Selling OTM Credit Spreads

Welcome to the Bullish Bears Options Trade Series. Each blog in this series is going to focus on specific tactics, actionable criteria, and strategic planning to pull the trigger on an options trade. In this post we are going to discuss selling OTM credit spreads; why we trade them, what market conditions we are looking at, and how to build the spread. 

Since this is a beginner’s blog on selling OTM Credit Spreads it will not cover technical analysis, options criteria, or Greeks. As a result, we need to get everyone on the same level before moving on to those subjects. 

However, this is not an introduction to options.

How accurately can you determine market direction? Even when you get the market direction right, how accurately can you predict the distance of that directional move? When trading options, there are many ways to make money in the market; including selling OTM credit spreads.

Selling OTM Credit Spreads

Why place money into a trade that requires a specific move to a specific price? In fact, when you place an options trade like this, you risk losing money if you get the direction wrong and you risk losing money if the move does not reach your target profit zone. 

How about market sentiment? As a result, let’s talk about this for a moment and find some common ground. What is market sentiment? However, when I think of market sentiment I think of bias and perspective. When you bring up a chart and you look at your favorite indicators what feeling do you have? 

Was there a news article or blog that causes you to feel mildly bullish or bearish? Is there some indication from your previous trading experience that gives you a hunch about where the market may go? That feeling is market sentiment. As a result, it helps with selling OTM credit spreads.

Markets

Did I lose you yet? Let’s talk about markets then. When I say market sentiment, what market am I talking about? Equity markets? 

BAA! You won’t hear me talk that finance geek talk! In fact, when I say markets, I am referring to the entire market symbols that are tradable on the broker platform you use. Want some examples?

Suppose I say that the market is $AAPL. Apple is a great example of market. In fact, I have a very particular market sentiment on $AAPL stock and a completely different sentiment about the Apple Company. $SPY? 

Yes, even though $SPY is not a company it is still market. Futures? Absolutely. In fact, in these blog posts, “market” is any ticker symbol that can be bought or sold with your funds on your trading platform. 

Selling OTM Credit Spreads

​As a result, now that we have found a common definition of markets and we have defined market sentiment how do we use that to make some money? Instead of specifically trading on direction and focusing on our trade hitting a specific price target I suggest that we instead develop a trade plan.

We want a stock market trading plan that uses our market analysis, market sentiment, and directional bias to determine where price is most likely going to be in the near future and place a trade that avoids the price action.

What is more likely? That we can determine the general trend of the stock and place a trade with a goal of avoiding price? Or that we can determine exactly where price will be at a specific time ​soon?

Market Direction

I think we can all agree that determining market direction based on trend analysis is an easy task compared to determining exact price action in the future. We can even use market sentiment, bias, and chart analysis of support, resistance, and price structure to help us determine trend. 

Suppose you are new and cannot do support and resistance very well? Maybe you are new and don’t have a strong grasp of chart analysis or price structure. In fact, these types of strategies can be used by new traders who have access to the Bullish Bears trading service​.

We offer ​trading rooms, watch lists, and the after-market subscriptions services like Black Box Stocks, Trade Ideas, or Trend Spider. Why? Because these types of trades rely on accurately determining market trend and momentum and everything listed above is offered to assist traders with exactly that!

Fairy Tales

Ok, you must think all of this is just too easy, right? Fairy Tales, or some sales trick? Nope. However, if you’re reading this then you have already bought the only thing you need: A Bullish Bears Community membership. 

Armed with a stock market trading membership, you now have all the tools you need to start trading actionable strategies based on the data offered while also having the free time needed to study, paper trade, and learn more about other trading concepts and techniques. 

What Is Out of the Money?

So, what is an Out of the Money Option? An OTM option is a stock option with a strike price beyond the current price of the underlying. HUH? Finance Geek! 

What I mean to say, is that a call option OTM is above the current price and a put option is below the current price. In fact, they’re not In the Money (ITM) because they are beyond the price. 

