A Winning Option Strategy Combo
11/06/2013 6:00 am EST
Option mentor Dan Sheridan talks about credit spreads, what they are, and how he uses them to create a profitable trading strategy that generates regular income.
SPEAKER 1: My guest today is Dan Sheridan and we are talking about credit spreads, what they are and how you use them as an option trader so, Dan, first of all, let’s define what a credit spread is.
DAN SHERIDAN: A credit spread is simply, let’s take an example in calls XYZ is at $100 and I am going to go sell the $110 calls and buy the $120 call, so you are selling, let’s say on the call side, a little closer in than the one you are buying so it is an out of the money call credit spread. Again, XYZ is at $100, selling one $110 call, buying one $120 call.
SPEAKER 1: So is this assumed that $100 XYZ is going to go to $120 or at least rise?
DAN SHERIDAN: Well, good question. Some people run a credit spread business and they are more directional. They would say, hey, I think XYZ is going to go down and XYZ is at $100, I am going to sell the $110 calls, buy the $120. That credit spread would benefit if the price went down. Other people like myself, more probability traders that don’t know which way the market is going every day, I am one of the few that don’t know which way the market is going every day, so what I do is more from a probability. I will say XYZ is at $100. Hey, I am looking at the charts. I think it looks like it is in a downtrend but, to get the probabilities in my favor because I want to make this a business, if XYZ is at $100, I will go out of the money and I will pick a strike that has maybe a delta of 15 or 20, and what that means is, let’s say for example, I sell a delta of 20 to pick my strike, the stock only has a 20% probability of going through that strike at expiration so I like to combine the probabilities plus direction to give me a business. Just doing it on direction I think is a very rough game but if I am starting out with 60%, 70%, or 75% probability and add a little bit of sound directionals, I think you have a winning combination.
SPEAKER 1: And that is where options really shine is the strategy, right, use those probabilities.
DAN SHERIDAN: Beautiful, you can get probabilities because that is what makes this as a business possible. The fact that I can look at a chart, I don’t know if that, in most retail traders’ situations, is going to translate into a consistent business model for monthly income but if you through probabilities in and good risk management, I think you have a powerful business.
SPEAKER 1: Let me run back to that credit spread example. What about the expiration? Am I going 30 days out for both of those, further out, shorter? What do you like?
DAN SHERIDAN: Good question. Generally, what I like to do, if I had allocated for my credit spread business $5000, I would allocate 70% of the $5000 or $3500 into credit spreads that are about 30 to 35 days from expiration and then I would allocate 30% of the $5000 or $1500 into this phenomena we call weekly’s or shorter-term trades, maybe 4 to 14 day trades, so I want to get some of the benefit of weekly’s, the time decay, less capital you have to commit, but I don’t want too much hot sauce. I just want to diversify my timeframes. Again, diversification is the principle that drives how I would run a credit spread business.
SPEAKER 1: Dan, thanks for your time.
DAN SHERIDAN: Thank you.
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