Tag: theta

1-1-2 Put Ratio Trade

1-1-2 put ratio option spreads are a very high probability trade. The 1-1-2 can be very profitable for sophisticated traders using margin. This trade has very high tail risk for extreme market moves.

I’m a big fan of front ratio type trades. I’ve written about my success with Broken Wing Butterflies and Broken Wing Put Condors. Taking this to a new level is the 1-1-2 Put Ratio trade. This is a new level of ratio trade, because it features naked options with a buffer of protection from a debit spread. The idea is a bit complex to grasp at first, and this is a trade only for traders that have a deep tolerance for risk. The trade involves buying one put and selling a total of 3 puts further out of the money to collect a net credit. Theta makes the value decay quickly, and over time, the purchased put can protect the short puts from most market moves.

I’ve written a separate post on the defined risk version of the 1-1-2 trade, the 1-1-2-2 Put Ratio, while the Broken Wing Put Condor, or 1-1-1-1 is a defined risk version of the 1-1-1, another ratio trade that is very similar. I don’t know of a named reference to a bird or insect for this trade, so I’m sticking with 1-1-2, although I’ve heard some liken the profit curve to that of a whale with a big profit hump and long tail.

I picked up the concept of this trade from one of my favorite traders, “Sweet Bobby” Gaines, who I have mentioned previously in at least one other page on this site. Bobby is a big proponent of the 1-1-2 trade, and has posted numerous videos on it on his YouTube channel, including his recent rising star appearance on Tasty Live. But really, these trades are the next level of evolution moving from broken wing butterfly to broken wing condor to “one louder” as they say in the mythical group Spinal Tap.

What all these trades have in common is selling an out of the money debit put spread, and financing by selling further out of the money puts. The combination delivers a net credit, but also sets up an interesting dynamic of extra rapid decay of the premium involved. The farther out puts decay faster than the closer debit spread, and often lead to the debit spread having more value than the farther out of the money put. This trade takes in a credit to open, and can possibly take in a credit to close. At least that’s how I set them up and manage them.

All these trades are a variation of a front ratio spread, where more options are sold than bought with hedges added to define risk. I’ve also written about back ratio spreads where more options are bought than sold. Front ratios are designed for maximizing decay, while back ratios set up multiple long positions paid for by a costly short position. So what is a 1-1-2?

1-1-2 Basic trade setup

The 1-1-2 takes this a step farther than the broken wing butterly or condor, because we use two puts very far out of the money to pay for the debit spread. The 1-1 part is buying a put around 25 delta and selling a put around 20 delta. The -2 part is selling two puts at around 5 delta. The goal is for the 2 puts to sell for about twice what the 1-1 debit spread cost. I like to set these up with 50-55 days remaining to expiration, quite a bit longer than the other ratio trades I’ve discussed. The added time allows the naked puts to be extremely far out of the money, while still having some meaningful value. I know other traders that go out even farther to over 100 days to get the strike price of the two very far out puts 25-40% below the current underlying price. Like all trades, it’s a matter of personal preference once you know the trade-offs.

What is the advantage of this setup? Well, because each of the two short strikes are further out, we greatly improve the odds of being profitable, and increase the initial rate of decay of the total position. We end up with a big gap between the debit spread strikes and the two short put strikes. Lots of good things happen with this setup. The biggest upside is that there is no upside risk- if price goes up, the trade makes money. The downside of this trade is that it can consume a lot of capital and has significant tail risk, which we will get into before we are done. Let’s look at a typical example.

The 1-1-2 setup is similar to the 1-1-2-2
The 1-1-2 trade has two naked puts sold short, but way out of the money.

While this table shows the risk as unlimited, it is actually $618,855, the value of two 3100 puts if SPX went to zero by expiration ($620,000) less the $1,145 collected to start the trade.

Some accounts and some brokers require all trades to be defined in their risk. For example, retirement accounts generally aren’t allowed to use option margin and so any naked put would have to be cash secured. That’s why I’ve written the note about the 1-1-2-2 trade which defines risk to just over $100,000 with two even further out of the money long calls (which is still a huge amount). For this 1-1-2 trade, eliminating those two long puts would mean the max loss would go up to $618,855, assuming that SPX went to zero, while we are holding two short 3100 puts. SPX will only go to zero if we see modern society end, and in that case, we’ll probably have bigger problems than our option positions. But rules are rules, and so if you want to trade without the long puts in a retirement account, you would need $620,000 capital to make a likely $800-$1200, or less than 0.2% return in 55 days or less, probably not the best use of capital. We’ll discuss other alternatives after we review the details of the 1-1-2 trade.

The profit profile for 1-1-2 is similar to 1-1-2-2
The profit profile for the 1-1-2 is very similar to the 1-1-2-2 other than the virtually unlimited loss.

This chart shows how changes in the underlying price will impact the profit and loss of the trade. We evaluate at four points in time. The green diamond shows our initial position at 55 DTE, underlying price is $4000, and the P/L is zero. The curvy lavender line shows how price would likely impact the position with 35 DTE. The green curve shows the likely profit at 14 DTE, and the sharp purple lines are the expiration values. We know exactly what expiration values will be at any price, but the curves are estimates based on likely impact to implied volatility as time passes and prices change.

The first thing I want to point out in this example is that the 3100 short put is 900 points below the current price of $4000. For that strike to get in the money, it would take a 22.5% decline in the market in 55 days. That won’t happen very often. To be fair, this example uses values with VIX at 25, a historically higher than average value, but for the timeframe of 2020-2022, a fairly middle of the road level. The higher that implied volatility is, the farther away the short strikes can be and still collect meaningful premium.

The next thing to point out in the setup numbers is the Greeks. Delta is fairly flat at +4.5. For a credit trade, that isn’t much and means that the position can handle some movement in price. Theta is $94/day, and we collected $1145. So, the position is expected to lose 1/12 of its value each day. But we have 55 days, so how does that work? Quite well, I’d say.

Remember that our starting underlying price is $4000 and the trade is profitable at expiration as long as price is above 3100. The chart above doesn’t show losses all the way down to zero price, but just imagine zero price and -$618,855. Our probability of profit is 96% if held to expiration based on the Delta of 4 for the naked puts.

1-1-2 Trade Expected Move Analysis

I’ve put in dotted lines to show the expected move and multiple expected moves down. If you need a refresher, check my earlier post on expected moves. It is likely that price will end up inside of one expected move, the dotted lines on either side of the current price of $4000. There is approximately a 2% chance that price will move two expected moves to the second dotted line below the current price, which would still be max profit for this trade at expiration. And there is approximately a 0.3% chance of moving three expected moves to the far left dotted line. We can go further, but the odds keep dropping as we go to lower levels. However, as history has shown, moves down tend to have somewhat higher probability than theoretical probabilities once we get beyond two expected moves. The point is that this trade is very likely to end up profitable, but there is risk that an extremely big move down could lead to an extremely big loss. We’ll talk about ways to reduce exposure later.

Let’s look at this another way. Prices don’t generally move immediately to a new level, but have probabilities of moves that get bigger over time. Again, going back to expected moves, let’s compare how we might expect price to move during the duration of the trade.

Price expected moves
This chart shows expected moves day by day from initiating the trade until expiration, and compares to the put strike prices.

In this chart I’ve shown several outcomes. The zero move is if price doesn’t change at all, a baseline. I’ve shown a +1% move which is in line with the positive drift of the market. There’s also a line for the positive expected move and the negative expected move, where price is likely to be within at any point in time. And finally I’ve shown a curve for a price move of two times the expected move down. Notice where the strikes are relative to the price curves are. The negative curves take time to get below the upper 1-1 put debit spread strikes, and never reach even the short put of the 2 further out short puts. This chart also shows where two even further out long puts would be placed for a 1-1-2-2 version, but that’s covered in the post for that trade. For most people trading this strategy, defining risk with deep out of the money puts doesn’t provide a lot of protection as it is extremely unlikely that those puts would ever be in a position to reduce the level of a loss as this chart clearly shows. So, let’s not dwell on them.

Now let’s look at what happens to the value of our premium if price were to follow each of these curves. This is a view that you don’t see much because it is based on lots of assumptions for the pricing models. Since implied volatility is not predictable in the future, we have to guess how it will change if underlying prices change and how that will in turn impact prices. Based on how price changes have historically impacted implied volatility, we can have a decent estimate of how it will likely change with future price changes. I’ve used a model to take all that into consideration for these position value charts.

value vs time for 1-1-2
Most scenarios eventually show a profit with 1-1-2. Note that this chart shows position values, not profit. All values start with a value of -11.45 (the opening credit); the green shaded areas represent profit.

Looking at 1-1-2 values over time at the same price moves that we looked at for the expected move multiples, we can see that the premium changes are fairly dramatic and more positive as expiration approaches if the market is down.

Initially, this position collected $11.45 in premium, so we start with a negative or short value of -11.45. From there the price moves shown in the previous chart drive the premium up or down along with time decay. If price is flat or going up, premium decays and moves quickly toward zero premium. If the price goes down, the positive Delta pushes premium to more negative values. The price move of negative two expected moves really does a number on our premium initially, driving it down to below -40.

But, remember our profit chart at expiration? The flat and positive moves end up with a profit of our initial premium (all the puts have zero value at expiration, and the negative expected move and negative double expected move end up at maximum profit. Since our debit spread is 50 points wide, the negative moves would leave it fully in the money for a premium value of +50 points. And that’s in addition to the initial premium collected to open the trade. The challenge is that to get that max profit, we likely will have points in time where our position loses money.

The probability of getting to max profit is low because it would require a price drop between 6 and 22%. Based on our put strike Deltas we can estimate that we have about a 20% chance of that. Most of the other 80% is expiring with all strikes out of the money. So, it might be wise to zoom in and understand what happens with the vast majority of trades.

zoom in on 1-1-2 value over time
Zooming in on most likely outcome’s value over time

If we zoom in on the likely outcomes with the market being flat to up, we see that premium behaves very uniquely during the life of the trade.

If price goes up or drops less than 200 points, we can keep our initial premium at expiration. We may be able to collect more. The profit curve at 14 DTE is actually above the expiration profit if the price remains the same. How is this possible? Because the 1-1 debit put spread decays slower than the 2 naked low Delta puts, eventually the 1-1 part is worth more than the -2 part, even though the -2 part started out with twice the value of the 1-1.

I used this chart as the featured image of this post because I thought it best illustrates how this trade plays out most of the time. If you remember when we discussed the Greeks, I pointed out that Theta is very high compared to the premium. From this chart we see that if price stays the same or is slightly up, premium will decay to zero by 32 DTE, or just 23 days into the trade. This is an example that Theta isn’t 100% accurate by itself as it looked like 12 days of Theta should move us to zero value. From the chart you can see that the curve is fairly consistent for no underlying price movement as the value of the 1-1-2 position approaches zero, but still we have very rapid decay that I don’t think anyone can complain about.

Like all ratio style trades we have discussed, this trade has the possibility of switching from negative to positive premium. The difference with this trade is that it is actually quite likely, and as such we need to plan for it and manage our profit accordingly.

I’ve colored in the area under our three flat-to-positive curves with three zones each. There is a green zone where positive premium is growing, a yellow zone where premium is topping out, and a red zone where positive premium is being lost. Notice that the curve of the 1% up move and no price move are fairly close together, and that’s because the price movement is relatively close to the same compared to the other moves we are analyzing.

Let’s review how this happens. This trade essentially has two components, a slow decaying debit spread (1-1), and a fast decaying pair of deep out of the money naked puts (-2). The two naked puts decay faster because they are way farther out from the money, and have twice the value to start with than the debit spread. All these factors help decay happen more quickly. As long as the price stays fairly stable, this relationship will hold. Theta will be the primary driver of the premium value, and the low Delta naked puts will get to be worth less than the narrow debit spread.

The most likely scenario is that we stay inside the expected move and travel somewhere close to the no price move or 1% up move. Let’s realize that the market doesn’t move in equal amounts every day like this chart, so think of it as a smoothed out version of what premium would do. In the real world, premium would bounce up and down with price. However, if our price is close to where we started with 20 days until expiration, we would expect that the premium switch to positive has about maxed out, and it is probably a good time to close out the trade. Hopefully,your trading platform has a analysis feature that lets you look at your position and see how profits are changing day by day to help determine when the position is as high as it can go.

Without a chart, another way to determine how close the trade is to switching direction is to watch the position Theta. At the beginning of this trade, Theta was 0.942, or $94.16 for the full contract per day. As the trade progresses, Theta will decrease and at some point when the premium goes positive, Theta will turn from positive to negative. As it gets close to zero, that is the peak premium value. I generally try to exit the trade a few days before Theta is projected to turn negative. A big up day for the market could quickly change my very positive premium to not as positive premium, so it isn’t a time to get greedy.

So that brings us to the curve for the positive expected move. This is the curve that assumes that the price follows the one standard deviation move up. The good news when this happens is that premium decays very quickly because Delta and Theta team up. The not so good news is because the price move gets so far away from the strikes, the total position won’t get to a very high positive value. This is because all the options will drop in value quickly, approaching zero, and the upper debit spread won’t have much value. A big move up means that the probability of any of the strikes going into the money will be very low, so there is very little premium. As a result, it is likely we won’t be able to get out for much positive premium if any at all, but we will be able to keep most, if not all the premium from the opening trade. This is the least stressful outcome of the trade. If the price moves up faster than the expected move, premium will likely drop to very close to zero and may not ever go positive. So, if price is up a lot and the trade can be closed for a credit, I take the money and run. I’m happy to have a quick, winning trade.

As the trade progresses another helpful element is that Delta tends to reduce to zero or even become negative as time goes on if the underlying price stays close to flat. If a trader adds on many of these trades with different expirations, the overall position tends to be fairly low Delta and trades that have been in place for a while can buffer more recent positions. This is true until a really big move down hits and tests the naked puts. Then Delta grows quickly making losses pile up quickly as down moves continue.

The risky negative outcomes of the 1-1-2 trade

Looking at the position vs time value chart, there are two lines that represent what happens if price goes down. One is the move down one expected move and the other is down two expected moves. Interestingly, in this example, both end up at max profit by the end of the trade. So, it would appear that the trade can’t lose, which is far from true. Notice that these premium values may go very negative if prices drop quickly after opening the trade. This is because the narrow debit spread doesn’t pick up as much value from increasing delta as the wide credit spread does in a down move. We know that if price stays above our credit spread short strike at expiration, we will make money, but when price moves quickly down, it isn’t clear that price will level off.