However, if the price moves to the strike price of the option, they are no longer OTM and are instead At the Money (or ATM). Why is this important?

If we open an options trade by SELLING an OTM option to enter the trade then to exit the trade later, we need to buy it back or let it expire worthless. If we sell a spread to open the trade in options that only have time value, they will slowly decay and become worthless if price never comes to our sold options strike price. 

Confused About Selling OTM Credit Spreads? 

Confused? ​We’ll go through a few different examples to clear things up. However, before we get into some examples, let me​ ask you for a favor. 

Forget all the classes or blogs or training sessions you have ever taken about options trading. Somewhere along the way the training or classes or coaching sessions lead up to a hook. Someone had an agenda. 

​Instead set all that aside and focus on the basic concepts presented here. Look at the overall concept and accept it for the reality that it is: an example of a trade strategy. 

A discussion of what selling OTM ​credit spreads means. How we can do it to produce consistent income with minimal risk? To be fair, I have an agenda too.In fact, my goal is to show you how to develop a trade plan and my goal is to give you the tools to act on that plan. 

Selling otm credit spreads

SHORT TERM BULLISH BIAS

Selling OTM Credit Spreads on $SPY

In the above picture of $SPY the short-term market trend is bullish. In fact, I would look to place a trade below the direction of the market trend. 

With some basic moving averages of 50 SMA and 200 SMA, a Stochastic Slow and RSI I have developed a short-term bullish bias. As a result, price right now shows $SPY to be $277.37. 

Since $SPY can move a good distance in a short period of time, I would look to place a trade with some distance below $277.37. As a result, let’s look at the options chain and pick a product.

Selling otm credit spreads

OPTION CHAIN FOR $SPY

Understanding Selling OTM Credit Spreads

​This is a LOT of information to take in ​at once! In fact, it’s a good idea to take each section separately; get an understanding of what we are looking at when selling OTM credit spreads.

Starting at the top left yellow box we can see that $SPY moved almost $3.00 in a day. With price at $277.37 we want to get an option below that. 

As a result, the $274.50 Put Option is close to $3.00 away from the current price and is in the opposite direction of the current trend. If we took that option as our trade, we could collect $30.00by selling this put (watch us do stock trading live each day in our trading rooms).

Staying with the left side of the picture, look to the lower left. Identify the box and arrow of the probability of profit. This is not a probability of max profit, only a probability that the trade could make $0.01or more before expiration. 

Examples on Selling OTM Credit Spreads

However, in our $SPY example, this trade has a 93%Probability of Profit (POP). Does that sound good? Sure, sounds good to me! 

Moving across the bottom to the right we see the max profit of $30.00. Now, that does not count the commissions paid to enter the trade. 

In fact, if you want to close this position before expiration it will also cost you money to do that on most brokers platforms. This is important to keep in mind since those fees will eat into your profits.

selling otm credit spreads

OPTION CHAIN FOR $SPY

Picture of Selling OTM Credit Spreads

I zoomed into this picture so that I could focus your attention on a critical aspect of this trade: MAX LOSS. In fact, selling naked options carries undefined risk. 

What does that mean? It means that you are on the hook for the promise made when entering the trade. What promise? You’re promising to buy this option back in the future, at whatever price it’s at. 

In fact, if $SPY suddenly tanked in a Black Swan event and fell $200.00 the price of this put would be beyond my calculation! The broker suggests that the max price of this put in a black swan event is $27,420.00. 

Is that a likely situation? No. Can it happen? Sure. I don’t take anything off the table when it comes to market events. Sure, it can happen. You can also win a million-dollar lottery with a scratch ticket. Is it likely? No, but it is possible (check out our learn options page).

Recap on Selling OTM Credit Spreads

​Let’s recap what we’ve covered thus far. We take our market bias of current directional trend and develop a trade based on this.

We’d enter a trade OTM and behind the direction of the current trend to avoid being run over. We sell an option to enter the trade. We buy that option back to exit the position. 

Since an option OTM has time value, we want to sell it and let time decay reduce that options value to $0.00. Why? 

