Beat Volatility With the Friday Payout Trade

I don’t need to tell you the market is insanely volatile right now. The S&P 500 is falling off a cliff one day and soaring higher than ever the next. It’s chaos.

But a little chaos can actually lead to greater income – if you know how to play it…

Every Friday, we have the opportunity to play the chaos in the market. A large volume of weekly and monthly options contracts expire on Fridays. Traders and market makers scramble to adjust their positions to hedge or close out expiring contracts. This leads to heightened volatility.

And that volatility is the secret sauce behind these outsize payouts we’re targeting.

The best part is this trade takes only a few minutes to set up… You can watch me demo a trade RIGHT HERE. It’s much easier than you likely think.

You also collect money immediately, your risk is limited, and you often don’t have to think about it after you’ve set it up.

It’s called a credit spread, and we’ll be making them on the Russell 2000 Index to leverage market volatility and take home weekly income as high as $6,000.

But first, let’s discuss what a credit spread is and how we’ll use it in my weekly livestreams to profit while minimizing our risk in a volatile market.

You’ve Got a Lot of Options

Let’s start with the basics: A credit spread is a type of options play.

If you’re new to options, you should know that an option is a contract. It gives its holder the right – but not the obligation – to buy or sell 100 shares of stock on a designated date. I have a whole options masterclass to help you get familiar with options. You can access it here.

As a quick primer… Every option is linked to a specific stock, index, or futures contract. So whenever you place an options trade, its price will be affected by the movement of its underlying asset.

There are two types of options: calls and puts. Options typically trade in lots of 100 shares (called contracts).

A call option gives you the right – but not the obligation – to buy 100 shares of a particular underlying stock at a specific price (the strike price) before a specified date in the future (the expiration date).

The opposite of a call is a put. A put option conveys the right – but again, not the obligation – to sell 100 shares of a stock at the strike price by the time the put option expires.

All options have expiration dates, which typically land on Fridays.

Here’s how they work.

You could choose to buy 500 shares in Company XYZ, which is currently trading for $10 a share.

Excluding commissions (which are increasingly becoming a thing of the past), that will cost you $5,000. However, you may not want to spend $5,000 on the trade.

So rather than buy the stock outright, you can buy options on it – which are significantly cheaper per share. If you bought five call options, it would give you the right to buy or sell those same 500 shares at a certain price by a certain time (5 call options x 100 shares per option = control over 500 shares). And those call options might be just $1 each, or $100 per contract. So you’d spend $500 to control 500 shares instead of $5,000 to buy the stock outright.

If the stock goes up, the option price should increase as well. Though not by the same amount. There are a variety of factors that influence this, including how much time is left until expiration, how volatile the stock is, and others.

But owning a call option is a way to take advantage of a stock going up without having to buy all of those shares. You can do it for much less.

Similarly, if you think a stock is headed lower, you can buy puts rather than shorting the shares.

Next, you need to pick a time frame for your scenario to play out – the end of which is known as the expiration date. This can be anything from days to years out from the day you bought the option.

Options prices vary depending on their expiration date, the strike price, and the volatility of the underlying stock or index. I’ll cover more on options pricing later.

Anyway, once you’ve done all that, you’re ready to buy.

When you buy an option, it is as though someone is saying, “I will allow you to buy or sell 100 shares of this company’s stock at a specified price per share at any time between now and the expiration date.”

And it’s further understood that for this right, they expect you to pay a fee.

That fee is called the premium, which will vary considerably depending on the exercise price and time until expiration as well as the stock’s volatility.

Alternatively, if you are selling (writing) the options, you collect the premium. I’ll have more on how we use that to our advantage later.

Approved!

To trade options, you will need your broker’s approval. But don’t worry, it’s not hard to get approved. To trade the credit spreads alongside me, you’ll need what’s called Level 3 approval, so be sure to ask for Level 3 approval. (Note: Charles Schwab starts its options trading account levels at zero, so for that broker it’s Level 2.)

You’ll simply fill out a form on your broker’s website.

When you do, make sure you indicate you have some experience. Even paper trading counts.

You’ll also want to select speculation or growth as part of your investment objectives.

Although credit spreads are a conservative income strategy, to get Level 3 approval, the broker will want to know that you’re comfortable taking on some risk, so be sure to choose moderate to high risk tolerance. We won’t be making high-risk trades, but your broker wants to know you can handle it if you choose to do so.

You may also have to disclose income or liquid net worth (you usually won’t have to provide any proof).

If you are asked why you want Level 3 approval, explain that it’s so you can trade credit spreads.

Follow these steps and you should be approved very quickly. Then you’ll be ready to trade right along with me, making the same trades I am.

Now on to the credit spread strategy that we will be using every Friday in Weekly Income Alert.

Credit Where It’s Due

A credit spread is a strategy in which you simultaneously buy and sell options that are of the same class (both calls or both puts), that are both out of the money, and that have the same expiration date, but with different strike prices. The result is that you get instant income.

