\Welcome to Part 3, where we’ll talk about broader guidelines and suggestions for tweaking the strategy to your needs. Just to recap – in part 1 I gave a quick intro to the put credit spread structure. Then in part 2 I shared a rules based approach to entering weekly credit spreads on SPY. In that post, I gave some fixed parameters like “$10 wide spread” or “collect $0.50”. I wanted to keep it on topic so I focused on what to do but didn’t talk about why. This video is the why, and with that you can start changing some of those parameters if you like.
But first, as always, a quick note that I am not a financial advisor. I’m just sharing my journey and what has worked for me.
What to trade: Any underlying with liquid options.
I mentioned last time that SPY has very liquid options. This means the bid-ask spread is very narrow. The wider the bid-ask spread, the more you have to give up to get filled. I always recommend starting at the mid-price, but with less liquid underlyings you will have to move your entry price farther against you to get filled and that’s a hidden cost in your trades. Let’s compare SPY options to TAP, a beer company. Notice that TAP has a much wider bid ask spread. Also note that TAP is ~7x smaller than SPY. So these spreads are actually 7x worse if you scaled up to equivalent size.
SPY: 2-3 cent spreads
TAP: 10-20 cent spreads
When to Trade: Weekly on a Down Day
Instead of entering one large trade, we break it up into small overlapping weekly entries. This spreads out our timing so if we enter at a very bad time, that is only a small part of our capital. So that’s the reason to enter weekly even though the trades overlap.
Next, let’s consider my insurance analogy from part 1. Imagine you are selling flood insurance to homeowners on the coast. As you would expect, the price of that insurance will be higher right after a flood. The risk is more front of mind in your customers and they’ll pay more for it.
In the same way, option premiums tend to go up when the market is going down. So we wait for a down day to enter to give us a little extra advantage. It’s not a huge effect and we don’t want to skip a week, so we enter Wednesday if we haven’t had a down day yet.
Which Expiration: 45+ DTE
In my experience, the further out in time you are selling options, the smoother the return tends to be. There isn’t really a “right” answer to picking duration but 45 is widely considered a sweet spot. Let’s look at a backtest I did of this strategy with 60+ DTE vs 30+ DTE. This was on SPX from 2008-2017, but would look similar on SPY. This isn’t a cherry picked timerange, my data ends in 2017, but it was a bull market.
As you can see, the shorter duration ekes out a little higher return, but the ride can be a bit rough. It’s much like choosing between a Ferrari or a Bentley. Both are cars, neither is better, it depends on how you value comfort vs speed. I strongly recommend comfort to start and I still prefer it today. (I’m more of a Subaru guy, but you get the picture)
I split the difference and went with 45. If you want a smoother ride, you can go longer, with more layers on at one time. If you want higher returns, you can go shorter, with less layers.
Trade Construction: 2% wide spread, $0.50 credit
I like using ~1% per month of duration as a minimum. For 45 DTE I round up to two months so 2%. 2% of 440 (current SPY price) is $9. I just rounded up to $10. Much like expiration, there is a trade off between wider and narrower spreads. Using 2% also keeps our risk the same each week and avoids having to discuss delta, which some traders like to use for strike selection. I’ll talk about delta in a future video.
$0.50 is the minimum credit I like to collect for a put credit spread like this one. Remember that equity options have a 100x multiplier, so that is really $50 per spread. The $10 width is really $1000 of risk and margin use. $0.50 is large enough that I expect the long-term returns to exceed commission and slippage. You could go higher, we can look at $2.00 credit as an example. Your potential returns will be much higher. However, the risk will be much closer to the market and you will have a much bumpier ride. Making this as a beginner strategy, I went for the smoothest ride possible. 5% of the width (0.50 is 5% of $10) is also probably as low as I would go.
Here I am showing the $0.50 credit version and a $2.20 credit version on the same P&L plot. Notice the $2.20 variant is extremely close to the market.
Profit Taking: 20% of the initial credit
Holding on until the expiration date to squeeze those last few pennies out is not generally worth it. Taking 80% of the credit lets us capture most of the potential profit. In this case, we collected $0.50 so we close at $0.10. That’s a $0.40 profit, which is really $40 with the multiplier.
Stop Loss: 200% of the initial credit
Especially for spreads like this where the credit is a small % of the max loss, I like to close at some loss level before things get out of control. If we let this spread hit max loss, it could take months or even longer to recover from a single losing trade.
Time Exit: Exit when we are 7 days out
If we haven’t hit our profit or loss targets yet, and we are a week out, we close the trade. The last few days of a spread can be very volatile and are worth avoiding.
Some Example Modifications:
Enter on Monday Morning:
I am currently in the Philippines. I don’t want to wake up at 3:45 AM to check the down day entry rule. So if I were trading this, I would drop the down day rule and just enter every Monday morning (New York time) which is around 10 PM local time.
No Layering, One Spread Only:
You could omit the overlap. Just enter one big position and follow the exit rules until it closes. Then enter the next position. This will lose the smoother ride of the overlapping entries but you will have more of your account allocated all the time and so returns may be slightly higher.
You could trade this on another underlying. For example, QQQ, IWM, DIA are also index funds that would work well. There are also pure “index options” like SPX or RUT. SPX is 10x the size of SPY, so I don’t recommend starting with it. The main advantage of SPX are that index options are covered by Section 1256 in the US tax system. That treats your P&L as 60% long-term and you will pay a lower tax rate. I am also not a tax professional, so you may want to consult with one before trading SPX or RUT. You can read more about Section 1256 at Investopedia here. When trading a different underlying, you can use the above guidelines – 2% width, $0.50/5% minimum credit, etc., to come up with a good set of starting parameters.
That sums up my favorite beginner-friendly option trade. I hope you found it interesting and educational. Thank you for following along this far. I’m going to cover other strategies and topics in future videos, so check back here or subscribe on YouTube/Rumble if you’re interested and I will see you there.