A More Detailed Explanation To My Article of Last Month On How
I Used Spread Profits To Buy My New House - Don Smeathers
The goal of this letter is to describe the way I use the Dow Jones Trading System program to trade OEX options.
This is not to be interpreted as to be the only way to use the program, but I have found it to be reliable and profitable.
I use credit spreads using OEX put options of the current months expiration as the trading vehicle. I determine how many contracts by using the Dow Jones Systems Trend Index, aggressive variable mode total contracts, the most recent trend. Thus, the most contracts that I would have ever use is 65, based on 13 positions of five contracts maximum exposure during the recent bull trend.
Then I would buy the nearest in-the-money put and sell the nearest out-of-the-money puts and take in the credit. I hold the contracts to expiration and pocket the profit.
If a trend is just starting on the Dow Jones (aggressive variable, actual Index), I add to my positions as your program indicates (five contracts at a time) using the same parameters for entry.
As the market continues to move thru strike prices I buy higher strike puts or continue to add to the current long strike puts and sell higher strike puts depending on the market.
The cost to add positions with a five point strike difference is $1000 per contract, therefore adding five contracts at a time requires $5000 (less the credit money that's generated). This program requires $15000 minimum equity and level two trading at Charles Schwab & Co.
At the end of each month's expiration I start with the total number of contracts that the Dow Jones program indicates to hold in open equity. That way I can continue to profit if the trend continues and even add additional contracts if they are generated by the system.
This program has permitted me to achieve a high degree of success in trading the OEX with reasonable confidence.
I check every day to see if the Dow Jones System confirms my trading action, but the OEX actual index and the OEX Harmonics seem to be too conservative.
I think that investors can use this system of trading using deeper in-the-money OEX contracts and achieve a more conservative return if they feel uncomfortable using the at-the-money and nearest strike of puts. The following is supporting documentation concerning spreads:
Monetary Requirements: $15,000 (Broad Based) minimum equity - $5,000 (Narrow Based/Equity Options) minimum equity - Cash or MCA to cover the difference in strike prices. Plus any other requirements.
Tips on Entering Order - (Chart Referred to is in Print Copy)
Enter the buy side first. When to use: If you think the market will go up somewhat or at least is a bit more likely to rise than fall. Good position if you want to be in the market but are unsure of bullish expectations. You're in good company: This is the most popular bullish trade.
Profit characteristics: Profit limited, reaching maximum if market ends at or above B at expiration*.
If call vs. call version (most common used), break-even is at A divide net cost of spread. Loss characteristics: What is gained by limiting profit potential is mainly a limit to loss if you guessed wrong on market.
Maximum loss if market at expiration is at or below A. With call vs. call version, maximum loss is net cost of spread.
Decay characteristics: If market is midway between A and B, no time effect. At B, profits increase at fastest rate with time. At A, losses increase at maximum rate with time. -Short side carries the risk of early assignment.
The Bullish Put Spread
In the put market, the bull call spread has an equivalent - sell the higher strike put and buy the lower strike put.
This would create a net credit because the premium of the sold put is higher than the one of the purchased put. The maximum profit of this position is the credit.
If the price of the underlying is above the strike price of the short put at expiration, both options expire worthless.
The bullish short put spread can have a distinct advantage over the bullish long call spread. Because the long call spread results in an initial debit, it must be paid for in full when it is established.
The short put spread results in an initial credit. Under current margin rules, it is only necessary for the risk of the spread, i.e., the credit received minus its maximum value, to be available in the account. There need not be an initial cash outlay if the margin account has excess equity.
Special Risks of Early Assignment
The second special situation that a spreader should be aware of involves spreads of American index options. If the short option in an index spread of this type is assigned early, the cash settlement mechanism of index options creates a debit in the account for the amount that the short option is in-the-money at the end of that business day, adjusted by the multiplier of the index.
When the long option is exercised, the amount credited to the account will be determined by the settlement value of the index on the DAY it is exercised. There is a full one day's risk if the long option is not sold at some time during the next trading day!
Summary of Spreading
The general rules of spreading are simple:
- A spread can only be worth as much as the difference of the strike prices of the options that define it.
- If a spread is sold, the maximum profit is the net amount received. The maximum loss is the maximum value of the spread minus that amount.
- Spreads must be done in a margin account. If a spread is sold, the difference between the credit received and the maximum value of the spread must be available.
The Trade-Offs of Spreading
The major trade-off of spreading is the elimination of the unlimited profit potential that goes with a long option position. The spreader trades in immediate performance for a lower cost of entry.
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