Income Traders – Methods & Goals

To get started in learning the strategies of our Income Traders Kojo and Richard, please read this introductory interview with Kojo. He helps familiarize us with terminology while explaining their methods and goals. 

Ilene: Hi Kojo and Richard, can you tell me a little about yourselves?

Kojo - Richard and I have similar backgrounds. We met at Washington University in St. Louis, at the Olin Business school where we were working on our MBAs. We both have extensive experience in business consulting in areas such as valuations, financial controls and credit risk analysis. I left consulting to concentrate on credit risk analysis for several years while Richard focused on consulting.  Between us, we have about 18 years of self-taught trading experience in equities and options. We have each made our share of investment mistakes and over time, through trial and error, we have reached a point where our returns are fairly consistent.

Ilene:  You stated that “Income Trader” uses option strategies, such as non-directional credit spreads, iron condors, and butterfly options, to generate consistent, monthly income, and that your goal is to earn a modest 2% to 8% monthly return on invested capital, using the RUT and SPY indexes specifically.

I have two questions. First, are you planning to provide one option trade per month, or more than that, in your section at Phil’s Stock World?

Kojo: Our goal is to provide at least one trade per month, but if we find more opportunities, we might post “supplemental trades.”

Ilene:  Second, what are non-directional credit spreads?  Iron condors?  And butterfly options?  When using one or all of these strategies, are you betting that the stock price will not change significantly?  

Kojo: A credit spread involves a purchase of one option and a sale of another option in the same class and with the same expiration dates, but different strike prices. Investors receive a net credit for entering the position and want the spreads to narrow or expire for profit. In contrast, an investor would have to pay to enter a debit spread.

For instance, if a stock is trading at $28 and you buy a call at strike price of $35 but sell a more expensive call at $30 strike price, the price of the sold call is higher than the price of the bought call, so your account gets credited.  This would be a Bear Call Spread.  

Ilene: Is a Bear Call Spread alone a Non-Directional Credit Spread, or only when coupled to a Bull Put Spread?

Kojo: It the combination of the two credit spreads and the establishment of a wide range between them in relation to the price of the index or stock that makes it Non-directional. So, a Bear Call credit spread alone is not a Non-directional Credit Spread.

Ilene: A Bear Call Spread then is a slightly bearish position, correct?  

Kojo: Yes and no, bearish to the extent it does not breach your short strike price. But if the short call is set up with a strike price about 2 standard deviations away, there can still be enough price movement on the upside without the trade getting into trouble.  As long as the price of the stock stays below the strike price of the sold call, in this example $30, the sold call will expire worthless, as will the bought call with the higher strike price.   

Ilene: What happens if the price of the stock rises above the sold call strike price?

Kojo: You will begin to incur what we term as a catastrophic loss, which we do not want to happen. As long as Congress does not passed any laws against adjusting or closing an iron condor or credit spread, there is no reason any one should let the short put/call position be breached. Since we start our positions 2 standard deviations away from this outcome, the only scenario where it can happen is when the market opens sharply down or up say 600 to 800 points. As long as that is not the situation, we monitor our trades and move out of harm’s way when our short strikes have a high probability of being breached. 

For example, if you established a 10 point spread on 10 contracts for an Iron Condor, your risk exposure is $10,000 less the credit taken in. So if you took in $1.20 credit per contract which translates to $1,200, then your exposure for the duration of the trade is $10,000 - $1,200 = $8,800. When the short strikes are breached, then you have entered into a catastrophic loss situation and have the potential of losing the whole $8,800.

We view our income trades as a business, so if you are making on average $1,200 a month on a good month, then in a bad month you should not loss more than $1,200, that is why we monitor our positions closely and adjust or buy insurance when our trade (delta) begins to breach our comfort zone.

Ilene: What are Non-Directional Credit Spreads?

Kojo: Non-Directional Credit Spreads involve two credit spreads, one slightly bearish and one slightly bullish--so the net effect is to cancel out direction:

  1. A Bull Put Spread - slightly bullish
  2. A Bear Call Spread - slightly bearish

A subcategory of a Non-directional credit spread is called an Iron Condor. An Iron Condor combines the use of an out of the money Bull Put Spread along with an out of the money Bear Call Spread.

Ilene: So this strategy is called a “NON-DIRECTIONAL” credit spread because it doesn’t matter which direction the stock moves, the profit on one side is offset against the lost on the other side.  Where does the profit come from?

