When I first started trading options, I took an unconventional route…Before I risked a single dollar, I talked to experienced professionals. My reasoning was simple. Why waste money on expensive mistakes, when I could be learning from some of the best traders of our time? Each expert had different strategies when it came to making money. But over and over again, I heard one piece of advice:“To know what everyone knows is to know nothing.”I think of that wisdom all the time. Of course, that doesn’t always stop me from doing what everyone else does. I’ve fallen into that trap plenty of times.As recently as 2020, I had to learn this lesson again — the hard way. I’d been following an options income strategy that everyone “knew” was safe…Until suddenly, it wasn’t.
I’d been selling puts for about four years when the pandemic hit in March 2020.It’s common knowledge that selling puts is a conservative way to generate income with options. And my track record certainly seemed to prove that…My win rate was 95%. I was enjoying steady income of about 8% a year.But when the market crashed, a series of three losses wiped out more than six months’ worth of gains.I’d stepped on a land mine… But unlike in Iraq, I wasn’t even aware of the threat.The low-risk strategy I’d been following suddenly seemed anything but safe. Not even a high win rate could protect me from devastating losses.In an instant, I realized my mistake…When it came to selling puts, I knew what everyone else knew. If I wanted to be successful, I needed to know what other traders didn’t know. And, after months of research, I found it…A little-known strategy that lets you sell options for income… AND know, with 100% certainty, how much risk is on the table.
Mastering the Options “Spread Trade”
The strategy I discovered is known as a “spread trade.” It can be confusing at first, so let’s place a hypothetical trade together.On Monday, Dollar Tree, Inc. (DLTR) gave a buy signal on my volatility indicator. Let’s say I decide to sell the July 15 $157.50 put for about $0.45.Because each contract covers 100 shares, I’ll receive $45 in income.Small gains are to be expected with a strategy like this. When you have a high win rate, they can add up to big fortunes over time.But, as I learned in 2020, not even a high win rate can make up for the risk in dollar terms.See, if DLTR falls below $157.50, I’m required to buy the stock at $157.50. It doesn’t matter if DLTR falls to $155… $135… or even all the way to zero. I will be required to pay $157.50 for my shares.So, I need a second way to limit my risk. That’s where the “spread” comes into play.I can cap my risk by buying a put on DLTR as well. In this case, I would buy the July 15 $152.50 put for about $15.This way, if DLTR falls, I can sell the stock at $152.50.This means my maximum gain is lowered to $30, after deducting the cost of the option I bought. But more importantly, my risk is capped at just $4.70 per share, or $470 per contract.To get that number, I simply take the difference between the two exercise prices, which is $5 per share. The contract covers 100 shares, so that’s $500. Once we subtract our gain of $30, we’re left with a risk of $470 on the trade. And remember, that’s the maximum risk. There are plenty of ways to limit it even further with this strategy.
For one, you can use short-term options. The chances of a steep decline in a week are low, unless there’s an unpredictable event like earnings. You can avoid that risk by not trading during a stock’s earnings season.You should also pay attention to the direction of the trend. In this case, DLTR is in a short-term uptrend, so we used a bullish spread. If the stock was in a downtrend, we could use a bearish spread instead.This trade setup has a 94% probability of success based on pricing models. It also requires less than $500 in a brokerage account to open the trade.That $30 in income is a 6% return in one week. Doing a trade like this every week, trading five contracts at a time, results in a 60% return on $2,500 in a year.It’s easy to see why I love this strategy. And as you learn more about it, I’m sure you will too.
Regards,
Amber HestlaSenior Analyst, True Options Masters