So, as a trader, we are left with a choice when the market drops, We can take a loss and get out of the trade, or wait to see if the market quits dropping before it tests or violates the credit spread strikes. If we are a week or two into the trade, a decent down move will not make a huge impact, but initially the trade can take a big hit from a down move. The longer we are into the trade without a big down move in price, the less the risk is of a loss. On the flip side, a big move down opens the possibility of additional big down moves that can lead to a very big loss. We reviewed the odds earlier- about 4% of the time the trade will lose based on the far short puts having an initial Delta of 4. If this trade is done enough times, there will be some losses. Let’s look at some management actions that could be taken.

1. Set a stop based on premium price. In this example, we collected just over $11 premium to open the trade. So, we could set a stop to avoid losing twice ($22) or maybe even three times ($33) our initial premium. This would mean a stop loss if premium climbs to $33 or $44, given that $11 premium is our starting break-even point. This is the simplest risk mitigation strategy. Using this will lower the overall win rate as many negative scenarios would end up fine if not closed, but this management technique will prevent huge losses that might impact the account dramatically.

2. Close the trade if the underlying price goes below a trigger point. We know this trade has a lot of cushion. We can handle much more than one expected move and be profitable. But if the move is much more than expected, we have to consider that the move is very unusual and dangerous for us. Perhaps our point to get out is when the debit spread is in the money, or when we are half-way between the debit spread and two naked puts. Or maybe it is the strike of the short naked puts that is the final trigger to get out. The further down we allow price to go down, the more we stand to lose. Pick the underlying price where it gets too uncomfortable and use that as the trigger point to get out of the trade.

3. Roll out in time if premium or price triggers are hit. If the position is rolled, it can be rolled out for a credit. This gives more time for the market to turn around. However, it gives more time for a losing trader to lose more, because we likely can’t roll down much lower and still get a credit, and we will likely have to pay to roll the debit spread. If the price move continues down, there will be much less room to maneuver going forward.

4. Simply hold on and hope the probabilities play out. With 55 days in the trade, we just need to move down less that two expected moves by expiration. If the capital is available, and the conviction is there, holding can bring max profit with a big down move. Note that as time passes and the naked puts stay out of the money, the premium has to go away, so the value can evaporate very quickly with very high Theta as expiration approaches. This can be observed in the value vs time graph for the -2 EM curve. It can also result in a very large loss. As expiration approaches, the difference between max profit and a much bigger loss is just a few percentage points of price movement and the potential loss is much more than max profit.

In this example we can see that a move down of one expected move really doesn’t challenge our position, while two times the expected move is playing with fire. So, one approach might be to hold as long as the move stays within the expected move to the downside and switch to closing or rolling once the move exceeds that or some other multiple of expected moves. In any case, a trader has to know their risk tolerance and have a management plan for both winning and losing trades.

What about calls?

A logical question might be- if this works so great for puts, why not double up and do it for calls as well? Well, there’s one problem- skew. On indexes implied volatility is higher as strikes go to lower values and declines for higher strike prices. As a result, out of the money puts have higher implied volatility than out of the money calls. More importantly, far out of the money puts have higher implied volatility than puts closer to the money.

Look at our setup for this example. Implied volatility of the single long put is around 25, while the two short puts have implied volatility of 39. This helps two ways. The short puts have more of their premium tied to volatility, bumping up their price compared to the long put. Also, the higher implied volatility pushes the strike price further down to get a matching premium to the debit spread, making the trade a higher probability of success. We are selling more of the higher implied volatility and buying lower implied volatility, a key reason to use front ratio spreads.

A similar setup for a 1-1-2 call trade would reverse the dynamics. The long call closest to the money would have the highest implied volatility and the two short calls would have the lowest. To collect similar amounts to the put trade, the call strikes would be much closer between the debit spread and credit spread, and the difference in the deltas of the strikes would also be closer together, meaning a narrower window of max profit, and a higher probability of max loss. While still a trade with positive probability, it generally isn’t as attractive as the put side.

Buying power requirements for 1-1-2

I usually don’t spend much time talking about buying power because most trades I do are defined risk credit trades where the amount collected is a significant portion of the capital at risk. This trade is not so much, as it is a naked ratio spread (1-1-2). In non-margin accounts, we collect 0.2%, which isn’t much.

Below is an analysis of different possible ways to trade. I looked at trading each of these strategies three different ways. First, I looked at a cash secured account, like a retirement account. Next, I looked at an account with margin for naked options. Finally, I looked at a much different approach, trading futures options with span margin. The margin and span margin amounts came from entering this trade into the tastytrade trading platform. I’m also showing the defined risk 1-1-2-2 version for comparison as well.

Buying power differences for Margin and Futures
Comparing buying power impact of different account types for the two strategies

I highlighted some key takeaway points. First, is how leveraged span margin with futures options can be for this trade. Our most capital efficient trade would be doing the 1-1-2-2 on futures span margin where we would collect 100 times the premium as a percentage of buying power (20%) than the non-margin account of the 1-1-2 trade (0.2%). Of course, with leverage comes much more risk. I chose to consider a loss of 10 times the initial credit as a practical worst-case scenario. The span margin would end up costing huge amounts more in a disaster and could potentially wipe out an account if the trade used a high percentage of the account’s capital. Span margin isn’t static, when a trade moves against a position, the span margin is re-calculated and the requirements can quickly explode in a big market move.

A couple of weird margin anomalies to point out. In my margin account, the defined risk 1-1-2-2 trade required almost twice the buying power as the undefined 1-1-2, which is weird because clearly there is more risk in the naked 1-1-2. I think it may be that the calculation for defined risk is normally much less than undefined and the software may just assume that margin is not useful in defined risk. On the other hand, defining the risk on the futures version cut the buying power by 1/3. Different brokers may calculate their margin requirements differently, so don’t take this as universal truth. Similarly, remember that while defining risk usually increases the return on capital, it makes outsize losses more likely, especially when scaling up. Notice that the highly leveraged futures 1-1-2-2 would lose twice as much as a percentage of capital that the futures 1-1-2 setup in a 10x loss. I discussed this phenomenon in detail in my post on comparing risk.

Remember that margin and span margin change as the trade progresses depending on the market behavior. Span margin is subject to big swings when prices go against a position. A broker may force a position to close much earlier than a trader would want to get out due to expanding capital requirements. So, while initially the position is cheap to enter, a trader needs to limit each position to a fraction of the overall account size.

But the good side of this is that this trade can be entered for a very small cost. The trade is very high probability. We can also make more than the premium collected. I didn’t include it in the chart, but maximum profit for the most leveraged choice above would be $5,805 profit on $4,000 buying power, a return on capital of 145%. And there is over a 20% probability of that happening.

One final note on the buying power analysis table. To keep the quantities an apples-to-apples comparison, I used double the number of /ES futures options because futures options only control half as much value as SPX index options. So, technically, those futures options trades listed are 2-2-4-4 and 2-2-4 because they use twice the number of contracts to get the same notional exposure. I reviewed differences between index options and futures options in detail in my post about different ways to trade options on the S&P 500 index.

What about small accounts?

Readers looking at this may be thinking, “Gee, this is great for multi-millionaires, but what if the account is too small to consider any of these buying powers?” Great question- there are other alternatives. First off, a trader could use half the buying power listed by just trading options on one contract of the Mini S&P 500 futures (/ES). The 1-1-2 example would only take $6,000 buying power for $572 premium received. But, if that is still too much, we can make it a lot less.

Many traders are more familiar with options on the SPY exchange traded fund, which trades at approximately 1/10 the value of the S&P 500 index. For futures options, there is also options on the Micro S&P 500 futures contract (/MES), equal to 1/10 of the /ES contract size, or 1/20 of the size of an SPX option. By using SPY or /MES, we cut the size of the trade down by 1/10 compared to the above table. If the account is taxable, another choice would be the $XSP index, a 1/10 value index of the S&P 500 with favorable tax treatment, but much lower liquidity with few options that far out in time. Again, all these alternative versions of S&P 500 options are discussed in my post on different S&P 500 choices.

So, for an account with futures trading capability, this trade could use /MES futures options and get into the 1-1-2 trade for just $600 buying power. An account with options margin could use SPY or $XSP and get into the 1-1-2 trade for $6,800 buying power. A trader doesn’t need a million dollar amount to trade this.

Concluding thoughts on 1-1-2 trades

I know a number of people who have traded versions of this trade during the bear market of 2022 without any issues. One trader I follow and interact with had one of their best years in 2022 because of this trade and the bear market that moved the market down, but not fast enough to ever drive the naked puts into the money. In fact, it could be argued that this trade, like most trades that collect credits from selling puts, works best if entering when the market is already down and implied volatility is high. Bad scenarios are already priced into option premium and there is a lot of cushion between strikes. This trade is most dangerous when volatility is low and prices are high- the probabilities are not as good, because a move of more than two times the expected move down is not nearly as far.

While not for everyone, the 1-1-2 trade provide a very high probability of success with a nice payout when used with leverage. The trade requires monitoring to maximize profit and to prevent catastrophic loss, so it really is not a set it and forget it trade. The key is to have a plan to manage the position if the market goes against the trade and stick to the plan.

5 Bullish Call Trades

Beginning option traders like to buy calls to start their option trading, and over time often learn the advantage of selling options and probability. But there’s a reason that long trades involving calls exist- the market goes up more than it goes down. We need strategies that use call trades to benefit from market moves up without experiencing huge amounts of time decay, or huge swings in positions. These 5 strategies provide some choices to get in on a bull market with calls.

(Without losing a lot of Theta decay)

Option buyers typically have low probability of profit because of the need to overcome Theta decay, the measure of how much option premium loses value every day. But often selling calls in a bull market is a loser as markets don’t offer much premium and go up more than expected. And the market is bullish 70-80% of the time. Are there call trades that take advantage and balance risk and opportunity better than others?

Here are five call trades that I like:

  1. Sell a Covered Call (yes, it is actually bullish)
  2. Buy a Long-term Deep in the Money Call (the stock replacement trade)
  3. Buy in the money longer duration call and sell short duration out of the money call (Poor Man’s Covered Call)
  4. Ride the up trend with an Out of the Money Call Debit Spread– double up and reset
  5. Buy Call Back Ratio for Credit and Zero Extrinsic Back Ratio (ZEBRA) trades

Each of these trades is built for a different type of trade mentality, so it is a personal choice based on risk, time frame, and how active a trader wants to be in the market. However, with the exception of the covered call, all leverage capital and risk a total loss of premium paid but with big potential gains.

When is a good time to do these kinds of trade? Selling options is best when IV is high. Buying options is best when Implied Volatility (IV) is low and option premium is cheap. When IV is high, big moves are anticipated, but even if the market goes up, IV can contract quickly and significantly counter the gains from an up move. One overall measure to watch is the VIX volatility index. VIX has a long-term average level of 18, and when it gets in the low teens, between 12-14, it doesn’t have much lower it can go. Individual stocks can be checked for their IV level by looking at IV rank or IV percentile. When VIX is low and a stock has an IV percentile or rank below 10, I’d consider the stock IV as low. This scenario happens frequently, especially in bull markets, which occur much more of the time than bear markets. On the flip side as the market goes up and IV goes down, selling options get less lucrative and more risky.

Let’s take the five strategies one at a time. There are also detailed write-ups of each on separate pages, so this is an introduction to these trades and to contrast the risks and benefits of each before digging in deep.

Covered Call Trades

Of the five trades listed above, the Covered Call is the most conservative and the only trade that is based on a net sale of options. The trade is a combination of owning 100 shares of stock and selling a call against the shares. Because the amount of capital at risk is essentially the value of the shares of stock, which are owned in the account, this trade has no leverage from options- instead it reduces leverage and risk by adding a hedge against the shares owned.

Let’s say a trader sells a call with a Delta of 30 against their shares. The net Delta of the Covered Call position becomes 70. This means the two part position acts like 70 shares instead of 100, making the position less volatile. Since the only option involved is one that was sold, time decay always works for the call seller.

Many traders love Covered Calls because it allows them to collect premium as a source of income on shares they already own, without taking on any additional risk. For many conservative option traders, this is the one and only option trade ever needed. Depending on the underlying and tactics used, it is possible to make 5-15% income on stocks in a portfolio. Because the trade involves selling options, the probability of profit is greater than 50%, the highest probability of the five trades listed.

Covered calls improve the probability of profit over owning stock alone in exchange for giving up unlimited upside.
Covered calls improve the probability of profit over owning stock alone in exchange for giving up unlimited upside.

So, what’s not to like? It depends on your perspective, but the Covered Call limits upside gains, but does only a little to reduce downside risk. If a Covered Call owner has stock that goes up a huge amount, the call will limit how much profit can be made. The trade will be a profit, but without the call, the profit could be more. By selling a call, the Covered Call trader is collecting premium in exchange for the possibility of missing out on a big up move. On the downside, collecting premium might be a small consolation if the stock drops dramatically.

For a conservative trader, the Covered Call is a way to reduce risk compared to simply owning stock outright. For an aggressive trader, the Covered Call uses a lot of capital to get a return potentially the same as the market, with no real downside protection. I’ve come full circle as a trader myself, going from a big fan, to dis-illusioned by the lack of upside, to recognizing the benefit of a less-volatile, positive probability trade.

Stock Replacement Call Trades

The next strategy is one that is often referred to as stock replacement. With this strategy, we can buy options that have the same upside as shares of stock but at a fraction of the cost. In theory any time someone buys a call, there is the same upside as stock, but some set-ups give a trader more of the upside benefit than others.

When I think of using options in place of stock, I’m looking for two things, relatively high probability and low Theta decay. When buying a option with no hedge, the natural way to lower time decay is to buy a call well out in time where it will decay slowly. To get it to move with the underlying stock, having an in-the-money option can get most of the move up (or down).

So for this strategy, I look for options 6-12 months out with a Delta value of 75-80. These options will likely cost 10-20% of the cost of the shares as they have significant intrinsic and extrinsic value. With over 6 months until expiration, time decay is slow, but still present.

buying a long-term call in the money has almost the same profit potential as buying stock, but for a fraction of the cost.
In this example, a call is purchased with 84 days until expiration with a Delta of 0.78. Notice that even after several weeks, the profit curve is very close to that of owning stock around the money. Purchasing even longer duration options than this would provide less daily decay with even better downside protection.

