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When selling options can limit your risk...

It is always a telling sign that something is changing in market dynamics when we get financial entertainers (e.g., Cramer) state after two or three weeks of extreme volatility “Anyone could have made money in the market the last three years by buying.” They are obviously implying that things are about to get difficult. The volatility gets magnified by (or is it the source?) when our political entertainers make ad hoc public statements that run against what we learned in 7th grade economics. Enough said.

It is often said that over the long term, the best way to profit in the market is to “sell” options for income. This is especially true in a high volatility market. I actually call it by another name: “selling volatility.” However, it is absolutely critical that you understand your risks as well as what you are doing.

I never get into a trade without knowing my risk. If I sell volatility, it is always through the use of credit spreads as the risk is defined.

Case Study on TLT

TLT (iShares Barclays 20+ year Treasury Bond Fund) has had the tendency to trade in $6.00 wide boxes for the past 18 months. Price action recently jumped back into a box that spans $116.50 to $112.50.

Courtesy of TC2000

Based on past behavior my theory is that if TLT reaches the edge of the box, which constitutes support or resistance, there is a high probability that it will bounce. One of my favorite strategies when a stock is potentially bouncing on support or resistance is to sell a credit spread.

For example, on February 21st when TLT was closing near $116.50, I sold a put spread a few minutes before the close, generating a $520 credit vs. a $780 risk.

Courtesy of TomsOptionTools.

My entry reasoning and trade plan was very clear:

Date: Feb 21, 2017

Time: 15:58

Underlying: TLT

Strategy: Bull Put Credit Spread

Option(s): Short $116.50 put/Long $115.50 put

Position Size: 13 contracts at $0.40 - $780 risk ($520


Entry trigger: EOD

Entry Rationale: Potential bounce off box resistance

Technical Stops: 1 daily close <= $116.50

Technical Targets: TLT > $116.50

Profit Target: 80% of credit

Mental Stops: 10% loss on max risk

I love it when a plan works out. My GTC order to buy back the spread for $0.08 was filled on Monday, February 26th after 5 days in the trade. I pocketed $416 minus commissions.

The lesson here is that organization of why one enters a trade, how and when it will be executed provides a road map that helps take emotion out and allows you to both stay in a position (not get out too early) or exit a position at a loss (not get out to late).