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The basic strategy applied by the monthly cash machine is as follows:

1. We will recommend between 6-8 "credit spread plays" during the month, which will be called THE RECOMMENDED SPREAD LIST. The NUMBER OF POSITIONS, IN THE RECOMMENDED SPREAD LIST, are based on a portfolio with a $35,000 minimum equity value, which can be in either the form of cash or marginable securities. (Please note that depending on your brokerage, the minimum maintenance required can vary.)

2. This RECOMMENDED spread List will be made up of either put credit spreads or call credit spreads and may include one of more index option credit spreads as well.

3. These spreads should generate $2,000 - $2,500 in premium per month based on 10 contract-spread positions.

(Example:)

Buy 10 ABC July 30 Calls to OPEN (cost $.25)

Sell 10 ABC July 25 Calls to OPEN (credit of $.90)

Receive a NET CREDIT of $0.65

4. Our goal is to select spreads far enough out of the money where both sides of the spread will expire worthless and we will net the credit received for each trade. As a profit.

5. We will keep you advised as to the disposition of each of the positions and inform you of any changes or adjustments that we need to make in regards to any position that potentially could be a loss. (And yes we do have some losses from them time to time). While no system guarantees 100% winners each trade. We believe that collecting premiums at the expense of the option buyers who are looking for the homeruns, will net us continuous cash flow profit over the long term.

6. We are looking to be profitable on 80% - 95% of our trades and keep our losses to a 2-1 or 3-1-risk/reward loss ratio. In other words, if we were to lose 2 out of 10 trades, with either 2-1 or 3-1 loss ratio, we should still be profitable month to month.

7. In addition, we will be offering a series of "Supplemental" spreads that you may also utilize. However, these "Supplemental Spreads" will not be followed in detail and should be viewed as just what they are "Supplemental" spreads used on a discretionary basis, based on your own individual risk tolerance and interest.

8. Our recommended plays will be issued around the last week of the current expiration period (or roughly with 5 weeks of time remaining until expiration). So as an example, the October spreads will be issued around the week of the 12th of September.

9. A total of 4-6 positions will usually be issued initially, with the remaining recommendations issued a couple of days shortly afterward. However, all 6-8 positions may be issued at once, based on varying market conditions of the individual issues involved or the overall condition or market direction itself.

10. Remember this is a conservative strategy in which we are attempting to generate income, consistent income; on a repetitive basis, this is by no means a get rich quick strategy.

11. To repeat our goal here is to average $2,000 - $2,500 a month in income from the option premiums we net out from our spreads by being sellers of positions that are out of the money. In actuality, we don't have to be right, but only either somewhat right or even only somewhat wrong, and we should still be profitable. A side ways moving market is just as effective for our strategy as a market move in our direction. The ultimate goal is the same. We want the positions to expire worthless at expiration time.
 

 

Introduction to Spread Trading
 

In option markets there are many ways to trade for profit. The most common strategy involves speculating on the direction in which the underlying security will move. If a trader correctly predicts the market direction and takes the appropriate position he can expect to make a profit. But even when the market moves in the expected direction, owning the correct position (call or put) will not necessarily be profitable. The problem is, while the trader is waiting for the option's price to move towards its theoretical value, the position is at risk from a wide variety of changes in the market which threaten its potential profit. For this reason, the majority of successful derivatives traders engage in spread trading.

A spread is a strategy which involves the buying and selling of simultaneous but opposing positions in different option series. The use of spreads or stock/option combinations is simply a way for traders to take advantage of favorably priced options, while at the same time reducing the effects of short-term changes in the market so that he or she can safely hold an option position to maturity. Spreading techniques basically help to maintain an acceptable level of profit while limiting potential losses and although there is no "perfect" strategy in the options market, successful traders attempt to reduce risk as much as possible in every portfolio position.