Note: “In the money” and “out of the money” refer to the amount a stock is above or below its strike price. If a call’s underlying stock is above its strike price, the call is in the money. If it’s below its strike price, the call is out of the money. If a put’s underlying stock is below its strike price, the put is in the money. If it’s above its strike price, the put is out of the money.

Let’s take a look at an example to illustrate. For the sake of this illustration and easy math, say we do this credit spread on Company X, which is trading for $100.

Now, there are two ways to play a credit spread, but the funny thing is you will use calls if you think the price of the underlying asset will go down and puts if you think it will go up. That’s the exact opposite of when you buy options in order to speculate on the direction of the stock or index. You’ll understand why in a moment.

So, let’s start with a bull put spread (also called a put credit spread). And bear in mind, you’ll be watching me place this same trade each week. It only takes about five minutes to execute.

To set up a bull put spread, you’ll want to sell (write) puts with a strike price below what you think the share price of the underlying asset could drop to. At the same time, you’ll buy the same number of puts with a lower strike price.

In a credit spread, you will always sell the strike price closer to the current price and buy the strike further away.  Because the option with the strike closer to the current price will be more expensive, that will generate a credit when you sell one option and buy another at a different strike.

So, back to Company X for an illustration. It’s trading at $100 and we think it’s going to rise higher by the end of the month, or simply not drop down to the strike price where we sold the put.

So we sell, or write, let’s say 10 $95 puts at $2.50 while buying 10 $90 puts at $0.50, all with the same expiration date. Each options contract represents 100 shares, so we will collect 10 x (2.50 x 100), or $2,500, from our put sale. At the same time, buying the 10 $90 puts at $0.50 will cost us 10 x (0.50 x 100), or $500.

That means our net credit for this spread is $2,000. We sold the $95 strike puts for $2,500 and bought the $90 strike puts for $500 for a net credit of $2,000, or $2.00 per option. That’s also our maximum profit.

With a credit spread, all of your return will come from writing options minus what you paid to buy options. We know exactly what our maximum profit is the minute we place the trade. We also know what the maximum loss is as soon as we place the trade. No surprises here. Buying the other options is a hedge to limit our potential losses.

Our maximum loss if the trade goes against us is the difference in strike prices, $95 – $90, or $5, then subtract the $2 net credit to get $3. Multiply by 100 (because each contract represents 100 shares) to get $300 and then by 10 for the number of options we’re playing, and you get $3,000.

So we’re risking $3,000 to make $2,000, or a 66% return on investment. Keep in mind that the way we are trading these credit spreads, the expiration dates are soon. So the chance of a big drop in the stock in a short period of time is not very good. It can certainly happen but is not especially likely.

Now let’s calculate our break-even point. That’s the point at which we begin to take a loss on the spread. To get it, we subtract the net credit, $2.00, from the short option, the one we sold at the higher strike price, which means $95. So our break-even point is $95 – $2, or $93. That means we need the share price of Company X to stay above $93 to make a profit.

Alright, we have our bull put spread set up, now let’s see what could potentially happen with our play.

If everything goes according to plan, Company X will rise over the course of the month and by the expiration date all of the puts, the ones we bought and the ones we wrote, will expire worthless and leave us with $2,000 in pure profit.

But what if we’re wrong and the play goes against us? Say Company X drops to our break-even point of $93. In that case, we will not exercise our $90 puts because they’re out of the money. However, our $95 puts will be assigned, and we will have to buy 1,000 shares of Company X at a cost of $95 for a total of $95,000.

We can then sell those at the market price of $93,000 to close our position at a loss of $2,000. However, because we had a net credit of $2,000, our net losses are $0. We didn’t make money, but we didn’t lose any either.

To make things easier, though, we could simply buy back the put we sold at the $95 strike and sell the put we bought at the $90 strike to close out our trade without having to buy or sell any stock and have a big outlay of cash.

The worst-case scenario is that we are totally wrong and Company X drops below $90 over the next month. That’s where the safety of the credit spread kicks in.

We will have to exercise our $90 puts and sell 1,000 shares of Company X for $90,000. At the same time, our $95 puts will be assigned and we will be required to buy back our short position for $95,000 to close. The difference between the buy and sell price for our spread is $5,000. But remember, we collected a $2,000 net credit, which limits our losses to just $3,000.

Again, you could close out the options trades just prior to expiration and not deal with large sums of cash and buying and selling stock.

If you had written the $95 puts without covering them by buying the $90 puts, your losses could be catastrophic, as the stock could drop to zero. It’s not likely, but it could happen in theory.

Now let’s go back to the beginning. What if we think Company X is going to go down?

In that case, we will be setting up a bear call spread, also known as a call credit spread.

To do that, we will sell (write) a $105 call at $2.50 while buying the $110 call. Once again, these all have the same expiration date. This gives us the same net credit as our put spread had at $2.00, or $2,000 for the whole trade. That is (10 x (2.50 x 100)) – (10 x (0.50 x 100)) = 2,500 – 500 = 2,000.

