PURPOSE OF AN INVERTED CREDIT SPREAD

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Rosemary Perry
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2 PURPOSE OF AN INVERTED CREDIT SPREAD The purpose of an Inverted Credit Spread is to extend duration on an iron fly or iron condor in order to hold the trade longer, lower the trade basis and turn a losing trade into a winning trade. This trade adjustment relies are market or stock / ETF cyclicality to profit. The premise is that if you lower basis and stay in the trade longer eventually your underlying will cycle back towards its previous price. The move does not have to go all the way back to the original price it only has to go back partially. If you understand what and how an iron fly trade works you can skip to section 3. 2

3 TABLE OF CONTENTS PURPOSE OF AN INVERTED CREDIT SPREAD... 2 ABOUT THE AUTHOR... 4 HOW ROBERT MODD BECAME A SUCCESSFUL OPTIONS TRADER... 4 WHY ROBERT S STORY IS DIFFERENT FROM THAT OF EVERY OTHER GURU... 4 SECTION DEFINITIONS... 7 VERTICAL SPREADS... 7 CALENDAR SPREADS... 7 DIAGONAL SPREADS AT THE MONEY... 7 OUT OF THE MONEY... 8 IN THE MONEY... 8 DEBIT SPREAD... 8 SECTION THE IRON FLY... 9 SYMBOL TLT... 9 IRON FLY POSITION... 9 SECTION THE ADJUSTMENT USING THE INVERTED CREDIT SPREAD EXTENDING DURATION SYMBOL TLT IRON FLY POSITION CONVERTED TO AN INVERTED CREDIT SPREAD IMPORTANT DISCLAIMERS AND TERMS OF USE

ABOUT THE AUTHOR HOW ROBERT MODD BECAME A SUCCESSFUL OPTIONS TRADER Robert Modd ran a multimillion-dollar chemical and water treatment company for years.

4 ABOUT THE AUTHOR HOW ROBERT MODD BECAME A SUCCESSFUL OPTIONS TRADER Robert Modd ran a multimillion-dollar chemical and water treatment company for years. He owned real estate and was successful in business most people would have been satisfied with this. Robert felt his money should be put to better and more productive use and started looking into all kinds of franchise opportunities and other businesses to invest in but they all had one drawback the financial investment was large but so was the investment of time something he really didn t have as a father of four. Robert wanted more. He wanted to find a way to invest that would produce passive income for his future so that he could work as much or as little as he wanted and still live the lifestyle he desired. In this quest to build passive income, Robert began trading options over 23 years ago. WHY ROBERT S STORY IS DIFFERENT FROM THAT OF EVERY OTHER GURU Unlike all of the other so-called gurus who will find ways to stretch the truth and tell you that they have never lost a dollar or made a bad trade,robert Modd is always 100% honest about the hard road he traveled to gain success. 4

5 During his first 15 years of trading options, Robert blew up his account six times. After his final setback in 2008, he had to write a check for more than $12,000 to his broker to cover his losses. Writing that check would give birth to eight years of successful trades. Because no matter what struggles he faced, Robert never gave up. He knew that option investing was the key to a life of financial freedom. After sending the check to his broker, Robert made a decision:he dedicated himself to learning everything there was to learn about trading options. So after years of hit or miss trading he started thinking about trading as a real business buying and selling stocks and options as a business. He didn t know if it could be done, but the idea intrigued him. He knew somebody, somewhere was making a killing in the markets and was determined to find them, learn everything they know and make a killing of his own. He was determined to run his trading as a business, not as a gambler, and that meant looking at opportunities, supply and demand, marketplace dynamics and managing his business based on solid business fundamentals: profit, loss, expenses, overhead and return on investment. Like any business his only concern was to buy something he could sell at a profit and with enough of a profit margin so that his expenses (although small) were covered leaving a consistent and reliable income. From he decided to reeducating himself, and since then he has developed and tested over 200 different trading models. He dismissed almost 150 different models because he found them to be not profitable. Of the remaining 50 trading models he developed, he spent months and months back-testing them (also known as paper trading). Many of them couldn t stand up to back-testing and were eliminated. However, Robert continued to test, refine and redevelop his trading models. This refining led to 17 models that were promising enough to forward-test (trading using his own money). Some of these were not up to Robert s high standards and were eliminated. 5

6 Of those 17 models, eight were successful; but Robert still wasn t satisfied. Robert took these eight models and tore them apart; he turned them inside out and flipped them upside down, looking for any flaws in their design. Finally, after years of testing and 192 disregarded trading models, those eight models have been developed into legitimate money-making proprietary trading systems. After 23 years of experience, years of education, and trial and error, Robert is now ready to reveal some of his most successful trading systems to date. 6

