This is the criteria and checklist for selling OTM spreads. In previous posts we’ve discussed various aspects of selling OTM spreads and the thoughts behind this trade. We discussed portfolio perspectives, how to build the spreads, and why someone would choose to sell OTM spreads rather than taking a directional trade.
Table of Contents
Selling OTM Spreads Criteria and Checklist
My decision to enter into a trade is different from yours. My acceptance of risk is based on my own reasons. Your acceptance of risk should be based on your own reasons. There are many different strategies for trading OTM spreads. With each of those strategies come different criteria.
Criteria and Checklist
The criteria and checklist for selling OTM spreads is covered in this blog post. This is completely different from taking a OTM trade for profits. Those may seem to be the same, but there are differences in the intent.
Does it matter? YES! Taking a momentum trade opportunity based on a binary event will have different criteria. Trading OTM spreads for income means we are developing this trade with criteria focused on probabilities.
We’re trading with an edge that comes from skew; from richly inflated stock options and mathematically calculated success. What does that mean? It means that if you try to apply this criteria in a situation where there are external binary events, you greatly increase you probability of failure!
What it also means, is that if you apply technical analysis with this criteria, you can greatly increase your probability of success. Let’s get into it.
Step 1
Perform a check for liquidity.
Wait, that’s it? YES! The first step in the criteria and check list for selling OTM spreads is to check for liquidity.
Why? If it’s not a highly traded product, then it is going to have a wider bid/ask spread. This is what’s known as causing “slippage”. It’s going to be difficult to get filled. In other words, it’ll be hard to find someone who wants to buy your spread.
Then it’s going to be difficult to manage that trade. Which means it will be hard to exit the position if the market turns against you or if you want to roll the trade into a different series. How do we know when there is enough liquidity?
The first thing you want to do is look at volume & open interest in the front month series. Does the product have weekly options? Is the volume of the ATM options and near the ATM options in the hundreds?
If the answer is no, then abandon the trade! Do not take a trade in a non-liquid product.
Step 2
Form a directional bias.
When selecting your directional bias, it is important to understand the price action. To choose the OTM spreads that will trade with the trend, not against the trend. This blog is not going to delve too deeply into determining trend.
We’re not going to discuss the different trade strategies for trading against the trend (like contrarian trading strategies). For the purposes of this discussion, the main concept focuses on choosing the OTM spread that is going in the right direction.
We sell puts to trade a bullish bias and we sell calls to trade a bearish bias. The OTM Spread strategy outlined here will focus on spreads that carry more risk and less reward. (WHAT?!?). Yes. Deciding to carry additional risk is ok, because this strategy has a higher probability of success.
When developing an OTM Spread, we are looking for a way to avoid price action and to stay out of the way. We do not want price to hit our trade and we will be building our spread below a bullish market or above a bearish market to avoid getting crushed.
There are different trades and different strategies for those trades that do involve stepping in front of price action, but that trade logic has no place in this strategy. For our purposes, we want to avoid price completely.
There are multiple ways to trade a short vertical but again, this strategy and the criteria defined in this blog post are for a single specific trade concept. We will develop the criteria to enter into those other types of trades in a different post.
Step 2 (continued)
When evaluating price action, look for a slower moving product that is not expected to move a great distance before expiration. Why? If we identify a trending stock that is expected to move a great deal, we’d want to trade that market with a different strategy.
If a market is expected to move a great distance before expiration we would want to capitalize on that move and take a potentially more profitable trade by using a spread designed for that type of price action.
Another thing about forming directional bias is looking at price action to identify potential support and resistance zones. Look to place your OTM Spreads behind a wall of support or resistance to help keep price away from our position.
A few things to look at are point to point trading concepts, indicators that project a band around the price action, volume support or resistance zones, gaps in price action, fib levels, and previous rejection points.
High implied volatility, high implied percentiles, or high implied volatility rank can be useful and even helpful but high volatility means high risk. Yes, high IV = high risk.
We want to minimize our risk and take trades all the way through the criteria defined here. That means following through with the entry and taking our exit when our profit target has been reached.
We do not want to focus too strongly on volatility in our price action analysis. Focus instead on choosing the right options with the right expiration.
