As a reminder, here is the breakdown of the strategy as described by Fahad:
5% - When trading options, never, ever in your life time allocate more than 5% of your portfolio in a single trade. It doesn't matter you have $10,000 or $1 million in your account, stick with the rule and it will serve you well in the long run.
10% - When doing a credit spread, the OTM strike you're selling or shorting, the difference between that and where the stock is currently trading at must be at least 10%. This is important because if the stock runs against you, it gives you a 10% cushion before your shorted option can get in the money.
20% - The total return or profit by selling the spread must be at least 20% each month. So, if it is a $5 spread, it should be done for no less than $1 credit; $1 spread should be done for no less than $0.20 credit.
International Business Machine (IBM) has been trading in a tight range in the last few weeks. Here is a one year chart:
Using the "the 5-10-20 Rule", you might consider the following trade on IBM:
- Buy IBM April 2012 175 put
- Sell IBM April 2012 180 put
- Sell IBM April 2012 205 call
- Buy IBM April 2012 210 call
The P/L graph looks like this:
IBM is currently trading around $193.42. The trade can be done for $1.50. The margin requirement is $350, hence the maximum gain is 42.8%. The trade is protected against a 8% down move and a 7% up move. This is slightly less than I would normally do, but IBM stock has a fairly good chance to stay in a trading range. Based on the deltas of the short strikes, the trade has a probability of 60% to expire worthless and gain the maximum profit.
Exit strategy: Watch the trade closely and consider cutting your losses if the stock moves enough to threaten one of the short strikes. Since we are getting fairly large credit, we can afford to make an adjustment if the stock makes a large move and still end up with a profit. With those trades, you should never allow the maximum loss. My rule of thumb is to cut the loss when it reaches about 1.5 times the potential gain.
Consider this trade if you think that the stock will be trading between $180 and $205 in the next 8 weeks.