 
Credit Spread Basics
 

A credit spread is a simple strategy that allows options traders to have time decay work in their favor while maintaining a favorable risk-reward outlook. To initiate a bullish credit spread, an investor would simultaneously write a put option and buy a put option that expire at the same time, but with different strike prices. The written option is closer to the price of the underlying issue than the purchased option, and therefore has a higher premium. Investors will receive a credit in their account, hence the name "credit spread." The objective is for both options to expire worthless so that investors can keep all of the credit (profit) in their account. Normally, a credit spread investor trades front-month options only, as the time decay evaporates most rapidly in the final month ahead of expiration. The time erosion benefits credit spreads, assuming no change in the other variables that affect option pricing such as the underlying security's price, option volatility, dividends, or interest rates.

 
Strategy Specifics - Bullish Put-Credit Spread
 

The bull-put spread consists of the purchase of one put, and the sale of another put with a higher strike price. An investor would use this strategy when he believes that the stock price will remain above the strike price sold at the end of the strike period. The position will yield a credit and this is the maximum amount of profit the investor can earn with this strategy.

 
The risk/reward calculations are:
 

Maximum profit = the initial (net) credit received

Maximum risk/collateral requirement = the difference between the strike prices - the net credit received

Break-even point = the sold (put) strike price - the net credit

Return On Investment = credit received / position collateral

 
Strategy Specifics - Bearish Call-Credit Spread
 

The bear-call spread involves the purchase of one call (higher strike) and the sale of a lower strike price call. This spread also produces a credit and the amount is the maximum profit gained in the play. The spread remains profitable if the underlying security closes below the lower strike price and the objective is for both options to expire worthless. This position requires the same collateral as the bull-put spread.

 
The risk/reward calculations are:
 

Maximum profit = the net credit received

Maximum risk/collateral requirement = the difference between the strike prices - the net credit received

Break-even point = the price of the sold (call) strike + the net credit

More information on collateral requirements and margin maintenance is available here: http://www.cboe.com/tradtool/marginmanual2000.pdf

 
Strategy Advantages
 

Most option spread strategies take advantage of the laws of probability by enabling a trader to remain in a directional option positions over longer periods of time. They also help to maintain acceptable profit potential while reducing short-term risk. While there is no perfect position in option trading, successful investors learn to "spread-off" risk in as many different ways as possible, minimizing the effects of undesirable market activity. You will not be able completely eliminate the risk, but you can reduce it much more than an inexperienced trader who does not use all of the available strategies.

 

Position Management
 

Spreads and other types of combinations, as well as all option trading techniques, need to have some type of exit point in case the market, stock, and/or sector or industry group moves in the opposite direction from that which is expected. In fact, learning when to initiate a closing transaction is probably the most important aspect of becoming a successful trader. In addition, the success of a high probability/low profit strategy such as (OTM) credit spreads is keeping losses at a minimum. There are never any big winners to offset the big losers, so there simply can't be any big losers. Obviously, a gapping issue will occasionally wipe out a portion of previous gains and there is nothing you can do about it. At the same time, you must manage the remaining positions effectively or there will be no profits to offset the (rare) catastrophic losers.

A spread trader has many different alternatives when the underlying issue moves beyond the sold strike price in a combination position but in most cases, the appropriate action should be taken prior to that event, when the issue experiences a technical change in character (such as "breaking-out" of a trading range or closing above/below a moving average). Most methods for taking profits and preventing losses, as well as making adjustments or rolling up/down and out to new positions, fit into one of two categories: a pre-arranged target profit or loss limit; or a technical exit based on the chart indications of the issue. The first technique, using a mechanical or mental closing stop to terminate a play or initiate a roll-out, is simple as long as you adhere to the initially established limits. The alternative method, a technicals-based exit, is more difficult. However, there are many different indicators available to establish an acceptable exit point; moving averages, trend-lines, and previous highs/lows, and with this type of loss-limiting system, you exit the play after a violation of a pre-determined level. In any case, the closing trade or adjustment should be based on the existing market, sector, and industry group conditions, as well as the current outlook for the underlying issue and the ratio of potential gain to additional risk.