These high probability trades are based more on selecting the right strike prices and the probability of touching and based less on price action analysis. Find a balance!
Step 3
Sell spreads 35 – 65 CALENDAR DAYS to expiration.
This is an important step in building our trade. If the expiration selection is too short, the directional risk will be too great. Selling short duration options with less than three weeks carry negative gamma which can seriously hurt our portfolio.
Due to directional risk we will look to sell the spreads with a higher expiration and then exit the position early to avoid getting tangled in heavy gamma.
While I have not created any blogs or written any material on the options Greeks I can recommend some great material if you have not yet mastered them. To learn more about the Greeks, take a look at our options trading course.
Step 3 (continued)
Theta is another reason to step beyond a three-week expiration cycle. We are selling OTM options that have a good amount of theta and we want these OTM options to lose their value as the theta decays.
Since the rate of decay is exponential, we want to make sure we sell the options before the theta decay has crossed over the threshold and then buy back our position once the option has suffered massive theta loss. Options Decay at the √Square Root of Time.
Lets look at the formula:
• Lets look at the first formula. Option for one month = $1
• Next, Option for two months = $1 x √2 = $1.41
• Finally, Option for three months = $1 x √3 = $1.73
And so on.
Step 4
Avoid earnings announcements and other catalyst events
We are not looking to take momentum trades and we do not want to participate in catalyst events. This means you need to search for various announcements such as FDA news, major products releases, etc.
Do NOT sell a spread in an expiration cycle where there is an earnings announcement or a major news event because the options will not decay in value. The market makers will price in those events and the Greeks will affect the options differently.
You can find this information in the ThinkorSwim platform by going to the Market Watch Tab and looking at the calendar. Also you can go to the options chain and look for volatility Skew.
Thus you can identify announcements by viewing the options chain from the current cycle out to 60-65 days. If you identify a volatility difference greater than 2%, then the market makers have priced in an event. Stop right there and abandon the trade.
Regarding earnings announcements, it is also a good idea to avoid selling an OTM spread within a week AFTER earnings. Earnings can cause the market to move very quickly, and that is counter-productive to the trade we are building.
Step 5
Selecting our strike prices
We are selling an option and we are buying an option to build this trade. While the goal is to sell an OTM spread, we must pick the right option to sell and the right option to buy to correctly trade this strategy. Since we are looking at building a high probability trade, we need to focus on trades with approximately 76% to 90% probability of success.
We do NOT use PROB of OTM and we do NOT use PROB of ITM on the option chain to determine our probability! This is very important. The calculation for probability “in the money” and the calculation for probability “out the money” on the options table factors in a variety of aspects including volatility and Skew. Remember, we are not looking to build our trade based off of volatility.
Step 5 (continued)
If you can not calculate the probability for the trade, then use delta to assist you in getting near the right strike prices. This will assist you in the selection process, but it is going to give you the correct probabilities.
“Close” is not accurate. “Close” is NOT close enough. You can start by looking at the short options with a delta between 0.10 and 0.24. Remember, when we are building this trade we are going to sell an option (the “short option”) and we are going to buy an option (the “long option”).
Once you have found the short option, buy another option $2.00 – $5.00 further OTM. Make sure the options spread is a minimum of $2.00. This is important in the criteria for this trade. If you want to trade a spread with less than $2.00, then you will want to trade a different strategy.
Make sure you keep the spreads at least $2.00 wide, but no more than $10.00 wide. If you go beyond the $10.00 spread, the trade can be affected by volatility Skew. If you are looking to bring in a greater profit, it is better to increase the number of contracts rather than increasing the width of the spreads.
Selling OTM Spreads Criteria and Checklist
Calculating our probability of success
How do we calculate our probability of success if we do not want to use the PROB OTM or PROB ITM? First, we calculate our success by taking the risk and dividing that by the width of the spread. (Now you understand another reason we do not want to go wider than $10.00 in the previous step).
So, what is our risk? Our real risk is determined by taking the width of the spread and subtracting the credit we would collect. If we collected $1.00 in credit and we had a $5.00 wide trade, our real risk would be $4.00. Once we have calculated our real risk, we then use that to determine our probability by dividing it by the width of the spread.
