- 2000: Volume 9, No. 1 Puts & Calls: Dr. Option Takes A Coffee Break

"Okay, I'll do it. But I could be wrong ..."

How many times have you heard that? How many times have you said that? Every trade has a cost of error. It's because of that traders learn money management. For futures traders, money management often entails selecting profit objectives, quantifying margin impacts, and dynamically managing protective stops. In short, it's a lot of work.

Face it - some of us are just lazy. If you're like me, sometimes the temptation to leave the screens and pop 'round the corner for an espresso is often irresistible. Wouldn't it be nice not having to fiddle with your trades, at least not always?

If you actually like tinkering with your positions, you're probably going to want to pass on this column for other reading. For those that need a break, however, lean closer.

As I write this in mid-January, the S&P 500 cash index looks toppy in the 1450-1460 range. Technically, the broadening top, weak relative strength, and an apparent exhaustion gap, point to a possible bear move, punctuated by choppiness, over the next thirty days.

It's that choppiness that bothers me. I admit it - I'm a chicken. The prospecting of shelling out over $23,000 in margin for an S&P futures contract makes me so. Even the $5,000 performance bond requirement for the E-mini contract makes me sqawk. I'd prefer to keep my exposure in the $1,000 range.

Selling vertical call spreads on the cash index seems better suited for pullet-prone traders like me. Here's how it works.

S&P 500 Cash Index (SPX) @ 1449.75
Long Short Net credit	3 March SPX 1430 calls 3 March SPX 1425 calls	@ 66 7/8 @ 68 1/2 1 5/8

The maximum potential risk in the trade materializes if option implied volatility explodes. Even then, risk is capped. The most that can be lost is the difference between the option strike prices less the net credit. That puts the position's maximum risk and therefore its margin requirement, at $1,012.50.

Of course, the highest potential profit for the trade is the limited to initial net credit, or $487.50.

Maximum potential profit: 1 5/8 x $100 x 3 contracts = $487.50 Maximum potential loss: 3 3/8 x $100 x 3 contracts = $1,012.50

I know what you're thinking. Why bother risking over a grand to make less than $500? On the face of it, the trade seems to carrry a 2:1 risk-to-reward ratio. But those figures allude only to the best- and worst-case dollar outcomes of the trade, not the probabilities of success. In fact, at current volatility levels, this trade has about an 85% probability of being profitable in the next thirty days.

In actuality, the 30-day odds for the trade are closer to 3:1 in my favor. Why? Because, to put it in gambler's terms, I'm the casino. A gambler placing a 3:1 bet puts down $1 and, on a winning hand, gets $3 in return plus the original wager. From the casino's point of view, the bet will generate $1, three or more times on average, before the house pays out $3.

If I sell call spreads, I'm acting like the 'house'. I'll receive a rather modest credit in exchange for the possibility of losing a larger but defined sum. Over several trades, chances favor me to keep the credit most of the time. Every now and then, I'll lose. Now I only need to know how much I'll lose on average, when destined to lose, and when I'm going to win, how much will I win on average?

The odds are simply determined by taking the expected winnings, when probabilities indicate profitable trades, divided by the absolute value of the expected losses when probabilities indicate losing trades. The higher the odds for the house (that's me) the better.

In sum, this trade's got both built-in risk controls and advantageous odds.

Now where's that espresso?

Brad Zigler is Dr. Option. He can be reached at dr_option@hotmail.com. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. The examples presented do not take into consideration commissions, tax implications or other transaction costs which may significantly affect the economic consequences of a given strategy. Options involve risk and are not for everyone.