get my money back, because the odds are somewhat switched the other way- I hope to get a big return on the additional capital I add to the position by recovering much of my loss.
Here’s a quick example of a credit/bull put spread. Let’s say I sell a $10 wide spread and collect $1 premium. In real money, I’m risking $1,000 to make $100. Since I collect $100, I’m really only risking the other $900. The odds are probably around 90% that if I hold the spread to expiration, the options will expire worthless. Or I probably have a 95% chance of being able to buy back the spread for $0.50 or less around halfway to expiration. I like those odds. (The odds are actually better, but that’s a different topic.) A few months ago, I did a trade like this over and over, and won 26 times in a row, each time keeping way more than half of what I collected. That’s great, but this post isn’t about the good times, it’s about that 5%, 10%, 20% or whatever percent that things don’t go as planned.
When a trade like the one above has the underlying equity drop in price many times more than the expected move, the position sits at max loss. So, the above $10 spread would sit with a value of $10, a cash value of negative $1,000 in my account. When this happens, it usually happens to a lot of positions at once, even if the portfolio of options is well diversified in every way possible.
Here’s what I do for this situation.
Plan A- get out
First, I try to get out before it gets this far- plan A. In a slow moving market, this is often possible, and I lose something like 1-2 times the premium I collect, but keep over half my capital. When I can, I do this, but there is downside to this practical strategy. Often, underlying prices fluctuate a lot and a position will show a loss, but then turn around for a profit. There is a whole statistic around this, the probability of touch. Read about it in my Greeks section of the website, under Delta. Suffice it to say, if I’m too quick to take a loss, I’ll take more losses than I should. So, the more time I have, the more leeway I give the position to recover. And when there isn’t time, I aggressively get out to preserve capital. In slow moving markets, that works, and it’s the smart trade.
Plan B – wait and see
When the market moves quickly against me and just blows through my strikes, I can continue with plan A and take a bigger loss, but assuming I’ve lost 80-90% + of my capital at risk, there isn’t much capital to preserve. At this point, closing locks in a huge loss to save a small amount of capital, or I can wait and potentially get a big chunk of capital back. Since I trade in a timeframe of several weeks, I like to take time to evaluate the situation. This is a luxury compared to day-trading options that are at expiration. The first question I ask is, how likely is the trade to turn around in the time left on the option contract? If the issue that caused the price drop appears temporary with the possibility of recovering by expiration, then it makes sense to do nothing but wait. If the issue behind the drop is continuing to make the underlying price drop, I will also wait to see how bad it gets before acting, even though that likely guarantees that the position will move to max loss. I wait, and I evaluate options.
Plan C- roll down and widen the position
When a position looks hopeless, I can either give up or do something about it. Generally, there is a way to roll any option position to a new more favorable position and even collect a credit, if more risk is taken on. This may mean converting a $10 wide spread to a $12 wide spread and collecting $0.05, but improving the probability of profit, or more accurately the possibility of profit.
Recently, I had a chance to do this when more than one put spread was blown out by the huge market drop from the coronavirus. Here’s one example. I had sold SPY puts spreads with strikes of 310 and 305 when SPY was trading at over 330 in mid February this year. I like to think of the trade in terms of Delta values. The 310 strike had a Delta of around 18 and the 305 was around 10. That is the sweet spot for me to open a put spread, and I collected $0.75 per share. Expiration was set for late March with a plan to get out in early March. However, the market dropped rapidly, due to the coronavirus, and SPY was well below 300 in a matter of days, and below 275 a week later. By that time, Delta values were between 80 and 90, and the spread was trading between $4.50 and $4.75. I was hopeful that maybe this was temporary, so I waited. When the price of SPY dropped to below $250 on a huge sell-off day, I rolled the spread down to 275 and 267.5 with an April expiration, and collected $0.03, and now increased my capital at risk. I thought more time would allow me to get out, even though my Deltas were still over 75. Unfortunately, the market kept going down. A little over a week later, SPY dropped below 220, and I decided to act again, rolling down to 240 and 230 for another $0.05 credit. Still, Deltas were over 75. Then the market went up, a lot. When SPY went over $250, the Deltas were under 30, and the spread could be bought for $2. I bought it back. In the end, I lost $1.18 premium per share. My original position would have expired a $4.25 loss. I could have rolled out and down again to get a chance at an actual profit by May, but I really wanted to free up capital with the market up. A few other similar positions were rolled down and out further using the freed capital, and maybe they’ll end up a profit. The point is, this position was set up for max loss, and by aggressively converting through a risk-adding roll, the loss was significantly reduced.
A few things I consider when I do this. I try to roll down underwater put spreads on big down days. This may seem counter-intuitive. If I’m at max loss and the market drops more, my position doesn’t actually change much. A $5 wide spread might go from a book value of $4.85 to $4.90 on a $15 underlying drop. I could then roll down the spread $15 for a small debit, or widen the spread to $5.50 or $6 and collect a small credit. I usually play around with different possible rolls, both on the same expiration date and later dates. If I can get more time for not a lot of extra cost or capital risk, that is preferable, since I’m waiting for a recovery.
Indexes vs. Individual Stocks
I also tend to do this more with equity index ETFs than I do with individual stocks. There is a lot of historic examples of markets bouncing back from big drops, even if the bounces are temporary. Individual stocks have more complexity in that they may or may not follow the rest of the market and have their own unique issues that drive their price in unique ways. My goal in a desperate situation is to use big declines in market value to reposition my option spreads to be able to get out of the money when a bounce occurs. I’ve just found that indexes are more likely to accommodate that strategy.
