Posted by From time to time, the markets will begin a period of unusually low volatility.
When this occurs, it can be more difficult to identify attractive income-generating credit spread trades that meet The Monthly Income Machine premium requirement at the strike prices the prescribed distance from the underlying stock, ETF, or index. So let me weigh in on this matter with a few reminders, using the time-honored “XYZ” as our underlying.
Distance Between Strike Prices – Flexibility
Assume available XYZ option strike prices are $10 apart for this example.
While it’s nice to have adjacent strike prices (the closer together the legs of the spread strike prices, the more slowly the spread net premium will move against us when the underlying is moving the “wrong” way), we do have flexibility in this matter.
If the XYZ 120 call is the one we want as our “short” leg of the spread because it meets the minimum distance entry criterion, we may find that the 120/130 call spread does not qualify as to premium.
We can certainly look at the 120/140 and 120/150 spreads as well. The general guideline (the actual “The Monthly Income Machine” rule is spelled out in detail in the book) is to use strike prices that are adjacent, or have one or two intervening strikes. Widening the legs of the spread will almost always provide more premium, and often that is enough to give us a conforming trade.
Keep in mind, though, that as you widen the legs the risk increase, so your margin requirement for the spread will increase as well.
Expiration Month- Flexibility
If we are well into an expiration month – say for example we have about 2 weeks until expiration – we may find that time decay has pushed XYZ premiums too low to meet minimum requirement even with the 120/150 call spread.
In this case, we should look at the option chain for the next expiration month. Doing so may well reveal that employing a spread with more remaining time until expiration does provide the premium we want, and does so with closer together strike prices (120/130 or 120/140 in our example).
Of course, if we are willing to accept a little more risk as a trade-off for more premium, we might elect to stay with the 120/150 for the next expiration month, even though tighter strike price legs may also qualify.
The Usual Suspects
As pointed in the article Stocks For Monthly Income Machine Credit Spreads, the broad list of potential candidates includes several underlyings that are most likely to offer enough premium, at enough distance from the current market, to meet all the conforming candidates trade entry requirements. I have dubbed these, “the usual suspects.”
What About Indices and ETFs?
The lower “distance” requirement for indices and ETFs reflects their historically lower volatility compared to individual stocks, although such “market basket” underlyings, too, can certainly have substantial moves in response to headline developments.
Despite their inherently lower volatility, I find that the aforementioned techniques of flexibilities in strike price distances and in expiration months, will often bring these underlyings into conformity with The Monthly Income Machine entry requirements, even during low volatility periods.
Where there’s a will, there’s monthly income!
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This article is very timely, and instructional. Currently we seem to have a very quiet market (VIX 12-13) while we are also entering a time period that has produced some major changes with much higher volatility in past years.
Because we use a delta value to screen out candidates that display too great a volatility risk, and because too little volatility can suppress conformers because they do not offer sufficient net premium at our required distances from underlying, the number of spread candidates can vary widely with the market’s volatility.