Because I’m buying an option with a Delta of 75-80, I have the equivalent of 75-80 shares of stock from a price movement stand-point. If the price goes up, over time the Delta will increase and the option will behave closer and closer to the movement of 100 shares of stock.

The risk to the downside is limited to the amount paid for the options, so a big market drop could wipe out the position, but even a big drop would still likely hold some value, but mostly the extrinsic time value. However, the really good news is that losses in the options on a downturn are less than the losses that would come from 100 shares of stock.

My goal in this trade is not to hold until expiration, but to either exit or roll to a longer duration before we get into the last quarter before expiration. If the stock price has gone up, I can roll to a new time at a higher strike price and collect the amount the stock has appreciated less the time decay that was lost.

This trade needs a small move up to break even, so the theoretical probability of profit is a little less than 50%. But, by getting out way before expiration, the odds get ever closer to 50/50, and in a bull market the unlimited upside with limited downside is a pretty compelling proposition.

One watchout with this trade (and the others as well) is thinking that since we use just one fifth or one tenth of the capital of buying stock that we can now buy five or ten times as many options and really cash in. We have to respect the downside risk. A big move down will wipe out this position. So we don’t want to put all our eggs in this basket.

But when the market is frothy and looking like it is going nowhere but up, this is a good way to participate in the upside while protecting the downside, assuming that there’s plenty of capital left to deploy if the market suddenly goes against the position.

Poor Man’s Covered Call Trades

Covered calls have a number of trading advantages- they reduce volatility, provide some income, somewhat cushion a position from a fall. But, to have a covered call, you have to own stock first to sell a call against it. However, we just discussed the idea of using long calls as a substitute for stock, so if we sell a call against our stock equivalent we can have a low cost equivalent of a covered call, in other words a Poor Man’s Covered Call.

One difference is that our long calls have decay, and we want to counter that decay by selling calls with the same or more decay in our favor. A great way is to create a diagonal spread, selling calls that are closer to expiration while buying calls that are further away.

By selling a call with faster decay against our long call with slower decay, we can actually get a trade that has a greater than 50% probability of profit. The trade-off is that we limit the upside. The trade has defined risk and defined maximum profit.

My typical setup is to buy a 75 Delta call about 12 weeks out and sell a 25 Delta call about 6 weeks out, or half the time. If we look at a chart of each of the options profit potential along with how they compare to just owning stock, we get a bit of a complex chart:

The two legs of the diagonal spread that make up a Poor man's covered call.
In this chart we have two options with their own profit profiles at expiration. But, since they don’t expire at the same time, it is more important to see how they will perform at a certain point in time, like half-way to expiration for the shorter duration short call. After 21 days, the short call profit profile hugs the expiration profit profile much closer than the longer duration long call.

The key thing when looking at diagonal spread positions is that we really can’t think that much about expiration, especially for the long duration portion of the trade because it expires later. So, we really have to pay attention to how the projected values will behave at different points in time prior to expiration.

Another thing to notice is that the short call we sold has a strike price much closer to the current price than the long duration call. This means that there is more potential downside than upside, but that’s true with a regular covered call as well, actually even more so. At least our downside on this trade is limited.

When we put it all together in a chart, we can see how the trade profits not only when the market is up, but when the market is flat as well. Profitability with no underlying price change is due to the faster decay of the shorter duration short calls.

The poor man's covered call is profitable in a wide range of price movement.
Notice the 21 days in trade profit line is profitable even in a slight down move.

Looking at the overall Delta of this trade, it opens with a net Delta of 50, or the equivalent movement of 50 shares of stock. So this position is half as volatile as owning 100 shares of stock for a cost equivalent to about 7.5% of owning 100 shares.

From a profit standpoint, our capital required was $750 and the maximum profit is $250. This shows how much upside we’ve given up by selling the call, compared to unlimited upside with the call alone. However, if we look at a “sweet spot” on the profit chart above, we can see that if price goes up from 100 to 102 in 21 days, the profit is around $150, a 20% return on capital for a 2% move. In comparison, a 2% price move on the earlier long call option only would yield about a 7% return on capital, and owning stock outright would net the owner, well, obviously 2%. one way or the other, I can roll out at the same time I’m repositioning the short leg.

Is there any magic to 84 and 42 days? Not really, it’s just a time frame that I find fairly manageable without a lot of stress, but with plenty of premium to collect on the short side of the trade. Longer durations have less stress, and shorter durations are more volatile with more potential profit. It’s a choice that depends on your trading preferences and risk tolerance.

There’s a lot of ways to manage the Poor Man’s Covered Call, and I’ve written about them in an extended post.

Buying an Out of the Money Call Spread

Buying an out of the money call spread seems counter to every theoretical calculation a person can do. The probability of expiring in the money is low by definition and time decay is the enemy big time. But, over the years I noticed that when I sold call spreads that were supposed to be profitable, either alone or as part of an Iron Condor, those spreads seemed to lose money often, and often lost a lot. One thing I’ve learned in trading is that if a strategy you use continually loses, try doing the opposite. So, here we are. I’ve done a lot of back-testing and trading my own positions to come up with a low probability strategy that actually wins over time.

As I tested different variations of this strategy, it became clear that the key was to keep the amount of capital required low with lots of upside potential, but high enough that the position has a chance for success. Also, this is a trade that works best when the trade is closed for a win and not held to expiration. It also does best with low implied volatility in a bull market.

There's a lot more upside than downside for an out of the money call spread.
There’s a lot more upside than downside for an out of the money call spread.

Buying a spread helps compared to buying a single out of the money call, because the sold call has similar Theta decay to the long call and counters the biggest reason for quick losses from buying calls.

With a little time and early management, this trade has a history of an actual positive average profit, even though the probability of profit from a single trade is well below 50%. Big wins can outpace a larger number of small losses. Read the detailed post about this strategy to find out the specifics to success with this trade that goes against virtually every concept I tend to advocate for.

The Call Back Ratio

In front ratio spreads, usually the goal is to sell more options than what is bought to have lots of decay protected a hedge of a long option. Front ratios are so much more common, that most people just call them ratio spreads and don’t even consider an opposite version, a back ratio.

A back ration spread involves buying more options than selling to take advantage of a big market move. With a call back ration, we may for example buy two calls and sell one call. If the market goes up, the two long calls will make more money than the short call will lose. The disadvantage is that Theta (time decay) can be a big problem. So, I have two variations of this trade that I use that somewhat counter this problem, but not completely.

A Delta neutral back ratio call spread is created by selling a call and buying two calls with exactly half the Delta of the call that was sold. The net Delta is zero, and the trade should net a credit- a trader is paid to enter the position. If both call strikes are out of the money, like when selling a 30 Delta call and buying two 15 Delta calls, it is very possible that the position will expire with everything out of the money and worthless, so the trader keeps the premium. If the market goes way up, the long calls will start to overcome the value of the short call with unlimited profit potential. Sounds great, doesn’t it? The downside is that the trade could end up with the short call in the money and the long calls out of the money worthless, so the trader is stuck with a loss quite a bit bigger than the credit received to start with.

A Delta-neutral call backspread makes money at expiration in a flat to down market or a big move up, but loses in a small move up.
A Delta-neutral call backspread makes money at expiration in a flat to down market or a big move up, but loses in a small move up.

An almost opposite variation flips the position of the long calls to make the trade a net debit and create the equivalent of 100 shares with zero extrinsic (time value). I picked up this concept on TastyLive.com. The Zero Extrinsic Back RAtio trade, or ZEBRA, buys two 75 Delta calls and sells one 50 Delta call for a net Delta of 100, or the equivalent of 100 shares of stock. The extrinsic value of these positions tend to cancel each other out, with twice as much time value in the short call as each of the long calls. So we get the movement of 100 shares of stock for a fraction of the cost and no extrinsic value for the position. In many ways this is a lot like the stock replacement discussed earlier.

The zero extrinsic value is a little deceptive in that the extrinsic value doesn’t decay equally. The extrinsic value of the two long calls decay faster than the extrinsic value of the short calls at the money. So, in the short term, Theta is negative, and we still need the market to move up to make money.

I discuss the ins and outs of both of these back ratio strategies in the extended post on this topic.

Conclusion

Beginning option traders like to buy calls to start their option trading, and over time often learn the advantage of selling options and probability. But there’s a reason that long trades involving calls exist- the market goes up more than it goes down. We need strategies that use call trades to benefit from market moves up without experiencing huge amounts of time decay, or huge swings in positions. These 5 strategies provide some choices to get in on a bull market with calls. Share your favorite bullish call trades in the comments.

Buy an Out of the Money Call Spread

Over the years I noticed that when I sold a call spread that was supposed to be profitable, those spreads seemed to lose money often, and often lost a lot. One thing I’ve learned in trading is that if a strategy you use continually loses, try doing the opposite.

Buying an out of the money spread seems counter to every theoretical calculation a person can do. The probability of expiring in the money is low by definition and time decay is our enemy big time. But, over the years I noticed that when I sold call spreads that were supposed to be profitable, either alone or as part of an Iron Condor, those spreads seemed to lose money often, and often lost a lot. One thing I’ve learned in trading is that if a strategy you use continually loses, try doing the opposite. So, here we are. I’ve done a lot of back-testing and trading my own positions to come up with a low probability strategy that actually wins over time.

Just to be clear, this trade can be named a lot of different things. Some may choose to call it a bullish or bull call spread because it benefits from prices going up. Others may call it a debit call spread because a trader pays a debit to get into it, versus a credit spread where the trader collects a credit. So, it’s a debit spread, a bull spread, and it means we are buying one call and selling a less expensive call.

As I tested different variations of this strategy, it became clear that the key was to keep the amount of capital required low with lots of upside potential, but high enough that the position has a chance for success. Also, this is a trade that works best when the trade is closed for a win and not held to expiration. It also does best with low Implied Volatility in a bull market.

In high Implied Volatility environments, options are expensive, and it is hard to justify buying them. A big move is needed to make up for the large amount of premium paid, and time decay eats away at the position.

In low Implied Volatility environments, the cost of options is low, and strikes with fairly low deltas are often inside the Expected Move. This is much more true for calls than puts, due to skew. So, for not much cost, we can get into a position that often out performs its probabilities. And with active management we can greatly improve the long-term profit and loss.

Why buy a call spread and not just buy a single call option, you might wonder? Two reasons, cost and time decay. Buy selling a lower probability call, I can significantly reduce how much I pay for the position, but see an even bigger decrease in Theta, the Greek variable measure for daily time decay.

A key relationship to know is that the Delta values of the two options in the spread give a relative calculation of the value of the spread. The average of the Delta values taken as a percentage represent roughly the percentage of the spread width that the premium is worth. A call spread of a 30 Delta call and a 20 Delta call will have a premium value of about 25% of the width of the spread. So, if the strikes are $2 apart, the premium will be approximately 50 cents. The percentage is usually a little closer to the Delta of the higher Delta strike due to skew, but as a rough estimate, the calculation works well. Why would we care? Because if we double our Delta values, we double the value of our premium in a spread. That will be a key theme for this particular trade.

Call Spread Set Up

Here is the set up of my preferred strikes for an out of the money call spread. I try to open this trade with somewhere around 6 weeks until expiration so that time decay isn’t too bad and I have plenty of time to manage the position. Like most option trades, I choose my strikes based on Delta values. For this trade I look for a call to buy that has a Delta value in the 20s, and a call to sell with a Delta in the teens. I want the difference in Deltas to be somewhere between 10 and 15.

Let’s look at an example of a stock or ETF currently trading at $100 per share. I find that the 103 and 105 strikes meet my criteria with 42 days until expiration. The Delta values are 29 and 16, a difference of 13. The premium is 54 cents, or 27% of the $2 width between the strike prices. We are closer to 29 than to 16 as a percentage value. Our short strike has 2/3 of the Theta decay as the long, despite being less than half the premium to start, a contrasting relationship to our advantage. The net Delta of 15 also represents that we have the equivalent of 15 shares of stock, but instead of paying $1500 for them, we only pay $54.

set up for out of the money call spread
There's a lot more upside than downside for an out of the money call spread.
There’s a lot more upside than downside for an out of the money call spread. The key is to avoid expiration and limit time decay.

Looking at the profit chart, most analysis of this trade by others would focus on the expiration values, and note that at expiration we need the price to rise to around 103.54 to just break even. That’s true if the trade is held to expiration. But look at the colored curve lines that represent the value at different stock prices in a week or in three weeks. Those lines don’t need much of an increase in price to be profitable, and hold decent value in a small downturn as well. These curves are the secret to succeeding consistently with this trade.

The curved lines also bear out that Delta tells us how much we make or lose based on a dollar change in the underlying stock. We should make or lose about $15 for a dollar move in the stock price, and we can see from the 35 DTE curve that this is about what we’ll get.

Finally, notice that the colored curved lines of profit and loss don’t drop very far below the starting point of zero profit at $100 stock price. This is because there is only a small amount of Theta or time decay at the beginning of the trade compared to the days that come as expiration nears. Our goal will be to avoid the times when time decay kicks in.

We also would like to act based on the part of the curve that is better before expiration than at expiration. If we hold until our position is in the money, Theta switches and moves our profit toward the maximum at expiration. But the probabilities are that we won’t see these positions go into the money and Theta will be taking money from us in ever increasing amounts every day.

Managing the Out of the Money Call Spread

Like most option trades, I like to evaluate the trade with three possible management tactics, hold, fold, or roll. Holding to expiration lowers the probability of success, but might make sense if the market jumps up shortly after entering the trade. Folding or getting out early isn’t a bad strategy to lock in gains or limit losses with this trade by using limit orders. Rolling out regularly is best if the goal is to stay in the trade for the long haul. Let’s take these one at a time in more detail.

Holding a Call Spread to Expiration

Call Spreads are an interesting contradiction in the way Theta decay works. Theta either works for the trade or against the trade, and it can switch depending on whether the trade is in the money or out of the money. Theta is driving the value of the trade toward either zero or maximum value. When we own a Call Spread, Theta works against positions out of the money, but works for positions in the money. Since this particular version of the trade starts with strikes well out of the money, we need the underlying price to go up in a substantial way to make money.

The best time environment to trade this strategy is when IV is low and markets are rising. So, a nice move up can often happen. When it does and the position is in the money, the call premium will be less than maximum profit because the two call options have different levels of extrinsic (time) value left. We can hold the position until expiration to get the last bits of decay and get maximum profit. The risk is that the price can also reverse back out of the money and make the call spread decay toward zero value. For this reason, this is a trade that I don’t like to hold to expiration, I like to get out with a big profit, either with a profitable limit order, or rolling to a longer duration while taking profit.