Kojo: Non Directional – The objective is to establish a wide trading range between the Bull Put Spread and the Bear Call Spread, enabling the underlying stock or index to move significantly in either direction and still be profitable. If, at expiration, the underlying stock or index finishes between the short put and the short call strike prices, all four options will expire worthless and you will you will retain all the premium collected from the two credit spreads.

Profit – Both the Bull Put Spread and the Bear Call Spread are credit spreads. You sell premium and the money shows up in your account.

Probability of profit – If you select a large enough range, you should be successful 80% of the time, profiting if the stock or index moves up, moves down or not at all. Why guess at a direction when the probability can be working for you? 

Ilene: Could you give me an example of how this works using an actual stock and options prices?  (What would have to happen for you to lose money on this strategy?) 

Kojo: How about our most recent trade?  We bought RUT 850 Call and 675 Put and sold the RUT 840 Call and 685 Put.  If the index ends up higher than the sold 685 Put and lower than the sold 840 Call at expiration, then we keep all the credit.  If the index is lower than the sold 685 Put or Higher than the sold 840 Call, then we will incur a loss if we did not manage the trade, keeping it from breaching the short strike prices. 

On the other hand if we manage the trade we might end up with a limited profit from the original credit taken in, as we give up some of our potential gains in adjusting the trade or we might end up with a limited loss depending on how many times we adjust the trade. For January, which was the strike date for this trade, we did not have to make any adjustments and we kept all the credit.

Ilene: What is the significance of the spreads being out of the money, I’m assuming that means all the puts and all the calls are out of the money?

Kojo: Yes, both spreads are out of the money at setup and you receive a credit for both of them. The goal during the duration of the trade is to manage the spreads such that at expiration they are still out of the money. If volatility spikes and the stock or index of choice is in a trending mode, then at some point the spreads will be closed for a limited lost and reestablished when conditions get calmer.

The butterfly spread is a neutral strategy that is a combination of a bull spread and a bear spread. It is a limited profit, limited risk options strategy. There are 3 striking prices involved in a butterfly spread and it can be constructed using calls or puts.

Butterfly Spread Construction: Using Calls or Puts

For example: Buying 1 In-The-Money Call, Selling 2 At-The-Money Calls and Buying 1 Out-Of-The-Money Call.

Ilene: What is the difference between a Butterfly Spread and an Iron Condor? 

Kojo: A butterfly spread can either be a call or a put, depending on the thesis of the trade. With a butterfly spread, we are counting on the instrument of choice consolidating around a particular price. With an iron condor, we are making room for it to move within a wider range and still make money. 

Ilene:  How long do your trades last?

Kojo: Our trades last anywhere from two to five weeks, depending on market conditions.

Ilene:  Do you only use the RUT and SPY indexes?  Why do you like those indexes?  

Kojo: We believe the RUT and SPY provide broader diversification and better premiums for our strategy. We also have extensive experience trading the RUT and the SPY.

Ilene:  You say you use other technical indicators, such as the Greeks.  What are the Greeks?

Kojo: Options traders often refer to the delta, gamma, vega, and theta of their option positions. Collectively, these terms are known as the "Greeks" and they provide a way to measure the sensitivity of an option's price to quantifiable factors. These terms may seem confusing and intimidating to new option traders, but broken down, they are simple concepts and can help you better understand the risk and potential reward of an option position. 

The numbers given for each of the Greeks are strictly theoretical and the values are projected based on mathematical models. Most of the information you need to trade options--e.g. the bid, ask, and last prices, volume and open interest--is factual data received from the various option exchanges and distributed by data services and/or brokerage firms.

The Greeks cannot simply be looked up in your everyday option tables. They need to be calculated, and their accuracy is only as good as the model used to compute them. The best commercial options-analysis packages will do this, and some of the better brokerage sites specializing in options (OptionVue & Thinkorswim) also provide this information.

Ilene:  For beginners, those who are just learning about options, what should they do to prepare to learn and follow your techniques?

Kojo: Beginners should acquire a basic understanding of credit spreads and how they can be combined to form an Iron Condor. Also, it helps to understand how to adjust credit spreads if the short strike price is getting close to being breached. Follow our trades for a couple of months to get a feel for our strategy, and post questions and comments at Income Trader on PSW. 

Ilene: Thank you, Kojo.

*****

Read more in the Income Trader section to see how these trades work in real-time. Please ask Kojo and Richard questions in the comment section at the end of the posts.