The rest of our play will work in almost exactly the same way. The only difference is that to get our break-even point, we need to add our net credit of $2.00 to the strike price of our short call, $105. That gives us a breakeven of $107.

As long as Company X stays below $107, we will make money on this trade. Now, how might it play out?

Once again, our best-case scenario is that we’re right and Company X drops over the next month. If that happens, all the calls expire worthless and we go home with $2,000 in profit.

If Company X rises to $107, like the put spread, it’s a wash. We don’t exercise our $110 calls because they’re out of the money, but our $105 calls will get assigned and we will be forced to sell short 1,000 shares of company X for $105,000.

However, we can then buy 1,000 shares for $107,000 and close out the short position. The difference between them is $2,000, the same as our net credit, so we didn’t make any money, but we didn’t lose any either.

Finally, say our trade goes against us completely and Company X surges to $115. If that happens, you’ll exercise your $110 calls and buy 1,000 shares of Company X at $110,000. Your $105 calls will be assigned at the same time, and you’ll be required to sell 1,000 shares for $105.

The difference between the buy and sell prices results in a loss of $5,000. But your net credit of $2,000 when you opened the trade softens the loss to $3,000. If you had written the $105 calls without covering them by buying the $110 calls, your losses would be theoretically infinite as there is technically no upper limit on how high a stock can rise.

Similar to the put spreads, you would likely just close out the options trades rather than deal with buying and selling stock.

Remember, when trading a credit spread, you’ll always sell the strike that’s close to the current price (because it’s worth more) and buy the one that’s further away.

And when you trade with me each Friday, I’ll show you exactly which strike prices I’m choosing.

That’s how a credit spread works in a vacuum. In our specific case, we will be holding for three weeks until the position expires. That’s not much time, which increases the chances that our strike prices will not be hit. Get paid upfront, hold, cash out. There may be times when we close out the position sooner, but the plan is to hold for three weeks.

Now, there will likely be other fees and commissions involved that might adjust your net credit and break-even points, but those will vary depending on your broker and the size of your position. Always reach out to your broker if you have any questions specific to their fees and the like.

Again, to trade options, you need approval from your broker. It’s very simple to do. Just search their site or ask them how to get Level 2 approval, which is what you’ll need to trade spreads.

Now on to the specific tickers we will be playing in this service…

Small Cap Trading

We will be trading options on the Russell 2000 Index. The Russell 2000 is composed of 2,000 small cap companies. Smaller companies are more volatile, and therefore the options are more expensive and we can collect more income.

Think of it as the S&P 500 for smaller companies. The Russell 2000 is the most widely quoted measure of the performance of small cap companies.

Critical for our strategy, the Russell 2000 is more volatile than the S&P 500. That volatility makes traders nervous, and nervous traders are willing to pay us more to take the other side of their trades. That means bigger premiums for us right out of the gate.

But that’s just one part of the equation… Friday creates this perfect storm as weekly and monthly options start expiring. Traders panic. Some dump their bullish bets… Others rush into bearish bets…

All that frantic activity drives up what they’re willing to pay us. So we’re locking in a double boost… both from the index’s natural volatility and from that Friday panic premium.

The options trade under the ticker symbol RUT on most brokers’ websites. Fidelity lists it as RUT. There may be some variation depending on your broker, but if you type in Russell 2000 in the symbol search, you should find it easily.

One cool feature of most index options is they have preferential tax treatment. Generally speaking, even though gains on these trades will be short term, 60% of the gain will be taxed at long-term rates, saving significant money on taxes. As I always recommend, speak with a tax professional about your individual situation.

Another thing to note is that the Russell 2000 was established by a British company, and as such the options that trade on it are “European-style.” That means they can only be exercised on their expiration day. The American-style options you may be more familiar with can be exercised at any point up to expiration. American style is how options on stocks are traded. The benefit of European style is that the buyer of an option that you sold can’t surprise you by exercising early.

For traders, RUT options are settled in cash based on the difference between the option’s strike price and the underlying index’s value at expiration without the transfer of assets.

In other words, if an option on a stock were exercised, shares of stock would be transferred between the two parties. With index options, there is no stock, only cash. But we’re not going to let that happen.

Credit spreads are usually “set it and forget it” sorts of trades that you normally hold until the options expire worthless or close out ahead of time.

And we’ll be doing this together in real time. I’ll be making the exact same trade, right along with you. Don’t worry about whether you’re a skilled enough trader to pull these trades off. Just follow me as I make the trade… The weekly sessions should eliminate all of your doubt.

Just join me every Friday at 10 a.m. ET and place the trade exactly as I do.

Remember, there will be a live chat, so you can always ask moderators and me any questions you might have.

Of course, it’s not a problem if you can’t make one of my live sessions. You’ll get an email from me with details on the trade we are making for that week.

For additional details and to watch me walk you through setting up a credit spread, watch my video How to Place the 5-Minute Friday Trade.

Welcome to Weekly Income Alert!