One way to trade S&P futures with limited risk is to write put credit spreads using S&P 500 futures options. A bull put credit spread is my preferred trade, for reasons that will become clear below. Among other advantages, these deep out-of-the-money put spreads can be combined with bear call credit spreads. By using both of these in conjunction, a trader can maximize mileage from margin requirements and minimize downside exposure. (For a full explanation of bear and bull credit spreads, see Vertical Bull and Bear Credit Spreads. You can also read about S&P 500 futures options in Becoming Fluent in Options on Futures.)

The best time to write deep out-of-the-money put credit spreads is when the S&P 500 gets oversold. These positions will profit if the market trades higher, trades moderately lower, or remains the same - this versatility is a major advantage over option-buying strategies, which, to be profitable, require a major move in the correct direction within a set time frame.

Credit spreads profit if they expire out of the money or if they are in the money by less than the original amount of the premium collected when the spread is established (minus commissions). The time premium (net options value) that you collect when you establish a spread will fall to zero if the spread remains out of the money upon expiration. The premium initially collected is thus retained as profit. Keep in mind that these spreads can be closed early for a partial profit.They can also be closed at a loss should they get too close to the money, and they can be placed farther out of the money, where they can hopefully expire worthless.

There are two ways to apply S&P put spreads. One way involves some degree of market timing, and the other approach is simply a quarterly system that ignores the trend in the market (we will not discuss the latter method here). The trade I present below is one based on identifying an oversold zone for the broad market (S&P 500), which implies some degree of market timing. To be successful with either of these approaches, you absolutely must practice rigorous money management techniques.

I like to establish a put spread when the market is oversold (the selling has gone too far) because this gives my deep out-of-the-money spread lots of wiggle room if my opinion on the market is wrong. And since the market is oversold when we establish the spread, we collect maximum premium. Premiums tend to be pumped up due to increased implied volatility during sell offs, a function of rising fear and increasing demand by put buyers. Basically, the idea is to establish the deep out-of-the-money put spread when we are near a technical market bottom, where we have a higher probability of success. Let's take a look at an actual example of an S&P 500 futures options put credit spread.

Selling Pumped-Up Premium
In my opinion, when the equity markets are in a sell-off and an exact bottom is anyone's guess, there could nevertheless be enough indicators flashing a technical bottom to warrant establishing a put credit spread. One of the indicators is the level of volatility. When implied volatility rises, so do the prices of options: writing a spread has an advantage at such a time. The premium on the options is pumped up to higher-than-normal levels, and, since we are net sellers of the option premium when we establish a put credit spread, we are consequently net sellers of overvalued options. With sentiment indicators like CBOE put/call ratio indicators screaming oversold, we can now look at some possible strike prices of S&P 500 put options to see if there is a risk/reward picture we can tolerate.

Our example will focus on the conditions of July 2002 for the September S&P 500 futures, which closed at 917.3 in trading session on July 12, 2002, after three consecutive down days and six out of preceding seven weeks were down. Since there was this much selling (the S&P 500 fell by more than 10% since March), we could be confident that we had some degree of cushion once we got into our put spread. Before establishing a deep out-of-the-money put spread, I generally like to see the CBOE put/call ratios well into the oversold zone. Since I am satisfied that these conditions are fulfilled, I prefer to go about 12% out of the money to establish my put spread. My rule of thumb is to aim to collect $1,000 (on average) for each spread, which I write three months before expiration. The amount of spreads you establish will depend on the size of your account.

The margin required to initiate this type of trade usually runs between $2,500 and $3,500 per spread, but it can increase substantially if the market moves against you, so it is important to have sufficient capital to stay with the trade or make adjustments along the way. If the market moves lower by another 5% once I am in the trade, I look to close the trade and roll it lower, which means to take a loss on the spread and write it again for enough premium to cover my loss. I then look to write one more spread to generate a new net credit. Rolling can lower margin demands and move the trade out of trouble. This approach requires sufficient capital and should be done with the help of a knowledgeable broker who can work the trade for you using "fill or kill" and limit orders.

An S&P 500 Bull Put Spread
If you look at the September 2002 put options on S&P 500 futures, you will see there were some very fat premium to sell at that point. We could have establish a put spread using the 800 x 750 strike price, which is about 12% out of the money. Exhibit 1 below contains the prices for such a spread, which are based on settlement of September futures on July 12, 2002, at 917.30.


Bear in mind that the amount of premium collected is for one spread only. Each point of premium is worth $250. We were selling the September put at the 800 strike for $3,025 and buying the September put at the 750 strike for $1,625, which left a net credit in our trading account, or a net options value equal to $1,400. If we had done nothing and this trade expired fully in the money (September futures at or below 750), the maximum risk would have been $12,500 minus the initial premium collected, or $11,100. If the spread had expired worthless, we would've been able to keep as profit the entire premium amount collected. Keep in mind this example is exclusive of any commissions or fees since they can vary by account size or brokerage firm.

For the spread to have expired worthless (and thus been a full winner), the September S&P futures would've had to be above 800 at expiry on September 20, 2002. If in the meantime the futures move lower by more than 10% or the spread doubles in value, I will generally look to remove the spread and place in lower and sometimes to a more distant month to retain the initial potential profitability. The risk/reward profile of this spread size (50 points) only makes sense if you limit your losses and do not let the position get in the money.

While just one example, this deep out-of-the-money put spread illustrates the basic setup, which has several key advantages:

  • By using a spread instead of writing naked options, we eliminate the unlimited loss potential.
  • Since we are writing these when the market is oversold and the spreads are deep out of the money, we can be wrong about market direction (to a degree) and still win.
  • When the market establishes a technical bottom and rallies higher, we can at the right time leg into a call credit spread to collect additional premium. Because futures options use the system known as SPAN margin to calculate margin requirements, there is usually no additional charge for the second spread if the risk is equal or less. This is because the call and put spreads cannot both expire in the money.
  • By writing these at technically oversold points, we are collecting inflated premium caused by heightened investor fear during market downturns.

The Bottom Line
It is worth noting that deep out-of-the-money put spreads can, as an alternative, be placed on Dow futures options. Dow spreads require less margin than S&P futures options and would be better for those investors with smaller trading accounts. Whether you are trading Dow or S&P futures options, you require solid money management and the ability to diligently monitor the net options value and the daily price of the underlying futures to determine if adjustments are needed to rescue a trade from potential trouble.

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