Make 3-5% per MONTH using Vertical Credit Spreads

Our Private Money Management Division uses Vertical Credit Spreads to significantly reduce the risk of a trade. Our process is simple, but very effective.

If you are new to options, then the following links may provide some educational background that hopefully helps you understand the rest of my blog. Please visit the links first if you feel like you need some education about options. If not, then proceed with the rest of the blog.

http://en.wikipedia.org/wiki/Call_option (for a full page explanation)

http://en.wikipedia.org/wiki/Put_option (for a full page explanation)

http://en.wikipedia.org/wiki/Bear_call_spread (for a 3 sentence definition)

http://en.wikipedia.org/wiki/Bull_put_spread (for a 3 sentence definition)

First, we search for a bullish or bearish trade set up. The chart below (double click on it for a closer view) of Google (GOOG) shows that on the hard right edge of the chart, which is the current price bar of the stock, that GOOG has reached a lower low compared to its swing low from a month prior. A downward sloping blue line connects these two swing low points to form a trend-line. The Momentum Indicator, positioned underneath the price chart of GOOG, forms a path of its own. If you take the same two dates that formed the downward sloping trend-line on the price chart, and match the same two dates on the Momentum Indicator chart, you will notice that the Momentum Indicator formed a higher low at the same time that price was forming a lower low. This created an upward sloping trend-line for Momentum, and hence a "Positive Divergence" to the downward sloping trend-line on the price chart. This is a sign of strength entering into the stock. This means that we have a legitimate Bullish trade set up. This meets our first criteria.

Momentum Indicator under price chart shows Bullish Divergence.

Since front-month options (options nearest to expiration) are utilized in our Vertical Credit Spread trades, the type of trade set up that we look for is a swing-trade candidate for a trade that would last 2 to 4 weeks. To search for the best candidates, stocks that have passed our proprietary screening process are next analyzed with Refined Elliott Trader software. Next, some good old-fashioned technical analysis is used for further confirmation about the stock's most probable direction for the next 2 to 4 weeks.

Our work up to this point creates a 70% probability of having a winning trade if we chose to enter a position according to our findings either Long or Short. Entering a position Long or Short means that you either purchased the stock (Long) or sold the stock (Short). Additionally, a trader may purchase a Call Option in-lieu-of entering a Long stock position. In either case, the trader is bullish. Conversely, a bearish trader may either Short the stock or purchase a Put Option. All of these examples represent what is called "Directional Trading". The reason is because the success or failure of your position is dependent upon the underlying stock moving favorably in the proper direction. We do NOT act upon our findings this way. Instead, we stack the deck even further in our favor by using a conservative Vertical Credit Spread Trade with options far out-of-the-money rather than using a more aggressive directional trade strategy of Buying Long or Selling Short (like most traders do).

The Vertical Credit Spread approach that we use is considered "Non-directional Trading" since the success or failure of the trade is NOT dependent upon the underlying stock moving favorably in a direction. In fact, success can be achieved whether a stock goes up, down, or sideways. It is only in the rare case of a stock moving dramatically against you that your Vertical Credit Spread can cause you to lose any money. This rarely happens!

In the case of GOOG, as of market close on March 2, 2007 the closing price was 438.68. At this point, we would enter into a bullish vertical credit spread trade by utilizing out of the money Put options. Looking at March expiration options, there will be 10 trading days over the next two weeks before the March options expire. If we conservatively target 5% gain or net credit for our trade, we would use Sell the March 410 strike Puts and Buy the March 400 strike Puts and achieve a 5.5% net credit. The two horizontal lines on the chart below (double click on it for a closer view) show these two strike prices. When GOOG stays above these two strike prices over the next 10 trading days, like our Momentum Indicator previously hinted would be the case, our spread trade ends successfully with a 5.5% gain in two weeks!! The arrows on the chart show that we win 5.5% if GOOG goes up, sideways, or even down (as long as it doesn't go down PAST 410). Remember, this is a 10 day trade and not a two month trade. GOOG has to drop 6.5% before we begin losing any money. This is highly unlikely with the Momentum Indicator diverging bullishly! No other approach to investing can promise positive results like this, regardless of the direction the stock moves!