If the market goes down instead of up, I think it makes even less sense to hold, because the probabilities will have gone down for profit, and the remaining premium will decay even faster. A turnaround to get into the money is needed and there probably isn’t enough time. So, I’d again fold or roll.

Folding with Limits

Many traders like to use limit orders to cash out wins, or limit losses. For traders that are inclined to use limits, this call spread trade set-up has some natural places to get out. Since the upside is higher than the downside, but the probabilities are that the trade loses more often than wins, we need to make sure that wins are much bigger than the losses. One easy natural limit is to take a win when the position doubles in value, or fold for a loss when the position is cut in half. Doing this means we need win better than one out of three trades to make a profit over time on the trades that close on a limit. Let’s look at each scenario, plus the scenario of hitting neither limit.

This trade starts with a long call that has somewhere around a 25% probability of expiring in the money. But it also has about a 50% chance of a touch- the price reaches the strike price sometime before expiration. Depending on exactly which strikes we started with in our call spread, our initial premium is likely 20-25% of the width of the spread, as we discussed earlier, based on the Delta of our two strikes. That means we need the width of the spread to move up to 40-50% of the width of the spread to double in value. Getting our long strike to go in the money, even briefly, should do the trick. Are you with me on the logic and statistics here? Based on all these assumptions, we have somewhere around a 50% chance to double our money on this trade at some point before expiration. But we don’t have a 50% chance to expire in the money. So, if and when it happens, the logical thing to do would be to take the money and run.

Wait, isn’t there some old trading rule that you are supposed to let your winners run and stop your losses? If we close for doubling our money, we give up the chance to get triple or hit max profit. Yes, but with options, time is limited. Markets go up and down, and nobody knows what will happen next. When we get a big win, it makes sense to take profit before it evaporates, and then don’t look back. Usually by the time we hit double our initial premium, a lot of time has passed and there isn’t that much time left in the option, and the probability of making more is still no better than 50/50. We started with a low probability trade, and have a shot to double our money 50% of the time, let’s take that.

A couple of additional factors to consider. Theta decay increases as the trade goes on, so if we can get out early before Theta has a big impact, the big decay at the end can be avoided. Second, one assumption going into the trade in a low Implied Volatility environment is that we are in a bull market, which actually helps our chances of a win.

What about limiting the loss? If we enter a stop limit at half the premium collected, are we giving up too early? Looking at our initial Deltas and how that relates to the width of the spread, our call spread will lose half its value if our Deltas drop in half. Whether that happens due to a downturn or due to time passing, the probabilities of a winning trade or especially doubling the initial value of the trade decline significantly, and the probability of the trade expiring worthless if left alone will have increased significantly. So, the idea is to cut our losses and save some of our capital for another day. Additionally, Theta decay is only going to increase and quickly doom the trade to zero if we don’t exit.

If we enter this stop loss limit order, how often will it execute? Somewhere close to 50% of the time, maybe a little more. But we can’t have a profit limit order executing 50% of the time, and a stop loss limit order executing over 50% of the time. That would be over 100% of the time, and we haven’t even talked about a third possibility. The issue is that if we use a stop limit, some of the occurrences that we are stopped out on are situations where we would have doubled our money if we hadn’t been stopped out. So we actually reduce our odds of doubling to less than 50% with a stop loss, but not a whole lot, because to go from a 50% loss to a 100% gain would take a 4x gain from that low point, a low probability, but not zero.

Let’s look at the math. If our long call Delta falls to the 12-15 range, our chance of that strike being touched would then be 25-30%. But if that situation happened in 50% of our total occurrences, we would be giving up 12-15% of our occurrences that are destined to win, so now our doubles are 35-38% of all occurances.

There’s a third possibility with our fold strategy. We could have neither limit order execute and the trade expire somewhere between losing half and doubling. This is a fairly low probability with the two limit orders in place, because as expiration nears, the trade gets more likely to move toward max loss or max gain. To expire between the long call needs to expire in the money and the short call out of the money. And the position would have to have crept into that position and been very stable especially in the last few days to not trigger either limit order. The probability of this happening are difficult to calculate, but will be well under 10%, maybe less than 5%.

If the trade gets close to expiration and hasn’t triggered a limit, it might be a good time to consider closing early to reduce drama and hopefully collect a profit on the trade. But again, that will change the overall probabilities slightly.

With the bull market on our side, let’s assume we can double our initial premium 40% of the time, stop loss limit out 55% of the time for a 50% loss, and hold on somewhere between to expiration 5% of the time. If these probabilities held up over time, we’d average a 13% gain on this trade.

For these probabilities to play out in actual results, a trader would need to trade the same amount in dollars or in number of contracts each trade. So, set aside the winning amounts to use for making up for losing trades. It’s likely that there would be many winning trades in a row, and many losing trades in a row. Having a variable amount of cash to both compensate for losses and bank winnings would be critical.

Alternatively, letting the size of the trade double or be cut in half based on the result of each previous trade wouldn’t work. Since there are more losses than winners, the account would get cut in half more often than it doubled, and eventually be cut to essentially no value.

Thinking about this way of managing the trade over time and the implications of huge wins and huge losses, this management tactic seems pretty extreme. It provides very extreme volatility, even if a trader consistently trades the same amount of capital trade after trade. As such, this would only make sense as a very small portion of a portfolio.

Continually rolling a credit spread

If you’ve read very many other trading strategies I’ve written about, you’ll know I generally like the concept of rolling my option trades. Rolling is the concept of closing an existing trade and opening a similar trade at a later expiration and/or different strike prices. In most platforms, this can be done in a single simultaneous transaction, so that the net result is clear- is the trade collecting a credit, or paying a debit to re-position?

With a debit call spread (a spread that we are buying), we can still collect a credit to roll from one position to another. This is because we can sell a call spread that has increased in value to buy a cheaper spread that is further out of the money. If we roll to new positions over and over, and the total of our credits are more than the total of our debits, this is a winning management tactic. Both back-testing and my experience show that this tactic works for this trade most of the time, particularly in bull markets.

I like to set up a trade like we’ve used as an example earlier in this post with 42 days to expiration, and then roll after a week. After a week, time decay is relatively small, and a price move up in the underlying of a percent or two makes more than a price move down of a percent or two loses on the trade. The longer the position sits, the more time decay moves the profit curve down, requiring a bigger up move to be profitable. If the market chops up and down, the trade can eke out a profit over time. The reason is that there is much more upside than downside because of the strikes that were chosen to start the trade. But, because the underlying market is bullish, the wins should be more frequent than losers, which really makes this strategy work over time.

Let’s take an example. We buy the call spread in our example for $54 with 42 DTE. After a week the stock is up 2% and our position is worth $80, a $26 gain. We roll this trade by selling our now 35 DTE call spread for $80, and buying a new 42 DTE call spread for $54 again, but now at $2 higher strikes than the week before to have essentially the same Deltas as the position we started with a week earlier. We collect a credit of $26.

A week later, the stock goes down 1% and our call spread is worth $34, a loss of $20. We roll out to 42 DTE again, and this time pay $20 to buy more expensive strikes at $1 lower prices. Now, we have a total of $6 collected from our two rolls.

The next week, the stock jumps 3.5% and our call spread is now worth $110. We roll our position out again to 42 DTE and buy higher strikes for $54, a net credit of $56. Now, we have $62 collected.

The next week, stock drops back 4.5% to our starting price of 100 and our call spread is only worth $3. Ouch- a $51 loss! But, we roll back to 42 DTE and our original strikes paying $54, paying a $51 debit.

After 4 weeks with a stock going up and down and ending in the same place, we have collected $11 total on a $54 use of capital. That’s a 20% return on capital on a stock that didn’t move.

But, we haven’t accounted for broker commissions. At 50 cents a contract, that’s $2 each week, or $8 for 4 weeks, most of our profit. So, we might want to look for stock that has a little higher price where the commission is less of a percentage of the likely profit.

We also expect the market to trend up in a bull market, so that winning weeks outnumber losing weeks.

The advantage of rolling and staying well away from expiration is that we avoid the rapid decay near expiration and we achieve much of the same result as the previous “folding” limit management tactic with constant trade size, but in a more disciplined drum-beat approach. We aren’t tempted to bump up our trade size or cut it way down, because we are just rolling the same number of contracts out week after week, adding or subtracting cash as we go.

From a practical standpoint, each week we have to evaluate what the right strikes to choose are. I try to maintain the same width, but then look for Delta values that meet my criteria. The higher the strike prices, the further out of the money the strikes are, and the lower the cost and the lower the Deltas. I can maneuver around a little to make my new position cheaper than the one I’m closing and collect a credit.

Also, if we have a big move in less than a week, I may choose to roll up my strikes in the same expiration to bank my profit and limit the downside in case of a reversal. In our example, if the stock price went up $4 in a couple of days, I’d roll up my strikes $4 and collect $65 to get my Deltas back to the starting range.

Why this Delta range works

Delta is a very handy measure for options. And for this call spread trade, its many uses really illustrate how this trade works. For call spread, we can take the combination of the Delta value of the two call options to get a net Delta value. In this example, with Deltas of 29 and -16, the net Delta is 13. (Call Deltas are positive. Owning a call is positive Delta, being short is negative Delta.)

If we look at Delta’s definition as a relation of change in price of the stock to change in price of the call spread, we can see that if the stock goes up $1 in price, our call spread premium goes up 13 cents, or $13 for the full contract. As a representation of equivalent stock, 13 Delta means we have the equivalent of 13 shares of stock.

Now, we could have this same price movement and share equivalent with any number of call strike price combinations. We could have bought a 50 Delta and sold a 37 Delta, or bought a 93 Delta and sold an 80 Delta and had the same behavior. 13 Delta is 13 Delta. So, what is the difference?

Remember, Delta is also a measure of probability and value of a spread. Both of these are tied to the individual Deltas more than the net Delta. Probability informs us of what is likely to happen to each option if held to expiration, or how likely it is that the stock price will touch the strike price before expiration. These probabilities inform our management of the option, as we’ve discussed earlier in this write-up. If we chose different strikes, we’d probably want to consider management tactics differently to optimize the trade.

But the real key is the relationship of Delta as a measurement of the value of the spread. Earlier, we mentioned that the average Delta of the two options in a spread roughly approximates the premium when calculated as a percentage of the width of the spread. Sounds complicated, but not really. In our example, our strikes are 103 and 105- the width of the spread is 2. The average of our Deltas is 23.5, so we should expect premium to be around 47 cents (23.5% of $2)- it’s actually 54 cents, but close enough for a rough estimate.

The value of our call spread can vary anywhere from 0 to $2 by expiration, so there is a lot further to go up than to go down. Picking lower delta strikes limits our downside, but gives us lots of upside. That plays out over time with this trade, as long as we don’t plan on holding on too long.

If we chose strikes deep in the money, we’d be virtually guaranteed to expire in the money, but our profit potential would be very limited, while our potential loss would be high. I think there are better ways to use deep in the money calls like a stock substitution strategy using calls, or a poor man’s covered call.

At the beginning of this writing, I mentioned how initially I used to sell call spreads, but realized I was consistently losing money. I looked at a lot of different ways to trade the opposite, to buy call spreads instead of selling. One tool I use for analysis is back-testing. As commercials like to say, “past results is no guarantee of future earnings,” but with big samples back-tests can provide a clue as to what works more often than not. I back-tested a wide variety of call spread values at different Deltas, different expirations, different management strategies, and different market environments before settling on this variation. I’ve traded it a lot myself with good results.

The example I’ve used in this writing is a little closer to the money than I’d ideally prefer. A little further out of the money would get the premium more around 20% of the width, which would cost less to start. The net Delta is fine, but if there were more choices, I might make is slightly less. Wider spreads are good for selling spreads, narrower is better for buying spreads, due to Theta differences.

Can we get too far out of the money, or too narrow? Yes, at some point the premium we pay and the potential profits get too small compared to the commissions and fees required. So, small spreads on cheap stocks may not make enough to pay for trading costs. And for those that might get options trades for free or close to free, there is still the cost of bad fills if an option is not extremely liquid.

This isn’t to say that other variations won’t work. There are pros and cons to every element of this trade. The differences in returns and risk can be adjusted many different ways. I’ve tried to illustrate the trade-offs so each trader can make their own informed choice.

Assignment Risk

One factor we haven’t discussed yet for buying call spreads that can’t be ignored is the risk of having a short call exercised while still holding the long call. As with other strategies that have an element of selling calls, there are some call assignments that can be avoided and some that can’t.

There are three situations that greatly increase the chance of a short call being exercised by the buyer. They are having a call in the money, having a call near expiration, and being short a call when a stock goes ex-dividend. The good news is that the way I execute this trade, these factors should rarely come into play.

First off, the short call is much less likely to end up in the money than the long call. If we start by selling a call with less than 20 Delta, it has less than a 40% chance of having the stock even touch its strike price.

My plan is never to hold until expiration, so that part of the assignment risk is mostly avoided. For those who hold in the money spreads near expiration to try and get max profit, this is a double dare to the buyer of the trader’s short call to exercise early. So, someone who holds a winning trade until expiration shouldn’t be surprised to wake up short 100 shares of stock instead of being short a call option.

Dividend risk is probably the hardest call exercise to avoid, but the key is to have a short call with more extrinsic or time value than the anticipated dividend, and have strikes further out of the money than the dividend. If a trader can do that, there is no reason for a call owner to execute from the other side of the trade. The easiest way to keep a high extrinsic value lines up with the other tactics- get out of positions close to the money and keep expiration away by closing or rolling anything with short duration.

As I’ve explained in other write-ups, having a short option assigned/exercised isn’t that big of a deal to undo, especially when it is part of a spread. A trader may wake up and find a large amount of short stock and a large amount of cash that wasn’t in the account the day before, but that’s what happens when shares that you don’t have get called away. In this case, the intrinsic/in-the-money portion of the long call will always be worth more than the intrinsic value of the short call, so the long call can be sold and the short shares that were assigned can be bought back, all in one transaction, for a tidy overall profit.

Final Thoughts

Buying a call spread like the trade discussed here should not be the core of a portfolio- the trade is simply too volatile for anything other than a way to supplement returns in appropriate market conditions. But, as used as a part of broader portfolio of trades, it can be a way to take advantage of a bullish market with low Implied Volatility. Buying calls out of the money doesn’t have to include a lot of decay. Using a spread reduces the time decay and makes what would seem like a losing trade show profits over the long haul.