One outstanding principle that new investors fail to adhere to is the need to outline a basic exit strategy, before initiating any position, to eliminate emotional decisions. This plan must be simple enough to implement while monitoring a portfolio of plays in a volatile market. In addition, these exit/adjustment rules should apply across a range of situations and be designed to compensate for one's weaknesses and inadequacies. Also, to be effective in the long term, they must be formulated to help maintain discipline on a general basis and at the same time, offer a timely memory aid for difficult situations. Using this type of system addresses a number of problems, but the most significant obstacle it eliminates is the need for "judgment under fire." In short, a sound exit strategy will help you avoid exposing your portfolio to excessive losses and that's important because the science of successful trading is far less dependent on making profits, but rather on avoiding undue outflows.

 
Specific Exit/Adjustment Strategies
 

Credit spreads are one of my favorite strategies and there are a few ways to limit potential losses or even capitalize on a reversal (or transition) to a new trend. With bullish credit spreads, there are three common methods to exit or cover a losing position and the alternatives range from "legging-out" or "rolling" into a long-term spread to "shorting" the underlying issue. (Bearish spreads offer similar adjustment opportunities but with calls and long stock positions.) The first alternative is to simply close the position at a debit and register the loss. Or, you can use a popular exit technique among day-traders; covering (by shorting the stock) the sold option as the stock moves through the short strike. This is a great method for bailing out on an issue in which the trend or technical character has changed significantly due to news or events, but you must be prepared to repurchase the stock in the event of a recovery.

Another strategy is to attempt a "roll-out" of the spread for a small profit or at least a break-even exit. To roll-out of a credit spread (in the current expiration period), place an order to close the short option when the stock trades, and preferably closes, below technical support or a well-established trend line or moving average on heavy volume. There are certainly more precise signals that can be used but this simple technique is based on the probability that, once a reversal has occurred, the stock should continue to move in that direction. After the sold (short) option is repurchased, wait for the new trend to lose momentum and sell the long position to close the entire play. It is a difficult technique to perform when emotion enters the formula but it works well once you become experienced at it. The key to success is using the method at known support levels or after obvious reversal signals, otherwise you are simply speculating about the stock's next move.

Finally, there modified version of the "roll-out" that involves a transition to longer-term options. This approach works best when the price of the underlying issue is near the sold option strike, but has not endured a significant change in (technical) character. To initiate this strategy, the current spread is closed and a new spread is opened with lower strikes and/or a more-distant expiration, in the best possible combination that will achieve a credit in the trade. The most optimum adjustment would use the same strikes in the closest available month, so that you would be selling the highest relative premium without committing to a long-term position. Obviously, this outcome is not always possible, and I caution against using this technique on all but the most high quality (blue-chip portfolio) issues, as you can quickly run out of downside margin if the stock declines further.

One thought I would add concerning position adjustments (as opposed to position exits) is that in almost every case, the decision you make about a specific trade should be based on your analysis of the underlying issue and your forecast for its future movement. That assessment is then factored into the risk-reward outlook for the strategy and the specific position you are considering. Of course, that's a very subjective task and the best advice I have seen on the subject is: If conditions dictate that a new position in the issue is viable, based on the fundamental/technical indications, the size of the premium/credit, and your personal criteria regarding the profit/loss outlook, then it should be considered as a candidate along with any other potential plays currently being evaluated.

The great thing about spreads is that once you understand them, you can turn many losing plays into winning ones with the effective use of stops and by rolling out-of/in-to new positions when the stock moves against you. When you do lose, at least you have reduced your losses by leveraging against another position. In all cases where an attempt to recover a losing position is made, you must be prepared for further draw-downs and have thorough knowledge of the strategy. Also, as with any trading technique, it must be evaluated for portfolio suitability and reviewed with regard to your personal approach and trading style.

Additional Information
 

The best books on the subject of spreads and combinations are the original bibles of option trading: "Option Volatility & Pricing: Advanced Trading Strategies and Techniques" by Sheldon Natenberg, and "Options As A Strategic Investment" by Lawrence G. McMillan (both available in your local library).

 

FAQs
 

1) What is the capital requirement and experience level for trading this portfolio?

