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Consistent Income Trading Options - the SPX

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In the last article we discussed how options offer high probability strategies so that non-professional retail traders, like Karen the Super Trader, can make consistent income. In this article we will discuss why trading the SPX, as Karen does, is the optimum approach when trading high probability strategies.

When selecting high probability option strategies, we are referring to the credit spread (Put or Call) and the Iron Condor (IC), which is a combination of two credit spreads: the Bull Put and Bear Call; I do not recommend naked shorts or strangles, which are called undefined risk strategies (see prior article, Options trading: The credit spread is a better solution than the naked short).

There are various reasons for selecting the SPX (options on the S&P500 index) as opposed to a basket of other assets (stocks, futures, ETFs, etc.). First, as an index, the SPX offers diversification since it represents 500 large cap stocks. Diversification has always offered a means of reducing risk, and an index is an excellent way to accomplish this without the transaction costs of purchasing and managing 500 individual stocks. Unlike stocks, the index is little affected by earnings, dividends, up/down-grades, and company specific news (like a change in management); hence the implied volatility (IV) of the SPX is typically far lower than most stocks.

Second, SPX options are liquid. This means that there is sufficient volume and open interest (the number of contracts) in the option chain to ensure that you can enter and exit option positions at fair value and at strikes that are far OTM (out of the money). Many stocks, even within the S&P500 index, have options that are not traded sufficiently to be liquid, which makes it difficult to trade them efficiently.

Third, the SPX is a European style option, as opposed to stock options that are American style. European style options offer two advantages: no early assignment, which enables you to hold your position till expiration; and cash settlement (there is no stock that you have to purchase or sell short). By the way, cash settlement occurs when the option is ITM (in the money) at option expiration. In addition, while European style options typically stop trading on the third Thursday of the month (for Monthly options) and settle Friday morning (after all stocks have posted a trade), the Weekly option and the monthly SPXPM stop trading on Friday and settle Friday evening (as do American style options); this is not the case for the other indices: Russell 2000 (RUT), Nasdaq (NDX), and the Dow (DJX).

Fourth, there is no dividend risk with the SPX, unlike ETFs like the SPY. When dividends are issued, it affects option pricing. Since the S&P500 is an index, there is no underlying stock; ETFs have an underlying stock, and typically have dividends as well.

And fifth, the SPX offers the highest premium for a given risk level (i.e., standard deviation). This is a result of institutions using the SPX to hedge positions, and is especially true for Put credit spreads (Bull Puts). We have back-tested 5-years of data for the SPX, RUT, NDX, Apple, and Google and the results have shown a significant advantage for the SPX at several risk levels: 1, 1.5, and 2 standard deviations. This certainly explains why Karen the Super Trader eventually migrated away from stocks towards indices, and eventually focusing predominantly on the SPX (with some RUT trades).

Given the reasons above, why aren't more option traders focusing on the SPX? There are two responses that I hear the most: first, it's too expensive; and second, the bid-ask spread is too large (compared to the SPY).

With regard to the first, I always suggest using a spread (specifically a credit spread) which results in a minimum cost or capital at risk of $500 (the SPX has $5 strike increments). This is certainly affordable for even small accounts.

The second response implies that options are bought and sold at market (at the bid or ask price); this is not the case (even when buying or selling a Put or Call). When working with a spread, you can typically get filled at the Mark (or midpoint between the bid and ask) or 5 cents off the Mark; the equivalent for the SPY, which is 1/10th the price, is a half-penny (which is not possible to trade).

In conclusion, if you are interested in high probability strategies using options, the SPX should be at the top of your list.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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