The Poor Man’s Covered Call

if we sell a call against our stock equivalent we can have a low cost equivalent of a covered call, in other words a Poor Man’s Covered Call. One difference is that our long calls have decay, and we want to counter that decay by selling calls with the same or more decay in our favor. A great way is to create a diagonal spread, selling calls that are closer to expiration while buying calls that are further away.

Covered calls have a number of trading advantages- they reduce volatility, provide some income, somewhat cushion a position from a fall. But, to have a covered call, you have to own stock first to sell a call against it. However, we have discussed the idea of using long calls as a substitute for stock, so if we sell a call against our stock equivalent we can have a low cost equivalent of a covered call, in other words a Poor Man’s Covered Call.

One difference is that our long calls have decay, and we want to counter that decay by selling calls with the same or more decay in our favor. A great way is to create a diagonal spread, selling calls that are closer to expiration while buying calls that are further away.

By selling a call with faster decay against our long call with slower decay, we can actually get a trade that has a greater than 50% probability of profit. The trade-off is that we limit the upside. The trade has defined risk and defined maximum profit.

My typical setup is to buy a 75 Delta call about 12 weeks out and sell a 25 Delta call about 6 weeks out, or half the time. If we look at a chart of each of the options profit potential along with how they compare to just owning stock, we get a bit of a complex chart:

The two legs of the diagonal spread that make up a Poor man's covered call.
In this chart we have two options with their own profit profiles at expiration. But, since they don’t expire at the same time, it is more important to see how they will perform at a certain point in time, like half-way to expiration for the shorter duration short call. After 21 days, the short call profit profile hugs the expiration profit profile much closer than the longer duration long call.

The key thing when looking at diagonal spread positions is that we really can’t think that much about expiration, especially for the long duration portion of the trade because it expires later. So, we really have to pay attention to how the projected values will behave at different points in time prior to expiration.

Another thing to notice is that the short call we sold has a strike price much closer to the current price than the long duration call. This means that there is more potential downside than upside, but that’s true with a regular covered call as well, actually even more so. At least our downside on this trade is limited.

When we put it all together in a chart, we can see how the trade profits not only when the market is up, but when the market is flat as well. Profitability with no underlying price change is due to the faster decay of the shorter duration short calls.

The poor man's covered call is profitable in a wide range of price movement.
Notice the 21 days in trade profit line is profitable even in a slight down move.

Looking at the overall Delta of this trade, it opens with a net Delta of 50, or the equivalent movement of 50 shares of stock. So this position is half as volatile as owning 100 shares of stock for a cost equivalent to about 7.5% of owning 100 shares.

From a profit standpoint, our capital required was $750 and the maximum profit is $250. This shows how much upside we’ve given up by selling the call, compared to unlimited upside with the call alone. However, if we look at a “sweet spot” on the profit chart above, we can see that if price goes up from 100 to 102 in 21 days, the profit is around $150, a 20% return on capital for a 2% move. In comparison, a 2% price move on the earlier long call option only would yield about a 7% return on capital, and owning stock outright would net the owner, well, obviously 2%.

Managing the Poor Man’s Covered Call

How do we manage a Poor Man’s Covered Call? Generally, there are three ways to manage positions like this: hold, fold, or roll. Let’s take them one by one.

Hold means we just hold until expiration. But, remember these options expire at different times, so we could hold until the short leg expires and close the long. We’ll get good Theta decay and not really need to pay much attention. Probability of profit is over 50%, so it’s a viable strategy. However, if we let both options expire independently, we can see from the expiration profit chart that we need an increase in price to be profitable, so we do need to get out of the long call before expiration, preferably when we exit the short call.

Folding or getting out with an early exit isn’t a bad choice either. We can set a profit target, say half the maximum profit and set a limit order and also have an equal stop loss or slightly larger stop loss, and let the trade play out. Probability is over 50%, so hopefully we catch a modest up move and miss any big down move, collect a nice profit, and move on. As a short term strategy, this can be a good approach, especially if we were to set up a ladder of ongoing versions of this every few weeks and just let each one play out individually.

If you’ve read much of the other parts of this site, you know that I tend to favor rolling strategies, often continuous rolls. I like to roll positions out in time, over and over, adjusting them up or down with the market. Generally, the plan for this trade is to actively manage the short duration leg more than the long duration leg, but keep the long duration out in time and the short duration around half the time as the long, give or take a bit.

Rolling a Poor Man's Covered Call can mean moving the legs independently.
Here’s an example of rolling a position that starts with a short call at 42 days and a long call at 84 days. Typically, the short leg will get rolled more often, since it is decaying faster and is more prone to changes in Delta value and its premium.

In the chart above, I’m illustrating the concept. The idea is that every two to three weeks the short leg gets rolled out in time. Well, which one is it, you might ask, two or three? I would look at it based on criteria, if the short has gotten way out of the money, say below a 12 Delta in two weeks, I’d roll out and establish a new 42 day position and collect a net credit. Or, if the short strike is being tested and has moved to a Delta of 40 or more, I’d roll out and try to reduce Delta and collect a credit in the process- it’s easier to roll a single short leg for a credit than to roll a spread, so I should be able to improve my position in the process. If however, the price keeps Delta between 12 and 40, let’s just keep collecting Theta and wait until 21 days left to roll. At that point, we roll out to 42 days again and pick a nice strike and get a nice credit for our effort.

For the long call, I mostly just leave it alone. I let it do its thing until it gets down around 42 days and kick it back out to 84 days. If the market is up, I can move the strikes up to 75 Delta and get a credit. If the market is down, I’ll have to pay to roll out. If there is a really big move one way or the other, I can roll out at the same time I’m repositioning the short leg.

Managing Big Moves

So, we can set up rules to guide our rolls and generally just let the data from the market dictate our actions. The only other thing to consider is what to do if the price jumps way outside our strikes? With individual stocks, this is a clear possibility, so there needs to be a plan. On a huge jump up, the choices are to close for a max profit and move on figuring that all the good news is priced in, or reset with a roll to new strikes in anticipation of further up moves. On a huge down move, we can close out both sides for whatever premium is left on the long call if it looks like the bottom has fallen out for good, or just hang on to the long call and hope for a reversal, maybe selling a new call at the same price to cushion the blow. There’s no right answer, just the right answer for each trader’s personal tolerance for risk. But, every trader needs a plan. The one strategy that many traders take by default is to cash in small gains and hang on to big losers, which pretty much guarantees a losing portfolio over time.

Overall considerations

Is there any magic to 84 and 42 days? Not really, it’s just a time frame that I find fairly manageable without a lot of stress, but with plenty of premium to collect on the short side of the trade. Longer durations have less stress, and shorter durations are more volatile with more potential profit. It’s a choice that depends on your trading preferences and risk tolerance. Many traders of this strategy like to go to much longer durations with their long strike, to six months or even a year, to keep Theta less, but the trade-off is that the cost and downside risk is more.

Similarly, is there magic to 75 and 25 Delta? Not magic, but the goal is to have more decay in the short strike than the long, so equally distant Deltas at different expirations should achieve that. Many traders will buy call strikes deeper in the money to make this advantage greater, with the trade-off of a higher premium cost and having more more capital.

Between time to expiration and the Deltas chosen, we can significantly adjust Theta of our long strike. We can also greatly control the amount of capital required for the long call, from around 5% of the cost of stock to 20%. Understand that this is the trade-off, capital cost and downside risk vs. decay. The ultimate extreme is going back to a covered call, where we own stock instead of a call. Buying a call instead saves capital, and also limits the loss. So, in choosing the long side of the strategy, consider the choice of time and Delta as part of a continuum of risk and reward.

Trade Sizing: Leverage and Risk

Finally, remember that just because a poor man’s covered call has less capital required than a standard covered call, it doesn’t mean that it is a good idea to do 10 poor man’s covered call positions instead of a single covered call. Just because a trade is affordable, it doesn’t mean it is a good idea to bet the farm on it. The poor man’s covered call is a trade of leverage. It can be a trade to reduce volatility or greatly enhance volatility.

Let’s look at our example trade on $100 underlying stock on a $10,000 account. We could buy 100 shares of stock for $10,000 as a base case and use all our capital and we have market risk all the way to zero with a Delta value of 100.

If we set up one contract of the poor man’s covered call like our above example, we risk $750 and have the equivalent of 50 shares of stock, so much less volatility and downside risk, while still controlling a notional 100 shares through our contracts. Our loss is limited to $750, which will occur if we hold our long to expiration with a stock price change of more than 7%. This becomes a very conservative trade compared to owning stock or a traditional covered call, if we keep the rest of the account in cash.

If we trade two contracts, we have 100 Delta in total portfolio for a cost of $1500. At this point, our volatility is the same as 100 shares at the current price. However, our loss is limited to $1500, not $10,000 like stock. But now, we lose 15% of the account value on a 7% down move as we are controlling 200 shares of notional value through 2 contracts. We also get double the benefit to the upside compared to one contract. We also get double the Theta of a covered call, or a single contract of a Poor Man’s Covered Call. So the trade acts like stock when the price stays close to the opening price, but shows some leverage on moderate price moves. Arguably, one could say the extra benefits of leverage are worth the potential added risk to the downside- we still are only risking 15% of the account value, not all of it.

What if we take the trade to an extreme? We can easily do 10 Poor Man’s Covered Call contracts for $7500 cost. Our Delta increases to 500, so we get 5 times the movement of owning 100 shares, and our ten contracts now control 1000 shares of stock, a notional value of $100,000! With all this leverage, we get huge Theta. We also get a lot of volatility. If the stock goes up 1%, we make 5%, but the downside is the opposite. The big risk is that we can now lose 3/4 of our account if the stock goes down just 7%. Now we’ve made this trade into a virtual roulette wheel, big wins or big losses. Our probability of profit is still over 50%, but we’ve taken on a huge risk. Our max loss is a move down of just one standard deviation, which is not that unlikely. In fact, if we trade like this for very long, we will surely hit max loss within a small number of trades. We can potentially limit worst case scenarios by cashing out when the going gets tough, but that goes against natural instinct and can be hard to follow as a plan. The bottom line is that this would be a clear example of way too much leverage.

The point of these capital use examples is to show that a trader has to really understand the advantages and risks of leverage in a trade like this. The same trade can be very conservative, or extremely risky, depending on the context of the account it is in. So it is up to each trader to evaluate how the combination of trades affects the performance of the full account. You can read more about these concepts in my write up on Portfolio Management.

Assignment Risk

Since the Poor Man’s Covered Call involves selling calls, there is always the potential for those calls to be exercised by the buyer. With an actual Covered Call, the exercise means the covered shares are sold to fulfill the contract. But with a Poor Man’s Covered Call, there are no covered shares, just a long call in the money. Assignment in this trade means that the account has to sell shares that aren’t in the account, so the account holder will end up with short shares plus cash from their sale.

From our example we have been using, let’s say that the stock goes up to $105 and the short call of our position gets exercised by the owner of the call. We wake up the next day with -100 shares of stock and $10,300 added to our account. And we still have our long call contract well in the money. It’s a mess. A lot bigger mess than just having our long stock sold, because there are more moving parts. But it’s a good mess, because our positions have made a nice gain, especially our long call.

We can untangle our mess by buying our short shares back. We can also sell our long call at the same time to get a clean slate and then decide whether we want to open new positions at Deltas that are closer to where we’d like to be. So it isn’t that hard to straighten everything out.

In my write-up on Covered Calls, I wrote a long section on how to avoid assignment. The discussion is the same for this trade, so I won’t repeat it. Read the Covered Call write-up if you want to explore those tactics. There’s really less concerns about assignment with a Poor Man’s Covered Call because eventually the long call needs to be sold or rolled and the combination of the two can be re-positioned together if needed.

Final Thoughts

The Poor Man’s Covered Call has a lot of advantages compared to owning stock and selling calls. The trade provides a bullish outlook with positive Theta decay, while limiting risk to the downside. It typically has a greater than 50% probability of profit, while being a debit trade, which is rare in options trading. The trade does provide leverage, so care must be taken in managing the size of the position within any account.

Replace Stock with a Call Option

Buy stock at a big discount? This strategy is often referred to as stock replacement. We buy calls, have the same upside as shares of stock but at a fraction of the cost. Look for two things: relatively high probability and low Theta decay.

Want to buy stock at a big discount? This strategy is one that is often referred to as stock replacement. With this strategy, we can buy options that have the same upside as shares of stock but at a fraction of the cost. In theory any time someone buys a call, there is the same upside as stock, but some setups give a trader more of the upside benefit than others.

When I think of using options in place of stock, I’m looking for two things, relatively high probability and low Theta decay. When buying a option with no hedge, the natural way to lower time decay is to buy a call well out in time where it will decay slowly. To get it to move with the underlying stock, having an in-the-money option can get most of the move up (or down).

So for this strategy, I look for options 6-12 months out with a Delta value of 75-80. These options will likely cost 10-20% of the cost of the shares as they have significant intrinsic and extrinsic value. With over 6 months until expiration, time decay is slow, but still present.

Stock replacement uses long call options to get similar returns as stock.
In this example, a call is purchased with 9 months (273 days) until expiration with a Delta of 0.78. Notice that even after a month or even three months, the profit curve is very close to that of owning stock around the money. Notice that the downside is significantly less than stock.

Because I’m buying an option with a Delta of 75-80, I have the equivalent of 75-80 shares of stock from a price movement stand-point. If the price goes up, over time the Delta will increase and the option will behave closer and closer to the movement of 100 shares of stock.

The risk to the downside is limited to the amount paid for the options, so a big market drop could wipe out the position, but even a big drop would still likely hold some value, but mostly the extrinsic time value. However, the really good news is that losses in the options on a downturn are less than the losses that would come from 100 shares of stock.

My goal in this trade is not to hold until expiration, but to either exit or roll to a longer duration before we get into the last quarter before expiration. If the stock price has gone up, I can roll to a new time at a higher strike price and collect the amount the stock has appreciated less the time decay that was lost.

This trade needs a small move up to break even, so the theoretical probability of profit is a little less than 50%. But, by getting out way before expiration, the odds get ever closer to 50/50, and in a bull market the unlimited upside with limited downside is a pretty compelling proposition.

