Paper Trading Credit Spread Option Trades to Learn

Paper trading using one of the many virtual trading systems provided by option brokers, and now CBOE, is so important if you have never traded options. This is especially important trading credit spreads, like Bull Puts and Bear Calls and ultimately Iron Condors. These are special strategy trades that must that must be fully understood before trading with your own funds. You must practice entering, closing and adjusting Bull Put and Bear Call spread trades. You must fully understand an Iron Condor trade and the requirements for making sure your broker only applies margin to one side of this 4 legged trade. And most important you must practice closing these spreads and rolling to new spreads when trades go against you.

I paper traded for six months using OptionsXpress’s virtual trading system before using my own funds. This is the system now used by CBOE so new traders no longer need to apply for a brokerage account to paper trade using a virtual account.

To get started you should establish a virtual trading account with your broker or just use CBOE’s free system. You must practice all types of credit spread trades like:

1. Entering new trades using the current bid.

2. Entering new trades using limits that are higher than the bids, like ½ of the bid/ask or midpoint. Then shave 5-10 cents off this midpoint.

3. Enter stop loss orders to close profitable spread trades for 10 cents or less freeing up margin for new trades.

4. Practice adjusting Bull Put and Bear Call credit spreads. You should close and roll to new credit spread trades to collect another credit. This is the most important one to practice and master before committing your own funds.

The 4 types of trades above should be practiced many times over for a period of 2 to 3 months. Never enter into one of these specialty options trades using your own funds until you completely understand all the risks. You must have an exit plan and know exactly what to do when a trade goes against you.

Once of the huge advantages you have with option spreads is that you can breakeven when a spread trade has to be closed. This is accomplished by adjusting, or rolling, to a new spread trade to collect a new credit. Sometimes this new credit offsets, or exceeds, the debit you incurred closing your original spread. This is a key risk management procedure that you can master paper trading. Once you complete a few of these rolling trades you will really get excited about trading credit spreads and be able to protect your monthly cash flow so that you are always adding net credits to your account.

New subscribers to my advisory service can request Flash Movie files that illustrate how each of the 4 types of trades are processed at different brokers.

Update on February Trades Expiring in 20 Days.

All 3 Bull Put Spread trades emailed January 20 were filled by the majority of subscribers at limit prices higher than the current bids. This strategy of using higher limit prices has increased our returns an average 1/2 of a percent and will be continued on all future trades. All open trades, including the NDX Bear Call from earlier in the month, are very safe. I almost had a few Iron Condor trades ready to order this week but the market did not stabilize in any one direction. Their is still a lot of uncertainty whether this bull market will continue. Their are still many major earnings reports due next week which could influence the market direction.

A subscriber is providing me lots of guidance and professional help creating Flash Movie files that illustrate all the steps to select and process a credit spread order, close an open order and roll to a new order. I plan on creating these files to illustrate these processes for the upcoming Paper Trading Training course. I have been sending samples Flash files to subscribers to test on their computers and so far the feedback has been very positive.

January Credit Spread Trades - Performance

All Bull Put Spread trades and one Bear Call NDX trade expired worthless on Friday January 19th. The market was continuing to rise in a very Bullish pattern so I closed my NDX Bear Call spread and rolled up to a Feb NDX Bear Call Spread on 1/11/2007. I will roll this Bear Call again in February if the NDX Index keeps rising to protect my cash flow. The total return this month was 1.2% ($100/$8,720). All credit and debit premiums collected totaled $100 (25+20+125-600+530) and $8,720 (975+980+2,375+2,420+1,970) margin was required per contract. Those subscribers who completed both sides of the 12/16/2006 NDX Iron Condor trade realized a 3.9% return ($170/$4,330) or (25+20+125/975+980+2,375).\

The NDX Index prices retreated last week and settled well below the 1850 short so those subscribers who could not close and roll this Bear Call Spread had this spread expire worthless earning an additional $80 or more credit per contract. This was a lucky event because whenever the index price is within 10 points of your short option strike corrective action should be taken to close and roll the trade. Those subscribers who had trouble with their brokers closing and rolling this Bear Call Spread trade should send me an email to be included in the upcoming Paper Trading practice session.