Here are some definitions from Investopedia:

Bear Call Spreads - A type of options strategy used when a decline in the price of the underlying asset is expected. It is achieved by selling call options at a specific strike price while also buying the same number of calls, but at a higher strike price. The maximum profit to be gained using this strategy is equal to the difference between the price paid for the long option and the amount collected on the short option.

For example, let's assume that a stock is trading at $30. An option investor has purchased one call option with a strike price of $35 for a premium of $0.50 and sold one call option with a strike price of $30 for a premium of $2.50. If the price of the underlying asset closes below $30 upon expiration, then the investor collects $200 (($2.50 - $0.50) * 100 shares/contract).

Bull Put Spreads - This type of strategy (buying one option and selling another with a higher strike price) is known as a credit spread because the amount received by selling the put option with a higher strike is more than enough to cover the cost of purchasing the put with the lower strike. The maximum possible profit using this strategy is equal to the difference between the amount received from the short put and the amount used to pay for the long put. The maximum loss a trader can incur when using this strategy is equal to the difference between the strike prices and the net credit received. Bull put spreads can be created with in-the-money or out-of-the-money put options, all with the same expiration date.

Iron Condor - An advanced options strategy that involves buying and holding four different options with different strike prices. The iron condor is constructed by holding a long and short position in two different strangle strategies. A strangle is created by buying or selling a call option and a put option with different strike prices, but the same expiration date. The potential for profit or loss is limited in this strategy because an offsetting strangle is positioned around the two options that make up the strangle at the middle strike prices.

This strategy is mainly used when a trader has a neutral outlook on the movement of the underlying security from which the options are derived. An iron condor is very similar in structure to an iron butterfly, but the two options located in the center of the pattern do not have the same strike prices. Having a strangle at the two middle strike prices widens the area for profit, but also lowers the profit potential.

 
 
 

Zero Hedge

Explosion Hits Russia's Largest Virus Lab Which Houses Plague, Smallpox, Ebola And Other Deadly Viruses

Courtesy of ZeroHedge View original post here.

A sudden explosion at a Siberian virus research center on Monday reportedly left the facility engulfed in flames, according to several Russian news outlets. 

Firefighters and other emergency personnel were dispatched to the "Vector Institute" located several miles from Novosibirsk - an emergency which was upgraded "from an ordinary emergency to a major incident," a...



more from Tyler

Phil's Favorites

The future of work will still include plenty of jobs

 

The future of work will still include plenty of jobs

Even though the future is unknown, Canada’s employment rate has risen steadily from 53 per cent in 1946 to more than 61 per cent today. (Shutterstock)

Courtesy of Wayne Simpson, University of Manitoba

There is now widespread anxiety over the future of work, often accompanied by calls for a basic income to protect those displaced by automation and other technological changes.

As a labour economis...



more from Ilene

Lee's Free Thinking

Is The Drone Strike a Black Swan?

Courtesy of Lee Adler

Pundits are calling yesterday’s drone strke a “black swan.” Can a drone strike on a Saudi oil facility, be a “black swan.”

According to Investopedia:

A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, their severe impact, and the practice of explaining widespread failure to predict them as simple folly in hindsight.

I seriously doubt that no one expected or could have predicted a drone strike on a Saudi oil facility.

Call Me A B...

more from Lee

Insider Scoop

New Relic Cuts 2020 Sales Guidance, Announces Changes In Management

Courtesy of Benzinga

New Relic (NYSE: NEWR) has reaffirmed its second-quarter guidance and cut its sales guidance for fiscal year 2020 from $600 million-$607 million to $586 million-$593 million.

The company’s chief technology officer, Jim Gochee, and chief revenue officer, Erica Schultz, have resigned. New Relic also named board member Michael Christenson as its chief operating officer. Christenson joins from his ...



http://www.insidercow.com/ more from Insider

The Technical Traders

Metals are following downside sell off prediction before the next rally

Courtesy of Technical Traders

It is absolutely amazing how the precious metals markets have followed our October 2018 predictions almost like clockwork.  Our call for an April 21~24 momentum base below $1300 followed by an extensive rally to levels above $1550 has been playing out almost like we scripted these future price moves.

Now that the $1550 level has been reached, we are expecting a rotation to levels that may reach just below the $1490~1500 level before attempting to set up another momentum base/bottom formation.  And just like clockwork, Gold has followed our predictions and price is falling as we expected. Just look at our October 2018 chart where we forecasted the price of gold...



more from Tech. Traders

Chart School

Crude Oil Cycle Bottom aligns with Saudi Oil Attack

Courtesy of Read the Ticker

Do the cycles know? Funny how cycle lows attract the need for higher prices, no matter what the news is!