One watchout with this trade (and other long call option strategies) is thinking that since we use just one fifth or one tenth of the capital of buying stock that we can now buy five or ten times as many options and really cash in. We have to respect the downside risk. A big move down will wipe out this position. So we don’t want to put all our eggs in this basket.

But when the market is frothy and looking like it is going nowhere but up, this is a good way to participate in the upside while protecting the downside, assuming that there’s plenty of capital left to deploy if the market suddenly goes against the position.

2022 Learnings

In 2022 I had a rough year in many ways, but also had many successes, and need to take away some lessons from it.

Moving into a new year, it is always good to review trading in the past year to see what can be learned. 2022 is no exception. I had a rough year in many ways, but also had many successes, and need to take away some lessons from it.

Overview

2022 was a bear market year. Coming into the year, I was trading some very aggressive, short-duration bullish options positions, despite lots of warnings of troubles on the horizon. This resulted in a big loss in January and February, until I adjusted to a more neutral approach. However, I got away from many core philosophies and still didn’t recover as well as I could have.

What didn’t work and why

My biggest losses came from three main strategic mistakes, one that was new to me, and two that I should have know better. The new one was selling short duration without an appropriate exit strategy. The old should have known better losers were trading options on individual stocks and selling calls too close to the money.

Short duration trades

In 2021 I rode the bull market with a trade that was perfect for an almost straight up market, the 7 DTE rolling put spread. I’ve written about it, and you can read about how great it worked. However, when the S&P 500 went down over 400 points in a month at the beginning of 2022, there was no defense with the strategy of rolling. Because I had so much success with selling 7 DTE put spreads, I was reluctant to admit that the strategy wouldn’t work. I wasn’t prepared for a move down that didn’t bounce back. We had plenty of warning that the Federal Reserve was going to stop pumping money into the economy and instead raise interest rates and reduce the money supply. But, I left myself exposed with lots of short duration put spreads as the year began.

I tried to fight the down moves with rolls and a variety of other tricks I’ve used over the years, but there really was no defense for short puts close to expiration in a plummeting market. As I’ve come to learn, in down markets puts can be underpriced for the risk, and short duration puts can actually be a good buy. The book “The Second Leg Down: Strategies for Profiting after a Market Sell-Off” by Hari Krishman details a number of studies to back this up.

I’ve heard from a number of people that they had success with short duration options even in 2022 by going a little further away from the current price and either holding or using stop losses to keep losses from getting too big. But, I didn’t do that. Later in the year I tried to get back into selling some short duration options and got burned again. My style of rolling is just not a good fit for short duration options.

So, as expiration approaches, there is a lot of time decay that is very tempting to take advantage of. The flip side is that to get that decay, options must be sold quite close to the current price making them susceptible to a sharp move. Short term move of several times the expected move are not uncommon, especially in a bear market. For me, the returns are not worth the risk. My temperament is just not set up for this kind of trade.

More time gives more forgiveness. Looking to reduce risk from short duration options, I’ve focused studying ways to get the most out of longer duration options. I’ve done additional research on optimal Delta for selling put spreads at different time durations to maximize Theta. I’ve also gotten back to waiting for down days to sell bullish put strategies.

The only short duration trade I’m currently doing is an opposite trade to most of my other strategies. I’m buying 1 DTE straddles, as I’ve written about in a previous post. So far, so good with that.

Selling Calls too Close to the Money

Even in a bear market, selling calls can be painful. In a bear market there are often large counter-trend rallies where calls with strike prices close to the money quickly end up in the money. Implied volatility on index options is almost always significant skewed to the downside, making calls cheaper than puts. Selling the lesser call premium tends to not be adequate for the risk of a big rally. When I combine selling calls close to the money and with fairly short duration, I set myself up to be whip-sawed back and forth, reacting to each move in ways that locks in losses each way.

Ideally, I want to have positions outside of the market moves, far enough away in time and price distance that day to day price changes have little impact on me and I can just wait for time decay to work my option prices down over time. Puts tend to have more strategies that can be profitable when selling than calls. If you don’t believe this, just try back testing short option strategies and see if you can find one where calls beat puts- I haven’t found one.

Selling Options on Individual Stocks

I’ve written a number of times about how indexes are much less likely to have extreme outsized moves than individual stocks. 2022 is a great reminder of that. Many formerly valuable stocks lost well over half their value during the year, and a number of them lost over 90% of their value. I was exposed to some of this mayhem when I sold puts well out of the money on a few that seemed like they couldn’t miss, but then did.

I completely botched a trade on a company that I really like. Generac makes back-up generators as well as systems that store and manage electricity generated from solar panels. With the electrical grid getting less reliable, people are in need of their products. So, to mix it up a bit, I sold at $20 wide put spread in the low 200s early in the year after the stock had fallen significantly and seemed to be on an upward trajectory. Despite all their success in the market, the stock slowly declined, and I found myself rolling my position down and out a few times. Then, I made the fateful decision to sell my long put of the spread and switch from a put spread with $20 risk, to a naked put with a strike price of $200, cash secured. I figured that the stock was surely at the bottom of its range, and I wouldn’t mind owning it if it dropped a little more. Then Generac announced that they were going to miss earnings substantially because of a lack of installers available to deliver and install their equipment at residences. Overnight the stock dropped 30% after previously losing over 20%. Before I knew it, I was stuck obligated to buy a $100 stock for $200. I tried to roll out, but there were no takers to make a trade. I was assigned the shares, losing $10,000 per contract on a trade that originally had a max loss of $2,000 per contract. Multiple bad ideas- individual stock risk, getting cute when tested, not accepting a loss and moving on.

I also sold puts on ARKK, the Ark Innovation ETF. It’s not an individual stock, but it is a volatile managed fund of a relatively small number of innovative companies. Again, I thought that we had seen the worst of the market drop, especially for this fund, and I sold cash secured puts in the middle of the year. Since then, the stock has fallen by half- I had about a 10% cushion to start, but that is long gone and now I have shares.

There are some others that weren’t that bad, but the conclusion is the same. Options on major indexes are much less likely to be hit by outsized moves, particularly if there is a decent amount of time until expiration and the strikes are well out of the money. That is one of my core mantras and I strayed at my own peril.

What went well

Fortunately, not everything went as badly as the trades described above. I re-discovered some strategies that I had stopped using that worked well, and started using some new strategies that I was either skeptical of or unaware of prior to putting them into practice.

Selling Long Duration Puts

I’ve sold puts well out of the money well out in time many times in the past, but the allure of big Theta from short duration started getting the best of me. Why sell at 6 weeks or 12 weeks when we can make bigger returns selling at one week? Well, lots of reasons. Short duration takes lots of effort and is much more stressful. It doesn’t take a big move to blow past strikes that have value less than a week until expiration, while positions outside of the expected move a month or more out in time are much less impacted.

With positions 4 to 6 weeks out or even more, we get more consistent results and can reduce volatility of the portfolio. When a big move happens, we can wait a few days to see if the move reverses before making any adjustments. Often it does and there is no reason to intervene.

I’ve found that I can still sell spreads with Delta values in the teens that are in their maximum percentage of decay weeks or even months before expiration. While the percentage return isn’t as high as short duration, it is more consistent and higher probability of being positive. It isn’t exciting, but that’s okay.

Put Ratio Trades

The most popular page on my site every month is my explanation of how I trade broken wing butterflies. For a while I got away from trading this, chasing some other “shiny object.” I re-started trading the strategy and got back to winning. I have been a little more opportunistic with this strategy, opening on down days to get my strikes lower with higher IV, but the trade is high probability with rapid decay. The way I trade it seems to be just far enough out in time to buffer it from the volatile weeks that have come along regularly in 2022.

I’ve also had good success with the other put ratio cousins of this trade, the broken wing condor (or 1-1-1-1), and the 1-1-2-2 trade. The common thread to each of these is that there are two competing spreads in each case. I start with a debit put spread, typically where I buy a 25 Delta put and sell a 20 Delta call which acts as protection for a higher priced and wider credit put spread at lower delta values. The wider and lower Delta valued credit spreads decay faster than the narrow debit spread, and often switch from a negative value overall position when sold to a positive value position that I can sell to close prior to expiration. This happens when the wide credit spread decays to the point that it has less value than the narrower debit spread. So, I often collect cash when I open and collect cash when I close these.

Finally, I’m seeing success in the naked versions of these trades as well. Instead of having two spreads, I sometimes skip using the low long leg of the credit spread and go with selling a naked put. This leaves me with a debit spread protecting a naked put or two below it. So I end up with 1-1-1 or 1-1-2 versions of the above trades- true ratio spreads. These have undefined risk to the downside unless cash secured, and I trade them on margin. That ties in nicely with some of my other take-aways.

Using Futures Options to Pump Up Returns

After avoiding futures for many years, I’ve really become fond of them. I avoided them because I didn’t see the strategic value of buying or selling futures contracts on an index or commodity. I was also scared by the risk of aggressive use of SPAN margin. But what I’ve found is that futures options in particular allow me to sell high probability positions for very low amounts of capital, and then allow me to buy or sell actual futures contracts to use as a hedge and neutralize overall Delta. It can get complex very quickly and a trader has to be avoid building a house of cards that could collapse in a outsized market event. But when used with care, futures options and futures themselves provide valuable tools to increase returns.

I haven’t written much about the use of futures strategies on this site because I’m still working to distil the approaches into content that can be readily applied. Risk vs reward becomes much more significant with futures options, so risk management becomes a primary consideration in every trade and isn’t something to jump into without a comprehensive understanding.

All that said, I’m finding futures options allow me ways to magnify returns and also hedge my risks. I’ll be writing more in subsequent strategy discussions, but if you look at pages on four different underlying types and four levels of risk, there’s some initial content to consider. One specific hedge trade I’ve started using, the 1 DTE Straddle, came from my futures experience.

Selling Naked Futures Options

One place where I’ve found success with futures options is selling naked options well out of the money well out in time. Because of SPAN margin, these trades don’t require much capital. They also don’t move that much because of the long duration. I’m finding trades with lots of decay and really seeing the appeal of naked options. Long duration and low deltas cushion the positions from big day to day moves and give me plenty of warning to adjust when needed. While spreads have windows where they can be rolled for credit and other Delta values where they can’t, naked options can always be rolled out in time for credit. The issue is that some rolls are more lucrative than others.

So I finally see the flexibility and adjustability that naked options provide in defending against big price movements. The key is to manage size to keep risk reasonable.

Naked to me involves a variety of strategies from selling a single option, to selling the naked put ratio trades mentioned above. As I better define consistent management and hedging approaches to these trades, I’ll explain my naked strategies in more detail.

Using Research to Test Strategies

Finally, I’ve re-discovered the importance of doing my own research to understand trades I’m doing. I’ve shared many of my insights on this website, but I always have new ways to look at trade set-ups, impact of management, and understanding risk. I’ve written about the sources I use to research the market, and I still use the same primary approaches. I use current option tables, I do backtests, I analyze historic trends, and I model potential outcomes.

Sometimes it is easy to get caught up in what I’m doing every day and not stop and ask if the approaches I’m using at the moment are really valid. I don’t look to see if there is a better way. Research keeps me fresh, and often validates findings I’ve observed in the past, but strayed away from in my current trading. So, constantly looking at data from different strategies in different ways actually keeps my trading focused on approaches that work.

I also find that the biggest beneficiary of the studies I share is me. Writing things down to share makes me double check my work and get clearer as to what I’m doing. Sometimes in the course of providing data for a trading approach I’m doing; I realize that I could do better, and revise based on what the data says.

I also get a lot of inspiration from other sources- groups I’m a part of and sites I follow. My favorite source of inspiration continues to be TastyLive, which I often have playing in the background while I trade. I interact with a lot of other traders which also helps. I’ve written about the value of community in the past.

So my final thought is that I need to challenge myself to always keep learning and base my trading strategies focused on proven approaches with high probability of success and manageable risk.

Best Delta for Rolling Put Spreads

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.
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
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.
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.
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.
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.
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.

Best Delta for Put Spreads?

Selling put spreads is a fairly simple trade that can generate one of the highest returns on capital of all option trades. The trade is fairly flexible to adjust for higher returns with higher risk, or more consistent, but lower returns with lower risk based on choice of duration until expiration. While I’ve written about put spreads in detail before, I recently did some additional studies to see if my earlier conclusions on best Delta values for entry were still accurate.

I’ve noticed from Google Analytics that many traders are searching for the answer to “What are the best Delta values to use for selling put spreads?” or some variation. While I think my earlier webpage on put spreads covers that fairly well, there have been enough people question me, and enough questions pop up from my own trading to cause me to go back and dig into the data a little deeper. The quick answer that I usually give to anyone on Delta values for a put spread is to sell the put strike with a 20 Delta value and buy the strike with a 13 Delta value. This optimizes position Theta, and also provides a nice, relatively high probability of profit. But is that answer true if the expiration timeframe is short, like just a few days, or really long, like several months?

Readers likely have a hint at results from the featured chart image at the top of this post. I decided to look at all the possible Theta values of short put spreads at different strikes. For the first example, I looked at 7 days to expiration (DTE), and chose 40 point wide spreads on SPX, the S&P 500 index. SPX is generally my go to choice for options on the S&P 500, but as I wrote in another post, there are lots of different ways to trade options on the S&P 500. So, the graph shows the Theta value relative to the Delta value of the short put of the spread of all possible 40 wide put spreads, expiring 7 days from November 18, 2022. The chart shows a very smooth curve peaking around 22 Delta.

7 DTE Theta values of put spreads
This chart shows all possible short put spread combinations around the peak Theta values as a percentage of the spread width.

Here’s a slightly different way to look at the different Theta possibilities of 7 DTE put spreads. The horizontal axis is the long strike value, and the vertical axis is the short strike. The various values are color-coded, where the greener the cell, the higher the Theta value is as a percentage of the spread width, while yellow means lower Theta. As I’ve written elsewhere, this is one of my favorite ways to evaluate decay of a spread. I also drew boxes around all the values where the spread is 40 points wide- the points that are plotted on the earlier chart at the top of this post. If you zoom in on this green-yellow table, you can see that each cell is a percentage value, while the left and top lines show the strike prices and Delta values of each strike price. This table goes out much further than what I’m showing, but this is the part of the table where values are highest, and you can see the values are lower at the edges of this chart.

Note that delta values of between 5 and zero for the long put tend to have lower Theta values. And when the short puts get into the mid-twenties to thirty, Theta drops off. There are a number of combinations in between that have good Theta, and one could make an argument for many different ones.

