- 2001: Volume 10, No. 5 The “Write” Way to Trade the S&P 500 Index

There are many ways to trade the S&P stock index, but there is only one way I know of that has a 90 percent accuracy rate—selling deep out of the money put spreads using options on S&P futures. This quarterly cycle S&P option strategy has limited risk and requires much less margin than buying or selling the S&P futures outright or selling naked options. A very nice feature of this trading strategy, furthermore, is the tiny amount of work it requires, as well as the psychological comfort of losing only 10 percent of your trades. As long as average losses on the losers are kept in check, this can be a very profitable trading approach.

Sell, Don’t Buy
I would argue that being a net seller rather than a net buyer of options is generally a better approach for traders. While there are certainly long position trades that offer profitable opportunities, I am convinced that selling premium offers a trader a strategic advantage for two central reasons--time becomes your ally and you no longer totally depend on directional movement of the underlying futures to profit.

There is evidence to support this claim. For example, in the case of S&P 500 options on futures, for the three years 1997 through 1999, an average of 83 percent of all S&P options expired worthless. Figure 1 contains additional data, showing a breakdown of S&P options expiring worthless into put and call options during this three-year period. This shows why put spreads are a better bet, especially given the long-term bullish bias of stocks. Here we see an average of 94 percent of S&P put options expiring worthless. Certainly if you can find the right options to sell, there is a pretty good chance of winning as an S&P put options writer.

Figure 1

Chicago Mercantile Exchange Expired Out-Of-The-Money Options CME Total and S&P Options (1997-1999)
Year	CME Options	S&P Options	S&P Puts	S&P Calls
1997 1998 1999	76.3% 75.8% 77.5%	81.7% 82.2% 84.7%	94.1% 93.1% 94.5%	54.8% 43.9% 66.7%

The Importance of Time Value
Since we are essentially selling time value, it is possible to profit without any movement of the underlying futures. Time value decay is not a function of movement of the underlying futures, but of the passage of time. While it can be affected by changing volatility levels, time value nevertheless marches to its inevitable terminal end--zero. Therefore, as a seller of time value, the option writer actually needs fewer conditions to profit.

For example, a writer of an S&P put spread would profit given the following scenarios:

1. The S&P trades sideways (trading range).
2. The S&P is bullish (prices rise by whatever amount).
3. The S&P is moderately bearish (prices fall by no more than 10 percent).

Condition 3, it is worth underscoring, produces a profit as long as the S&P decline is not too big. As you will see below, I will set my exit point at 10 percent below the level of the S&P at the entry point of the trade. As long as the S&P futures do not trade lower by more than 10 percent, the trade will expire a full winner. As Figure 2 shows, during past quarterly cycles the S&P has traded lower by more than 10 percent only seven times in the 18 years of our study. By exiting at this 10 percent swing-low point, my losses are kept under control. But as you will see, an exit at this 10 percent mark may produce small partial winners due to help from time decay.

Figure 2

Quarterly Swings-Low Frequency Tabulation (1982 - 2000)
Swings	More Than	More Than	More Than	More Than
Low (%) Frequency	5% 23	10% 7	15% 3	20% 1

Constructing a Put Credit Spread
The strategy emphasized here for trading S&P 500 options on futures is the basic credit spread, which is also known as a bull credit spread if written with put options. These are the opposite of bull call spreads or bear put spreads, which are net buying trades. With S&P 500 futures credit spreads a trader has an excellent hedged approach to trading, and one that, if done correctly, does not eat up loads of your trading capital through onerous margin requirements associated with either taking outright positions in S&P futures or selling naked options on S&P 500 futures.

In order to construct an out-of-the-money put credit spread we need to sell one option and buy another in the same named option month. More specifically, the trader sells the higher strike and buys the lower strike to generate a credit when writing a put credit spread. For a credit to be generated with a call credit spread, it would be necessary to sell the lower strike and buy the higher strike to generate a credit.

While there are numerous ways the basic credit spread approach can be constructed and managed (i.e., you can also sell a call spread with the put spread, as well as hedge the position instead of exiting), I like to sell a put on the S&P, 15 to 20 percent out-of-the-money, preferably near to or at the start of each quarterly cycle (March, June, September, December), and try to collect about $1,000 in premium. This premium will sometimes be higher or lower depending on how much implied volatility exists in the option premium. But on average it is possible to collect between $750 and $1,000 (four premium points worth $250 each). Average initial margin is $2,500.

