Credit Spread Mistakes | Avoid Them with “The Monthly Income Machine”
Good news: most investor credit spread mistakes can easily be avoided.
After years of developing “The Monthly Income Machine” (MIM) option technique, writing the how-to book detailing the entry and trade management rules for conservative investors seeking monthly market income, and answering questions asked by income investors who use the technique, here’s a summary and checklist for the easily avoided “big 8” credit spread and Iron Condor mistakes.
Option credit spreads surely offer one of the most conservative, reliable techniques for generating an ongoing monthly income stream.
But both new and experienced credit spread and Iron Condor income investors can experience difficulty when choosing from among a series of promising spread candidates or managing trade risk once the trades are established.
This is the case whether the investor does his own screening for conforming credit spread candidates, or employs the optional weekly “Conforming Credit Spreads Service” which does the preliminary screening for him.
The “Monthly Income Machine” (MIM) and other screening strategies can identify the most promising credit spread and Iron Condor candidates – and even guide trade management once spreads are established.
“The Monthly Income Machine” does so through a balanced series of extremely specific “entry rules” that arms the income-seeking investor with the highest probability trade candidates from the thousands of potential option spread combinations.
Whether the investor does his or her own screening for credit spread candidates that fully conform to the entry criteria, or uses the optional “Conforming Credit Spreads Service” that does the screening for him, the investor should not reduce the system’s profit potential by “bending” the entry rules and thereby imperiling the powerful MIM technique through easily avoidable mistakes.
The 8 Worst Credit Spread Mistakes:
1. Too Little Distance Between the Option Credit Spread Strike Prices and the Underlying Stock, ETF, or Index Price
Properly constructed credit spreads and Iron Condors can deliver profits (target: 4-8% per month) whether the underlying stock, ETF, or Index goes up, goes down, or doesn’t move at all.
Since the underlying trades at varying prices prior to option expiration, it is very important that the option strike prices of the selected credit spread safely include “breathing room” to accommodate these ups and downs without threatening the spread.
A specific “Machine” entry rule regarding the correct minimum distance of the spread options’ strike prices compared to that of the underlying provides that safety. The proper minimum distance is dependent on the type of underlying (stock, ETF, or Index) and the amount of time remaining until option expiration.
The premium collected up front on the credit spread gets larger as the price of the underlying and the selected spread’s strike prices are established closer together. But the risk of being forced out of the position during a relatively small adverse move in underlying price is too great if the selected spread’s strike prices start out too close to the price of the underlying.
More often than not, choosing option strike prices that are too close to the current price of the underlying (in order to boost collected premium income) hurts rather than helps the trade outcome.
2. Too Great an Interval Between Credit Spread’s Long and Short Strike Prices
A credit spread is made up of a “long” strike price option and a “short” strike price option. The purpose of the long strike price is to limit the amount of loss that could result if the underlying moves adversely to the investor’s spread. Furthermore, the long strike price option that completes the spread also greatly reduces the amount of the investor’s required margin investment.
The long strike price sets an absolute limit on any potential loss on a credit spread trade. The further that long strike price is from the short strike price, the less protection it provides.
Consequently, “The Monthly Income Machine” entry rules set a specific maximum interval between the spread’s two strike prices.
It’s a credit spread mistake to over-widen the strike price interval in order to increase premium income…. because it increases risk too much compared to the greater income potential.
3. Too High a Delta Value
The degree of price swings (volatility) that an underlying displays is factored into an option’s price (premium) through a mathematical formula that produces a “delta value” for every option at every moment in time.
That delta value provides an estimate of the likelihood that the option will expire “in-the-money,” which is what we want to avoid with credit spreads and Iron Condors.
If the investor establishes a credit spread with too great a delta value – even one that meets the “rules” for distance from the underlying and interval between strike prices – he is greatly reducing the likelihood of his trade being successful.
“The Monthly Income Machine” therefore includes an entry rule regarding the maximum delta value that is acceptable when establishing the trade.
Put another way, it’s definitely a mistake to ignore the current volatility of the underlying and its options when selecting which strike prices to use for a credit spread and/or Iron Condor.
4. Too Little Net Premium
The net premium on a credit spread is the difference between the price received on the short strike price option and the price paid for the protective long strike price option at the outset of the trade.
While we are seeking profit on the trade, and our entry rules are geared to maximizing the probability of that profit being realized, we must also recognize the possibility of a loss.
As with any investment, then, we must consider reward vs. risk, and the reward must be sufficient for the investment to be a rational one.
Thus, “The Monthly Income Machine” investment technique includes an entry rule that demands at least a specific minimum dollar profit if the trade is successful.
If the investor must take less than “The Monthly Income Machine” recommended minimum profit on a credit spread, the credit spread does not meet the trade entry rules and should not be done irrespective of the fact that the contemplated trade might conform to all the other entry rules.
5. Not Avoiding Earnings Reports
Earnings reports relate, of course, only to credit spreads where the underlying is a stock.
The release of a company’s earnings report (generally a quarterly matter) can produce “surprises” that result in sharp price moves far in excess of the stock’s typical daily trading ranges. While an earnings report surprise that favors the investor’s credit spread would bring happy smiles, an earnings report that drives the underlying stock in the adverse direction to can ruin one’s day… and week and month!
This risk can and should be avoided. For this reason, if an earnings report is scheduled for a stock prior to option expiration day, credit spreads employing options subject to an earnings report on the underlying are categorically “off the table.” The same is true for any other potential news events related to the underlying that have an expected date of exposure that is prior to option expiration.