These are the questions before markets on on Monday 16th Aug 2019:

1) A much higher oil price in quick time can not be tolerated by the consumer, as it gives birth to much higher inflation and a tax on the average Joe disposable income. This is recessionary pressure.

2) With (1) above the real issue will be the higher interest rate and US dollar effect on the SP500 near all time highs.

3) A moderately higher oil price is likely to be absorbed and be bullish as it creates income for struggling energy companies and the inflation shock may be muted. 

We shall see. 

...

more from Chart School

Kimble Charting Solutions

Bond Yields Due For Rally After Declining More Than 1987 Stock Crash

Courtesy of Chris Kimble

U.S. Treasury Bond Yields – 2, 5, 10, 30 Year Durations

The past year has seen treasury bond yields decline sharply, yet in an orderly fashion.

This has spurred recession concerns for much of 2019. Needless to say, it’s a confusing time for investors.

In today’s chart of the day, we look at a longer-term view of the 2, 5, 10, and 30-year treasury bond yields.

Short to long term bond yields are all testing 7 to 10-year support levels as momentum is at the lowest levels in a decade.

A yield rally is likely due across the board after a recent decline that was bigger than the stock crash in 1987!

If yields fail to ral...



more from Kimble C.S.

Digital Currencies

China Crypto Miners Wiped Out By Flood; Bitcoin Hash Rate Hits ATHs

Courtesy of ZeroHedge View original post here.

Last week, a devastating rainstorm in China's Sichuan province triggered mudslides, forcing local hydropower plants and cryptocurrency miners to halt operations, reported CoinDesk.

Torrential rains flooded some parts of Sichuan's mountainous Aba prefecture last Monday, with mudslides seen across 17 counties in the area, according to local government posts on Weibo. 

One of the worst-hit areas was Wenchuan county, ...



more from Bitcoin

Biotech

The Big Pharma Takeover of Medical Cannabis

Reminder: We are available to chat with Members, comments are found below each post.

 

The Big Pharma Takeover of Medical Cannabis

Courtesy of  , Visual Capitalist

The Big Pharma Takeover of Medical Cannabis

As evidence of cannabis’ many benefits mounts, so does the interest from the global pharmaceutical industry, known as Big Pharma. The entrance of such behemoths will radically transform the cannabis industry—once heavily stigmatized, it is now a potentially game-changing source of growth for countless co...



more from Biotech

Mapping The Market

How IPOs Are Priced

Via Jean Luc 

Funny but probably true:

...

more from M.T.M.

Members' Corner

Despacito - How to Make Money the Old-Fashioned Way - SLOWLY!

Are you ready to retire?  

For most people, the purpose of investing is to build up enough wealth to allow you to retire.  In general, that's usually enough money to reliably generate a year's worth of your average income, each year into your retirement so that that, plus you Social Security, should be enough to pay your bills without having to draw down on your principle.

Unfortunately, as the last decade has shown us, we can't count on bonds to pay us more than 3% and the average return from the stock market over the past 20 years has been erratic - to say the least - with 4 negative years (2000, 2001, 2002 and 2008) and 14 positives, though mostly in the 10% range on the positives.  A string of losses like we had from 2000-02 could easily wipe out a decades worth of gains.

Still, the stock market has been better over the last 10 (7%) an...



more from Our Members

Promotions

Free eBook - "My Top Strategies for 2017"

 

 

Here's a free ebook for you to check out! 

Phil has a chapter in a newly-released eBook that we think you’ll enjoy.

In My Top Strategies for 2017, Phil's chapter is Secret Santa’s Inflation Hedges for 2017.

This chapter isn’t about risk or leverage. Phil present a few smart, practical ideas you can use as a hedge against inflation as well as hedging strategies designed to assist you in staying ahead of the markets.

Some other great content in this free eBook includes:

 

·       How 2017 Will Affect Oil, the US Dollar and the European Union

...

more from Promotions





About Phil:

Philip R. Davis is a founder Phil's Stock World, a stock and options trading site that teaches the art of options trading to newcomers and devises advanced strategies for expert traders...

Learn more About Phil >>


As Seen On:




About Ilene:

Ilene is editor and affiliate program coordinator for PSW. She manages the site market shadows, archives, more. Contact Ilene to learn about our affiliate and content sharing programs.

Market Shadows >>