It is this final step in the process (using credit spreads rather than a directional method) that increases our winning percentage rate to over 95%!!

The image below (double click on it for a closer view) is what a trading order entry screen (using TradeKing brokerage) looks like for this trade.

If we are Bullish on a stock, then a Bullish Vertical Credit Spread is used. We sell an Out-of-the-Money Put Option while simultaneously purchasing an even further Out-of-the-Money Put Option. This creates a Net Credit to our account and defines our risk to equal the difference in the Strike Prices of our Put Options minus our Net Credit Spread. Our goal is to capture between 5% and 10% Net Credit on each VCS trade made. This does not seem like a lot to get excited about, and you probably won't be excited from month to month. However, with these kind of consistent results, $10,000 grows into $1,000,000 in 64 months with an average monthly compounding rate of 7.5%!! Now that is something to get excited about!!

Think of the possibilities. Imagine taking $10,000 and using the Vertical Credit Spread approach to investing and being able to pay off your mortgage in less than 5 years! Would you like to be able to retire in less than 5 years? Consistent small gains every month make the difference. One of the problems with mutual funds is that they are subject to the ebbs and flows of the market direction every month. To make money in your growth mutual fund next month, the market has to go up. What are the probabilities of that occurring? 50/50? Why not stack the deck to 95/5 probability of success every month using Vertical Credit Spreads instead?

If we are Bearish on a stock, then a Bearish Vertical Credit Spread is used by selling an Out-of-the-Money Call Option while simultaneously purchasing an even further Out-of-the-Money Call Option. This creates our Net Credit, which typically equals 5% to 10%.

Since there is significant time decay involved with current month expiration options (a.k.a Front- Month Options), it is more conservative to be selling these options rather than purchasing these options. A buyer of these options has time working against him/her. A seller of these options has time working for him/her. The seller of an option collects a premium from the option buyer at the time of the sale, and gets to keep that premium when the option expires worthless, which happens most of the time with deep out-of-the-money options. The time decay in Front-Month and Out-of-the-Money Options is dramatic! These are the cheap options that traders swinging for a home run will purchase. A naive investor that doesn't understand time decay will purchase these cheap options as well. Most of these options expire worthless. It is this rapid time decay in these front month options that we exploit by using Vertical Credit Spreads. We take advantage of greed (home run hitters) and stupidity (naive investors). We'll gladly SELL an Out-of-the-Money and near expiration option to a willing buyer since we know that the option has a very high probability of expiring worthless in our favor! Simultaneously we purchase an even cheaper (further out of the money) option to define our risk and cover our sell position. This keeps our broker happy by having a defined risk for the trade. Otherwise, our risk is unlimited by only selling an option without the simultaneous purchase. Remember, time decay is the option buyer's worst enemy, but the option seller's biggest ally.

Since we use front month options expiring on the 3rd Friday of every month, we can only do Vertical Credit Spreads monthly. We like to set up four Vertical Credit Spreads each month (four different companies) for diversification purposes. This reduces our risk even further. Each month we want these four credit spreads to expire worthless. Repeating the process each subsequent month means 12 months of compounding at 5% to 10%. Your account should easily double in size every year!

Contact John A. Shalvey at: JAShalvey@gmail.com to learn more.

Government Disclaimer :

John A. Shalvey is neither a registered Investment Adviser or a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed. Prior to buying or selling an option, an investor must have a copy of Characteristics and Risks of Standardized Options. You can access and download the booklet on The Options /Clearing Corporations' (OCC) website at:

http://www.optionsclearing.com/publications/risks/riskchap1.jsp
This link reference is provided as a courtesy and does not imply that the OCC is endorsing John A. Shalvey or its products. This booklet is also available for free from your broker or from any of the U.S. options exchanges. There is risk involved in investing, and stated performance results may be atypical. We do not in any way warrant or guarantee the success of any action which you take in reliance on our statements. Readers are urged to consult with their own independent financial advisers with respect to any investment. All information contained in this report and website should be independently verified.