If your spread is outside of the 76% – 90% probability range, you need to abandon the trade or look at adjusting the trade with different strike prices. This means if you calculate the probability and get a 91% probability, you abandon the trade or change the strikes! Only take the trade if the probability is between 76% and 90%.
Does that sound confusing? Here is an example:
CREDIT = $1.00
TOTAL RISK = $5.00 (width of spread)
REAL RISK = $4.00 (total you can lose)
Real risk is the width of the spread minus the credit received.
PROBABILITY = Real risk/width of spread Calculation = $4.00/$5.00 = 80%
Step 7
Contracts and position size
These OTM spreads that we are selling are developed with high probability and our risk is determined by looking at the width of the spreads so to increase our profit potential we would increase the contracts in the trade.
This is an important point that needs to be hammered home 100%. The risk management is strike selection and the calculation of our probability. You need to be 100% comfortable with a TOTAL LOSS.
We are not looking to manage this trade with a stop loss. There is never a reason to use a stop loss in a spread trade.
One of the greatest mistakes I see people struggle with is using a stop loss on their spreads and or bailing out of the trade early because they can not wait out the trade.
If you trade in a contract size that carries more risk than you are willing to take, you will not stay in the trade and allow it to mature. Have you ever been in a trade that turned against you and after you exit the position price turns around and goes where you wanted it to go? If you had stayed in the trade, you would have had a profitable position.
Step 7 (continued)
The reason people bail out of a trade early is because they were in a trade beyond what they were willing to lose. Do not let this happen to you. Only take trades within your comfort level.
Only take trades at a cost you are willing to lose 100%. Stops will cause you losses beyond our probability of success. We do NOT use a stop loss. We do have criteria for getting out of the trade and we will examine that criteria later in the post.
To determine what contract size is right for you, calculate the size by taking the real risk and multiplying it by 100 shares per contract. For example, you sell a $5-wide spread for $1.00 credit.
The risk equals $4.00 per share X 100 shares per contract. If I wanted to trade three spreads, then I would multiply $4.00 by 300. I can not determine what contract size is right for you. You must decide what you are comfortable losing.
Step 8
Executing your trade
Try to sell this position for a good price. Try selling it for the MID or MIDDLE bid / ask spread. There is no reason to rush this step. Place the order at the mid-price and send it into the market.
Let it sit there for a while and give it time to work. After 30 – 45 minutes, take another look at the spread and make changes in penny increments. The market moves and expands / contracts so there is no reason to force a trade.
When looking to enter a trade 35 -65 days out, there is no reason to sell the trade for a bad price. This is called “working the order.”
Trade Exit
Profit
We sold this spread to enter the trade and to exit the trade we need to buy it back. You sold to open and you need to buy to close. How do you know when to exit the trade?
In the criteria developed for this trade and to achieve the probability of success we calculated above, you need to look at closing this trade when you have achieved 55% or 65% of profits.
For example, if you sold a spread for $1.00 you would look to close the trade when the price of the spread can be bought back for $0.45 or $0.50.
A few notes about profits. First, this is a high probability trade, but losers will happen. You need to be comfortable with taking a loss.
These spreads have a high probability of success but that probability lines up as the number of trades build up. What does that mean? It means if you trade at a 80% probability of success but only make three trades the probability will not work out in your favor.
After placing hundreds of trades, you will recognize the probabilities are lining up to the numbers you calculated, and you will begin to achieve that win rate.
Checklist for Selling OTM Credit Spreads
Does that mean you will only make profits by only making hundreds of trades? No. When looking to see success at 8 out of 10 trades, then you need to make more than those 10 trades.
Probabilities are calculated by hundreds of thousands of occurrences. The back-tests for this trade and the criteria used to develop the trade come from probability calculations.
If you flip a coin three times, you could get heads three times. That can easily happen. If you flip that same coin 5,000 times you will come very close to half heads and half tails.
With absolutely no assistance in price action or in trade management, you could trade the market with a 50 % chance of success. The trade criteria within this strategy will give you an edge and the probability is in your favor, adding an additional 16% – 40% probability of success.
Choice 1
Take the Loss
These positions are built with a probability of touching less than 50% but the markets can move against you and violate your spread positions.
Do NOT exit the trade just because the market was touched your short option. Close the position only when the short option delta reaches 0.58. Yes, this means we will let the short option go slightly into the money before closing the spread.