Bending the trade entry rules by establishing an option credit spread or Iron Condor when an earnings report is due for the underlying prior to options expiration day is a major – easily prevented – mistake.
6. Not Employing Stop Loss Orders
One of the most common – and dangerous – mistakes investors make with credit spread and Iron Condor investing is a breakdown in trade management discipline.
“The Monthly Income Machine” technique provides a carefully balanced series of entry criteria geared to producing a very high probability of success and a very good ROI for that success.
Nevertheless, there will inevitably be trades that do not work out as desired. It is critical that the investor not let the relatively infrequent losers be so large as to wipe out much of the profits earned on the more numerous winning trades.
The key trade management feature of the “Machine” (and it should be so for any market investment) is to exit from a trade that reaches a predetermined maximum loss level. (The “Machine” recommends that we exit from a trade if the resulting loss represents 1.5 to 2.0 times the net premium we collected on the trade up front.)
Note: using a “stop loss” to trigger trade exit if too large an adverse move develops for the trade is a MIM “rule;” but the definition of where that point should be can be adjusted up or down somewhat by the investor depending on his risk tolerance. (As noted, we recommend 1.5 to 2.0 times net premium collected at the outset of the trade as the maximum acceptable amount of loss during an adverse move; if that level is reached, we exit from the trade.)
Bottom line, establishing a maximum acceptable trade loss is a rule; what that maximum amount of loss should be is a “Machine” recommendation.
Not having a stop loss trigger point at all, or having one but not having the discipline to act if and when it is breached, sadly is a very common, costly, and needless investor credit spread mistake.
7. Employing Good-Until-Canceled Stop Loss Orders
Having discussed the importance of avoiding the “no stop loss” mistake, we also need to be aware of a stop order process mistake that should be avoided.
While employing the stop loss order on a good-till-cancelled (GTC) basis has the virtue of being a low maintenance process, I recommend not using GTC stop loss orders for option credit spreads.
A GTC order can be filled on the opening, i.e. when trading begins for the day. However, there is a significant (and needless) risk that because a GTC order is “live” in the market when it opens, the order could be filled even though such an order fill would be unwarranted based on the price of the underlying.
This can happen because stop loss orders are triggered not only by a trade taking place at the trigger price, but also by a bid or ask order being placed at or beyond the trigger price.
Wild bid or ask prices thrown into a market before the underlying has begun to trade with any volume thus can – and do – produce great “fills” for the person placing the unjustified Hail Mary high or low bid or offer. But when such orders get filled it means an investor victim has been knocked out of a trade that he should still be in based on the trading price level of the underlying.
The solution: don’t use GTC stop loss orders. Instead, place your stop loss order as a “day-order” each morning after the market has been open and trading for 15 minutes or so.
Yes, this means more order placement work, but it also means much less chance of unwarranted, teeth-gritting stop-outs that should not have occurred.
8. Overlooking 2-Step Iron Condors (“legging into the Iron Condor”)
One of the most tasty aspects of credit spread investing is the Iron Condor.
An Iron Condor is composed of two credit spreads – one bullish spread (a put spread) and one bearish spread (a call spread) established in the same underlying and the same option expiration month, with the interval between the spreads’ long and short strike prices being the same.
If we are using the entry rules for “The Monthly Income Machine” and both spreads fully conform to the rules, our expectation is that we will make our profit on both spreads, i.e. the underlying may move up and down along the way before expiration, but will expire somewhere between the strike prices of the call spread and the put spread without ever having reached in-the-money status.
Here’s the beauty of the Iron Condor: since even in the worst case it’s impossible for both spreads to expire in-the-money, an options-friendly brokerage firm will only require margin deposit on one spread.
That means the investor’s potential ROI in essentially doubled with no increase in risk whatsoever.
The bad news is that it is often not possible to find a bear call spread and a bull put spread in an underlying that are both fully conforming to the MIM entry rules at the same time… and it would obviously be a mistake to put on either spread if it were not conforming to the entry rules. Thus, we are shut out of the possibility of establishing what I call a one-step Iron Condor.
Happily, we can still end up with the same Iron Condor and its single margin advantage even if we put on the two requisite spreads at different times… even days or weeks apart. I call this the two-step Iron Condor.
Consequently, we can establish one spread of an Iron Condor now, when it is conforming, and then the other spread at some future time when market movement has moved it into conformity with our entry rules.
So, don’t make the mistake of missing out on Iron Condor benefits simply because both necessary spreads are not conforming to the entry rules at the moment you are contemplating a trade.
Credit spread mistakes are unnecessary and can be costly.
If you seek an ongoing, reliable approach to generating a market-based monthly income stream, the conservative option credit spread and Iron Condor approach should be high on your list of possible investment strategies.
If the strategy is executed properly, the investor can expect credit spread investing to produce a relatively high percentage of profitable trades: with the entry and trade management “rules” of “The Monthly Income Machine,” we target at least 80%+ winning trades.
Since the entry/trade management rules are very specific and objective, three important caveats to the 80%+ successful trade target are that (1) the investor only establishes trades that meet all his trade entry criteria; (2) the investor employs disciplined trade risk management; and (3) the investor avoids the 8 enumerated “mistakes” detailed in this article.
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P.S. Other “white paper” articles by Lee concerning selection of best reward/risk ratio credit spread and Iron Condor income candidates: