Simple SPX Put Credit Spread Strategy (Part 2)

Today I want to give more details about the simple (hopefully) SPX put credit spread strategy.

Much of what I said in Part 1 can be expanded but I will start with some benefits about trading SPX:

• SPX is highly liquid to minimize transaction fees (perhaps the only thing always lost when trading securities).
• SPX options are Section 1256 that means favorable tax treatment (60% long-term capital gains and 40% short-term despite holding period being far less than one year).
• Underlying index has no earnings events to be avoided.
• Cash-settlement avoids the risk of being assigned 100 shares per contract.
• European exercise means no early assignment risk.
• Plethora of expirations available (e.g. AM-settled, PM-settled, Weeklys, Monthlys, Quarterlys, etc.).

Expectancy is the long-term average profit across many trades: (% wins * mean win) – (% losses * mean loss).
Supposing average spread is sold for $1.00 with $3.00 max loss and 80% winners:

Expectancy = [0.8 * ($100 * 0.5)] – (0.2 * $200) = $0 (breakeven).

Although each spread is sold for $1.00 (100 multiplier to get $100/contract), recall profits are taken at 50% net credit = $50 and losses closed for 3x initial credit result in a net loss of $3.00 – $1.00 (credit initially received) = $2.00 ($200/contract).

Supposing the strategy produces 85% winners:

Expectancy = [0.85 * ($100 * 0.5)] – (0.15 * 200) = $12.50/trade.

Supposing the strategy produces 90% winners:

Expectancy = [0.90 * ($100 * 0.5)] – (0.10 * 200) = $25.00/trade.

With the spread being 25 points, the net risk is $2,500/contract minus initial credit. To calculate Return on Risk (ROR), divide expectancy by net risk. ROR for 85% winners is therefore [ $12.50 / ($2,500 – $100) ] * 100% = 0.52%. If average trade is 3-4 weeks then roughly one trade per month is (0.52% * 12) ~ 6.2% per year.

While I am admittedly underwhelmed by that number, the calculation does use conservative inputs. Win percentage will probably be higher and days in trade will probably be lower.

Capital usage is not understated and difficult to quantify. ROR denominator is the maximum amount of capital ever allocated to the strategy. The number of open trades will constantly vary so returns are going to be somewhat diluted by additional cash on the sidelines as dry powder.

Setting a maximum number of open trades is one way to limit capital usage. For example, no more than one trade allowed per week with no more than four trades open at any given time limits total risk to $2,400 * 4 = $9,600. A total return can now be calculated by dividing net profit by $9,600.

Here are some other ideas to consider:

• Add no new trades if SPX is below its 50-SMA as losses tend to cluster around sharp market downturns [rare].
• In addition to down days, consider opening trades when SPX is near swing lows.
• Section 1256 underlyings offering favorable tax treatment but worse liquidity and fewer expirations: XSP, NDX, and RSP.

I will continue next time with more potential strategy tweaks.