Click to view details of these January trades.

Credit Spreads and Iron Condor Paper Trading

Paper trading using one of the many virtual trading systems provided by option brokers, and now CBOE, is so important if you have never traded options. Credit spread trading has special characteristics that must be fully understood before trading with your own funds. You must practice entering Bull Put and Bear Call spreads on one or more Indexes. You must fully understand an Iron Condor trade and the requirements for making sure your broker only applies margin to one side of this 4 legged trade. And most important you must practice closing these spreads and rolling to new spreads.

I paper traded for six months using OptionsXpress’s virtual trading system before using my own funds. This is the system now used by CBOE so you no longer need to apply for a brokerage account to paper trade.

I am encouraging all my new subscribers who have never traded options to paper trade all my trades during their 60 day free trial. And if they still want to paper trade longer I am extending their free trial another 30-60 days, or however long it takes. I am very committed to helping everyone learn the basics to this trading strategy before using their own funds.

Objectives of Index Spread Trading

• Investopedia defines a credit spread is defined as “An options strategy where a high premium option is sold and a low premium option is bought on the same underlying security.” The result of this transaction is to receive the difference in premium between to two options. Your goal would be to have both options expire worthless, allowing you to profit from the premium received.
  
  
• 1) Earn consistent cash profits month after month averaging a 3% (2%-5%) net return. Earn these profits in bull and bear markets.
  
  
• 2) Establish the appropriate stops to protect each spread trade from realizing a MAX loss.
  
  
• 3) Enter Bull Put Credit spread trades on the SPX, NDX and RUT Indexes that have a very high probability of expiring worthless. This is a low risk options trading strategy.
  
  
• 4) Complete Iron Condor trades to double the return on the required margin capital that only covers one side of the Iron Condor.

Benefits of Index Spread Trading

Benefits of Index Spread Trading

1) Credit spread trading is a simple, safe, and stress-free type of trade that does not require a great deal of monitoring. You just place the trade, collect the credit, and wait for the options premiums to decrease or expire worthless. Minimum time is required to process and track these credit spread trades.

2) You receive the proceeds of each credit spread trade immediately when your order is filled and you keep these proceeds no matter what happens.

3) The credit spread has two primary advantages as an income generating strategy. First, the position benefits from time decay. Since options decay in value with the passage of time, the value of the credit spread will in turn decay over time. By writing a credit spread, you are selling a decaying asset and receiving a credit or a premium up front. If the underlying market remains stable until expiration, the spread expires worthless, allowing you to keep the premium received. In a sense, you profit from the passage of time.

4) The credit spread also allows you to benefit from market movement. If one writes a bullish credit spread using puts, the value of the spread would rapidly decline as the market moves higher. The converse is true for bearish call spreads. With this flexibility you can inject an element of trend following into your trading program to increase your odds of success.

5) Gains on stock index spread trades are considered ITC Section 1256 contracts. This means any gains made in these trades are taxed under a 60/40 rule. This rule states that gains are treated as 60% long-term capital gain income and 40% short-term capital gain income (ordinary income) regardless of how long the investment was held. So when we hold a index spread trade for 30 days (our average holding period), 60% of the profit made from that trade is treated as long-term capital gain income and taxed at 15% or 5%.

6) Trading capital is only used to support margin requirements when trading credit spreads. Most option brokers allow you to invest your trading capital elsewhere to be used as collateral for spread trading. Trading capital can be invested in closed-end funds that pay dividends monthly and are diversified across munis, preferreds, REITs, corporate bonds, floating rate loans, convertible bonds and other fixed instruments. Between the dividend yield and capital appreciation you can earn 7%-10% annually. Most brokers allow you to margin 100% of cash amounts, 90-95% of t-bill amounts and 50% of the stock amounts like closed-end funds.