​If we ​must buy it back to close this trade, we want to spend as little as possible! In our $SPY example, the option we looked at was $30.00. 

If I sold that option for $30.00 and I must buy it back to close my position. I want to buy it back for less money than I sold it. I would rather buy back my position for $0.00!

Issues

Have you identified where we may have issues in placing this trade? Yes, the max loss. The max loss would keep me out of this trade because I trade with an account far less than $27,000.

The idea is a great idea, selling an option that only has time value; then letting the clock decay the price of the option until it expires worthless. We just need to develop a trade that eliminates this undefined risk.

How do we do that? We buy an option. HUH? What? You thought we were selling options, right? Well, that is the plan, but we also need to protect our backside (or, our downside) and we do this by buying an option. Let’s look at an example of selling otm credit spreads. 

selling otm credit spreads

ADDING A SECOND LEG TO MAKE THIS TRADE INTO A SPREAD WILL DEFINE OUR LOSS

Adding Option

In the picture above, I’ve added an option to cap our loss or to define our risk. Since we must buy an option to accomplish this, it reduces the amount of money we would receive from the sell of the first option.

​There’s not a lot of time value left in these options so there is not much money to be made. Once we factor in the commission fee, this trade would​ offer us very ​little profit. That isn’t the point of this example, however.

The point was to demonstrate how we could sell an OTM option and make a profit by allowing time to decay the value of that option. The example was to show how we can use a spread to define our risk and protect our account from a black swan event. 

Taking Trade in Pieces

By walking through the example, we’re able to take the trade in pieces, understanding why each part of the trade was taken.

First, we develop a market bias and determine trend. Second, we look at the options table to determine what money the option would generate. Third, we find an option to protect our downside and define our risk. Let’s look at another example.

credit spreads

$5.00 WIDE CREDIT SPREAD

More Time Value

In this example, I have gone into a deeper series to find options with more time value. ​The previous example had the short-term option with very little time value left. ​

As a result, the trade would barely cover our commissions. In this example, I went a few weeks away and highlighted a $5.00 wide spread that could be sold for a max profit of $71.00. The Probability of profit is76%, the Expected Move (EM) is $4.72 and the max loss is defined at $429.00. 

This strategy is not restricted to only selling puts in a bullish market. We can place the same strategy with call options in a bearish market. How? Let’s look at the example below for selling otm credit spreads. 

spreads

$10.00 WIDE CREDIT SPREAD

Options Table

In the picture above is an options trade in $AAPL options table. This is a bearish position that looks to avoid getting in front of the trend momentum by building a spread above price of $AAPL.

This $10.00 option spread has a max profit of $159.00 and a max loss of $841.00. The probability of profit is 70%, and the current price of $AAPL is $170.42. 

Let’s take a moment to discuss this max loss in more detail. I understand that this trade looks skewed if you haven’t not sold options before.

The risk reward ratio seems very heavily one sided, right? Who would risk $840 to make $160? I WOULD. The probability of profit and the fact that I can close the position early means that I not only have a better than 50% chance of making money; it also means that if price begins to move in my direction I have a lot of time to exit this position or adjust this position.

The only way I would take the entire max loss is if I placed this trade and never looked back. Who would do that? 

Market Trend

Selling options OTM is a strategy that takes advantage of market trend and momentum. We want to avoid getting run over by price action.

As a result, we enter a trade behind the price action. This strategy doesn’t participate in the price move; which means if the price moves $0.10 or $10.00 we still make the same amount if the price follows the market trend from our analysis. 

You now should have a very solid understanding of what selling OTM options means and how to build the spread. This is not the end of this discussion.

There is a lot more detail we need to cover to give our trades a greater chance of success. Hence we also need to discuss different ways to adjust this trade if price starts to move against us. In fact, we’ll discuss these things in ​a following blog post.

​We’ll cover using technical analysis to improve our probabilities, choosing the strike prices, the Greeks, and everything else mentioned above. I look forward to seeing you there! 

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