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:
- A Bull Put Spread – slightly bullish
- 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.