Spreads partially in the money
I want to differentiate between a spread that is fully in the money and one that is partially in the money. When I have a credit spread where both the short and long options are in the money, then I’m fully in the money, and max loss is a real possibility. When only the short option is in the money, but the long is still out of the money, I’m likely only sitting with a premium value of around half the width of the spread- $2.50 for a $5 wide spread, so the position is partially in the money. When a position is partially in the money, I have a couple of active choices, close before I lose the other half, or roll out for additional time and a credit. If the underlying price is actually closer to the short strike than the long, I can almost always roll out to a later expiration date with the same strike prices for a credit, and I may be able to roll down or narrow the width for less credit. The point is there are more positive choices that don’t add capital risk when a spread position is only partially in the money.
Naked put considerations
I also want to point out that these types or rolls are for credit put spreads, not naked puts. If you sold a naked put and you are in the money, the only choice available to avoid a loss is to roll out in time. The good news is that it is almost always possible to roll to the same strike price at a later date and collect a credit, something that isn’t true with a spread. The bad news is that there aren’t really any other choices. A naked put has undefined risk, and if the underlying price keeps dropping, the losses keep adding on.
Reverse an early assignment
When positions get deep in the money, the risk of early assignment grows. Assignment is when an option buyer exercises the option before expiration. Since we are talking about market downturns in this post, this is when a put buyer makes a seller buy the underlying security. Because I try to close or roll positions well before expiration, I don’t get assignments very often. But it can happen, and when it happened the first few times, it can be very troubling. I woke up one day and found that I had bought $500,000 of SPY, and also had an accompanying -$500,000 cash balance due. Before panicking, remember that a spread has an equal amount of long contracts to the amount of contracts that were assigned. If I had 20 short contracts assigned into 2,000 shares, I also had 20 long contracts still sitting in my account. When I get an early assignment, it usually means I get a negative cash balance in my account, and I can’t make any other trades until the assignment is adjusted in some way. There are a number of choices on how to get out of this and either not lose any more, or even reverse the situation and roll into a position to get some of the losses back.
The simplest thing to do would be to just sell the shares, which would likely get the cash balance back positive, and eliminate all the new shares. However, if the assigned shares are sold by themselves, the link between their value and the long options hedging them is broken. What link am I talking about, you may ask?- I don’t have a spread anymore, I have shares and long options. The link is that the shares were bought at the short option strike price. Let’s say I have a $5 wide spread, short a $250 strike put, and long a $245 strike put. If one contract is assigned, I buy 100 shares for a total of $25,000. But the assignment was because the underlying security was trading for less, say $225 a share. If I sell the shares at the market, I’ll only get $22,500 for them, a loss of $25 a share. Didn’t I buy a $245 put for some reason to help with this?
Another transaction I could do would be to sell both the shares and long put at the same time. Most likely both are well in the money. If that is the case, I could sell the combination and lose no more than the difference in strike prices. In my example above, I would make at least $24,500 to sell the combination of shares, because the long option price would be relative to the underlying price. For example, if the underlying price is $220, the long option would be worth $25, and the sale of the combination would be $245 per share, or $24,500 cash. If the underlying price was closer to the strike price, the sale might make a little more if there is time value in the long option.
My experience is that puts that are exercised early usually are exercised at very near the low of whatever is going on, say after a day when the market was just devastated. If the shares are sold alone and the long put is held onto, the market is more likely to go up and eat away the value of the long puts, which locks in the oversize loss. I’ve done it myself, but I don’t do it anymore. Instead, I look for ways to reset my position without losing a hedge.
An easy way to reset the position that was in place before an assignment is just undo the assignment- sell the shares and sell the same put that was assigned. So, if a $250 strike short put was assigned, just sell the assigned shares and re-sell the $250 strike short put. Likely, the sales price will be just under $250 per share total, maybe $249.90- just under due to the bid-ask spreads of each leg and any remaining time value in the option being sold. For example if the underlying was trading at $220, the shares would well for $220 and the $250 strike option would sell for just under $30, at total of just under $250. So, the total cash received would be just less than the $25,000 that was required to buy the shares. And we’d basically be back to where we started before the assignment, less a tiny amount of pricing spread and maybe some time value in the option. The problem is that since shares were assigned the previous night, they might be assigned again the next night, and the we’ll be right back in this mess again.
Here’s one more choice- let’s reverse our position at a different price and different expiration, a four legged trade. Some brokers allow this to be done as one trade, but most will require this to be done in at least two separate trades, which is fine. The plan is to sell the newly assigned shares with the remaining long put, and then open up a new spread that is more favorable, like we could have if the short option hadn’t been assigned. Using the example, we’ve been using with our $250/$245 spread with the $250 short strike assigned to us, we’d sell the shares and the $245 strike long put for about $245 a share, or a total of $24,500 cash. Then we sell a new put spread closer to the money, and maybe a bit wider to collect a $5 or more credit per share or $500 total per contract. After all that, we have a position more likely to get out of the money with more time, albeit with a bit more capital at risk.
Conclusion
So, when the market trashes a put spread, there are ways to recover, even if there is an early assignment. I try to pick the least bad of several terrible choices. Some ways are more complicated than others, but desperate positions may lead to desperate measures.
Final disclaimer- this information is just information, and not my advice. Trading options involve significant risk, often multiple times the value of the initial trade, and every trader has to understand and consider the risk of a trade for themselves. Every situation is different, and there is no correct answer for every situation. Adding addition capital to a lost position can likely lead to loss of that capital as well.