If you set delta alerts and manage your trade, you can take consistent loss. Why is that important? Because when we are building the trade and we calculate the max loss we can also look at salvaging our losing trades with a consistent loss %.
Every trader will take losses, the key to surviving and being successful at trading is managing our trades and staying consistent with the loss.
If closing a $5.00 wide spread when the short option hits 0.58, the spread should cost between $2.40 – $2.90. If this spread was entered for a $1.00 credit, then your loss of $2.40 – $2.90 will be reduced by $1.00. This comes out to a loss of $1.40 – $1.90 per spread.
Choice 2
Roll the Trade
If you are looking to manage the trade by rolling it out into a further expiration cycle, then you need to decide early. How do we decide this?
You need to anticipate price and look to roll the spread if the delta hits 0.50. Do not wait, because you can not roll a spread for a credit if the delta has moved beyond the 0.50 delta.
This is critical, because we do NOT roll the trade for a debit. When setting trade alerts, set the alert for .48 to make sure you have time to log into your trading platform and perform the roll. Again, you MUST roll the trade before the delta gets to .51.
We “roll” the trade by buying back our spread and selling it in an expiration cycle further out (again looking for 35 -65 days of expiration). When looking to roll a spread, make sure there are no earnings events.
When trading markets that have earnings, the trade criteria may block you from rolling a trade. If there is an earnings event in the expiration cycle you are looking to roll into, DO NOT take the trade!
Wrap Up
Remember that options will not decay before an earnings announcement. When rolling a trade, make sure that your logic behind the roll is solid. What does that mean? It means do not roll a losing trade just because it is losing.
That only increases your loss. Roll the trade if the reasons you entered the trade are still good and you believe that the market analysis will play out if given more time.
The ability to analyze and accurately determine if a trade is still viable comes with time and practice. If you are unsure about taking the roll, ask a Bullish Bears Moderator in our trading rooms to look over the position for you and help you find the answer.
Remember, we do not roll losing trades. Rolling a trade typically places the whole spread at risk and can lead to a 100% loss. This means if you trade a $5.00 wide spread, you could take a $5.00 loss (minus the credit you received).
Paper Trading
If you are a new trader and want to paper trade this strategy there are a few things to mention which can help you in the learning process. Place the trade after performing the steps outlined above and repeat the process again and again.
Find news sites or develop an understanding of your broker platform to more easily identify products with earnings announcements or events that could endanger your spread.
Review the steps for calculating the probabilities and develop a strong understanding of what you are calculating. Repeat the steps to become familiar with the calculations and to gain a stronger understanding of probabilities.
Continue to study the Greeks and develop a common understanding of how they work and how they will affect your positions. Just because the steps are outlined above, does not mean that you can not develop a stronger grasp of the formula and dial in a more precise checklist.
This trade strategy and the criteria for this trade is aimed at giving a universal trading strategy to the various traders here at the Bullish Bears. It can be dialed in to be even more effectively by a trader who has a strong understanding of the Greeks.
Be consistent in your targets. Take profits and exit losing trades as consistently as possible to help you become a better and more effective trader.
By working at consistent trading, your other trading habits will begin lining up in the same way. Consistent trading also helps you realize when things are going wrong and can help you correct your mistakes in future trades.
Final Thoughts
Practice placing the trade. The structure of the spreads is important and developing a strong understanding of the structure of the trade is critical for success. Place the trade on the call side and the put side.
Take bullish and bearish positions. Practice setting up alerts for the trades and review the entrance and exit criteria. Work to understand when a trade is a loser or if the trade should be rolled.
Take the time to continue learning price action and market analysis but do not let direction get in your way. Trade small positions at first and learn the concepts for the trade. The criteria for this trade was developed with a focus on probabilities and execution.
I’ve developed an Excel spread sheet which will do the spread calculations for you and this can be found by going to the Members Only Section of the Bullish Bears Website and scrolling to the bottom to find “Signets Corner.”
Once you access that section of the website, you will find a download-able file called Credit Spread Calculator. If you do not have Excel, you can download a google product to open that document by clicking on this link here.
In the next Options Series, we will look at trading debit spreads. I look forward to seeing you there.
