In the initial post and replies to the questions I have outlined the basics of the strategy. In this post I would like to highlight some of the key points of success and outline a strategy for anyone wanting to try it out.
The key aspects of the successful option spreads selling:
1) Diversification
Diversification is probably one of the most important aspects of this strategy. When entering a trade it is impossible to say whether it will be a winner or a loser therefore being exposed to different markets at the same time ensures that something will always go in your favor helping you to survive difficult times and thrive in good ones.
Make sure that you are either selling options in the uncorrelated markets or sell opposite directions in the correlated markets.
I will give two examples:
- Selling spreads in pork bellies and spreads in coffee or crude oil
In the normal markets there is a little relationship between price of pork bellies and coffee, therefore if you are loosing in one market there is a chance that you have a better trade in another market
- Selling put spreads on S&P and put spreads on interest rates
In this case we are selling spreads in different direction on correlated instruments. The financial markets are defined by flow of money from bonds into stocks known as risk on trade and back to bonds known as risk off trade. Eventually this relationship will be broken, however now and in the foreseeable future it should hold and thus can be exploited.
2) Selling as far out of the money as possible. Trade time for distance
The further out of the money you sell the better you will sleep at night. There are many strategies to selling option spreads, some people prefer to sell close to the money to collect high premium, however the downside in my opinion outweighs the benefits as it decreases the room for error. For example selling crude oil 92/96 call spread while oil is at $86 is a high risk trade in my book I would be much more comfortable selling 105/106 or 110/111 spread knowing that market will give me plenty of time to correct the error.
3) Entering one trade at a time
Do not enter all of your positions in one day, instead have a goal of entering one position a day. This way you are minimizing the risk of taking a major position just before the crash or rally.
4) Margin management
The second most important pillar of this strategy is effective margin management, in spread selling the following equation holds true:
Lazy money=Skinny account
Selling spreads is like looking for a job, in this case you are trying to find employment for your money. Ideally you should have 50-70% of your capital tied in margin. The advantage of spread selling is that there is quite a bit that you can do to squeeze more yield out of your trading funds. There are two basic ways of doing this:
- Rolling your spreads early
- Selling more spreads
How to start selling spreads
Starting out is pretty simple, you will need the following to begin:
- Account with InteractiveBrokers or some other low cost broker (transaction costs should be as low as possible, preferably the lowest in the industry)
- $10k or so in starting cash
- Good understanding of the option markets, vertical spreads, futures, trading platform, margin requirements and basic Excel skills
As a start set up yourself a goal of making 3-5% p/a in return, the lower your expectations are the better. Look at the major futures with highly liquid option markets such as S&P minis (ES) and 10 year bond futures. Wait for the market to move to one extreme or another and then sell one or two option spreads 70-90 days out as far out of the money as possible. Don't worry too much about collecting a decent premium - as long as you can get $50-100 per spread with $1000 of max downside you should be fine.
Wait a week or two for the spread to drop to 50-60% of it's initial value at which point either roll it or close and open another one in the another instrument. Look at expanding the range of traded markets, for each new market always initialy try selling far out of the money spreads just to get a feel for the market.
Repeat the process until you feel comfortable with the strategy at which point start concentrating on increasing your profits by managing margins more effectively, converting vertical spreads into condors and rolling positions.