Investors who participate in the MonthlyCashMachine Portfolio should have a fundamental knowledge of common option trading strategies and position adjustment techniques. Traders who write options (even those which are "covered") should also have a thorough understanding of margin maintenance requirements and the potential obligations that the sale of an uncovered option entails. More information on margin is available here:

http://www.cboe.com/tradtool/marginmanual2000.pdf

In addition, all derivatives traders are required to read the Characteristics and Risks of Standardized Options before opening a position. Here is a link to that document:

CharacteristicsandRisksofStandardizedOptions.pdf

As far as capital requirements, the objectives of the MonthlyCashMachine Portfolio can generally be achieved with a $35,000 account balance. However, large unexpected swings in the market (or a specific issue) can lead to position adjustments that significantly increase the margin maintenance requirement. When this occurs, it may be necessary to secure additional funds to manage the portfolio efficiently. Traders who are not certain they will be sufficiently capitalized should be very conservative with position selection and consider reducing the number of contracts for a specific issue.

2) How do you choose the positions in the MonthlyCashMachine portfolio -- what is your primary selection criteria?

In choosing the portfolio candidates, we generally look for positions that provide a minimum potential profit of 3-4% per month (annualized) with downside protection of at least 10%. Using credit spreads, that allows us to focus on "out-of-the-money" positions with a very high probability of profit, sometimes as high as 90%, which corresponds roughly to the 2nd standard deviation of a normal distribution. (For those of you who like statistics, the market almost always remains within the 2nd standard deviation of a normal distribution). Obviously, it would be great if every published position were in this category but since that isn't possible, the best course of action is to choose trades that offer a favorable balance between probability of profit and potential downside risk. That's the real challenge in any form of trading and although we try to identify only spreads that will achieve the specified goals, not every play is a winner so the main objective is to limit losses and close losing positions before they become costly, preserving your trading capital for the next success.

3) What is the "target credit" and why do you list that price for each position?

Many of our subscribers are less experienced traders that need simple, easy to understand strategies and one of the first skills participants must learn is to execute a favorable opening trade. A good technique for initiating a combination position such as a credit spread is to place the order as a "net" credit (or, with certain strategies, a net debit) for both positions in the spread. When a new spread position is listed, we include a suggested "net credit" target to help traders open the position. This is simply a recommended entry point; just an opinion of what a trader might use as an initial "limit" for the spread order. It should be a reasonable price to initiate the play even with small changes in the stock and option quotes. The target price is always less than the straight BID/ASK numbers (Do not pay "market" price for spread orders!) and generally, you can expect to shave $0.10-$0.20 off the composite BID/ASK price when opening or closing even the smallest spread order. The margin can be more or less, depending on the price of the options, whether they are ITM or OTM, the time value remaining, the volatility of the stock, etc. The published "target" is intended to give beginning traders an idea of the value of the spread because the option prices are always different the next day. Of course, you may need to adjust this target based on the activity of the underlying issue, the trading volume of its options or the implied volatility of the series being traded.

4) How do we know when to exit a position?

Spreads and other types of combinations, as well as all option trading techniques, need to have some type of position closing mechanism in case the market, stock, and/or sector moves in the opposite direction from that which is expected. Most methods for taking profits and preventing losses, as well as making adjustments or rolling up/down to new positions, fit into one of two categories: a pre-arranged target profit or loss limit; or an exit trade based on the historic prices/technical character of the underlying issue. The easiest system for directional, option-based strategies involves a mechanical or mental stop to close the position (or initiate a "roll-out" to a new play). Technical analysis -- moving averages, trend-lines, and previous highs/lows -- is generally used to establish the exit or "stop" point and with this type of loss-limiting system, you simply close the spread after the underlying stock violates the pre-determined level. If you choose to adjust or roll forward into a new position, always consider the existing market, sector, and industry group conditions, as well as the current (technical) outlook for the underlying issue and the ratio of potential gain to additional risk. More information on position adjustment techniques is available in the strategy tutorial here: http://www.optioninvestor.com/premium/89/tutorial.aspx

5) Do you provide portfolio data for "auto-trading" services?

No, not at this time. However there are plans to offer the service at a later date. More information on this subject will be published when it becomes available.

 










 
 


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