This white paper will detail: (1) Option credit spreads for the risk-adverse income seeker; (2) The Monthly Income Machine specific trade entry criteria I recommend for selecting promising option credit spread candidates; (3) A new, completely optional screening service that completes this most time consuming part of identifying conforming credit spread candidates for you. You can join our Free Membership to check out sample screening reports.
The Case for Credit Spreads
Professionals and other sophisticated investors routinely make use of the credit spread to generate a recurring monthly income stream. Even though option credit spreads are low risk and are even approved for IRA and other retirement accounts, many investors associate the word “option” only with highly leveraged, highly speculative, all-or-nothing gambling. They may even have “been there, done that” with stock options and would prefer a nice root canal rather than repeating the experience.
Although credit spread investing for monthly income utilizes options as the vehicle, and the targeted rate of return is very attractive, the credit spread technique we use is decidedly lower risk.
I’ve spent much of my adult life as a stock broker and investment advisor focused on avoiding risk. For me, employing option credit spreads on underlying stocks, ETFs and indices is the right way to go for income-seekers because it’s the investment vehicle that truly gives one an “edge.”
That investment edge comes from:
If anything cited in the above paragraph is not already totally clear to you, you should put this article aside for now and first review Monthly Income for the Risk-Adverse
Conservative investors seeking a reasonably reliable income stream typically rely upon stock dividends and/or bonds. Dealing with today’s world – and likely well into tomorrow’s – in which pundits pant over 3% annual returns that they refer to as “high yielding” is frustrating for many investors and many of their broker-advisors.
The good news is that option credit spreads (also called vertical spreads) can produce 4% (and more) returns monthly, and do so with controllable and relatively low risk. That said, the first step toward mining the monthly income stream that credit spreads can produce is to successfully identify the most promising trade opportunities each month from among the thousands of potential candidates available.
The Monthly Income Machine Trade Entry Criteria for Conforming Credit Spreads (set-up rules)
With credit spreads, we want trades with a very high (and mathematically measurable) likelihood of success, coupled with a significant stream of income from those trades. Within this objective lies an important concept that underpins our trade identification process and therefore the trade entry rules: we want to maximize safety rather than seeking to maximize return.
Here are the criteria SaferTraders, myself included, use every month. They represent “rules” that I believe must be employed in selecting the most desirable credit spreads. The actual value we use for each criterion is spelled out in the book “The Monthly Income Machine”, but our focus here is on reviewing which factors are important in establishing a credit spread irrespective of the entry rules the investor employs.
Regarding entry rules, I recommend in the strongest terms that whatever set of entry criteria you might use to select trade candidates (our criteria and their values, or a different set of criteria/values), please do not establish a position unless ALL of the criteria are met. You can be assured that the one you decide to “cheat” on is likely to be the one that bites you in the end… pun intended!
We only want to consider underlying stocks, ETFs and indices that are actively traded and thus provide reasonably tight bid/ask quotes. This will provide relative ease of entering and exiting from positions with good “fills.” In addition to setting a minimum daily volume requirement, we want to set a minimum price requirement for the underlying as well since very low priced underlyings rarely can provide us with sufficient premium earnings for the credit spreads.
We want to set a minimum acceptable amount of premium for any credit spread we establish. While our focus is on safety first, investing is not risk-free. Accordingly, we must have the opportunity to generate an acceptably useful profit or why assume any risk at all?
We must not have an earnings report due prior to option expiration day. We don’t want to risk a big earnings report surprise that can produce such a large adverse move in the underlying stock, and our credit spread options, as to threaten reaching our credit spread strike prices.
While one of the major advantages of credit spreads is that we really don’t care if the underlying rises or falls moderately, a really powerful move in the wrong direction can force us to abandon the trade from a sound money management standpoint.
Very critically, we must insist on a substantial, minimum distance-from-the-market for our credit spreads. We want our credit spread’s strike prices to be a long way from where the underlying is currently trading.
We also modify the basic distance requirement for all classes of underlying when we are in the “sweet stop” with respect to limited time remaining until expiration.
- More “breathing room” confers safety and makes a successful trade much more likely, but we need to strike a balance between distance-from-the-market and premium. Therefore we want to set a minimum distance between the current price of the underlying and our credit spread’s strike prices.
However, at that minimum required distance, we must still meet our minimum premium requirement. (There is a trade-off. The further away the strike prices of the credit spread are from the underlying, the smaller is the premium we can earn.)
Interval between legs (strike prices) of the spread
We want the interval between the short strike price and the long strike price of our credit spread to be wide enough apart to provide a useful premium, but not so wide as to make the spread liable to go rapidly against us if there is an adverse move in the underlying stock, ETF or index.
The interval between the spread’s strike prices also has a direct and major impact on the margin requirement for the spread, which in turn materially affects our ROI.
We want the “delta” value of our spread to be very low in order to confirm – using an objective measurement – that there is a very low likelihood of the price of the underlying reaching our spread’s strike prices prior to expiration.
Subscription Service Weekly List of Conforming Spreads
The step-by-step approach for identifying “conforming” credit spread candidates, and trade management once a credit spread position is established, is the focus of the book, “The Monthly Income Machine.” An overview of process is contained in the white paper Screening Stocks for Monthly Income Machine Credit Spreads
Although not required to implement the “Machine” technique, there is now a separate subscription service – Conforming Credit Spread Service – available only to currently registered owners of “The Monthly Income Machine.” NOTE: It is absolutely necessary that the investor fully understand and be able to apply the “Machine” process and position adjustments in order to correctly work with the Service’s list of “conformings.”
The service provides the list of conforming spreads based on Friday’s closing prices and is provided for the 1st and 3rd Friday of every month (basic service) or every Friday (premier service).
Although it is truly optional, the additional benefits provided by the Conforming Credit Spread subscription service can be very substantial:
It may also surface candidates that the investor doing his own manual searches may overlook.
For a full description of the Service, and the subscription form, go to Conforming Credit Spread Subscription Service
Contact Customer Service (info@SaferTrader.com) for a complimentary sample of the current Friday report.
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Note: We can – and do – guarantee your satisfaction with “The Monthly Income Machine” detailed how-to blueprint for conservative income investors. No one, however, can guarantee market profits. For a full description of the risks associated with such investments, see Disclaimers.