On this chart each line represents the Theta values of different spread widths at different strike prices.
On this chart each line represents the Theta values of different spread widths at different strike prices.

One more way to look at this is to look at a graph with each line representing a different spread width. Notice that the most narrow width of 5 points has a lot of variation- this is because the Theta difference is so small, yet divided by a small width and a few nickels change in the difference in Thetas doesn’t scale smoothly. I’ve highlighted the 40 wide line that I’ve used earlier. One could argue that another line might be a better choice, but as we go wider, the peak gets closer to the current price which makes the probability of expiring in the money higher and higher.

Since the chart is made based on the short put strike, the curves move higher and higher as the spreads widen. Notice that as the spreads get wider, the peak Theta percentage gets smaller.

Longer Duration put spreads

Let’s go a little further out in time and see if the data is different. At 42 days to expiration, we get somewhat similar results.

For 42 DTE on SPX. I chose 100 wide spreads and Theta peaked right at the 20 Delta short strike.
For 42 DTE on SPX. I chose 100 wide spreads and Theta peaked right at the 20 Delta short strike.

I also did a similar thing with a table of percentage Theta values, highlighting the 100 wide spreads.

This table shows the Theta as a percentage of the spread width, and is color coded with more green meaning more Theta return. Lines on the chart mark key Delta values.
This table shows the Theta as a percentage of the spread width, and is color coded with more green meaning more Theta return. Lines on the chart mark key Delta values.

Even longer duration put spreads?

Let’s look at 90 DTE for an even longer duration.

At 90 DTE, Theta peaks out just under 20 Delta
At 90 DTE, Theta peaks out just under 20 Delta

We can also look at a table of Theta values as well for 90 days to expiration.

The boxed values are 200 point wide spreads.
The boxed values are 200 point wide spreads.

Again, the highest values have short strikes in the teens and low twenties for Delta. However, it probably is worth noting that the values shown are not that different between the yellow and green cells. So, maybe we should look at different spread widths to see it graphically.

Virtually all spread widths have a lot of combinations of strikes with values over 0.06% Theta per day. Compared to shorter durations, these Theta values are fairly low.
Virtually all spread widths have a lot of combinations of strikes with values over 0.06% Theta per day. Compared to shorter durations, these Theta values are fairly low.

When selling spreads this far out in time, the idea is to have a large buffer from the current price and get much of the premium to decay well before expiration is even close. Let’s look at an example of how this might work.

This chart shows how the premium of a 200 point wide spread is likely to decay over 90 days, assuming no change in underlying price or volatility. The small triangles represent the Delta values of each of the strikes in the spread as time passes.
This chart shows how the premium of a 200 point wide spread is likely to decay over 90 days, assuming no change in underlying price or volatility. The small triangles represent the Delta values of each of the strikes in the spread as time passes.

Starting with low deltas below 20, we can see that much of the decay of this spread happens well before expiration is even close. In fact, the last 20 days have virtually no premium left, which would suggest closing early and moving on. I plan to do a lot more studies on the decay curves of different spread widths and strikes to help identify the pros and cons of different entry points.

Conclusion

I think it is safe to say that the original study on spread width still stands. However, the data shows that there is some wiggle room around our old ideal of 20 Delta short and 13 Delta long strikes. We just need to be in the neighborhood. We don’t have to be exact.

Where’d the data come from?

Readers may wonder the source of the data for all these charts and tables. Actually, it’s a source that anyone can access and replicate. I simply copied an option table from my broker’s site and pasted it into Excel. Then I used a pivot table to organize the data so that it was friendly for the analysis I wanted to do. The option table had Delta and Theta values for each option contract available, and I had to use some formulas to figure out percentages of spread widths, but it wasn’t any really difficult challenge.

I do worry that my broker is changing the format of the option tables it presents, and copying every contract may be a bigger challenge in the future, but for now, I can display all contracts and select all with Control-A, then paste as text in Excel. In the future, I may have to paste a smaller amount of data each time. Readers trying to replicate these studies may face the same problem.

The 1-1-2-2 Put Ratio Trade

Like all the front ratio type trades I have shared, this trade is a defined risk version of a very similar front ratio trade featuring naked short puts. My versions hedge the trade with long puts to limit the risk. However, in this trade, I will also discuss the unlimited risk version of the trade, the 1-1-2, because the additional risk isn’t that much from a practical standpoint.

I’m a big fan of front ratio type trades. I’ve written about my success with Broken Wing Butterflies and Broken Wing Put Condors. Another trade that fits in the group is the 1-1-2-2 Put Ratio. I don’t know of a named reference to a bird or insect for this trade, so I’m going with 1-1-2-2. Like all the front ratio type trades I have shared, this trade is a defined risk version of a very similar front ratio trade featuring naked short puts. My versions hedge the trade with long puts to limit the risk. However, in this trade, I will also discuss the unlimited risk version of the trade, the 1-1-2, because the additional risk isn’t that much from a practical standpoint.

I picked up the concept of this trade from one of my favorite traders, “Sweet Bobby” Gaines, who I have mentioned previously in at least one other page on this site. Bobby is a big proponent of the 1-1-2 trade, and has posted numerous videos on it on his YouTube channel, including his recent rising star appearance on Tasty Trade. But really, the trade is the next level of evolution moving from broken wing butterfly to broken wing condor to “one louder” as they say in the mythical group Spinal Tap.

What all these trades have in common is selling an out of the money debit put spread, and financing by selling further out of the money puts or wider credit put spreads. The combination delivers a net credit, but also sets up an interesting dynamic of extra rapid decay of the premium involved. The farther out puts or put spreads decay faster than the closer debit spread, and often lead to the debit spread having more value than the credit spread. These trades take in a credit to open, and often can take in a credit to close. At least that’s how I set them up and manage them.

All these trades are a variation of a front ratio spread, where more options are sold than bought with hedges added to define risk. I’ve also written about back ratio spreads where more options are bought than sold. Front ratios are designed for maximizing decay, while back ratios set up multiple long positions paid for by a costly short position.

The previously discussed broken wing condor could also be called a 1-1-1-1 trade. In that trade we buy a put spread and then sell another put spread further out for more money, collecting a net credit. Four different strikes, 1 contract each. So what is a 1-1-2-2?

1-1-2-2 Basic trade setup

The 1-1-2-2 takes this a step farther, because we use two credit spreads very far out of the money to pay for the debit spread. The 1-1 part is buying a put around 25 delta and selling a put around 20 delta. The 2-2 part is selling two puts at around 5 delta and buying two puts around 1 delta. The goal is for the 2-2 to sell for about twice what the 1-1 cost. I like to set these up with 45-55 days remaining to expiration, quite a bit longer than the other ratio trades I’ve discussed.

What is the advantage of this? Well, because each of the two short strikes are further out, we greatly improve the odds of being profitable, and increase the initial rate of decay of the total position. We end up with a big gap between the debit spread strikes and the two short put strikes. Lots of good things happen with this setup. The biggest upside is that there is no upside risk- if price goes up, the trade makes money. The downside of this trade is that it can consume a lot of capital and has significant tail risk, which we will get into before we are done. Let’s look at a typical example.

Pricing and Greeks for the 1-1-2-2 position
In this example, each of the two low delta puts collect about what the debit spread costs (~$10).

The first thing I want to point out in this example is that the 3100 short put is 900 points below the current price of $4000. For that strike to get in the money, it would take a 22.5% decline in the market in 55 days. That won’t happen very often. To be fair, this example uses values with VIX at 25, a historically higher than average value, but for the timeframe of 2020-2022, a fairly middle of the road level. The higher that implied volatility is, the farther away the short strikes can be and still collect meaningful premium.

The next thing to point out in the setup numbers is the Greeks. Delta is fairly flat at +3. For a credit trade, that isn’t much and means that the position can handle some movement in price. Theta is $69/day, and we collected $805. So, the position is expected to lose 1/12 of its value each day. But we have 55 days, so how does that work? Quite well, I’d say.

Finally, we can’t ignore the capital risk of $115,000. How can this be? If the price drops below $2500 at expiration, a 47.5% drop, the loss would be $115,000. While extremely unlikely (we didn’t lose that much in the Covid crash of 2020), it is possible in some disastrous scenarios. We’ll discuss this later as it impacts capital requirements and how one perceives risk. At the end of this post, I’ll explain how we can get into this trade for a fraction of this buying power.

Numbers are one thing. A picture or three might help make this all more clear.

overall profit profile chart
The dotted lines represent expected moves. This trade is profitable at expiration if the market doesn’t go down more than two expected moves.

This chart shows how changes in the underlying price will impact the profit and loss of the trade. We evaluate at four points in time. The green diamond shows our initial position at 55 DTE, underlying price is $4000, and the P/L is zero. The curvy lavender line shows how price would likely impact the position with 35 DTE. The green curve shows the likely profit at 14 DTE, and the sharp purple lines are the expiration values. We know exactly what expiration values will be at any price, but the curves are estimates based on likely impact to implied volatility as time passes and prices change.

I’ve put in dotted lines to show the expected move and multiple expected moves down. If you need a refresher, check my earlier post on expected moves. It is likely that price will end up inside of one expected move, the dotted lines on either side of the current price of $4000. There is approximately a 2% chance that price will move two expected moves to the second dotted line below the current price, which would still be max profit for this trade at expiration. And there is approximately a 0.3% chance of moving three expected moves to the far left dotted line. We can go further, but the odds keep dropping as we go to lower levels. However, as history has shown, moves down tend to have somewhat higher probability than theoretic probabilities once we get beyond two expected moves. The bottom long puts are a final defense to limit losses for going even more extreme in a rapid crash. The point is that this trade is very likely to end up profitable, but there is risk that an extremely big move down could lead to an extremely big loss. We’ll talk about ways to reduce exposure later.

Now that we’ve talked a bit about the very unlikely outcomes, let’s zoom in and discuss the most likely scenarios. Here’s the profit chart showing prices down to 25% below the current price with profit and loss zones highlighted.

This chart shows the profit and loss compared to most likely underlying price levels.

Zooming in allows us to see the profit levels in the timeframes referenced above. Notice that down moves initially can drive the position to a loss, but if the move doesn’t go below the two short puts at 3100, the position will be highly profitable at expiration. In fact, this trade does best in the very wide range of a price drop between 6 and 22 percent, bringing in up to $5000 additional credit.

If price goes up or drops less than 200 points, we can keep our initial premium at expiration. We may be able to collect more. The profit curve at 14 DTE is actually above the expiration profit if the price remains the same. How is this possible? Because the 1-1 debit put spread decays slower than the 2-2 credit spread, eventually the 1-1 part is worth more than the 2-2 part, even though the 2-2 part started out worth twice as much as the 1-1.

Let’s look at this another way. Prices don’t generally move immediately to a new level, but have probabilities of moves that get bigger over time. Again, going back to expected moves, let’s compare how we might expect price to move during the duration of the trade.

Price expected moves
This chart shows expected moves day by day from initiating the trade until expiration, and compares to the put strike prices.

In this chart I’ve shown several outcomes. The zero move is if price doesn’t change at all, a baseline. I’ve shown a +1% move which is in line with the positive drift of the market. There’s also a line for the positive expected move and the negative expected move, where price is likely to be within at any point in time. And finally I’ve shown a curve for a price move of two times the expected move down. Notice where the strikes are relative to the price curves are. The negative curves take time to get below the upper 1-1 put strikes, and never reach even the short put of the 2-2 credit spread.

Now let’s look at what happens to the value of our premium if price were to follow each of these curves. This is a view that you don’t see much because it is based on lots of assumptions for the pricing models. Since implied volatility is not predictable in the future, the chart makes assumptions for how price and time will most likely impact volatility and premium value.

option premium vs time
This chart shows how different underlying price trends would likely impact option premium over time.

Initially, this position collected $8.05 in premium, so we start with a negative or short value of -8.05. From there the price moves shown in the previous chart drive the premium up or down along with time decay. If price is flat or going up, premium decays and moves quickly toward zero premium. If the price goes down, the positive Delta pushes premium to more negative values. The price move of negative two expected moves really does a number on our premium initially, driving it down to below -30.

But, remember our profit chart at expiration? The flat and positive moves end up with a profit of our initial premium (all the puts have zero value at expiration, and the negative expected move and negative double expected move end up at maximum profit. Since our debit spread is 50 points wide, the negative moves would leave it fully in the money for a premium value of +50 points. And that’s in addition to the initial premium collected to open the trade. The challenge is that to get that max profit, we likely will have points in time where our position loses money.

The probability of getting to max profit is low because it would require a price drop between 6 and 22%. Based on our put strike Deltas we can estimate that we have about a 20% chance of that. Most of the other 80% is expiring with all strikes out of the money. So, it might be wise to zoom in and understand what happens with the vast majority of trades.

1-1-2-2 value vs. time chart
In most situations, the premium of the 1-1-2-2 front ration decays quickly, maxes out, and then levels off before losing value.

I used this chart as the featured image of this post because I thought it best illustrates how this trade plays out most of the time. If you remember when we discussed the Greeks, I pointed out that Theta is very high compared to the premium. From this chart we see that if price stays the same or is slightly up, premium will decay to zero by 35 DTE, or just 20 days into the trade. This is an example that Theta isn’t 100% accurate by itself as it looked like 12 days of Theta should move us to zero value. It could be that IV modeling is slightly off or the Theta was off, but still we have very rapid decay that I don’t think anyone can complain about.

Like all ratio style trades we have discussed, this trade has the possibility of switching from negative to positive premium. The difference with this trade is that it is actually quite likely, and as such we need to plan for it and manage our profit accordingly.

I’ve colored in the area under our three flat-to-positive curves with three zones each. There is a green zone where positive premium is growing, a yellow zone where premium is topping out, and a red zone where positive premium is being lost. Notice that the curve of the 1% up move and no price move are fairly close together, and that’s because the price movement is relatively close to the same compared to the other moves we are analyzing.

Let’s review how this happens. This trade essentially has two spreads, a slow decaying debit spread (1-1), and a fast decaying credit spread (2-2). The credit spread decays faster because it is farther out from the money, is much wider, and has twice the value to start with. All these factors help decay happen more quickly. As long as the price stays fairly stable, this relationship will hold. Theta will be the primary driver of the premium value, and the wide credit spread will get to be worth less than the narrow debit spread.