I should point out that S&P futures options trade based on the underlying futures. For example, if you write a September put spread, the spread would expire with the September S&P futures on the third Friday of September. Therefore, once a put spread is established, it will usually stay open for a three-month period unless it is closed at our pre-determined exit point, which I will come back to below.

Figure 3 shows a profit/loss chart for a September S&P put spread written with just two months remaining on the options and the September S&P futures trading near 1215. This is later than I like to enter the quarterly cycle but will still work to illustrate the point. By selling the 975 strike, we collect 2.3 points ($250 x 2.3 = $575). We then buy the lower strike at 875 for a debit of .5 points ($250 x .5 = $125), leaving a net credit of 1.8 points or $450. As already mentioned, the basic idea is to profit from time decay. By writing deep-out-of-the-money credit spreads, there is a high probability that spreads will profit. Since this trade would be established already one month into the quarterly cycle, less premium is available. But there is also less probability that the trade will be a loser. While maximum loss is the distance between the strikes (100 points, or $25,000 minus the initial credit), in practice using an exit target, losers can be contained to an average loss close to the amount of the average winner.

Figure 3:

Trade Management
Historical ranges of the S&P futures starting in 1982, the year the contract was launched, show that most of the highs and lows of a calendar quarter stay within a rather well behaved range. The key question for an option spreader is this: what boundary should be set for establishing a put or credit spread? Based on my experience and analysis of the data, quarterly options spreads work best when placed 15 to 20 percent out of the money (the short leg), using either a maximum money loss amount or a percentage move of the underlying futures as a stop-loss exit target.

Statistical data in Figure 2 reveals that the S&P futures trade inside an identifiable band, which I measure from the previous quarterly close to current quarterly high and low. Past data shows that for swings low, the 15 percent mark contains over 95 percent of the periods. For swings high, 91 percent of the periods of the study fall within 15 percent. But I will use the 10 percent band for swings-low. As Figure 2 shows, the S&P futures have traded lower by more than 10 percent just 10 percent of the periods. In other words, only seven periods experienced swings low during 72 periods between 1982 and 2000.

The trick to making this system work is having the ability to exit at the right time. By exiting at a swing-low target of 10 percent, losses are kept to acceptable levels, and the high probability of success for each trade is retained (90 percent). For example, taking our example of a September S&P put spread with strikes 975 and 875, if we have a swing low of more than 10 percent during the two months left in the quarterly cycle, the trade would be closed. The size of the loss will depend on when the 10 percent mark is hit. An alternative exit plan is to close the spread when it widens by a predetermined amount. For example, the exit point may be set at a point spread 1.5 times the size of the initial point spread when the trade was established. Either way works well.

Let’s look at my 10 percent swing-low stop-loss exit plan. Figure 4 has different profit/loss functions for our September put spread at different time intervals during the quarterly cycle. If the 10 percent mark is touched less than two weeks before expiration, the trade will be a partial winner since the spread will have decreased due to the erosion of time value. An exit here is tough because there is the temptation to hang on for a full winner. Best to stick to the plan. If the 10 percent mark is touched one month before expiration, a loss of about $695 will be registered. At 16 days into the trade, a 10 percent move lower of the S&P futures would produce a loss of $1,300. Based on experience, a stop out will most often occur during the second half of the cycle, since it takes some time for the S&P futures to trade lower by 10 percent. In other words, it is less likely for the futures to plunge 10 percent in two weeks.

Figure 4:

Assuming an average of all of these possible losses at different time intervals for our loss management amount, we would come up with a stop-out loss amount of approximately $650 to $700. Obviously, this is an average. Sometimes it may be $1,300, other times breakeven, or even a partial winner. The point here is to be disciplined so that average losses are manageable. Based on past performance, and past performance does not guarantee future results, given that 10 percent of the trading periods hit the 10 percent mark during a quarterly cycle, this leaves an excellent performance profile. Average losses are kept low while the high probability of winning each trade is retained at 90 percent.

Based on this approach, it is possible to produce an annualized return of over 100 percent on margin if all goes according to plan. Based on a $10,000 account, simple (non-compounded) annual returns would be between 30 percent and 40 percent. Aggressive money management techniques can push this annual return substantially higher. While there are other ways to plan your trade management and placement of spreads (I like to use the monthly cycles, too), the art of the exit is the key.

Other approaches may work better, but the simple mechanical method presented above is a good place to start.

John F. Summa is a NFA registered Commodity Trading Advisor. He is also the founder of OptionsNerd.com, a free options trading advisory/educational Web site.