When it comes to trading, probability is king.
It’s typically better to take small wins often than a rare big win. It’s good for the psyche, and at the end of the day, it’s better for your wallet.
With options, generating those consistent, high-probability returns is a piece of cake – when you know how to do it.
And today, I’m going to show you a strategy to churn out the highest-probability trades in the market.
Here’s how to score consistent returns every single month…
Create the Perfect RUT “Profit Zone” to Generate Monthly Profits
Let’s say that over the next 30 days, you could make a 25% profit. Sure, it’s not doubling your money – but your chances of making that 25% are at 75% probability.
Sometimes, less is more. This is one of those times.
Here’s what I’m talking about…
Take a look at the 3-month chart below on the Russell 2000 Index (RUT), with the bottom 2,000 stocks in the Russell 3000 index.
At the time this screenshot was taken, the RUT was channeling between $1500 and $1600. The green “Profit Zone” shown is set at $1490 and $1645 – that’s wider than the RUT’s existing channel.
Without getting into statistical probability, the picture above is compelling. The
RUT has played well within the green zone over the past three months.
The probability that it will stay in this wide zone over the next 30 days – the length of our trade – is high. All we have to do is construct the “iron condor.”
Iron Condor Construction
To create such a wide profit zone range, you need to sell two credit spreads:
- Bear Call Spread (a.k.a. Short Call Spread) at the upper end of the range.
- Bull Put Spread (a.k.a Short Put Spread) at the lower end of the range.
A bear call spread is constructed by selling a lower strike call and buying the next higher strike call.
A bull put spread is constructed by selling a higher strike put and buying the next lower strike put.
To construct the spread, we’ll buy a $1650 strike call and sell a $1645 strike call to create the bear call spread.
Then, we’ll buy a $1485 strike put and sell a $1490 strike put to create the bull put spread.
If we sell both spreads for $0.50, then we’ll end up with a $1.00 credit.
And now, for the most important part – the risk.
We calculate risk by subtracting the net credit from the distance between the strikes in one of the credit spreads.
In this case, the distance between our spreads is $5.00 ($1490-$1485, or $1650-$1645). And our net credit is $1.00. So, that makes our risk $5.00 – $1.00 = $4.00.
Divide our risk ($4.00) by our entry credit ($1.00), and we get our high-probability return on investment – 25%!
Capping Risk and Taking Rewards
Now, with the inverted risk-to-reward ratio (make $1, risk $4), it’s critical that you practice vigilant risk management. If the RUT gaps, then we could be at $400 max risk in a heartbeat.
There are many ways to avoid maximum risk, but a very simple way is to exit a losing credit spread if the RUT jumps out of the profit zone. In other words, if the RUT closes above the short call in the bear call spread ($1645), or if the RUT closes below the short put in the bull put spread, buy back the losing spread.
On the other side, you should take a winning credit spread off the table when you can buy it back for 20% of what you sold it for. So, if we’re getting $0.50 per spread, we’ll want to buy it back for $0.10 – that’s 80% of the maximum credit.
Iron Condor Rules
And now, you’re ready to harness the power of the iron condor!
Until next time,
Tom Gentile
America’s #1 Pattern Trader