The most likely scenario is that we stay inside the expected move and travel somewhere close to the no price move or 1% up move. Let’s realize that the market doesn’t move in equal amounts every day like this chart, so think of it as a smoothed out version of what premium would do. In the real world, premium would bounce up and down with price. However, if our price is close to where we started with 20 days until expiration, we would expect that the premium switch to positive has about maxed out, and it is probably a good time to close out the trade. Hopefully,your trading platform has a analysis feature that lets you look at your position and see how profits are changing day by day to help determine when the position is as high as it can go.

Without a chart, another way to determine how close the trade is to switching direction is to watch the position Theta. At the beginning of this trade, Theta was 0.688, or $68.80 for the full contract per day. As the trade progresses, Theta will decrease and at some point when the premium goes positive, Theta will turn from positive to negative. As it gets close to zero, that is the peak premium value. I generally try to exit the trade a few days before Theta is projected to turn negative. A big up day for the market could quickly change my very positive premium to not as positive premium, so it isn’t a time to get greedy.

So that brings us to the curve for the positive expected move. This is the curve that assumes that the price follows the one standard deviation move up. The good news when this happens is that premium decays very quickly because Delta and Theta team up. The not so good news is because the price move gets so far away from the strikes, the total position won’t get to a very high positive value. This is because all the options will drop in value quickly, approaching zero, and the upper debit spread won’t have much value. A big move up means that the probability of any of the strikes going into the money will be very low, so there is very little premium. As a result, it is likely we won’t be able to get out for much positive premium if any at all, but we will be able to keep most, if not all the premium from the opening trade. This is the least stressful outcome of the trade. If the price moves up faster than the expected move, premium will likely drop to very close to zero and may not ever go positive. So, if price is up a lot and the trade can be closed for a credit, I take the money and run. I’m happy to have a quick, winning trade.

The risky outcomes

Looking at the position vs time value chart, there are two lines that represent what happens if price goes down. One is the move down one expected move and the other is down two expected moves. Interestingly, in this example, both end up at max profit by the end of the trade. So, it would appear that the trade can’t lose, which is far from true. Notice that these premium values may go very negative if prices drop quickly after opening the trade. This is because the narrow debit spread doesn’t pick up as much value from increasing delta as the wide credit spread does in a down move. We know that if price stays above our credit spread short strike at expiration, we will make money, but when price moves quickly down, it isn’t clear that price will level off.

So, as a trader, we are left with a choice when the market drops, We can take a loss and get out of the trade, or wait to see if the market quits dropping before it tests or violates the credit spread strikes. If we are a week or two into the trade, a decent down move will not make a huge impact, but initially the trade can take a big hit from a down move. The longer we are into the trade without a big down move in price, the less the risk is of a loss. On the flip side, a big move down opens the possibility of additional big down moves that can lead to a very big loss. We reviewed the odds earlier- about 4% of the time the trade will lose based on the far short puts having an initial Delta of 4. If this trade is done enough times, there will be some losses. Let’s look at some management actions that could be taken.

1. Set a stop based on premium price. In this example, we collected just over $8 premium to open the trade. So, we could set a stop to avoid losing twice ($16) or maybe even three times ($24) our initial premium. This would mean a stop loss if premium climbs to $24 or $32, given that $8 premium is our starting break-even point. This is the simplest risk mitigation strategy. Using this will lower the overall win rate as many negative scenarios would end up fine if not closed, but this management technique will prevent huge losses that might impact the account dramatically.

2. Close the trade if the underlying price goes below a trigger point. We know this trade has a lot of cushion. We can handle much more than one expected move and be profitable. But if the move is much more than expected, we have to consider that the move is very unusual and dangerous for us. Perhaps our point to get out is when the debit spread is in the money, or when we are half-way between the debit spread and credit spread. Or maybe it is the short strike of the credit spread that is the final trigger to get out. The further down we allow price to go down, the more we stand to lose. Pick the underlying price where it gets too uncomfortable and use that as the trigger point to get out of the trade.

3. Roll out in time if premium or price triggers are hit. If the position is rolled before the credit spread is in the money, it can be rolled out for a credit. This gives more time for the market to turn around. However, it gives more time for a losing trader to lose more, because we likely can’t roll down that far and still get a credit, and we will likely have to pay to roll the debit spread or narrow the distance between spreads, making the trade less attractive. If the price move continues down, there will be much less room to maneuver going forward.

4. Simply hold on and hope the probabilities play out. With 55 days in the trade, we just need to move down less that two expected moves by expiration. If the capital is available, and the conviction is there, holding can bring max profit with a big down move. Note that as time passes and the credit spread stays out of the money, the premium has to go away, so the value can evaporate very quickly with very high Theta as expiration approaches. This can be observed in the value vs time graph for the -2 EM curve. It can also result in max loss. As expiration approaches, the difference between max profit and max loss is just a few percentage points of price movement and max loss is much more than max profit.

In this example we can see that a move down of one expected move really doesn’t challenge our position, while two times the expected move is playing with fire. So, one approach might be to hold as long as the move stays within the expected move to the downside and switch to closing or rolling once the move exceeds that or some other multiple of expected moves. In any case, a trader has to know their risk tolerance and have a management plan for both winning and losing trades.

What about calls?

A logical question might be- if this works so great for puts, why not double up and do it for calls as well? Well, there’s one problem- skew. On indexes implied volatility is higher as strikes go to lower values and declines for higher strike prices. As a result, out of the money puts have higher implied volatility than out of the money calls. More importantly, far out of the money puts have higher implied volatility than puts closer to the money.

Look at our setup for this example. Implied volatility of the single long put is around 25, while the two short puts have implied volatility of 39. This helps two ways. The short puts have more of their premium tied to volatility, bumping up their price compared to the long put. Also, the higher implied volatility pushes the strike price further down to get a matching premium to the debit spread, making the trade a higher probability of success. We are selling more of the higher implied volatility and buying lower implied volatility, a key reason to use front ratio spreads.

A similar setup for a 1-1-2-2 call trade would reverse the dynamics. The long call closest to the money would have the highest implied volatility and the two short calls would have the lowest. To collect similar amounts to the put trade, the call strikes would be much closer between the debit spread and credit spread, and the difference in the deltas of the strikes would also be closer together, meaning a narrower window of max profit, and a higher probability of max loss. While still a trade with positive probability, it generally isn’t as attractive as the put side.

1-1-2 vs 1-1-2-2

I haven’t talked much about the two long puts bought at less than one Delta to open the trade. They are very unlikely to ever be in the money, and most traders would opt to close or adjust the trade well before they came into play. So, why have them? The simple answer is that they define or limit the risk of the trade, potentially reducing the capital required for the trade, and protecting from absolute disaster in the event of a market crash of over 37.5% in under 55 days. It could happen, like it did in February and March of 2020 during the Covid pandemic. We are giving up 20% of our premium to protect for a once or twice in a lifetime super crash.

So, what if we eliminate the long puts and do a naked 1-1-2 ratio spread? Is it different in outcome or probabilities? The answer is that it is very similar in most ways, and we will also see that a lot depends on the type of account you are trading in as to what choices there are. First, let’s start with the setup of the 1-1-2 trade.

The 1-1-2 setup is similar to the 1-1-2-2
The 1-1-2 trade has two naked puts sold short, but way out of the money.

While this table shows the risk as unlimited, it is actually $618,855, the value of two 3100 puts if SPX went to zero by expiration ($620,000) less the $1,145 collected to start the trade.

Some accounts and some brokers require all trades to be defined in their risk. For example, retirement accounts generally aren’t allowed to use option margin and so any naked put would have to be cash secured. For this trade, eliminating the two long puts would mean the max loss would go up to $618,855, assuming that SPX went to zero, while we are holding two short 3100 puts. SPX will only go to zero if we see modern society end, and in that case, we’ll probably have bigger problems than our option positions. But rules are rules, and so if you want to trade without the long puts in a retirement account, you would need $620,000 capital to make a likely $800-$1200 or less than 0.2% return in 55 days or less. We’ll discuss other alternatives after we review the details of the 1-1-2 trade.

The profit profile for 1-1-2 is similar to 1-1-2-2
The profit profile for the 1-1-2 is very similar to the 1-1-2-2 other than the virtually unlimited loss.

Remember that our starting underlying price is $4000 and the trade is profitable at expiration as long as price is above 3100. The chart above doesn’t show losses all the way down to zero price, but just imagine zero price and -$618,855. Our probability of profit is 96% if held to expiration based on the Delta of 4 for the naked puts.

value vs time for 1-1-2
Most scenarios show a profit with 1-1-2

Looking at 1-1-2 values over time at the same price moves that we looked at for the 1-1-2-2 trade, we can see that the premium changes are fairly similar. Staying within one expected move keeps the trade moving in the direction of decay.

zoom in on 1-1-2 value over time
Zooming in on most likely outcome’s value over time

If we zoom in on the likely outcome, we see that premium behaves very similarly to what we saw with the 1-1-2-2 trade setup. We just have more premium collected to start with, taking a bit longer to fully evaporate and have the premium turn to a credit for closing. The concept is the same.

Summarizing the differences between the 1-1-2-2 trade and 1-1-2 trade, the 1-1-2 trade collects about 20% more premium in exchange for more loss if the market drops more than 37.5% in the 55 days of the trade. How likely is it for the market to drop more than 37.5%? Is buying the long puts for protection worth it? That’s up to each trader to decide.

Buying power requirements

I usually don’t spend much time talking about buying power because most trades I do are defined risk credit trades where the amount collected is a significant portion of the capital at risk. This trade is not so much, whether defined risk (1-1-2-2) or a naked ratio spread (1-1-2). In non-margin accounts, we collect 0.7% or 0.2% respectively, which isn’t much.

Below is an analysis of different possible ways to trade. I looked at trading each of these strategies three different ways. First, I looked at a cash secured account, like a retirement account. Next, I looked at an account with margin for naked options. Finally, I looked at a much different approach, trading futures options with span margin. The margin and span margin amounts came from entering this trade into the tastyworks trading platform.

Buying power differences for Margin and Futures
Comparing buying power impact of different account types for the two strategies

I highlighted some key takeaway points. First, is how leveraged span margin with futures options can be for this trade. Our most capital efficient trade would be doing the 1-1-2-2 on futures span margin where we would collect 100 times the premium as a percentage of buying power (20%) than the non-margin account of the 1-1-2 trade (0.2%). Of course, with leverage comes much more risk. I chose to consider a loss of 10 times the initial credit as a practical worst-case scenario. The span margin would end up costing huge amounts more in a disaster and could potentially wipe out an account if the trade used a high percentage of the account’s capital.

A couple of weird margin anomalies to point out. In my margin account, the defined risk 1-1-2-2 trade required almost twice the buying power as the undefined 1-1-2, which is weird because clearly there is more risk in the naked 1-1-2. I think it may be that the calculation for defined risk is normally much less than undefined and the software may just assume that margin is not useful in defined risk. On the other hand, defining the risk on the futures version cut the buying power by 1/3. Different brokers may calculate their margin requirements differently, so don’t take this as universal truth. Similarly, remember that while defining risk usually increases the return on capital, it makes outsize losses more likely, especially when scaling up. Notice that the highly leveraged futures 1-1-2-2 would lose twice as much as a percentage of capital that the futures 1-1-2 setup in a 10x loss. I discussed this phenomenon in detail in my post on comparing risk.

Remember that margin and span margin change as the trade progresses depending on the market behavior. Span margin is subject to big swings when prices go against a position. A broker may force a position to close much earlier than a trader would want to get out due to expanding capital requirements. So, while initially the position is cheap to enter, a trader needs to limit each position to a fraction of the overall account size.

But the good side of this is that this trade can be entered for a very small cost. The trade is very high probability. We can also make more than the premium collected. I didn’t include it in the chart, but maximum profit for the most leveraged choice above would be $5,805 profit on $4,000 buying power, a return on capital of 145%. And there is over a 20% probability of that happening.

One final note on the buying power analysis table. To keep the quantities an apples-to-apples comparison, I used double the number of /ES futures options because futures options only control half as much value as SPX index options. So, technically, those futures options trades listed are 2-2-4-4 and 2-2-4 because they use twice the number of contracts to get the same notional exposure. I reviewed differences between index options and futures options in detail in my post about different ways to trade options on the S&P 500 index.

What about small accounts?

Readers looking at this may be thinking, “Gee, this is great for multi-millionaires, but what if the account is too small to consider any of these buying powers?” Great question- there are other alternatives. First off, a trader could use half the buying power listed by just trading options on one contract of the Mini S&P 500 futures (/ES). The 1-1-2-2 example would only take $2,000 buying power for $402 premium received. But, if that is still too much, we can make it a lot less.

Many traders are more familiar with options on the SPY exchange traded fund, which trades at approximately 1/10 the value of the S&P 500 index. For futures options, there is also options on the Micro S&P 500 futures contract (/MES), equal to 1/10 of the /ES contract size, or 1/20 of the size of an SPX option. By using SPY or /MES, we cut the size of the trade down by 1/10 compared to the above table. If the account is taxable, another choice would be the $XSP index, a 1/10 value index of the S&P 500 with favorable tax treatment, but lower liquidity. Again, all these alternative versions of S&P 500 options are discussed in my post on different S&P 500 choices.

So, for an account with futures trading capability, this trade could use /MES futures options and get into the 1-1-2-2 trade for just $200 buying power. An account with options margin could use SPY or $XSP and get into the 1-1-2 trade for $6,800 buying power. A trader doesn’t need a million dollar amount to trade this.

Concluding thoughts

I know a number of people who have traded versions of this trade during the bear market of 2022 without any issues. In fact, it could be argued that this trade, like most trades that collect credits from selling puts, works best if entering when the market is already down and implied volatility is high. Bad scenarios are already priced into option premium and there is a lot of cushion between strikes. This trade is most dangerous when volatility is low and prices are high- the probabilities are not as good, because a move of more than two times the expected move down is not nearly as far.

While not for everyone, the 1-1-2-2 and 1-1-2 trades provide a very high probability of success with a nice payout when used with leverage. The trade requires monitoring to maximize profit and to prevent catastrophic loss, so it really is not a set it and forget it trade. The key is to have a plan to manage the position if the market goes against the trade and stick to the plan.

The power of rolling Iron Condors

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.

California Condor
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.

Premium and Greeks for Iron Condor
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.
Profit Curve
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.

Strikes compared to EM
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.

roll down and out
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.

Premium and Greeks for Iron Condor
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.

Closing position
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
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:

new roll position
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.

roll result
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.

Closing the rolled position
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.

Good luck trading and rolling Iron Condors!

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