7 SECTION 1 Definitions In order to understand an inverted credit spread these basic definitions need to be understood. First what is an equity option? According to Wikipedia: Equity options are the most common type of equity derivative. They provide the right, but not the obligation, to buy (call) or sell (put) a quantity of stock (1 contract = 100 shares of stock), at a set price (strike price), within a certain period of time (prior to the expiration date). What is a spread? According to Wikipedia: Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates. The three main classes of spreads are the horizontal spread, the vertical spread and the diagonal spread. They are grouped by the relationships between the strike price and expiration dates of the options involved. Vertical Spreads, or money spreads, are spreads involving options of the same underlying security, same expiration month, but at different strike prices. Horizontal, Calendar Spreads, or time spreads are created using options of the same underlying security, same strike prices but with different expiration dates. Diagonal spreads are constructed using options of the same underlying security but different strike prices and expiration dates. They are called diagonal spreads because they are a combination of vertical and horizontal spreads. At The Money refers to a strike price as close to the actual stock or ETF price as possible. For example if TLT is trading at $ per share then the 118 strike call and the 118 strike put are both at the money. 7

8 Out of The Money refers to a strike price not At The Money and not In The Money An Out of The Money Strike is away from the stock or ETF price and only holds extrinsic value. For example if TLT is trading at $ per share then The 120 strike call is Out of The Money and the 116 strike put is Out of The Money In The Money refers to a strike price not At The Money and not Out of The Money An In The Money Strike is away from the stock or ETF price and holds intrinsic value and can also have extrinsic value. For example if TLT is trading at $ per share then The 115 strike call is In The Money and the 119 strike put is In The Money Credit Spread is a spread sold for a credit. Credit spreads are typically sold by a seller who would buy it back for a lower price in order to profit. Debit Spread is a spread purchased for a debt. Debit spreads are typically purchased by a buyer who would sell it back for a higher price in order to profit. 8

9 SECTION 2 THE IRON FLY The strategy taught in this guide The Inverted Credit Spread is a type of vertical credit spread. Which means the Inverted Credit Spread involves options of the same underlying security, same expiration month, but at different strike prices. Inverted Credit Spreads are used as an adjustment to an iron fly position. An iron fly is also a type of vertical credit spread. You can also use The Inverted Credit Spread as an adjustment to an iron condor. An iron condor is two vertical credit spreads usually one on the put side and one on the call side. To explain in detail lets use an example of an iron fly which we will eventually adjust into an Inverted Credit Spread. I will use the ETF symbol TLT: Symbol TLT IRON FLY POSITION Trade TLT Call Long Call Short Inversion Put Short Put Long Position DTE Date Value Strike Strike Strike Strike Strike Credit 6/16/ $ /16/15 = Date trade was opened = TLT price at the time of trade = The strike of call bought 119 = The strike of call sold 9

10 0 is the dollar amount between the sold call strike and the sold put strike 119 = The strike of put sold = The strike of put bought $ 1.56 = The dollar amount collected The 119 short call combined with long call is a vertical spread The 119 short put combined with long put is a vertical spread DTE is the days until expiration. The options have a life of 7 days left as of 6/16/15 in the example. Each strike in a position is also called a leg. The vertical spreads contain two legs or two strike prices. The combination of the 119 short call long call short put long put is four legs. This combination of four legs is called an iron fly. An iron fly trade is when the at the money call and at the money put are sold in combination with purchasing an out of the money call and an out of the money put all in the same expiration cycle. This four leg combination can be positioned for any stock or ETF that has options available. What happens to this positions in 7 days when the options expire? Let s look at 4 possibilities. 1. TLT price is a. The 119 sold call expires worthless b. The bought call expires worthless c. The 119 sold put costs $3.50 to buy back d. The bought put can be sold for $1.00 The position losses $2.50 from buying the 119 put and selling the put, but remember the position was sold for $1.38. Actual loss $2.50-$1.56=.94 loss. (This is the width of the spread minus the credit received) 2. TLT price is 118 at Expiration a. The 119 sold call expires worthless b. The bought call expires worthless c. The 119 sold put costs $1.00 to buy back d. The bought put expires worthless 10

11 The position losses $1.00 from buying the 119 put, but remember the position was sold for $1.38. Actual gain $1.56-$1.00=.56 gain. 3. TLT price is 123 at Expiration a. The 119 sold call costs $4.00 to buy back b. The bought call costs $1.50 to buy back c. The 119 sold put expires worthless d. The bought put expires worthless The position losses $2.50 from buying the 119 call and selling the call, but remember the position was sold for $1.56. Actual loss $2.50-$1.56= $.94 loss. (This is the width of the spread minus the credit received) 4. TLT price is 120 at Expiration a. The 119 sold call costs $1.00 to buy back b. The bought call expires worthless c. The 119 sold put expires worthless d. The bought put expires worthless The position losses $1.00 from buying the 119 call, but remember the position was sold for $1.56. Actual gain $1.56-$1.00=.56 gain. Remember each price is multiplied by 100. For example selling the iron fly for $1.56 is actually selling it for $ With this particular iron fly any move up or down beyond $1.56 away from the strike price of $119 will be a loss at expiration. One advantage is that TLT could move to any level say all the way down to 110 or up to 130 for example and as long as it s within $1.56 of the 119 strike at expiration the trade profits. This is one advantage of using options over trading stocks with stop losses. 11

