A Different Way to Profit From Options

Many traders are familiar with simply buying options.

By buying an option, you can gain exposure to a stock’s moves without needing to own shares.

If you get your timing and direction right, it can pay off with outsized gains.

But if the move you expect doesn’t come, your option’s value can shrink fast.

That’s why at The S&P Trader, I flip this idea on its head…

I don’t try to work out where the S&P 500 (SPX) is heading. Instead, I look for a range where SPX is unlikely to trade.

That might sound confusing, but this strategy is one of the best ways I know to generate regular income.

In fact, it played a big role in how I went 20 years without a losing year during my career on Wall Street.

So let me explain using a trade we did earlier this month.

This options strategy gave my subscribers the chance to make a $644 gain (per contract) in a day…

Capturing Premium

The strategy we used to generate that $644 premium is a “bear call spread.”

We’re “bearish” about SPX. So we think the SPX will close below our call options’ strike prices.

And a “spread” simply means there are two parts (“legs”) to the trade.

With this strategy, we sell a call option and buy a slightly different one at the same time.

To see how it works, let’s check out our SPX trade in the chart below…

S&P 500 Index (SPX)

Source: eSignal

On May 1, SPX started the day by rallying strongly despite the recent downtrend.

I suspected that sellers still had the upper hand, though. And I didn’t see any data releases coming out soon that had much potential to shake the market up.

So when the market reversed sharply later that day, I decided it was time for a trade.

I placed a bear call spread that expired the next day…

We sold a call option with a 5100 strike price (lower orange line). That was just above the day’s high of 5096.

At the same time, we bought a call option with a strike price of 5120 (upper orange line).

Our sold option earned us a credit, while our bought option cost us a smaller amount.

Together, they generated $6.44 in premium. That equates to $644 per contract.

And as long as SPX closed below both our strike prices (5100 and 5120), we would get to keep all of that premium.

Happily, that’s exactly what happened.

SPX did recover somewhat the following day. But it closed out at 5064.

So the full $644 premium remained ours. That’s a handy income in just a single day.

Managing Risk

You might wonder why we bother with doing a spread in this case…

Why not only sell an option and earn even more premium – and forget about buying the second leg?

Yet there’s a vital reason we structure our trade this way. It has to do with risk management.

Let’s imagine this trade went against us.

Instead of closing at 5064, what if SPX rallied up to 5100 – or even higher?

Ultimately, that could be a catastrophic loss. We would be responsible for any amount SPX closed above our strike.

In our spread, though, our bought option caps our maximum loss.

The most we could lose is the difference between the two options’ strike prices (minus the premium we received).

In this case, that’s a max loss of -$20 (5120 – 5100) minus the $6.44 we received for the trade.

So even if SPX closed above 5120, the most we could lose would be $13.56. This equates to $1,356 per contract.

That still hurts. But it’s much better than a completely unbounded loss.

Better still, our winning rate at The S&P Trader is around 80%. We’re banking far more wins than losses.

If you joined me at the start of this year, you’d have had the chance to bring in $32.58 (or $3,258) in profits so far for each contract you traded, as of last Friday.

That’s the power of using this spread strategy to draw in income.

If enjoyed this deep dive, be sure to let me know. You can always send in your thoughts and ideas to [email protected].

Regards,

Larry Benedict
Editor, Trading With Larry Benedict