12 SECTION 3 The Adjustment Using The Inverted Credit Spread Now that you comprehend what an iron fly is and how it can make or lose money let s go over how to keep the iron fly trade alive rather than taking a loss. Rather than taking a loss, adding more time to the trade until it can be profitable is commonly referred to as Extending Duration. To extend duration on an iron fly we can use an inverted credit spread. An inverted credit spread can also be use to extend duration on an iron condor. Why use an inverted credit spread? 1. We can stay with the trade longer which means it s possible to turn a loser into a winner. 2. We can sell more premium and add more credit to lower basis and increases the possibility of turning a loser into a winner. This method relies on the stock or ETF to be cyclical. Cyclicality is the reason this adjustment strategy can profit. Back to our example with the adjustment SYMBOL TLT Trade TLT Call Long Call Short Inversion Put Short Put Long Position DTE Date Value Strike Strike Strike Strike Strike Credit 6/16/ $ $ /26/ $ Above is an IRON FLY POSITION CONVERTED TO AN INVERTED CREDIT SPREAD. 7 days after the iron fly was placed TLT dropped from to Closing the position would be taking a loss of 119 put put = = -.94 or minus $ The calls would expire worthless. 12

13 In the example the DTE call is traded for the 119 7DTE call. The DTE short call is traded for the 7 DTE short call. The DTE short put is traded for the DTE short put. The DTE long put is traded for the DTE long put. The 0 DTE credit spread was left to expire worthless then the 7 DTE credit spread was sold for a credit of $.30. The 0 DTE 119 short put was in the money and purchased back while simultaneously selling another DTE short put for $.49 credit. The DTE long put was sold for $.91. The DTE long put was purchased for $.12 This has created two credited spreads inverted by $1.50. Thus an Inverted Credit Spread This Inverted credit spread has zero upside risk and has a best case scenario of being purchased back for $1.50 providing an opportunity for cyclicality to make $ $1.50 = $1.64 or $ What happens to this positions in 7 days when the options expire? Let s look at 3 possibilities. 1. TLT price is a. The 119 bought call expires worthless b. The sold call expires worthless c. The 119 sold put is bought and re sold for a credit extending duration 7 more days d. The 111 bought put expires worthless e. Another 110 put is purchased for around $.10 TLT continued down so we extended duration and may extend by adding more credit or breaking even keeping our credit at $3.14. Meaning our total credit for the position will still be $3.14 or a little higher. With $3.14 in credit we are adding more time for TLT to come back higher to ( = ) to break even or higher than to profit. 2. TLT price is at Expiration a. The 119 bought call expires worthless b. The sold call expires worthless c. The 119 sold put is bought and re sold for a credit extending duration 7 more days d. The 111 bought put expires worthless e. Another 111 put is purchased for around $.10 13

14 TLT doesn t move much going from to We will add more credit to our $3.14 and lower our breakeven level. This extends duration until we get cyclicality waiting to take profits when TLT rises. 3. TLT price is at Expiration a. The 119 bought call is sold for $3.50. b. The sold call is bought for $5.00. c. The 119 sold put expired worthless d. The 111 bought put expires worthless The position profits ($ $3.50 = $1.50) $3.14-$1.50 = $1.64 or $ (This is the width of the spread minus the credit received). Notice it doesn t matter how high TLT goes anything above $ is full profit. Notice our original position neutral at 119 and potentially profitable within a range of ( = ) or ( = ) to was upgraded to becoming profitable any price above Opening a position at 119 that is non directional and creating an opportunity to profit if it s $ or higher creates a higher probability of profit verses just selling an iron fly and closing the trade at expiration. Using the inverted credit spreads to adjust iron fly and iron condor trades supercharges your potential for profits by adding duration and profiting from the concept of cyclicality. Note: In the adjustment we could have used the synthetic equivalent of short Put and long 111 Put or Long 111 Call and short Call. These alternatives were not used in order to simplify for teaching purposes. 14

15 DISCLAIMER IMPORTANT DISCLAIMERS AND TERMS OF USE U.S. Government Required Disclaimer Trading financial instruments of any kind including options, futures and securities have large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the options, futures and stock markets. Don t trade with money you can t afford to lose. This video / web site is neither a solicitation nor an offer to Buy/Sell options, futures or securities. No representation is being made that any information you receive will or is likely to achieve profits or losses similar to those discussed on this video / web site. The past performance of any trading system or methodology is not necessarily indicative of future results. Please use common sense. This video / web site and all contents are for educational and research purposes only. Please get the advice of a competent financial advisor before investing your money in any financial instrument. Additional Disclaimer: I strongly recommend that you consult with a licensed financial professional or therapist before using any information provided on this video. Any market data or commentary used in this video is for illustrative, educational, and creative expression purposes only. Although it may provide information relating to investment ideas and the buying or selling of securities, options or futures, you should not construe anything on this video as legal, tax, investment, financial or any other type of advice. If you do, it s your own fault. Nothing contained on this video constitutes a solicitation, recommendation, promotion, endorsement, push or offer to buy or sell any security by anyone involved with this research. 15

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