In this video, we will be discussing an interesting option strategy called the Jade Lizard. Don’t worry if you’re new to options trading, this strategy was actually coined by the experts at Tastytrade, a brokerage education company. The Jade Lizard combines both an undefined risk strategy and a defined risk strategy, making it a unique hybrid. One of the main advantages of this strategy is its ability to take advantage of the put skew in index ETFs. By selling more expensive options and buying cheaper options, you can potentially generate higher profits. Furthermore, the Jade Lizard eliminates the risk of a naked call, making it a more comfortable strategy for those who are concerned about potential losses. So, if you’re looking for an effective and versatile option strategy, the Jade Lizard might be worth considering.
1. Overview
1.1 What is the Credit Spreads Strategy?
The credit spreads strategy is a popular options trading strategy that involves selling options contracts to generate income. It is a type of vertical spread strategy that aims to take advantage of the time decay of options. This strategy can be used in both bullish and bearish market conditions, offering flexibility to traders.
1.2 The Jade Lizard Strategy
The Jade Lizard strategy is a specific type of credit spread strategy that combines both an undefined risk strategy and a defined risk strategy. It involves selling a short put option and implementing a bear call spread simultaneously. This strategy is designed to take advantage of the put skew in index ETFs and is particularly suitable for these types of assets due to the availability of strikes.
1.3 Benefits of the Credit Spreads Strategy
The credit spreads strategy, including the Jade Lizard strategy, offers several benefits to options traders. Some of these benefits include:
- Income generation: By selling options contracts, traders can generate income through the premiums received.
- Limited risk: Unlike some other options strategies, credit spreads limit the trader’s potential losses to a predetermined amount.
- Versatility: Credit spreads can be employed in various market conditions, including bullish, bearish, and neutral scenarios.
- Flexibility: Traders have the ability to adjust and manage their credit spread positions based on changing market conditions.
- Time decay advantage: Credit spreads benefit from the erosion of option value over time, known as time decay.
2. Understanding the Jade Lizard Strategy
2.1 Combining Undefined Risk and Defined Risk
The Jade Lizard strategy combines the elements of both an undefined risk strategy and a defined risk strategy. By selling a short put option, traders take on the risk of potential losses if the underlying asset’s price declines significantly. However, the implementation of a bear call spread introduces a defined risk component that limits the potential losses to a predetermined amount.
2.2 Taking Advantage of Put Skew in Index ETFs
The Jade Lizard strategy specifically targets index ETFs due to the presence of put skew. Put skew refers to the phenomenon where options with lower strike prices have higher implied volatilities than those with higher strike prices. By selling options at strikes with higher implied volatility and buying options at strikes with lower implied volatility, traders can benefit from the price discrepancies in index ETF options.
2.3 Suitable Strategy for Index ETFs
The Jade Lizard strategy is particularly suitable for index ETFs because these assets typically offer a wide range of strikes to choose from. This provides traders with more flexibility in constructing the strategy and adjusting the strikes to achieve their desired risk-reward profile.
2.4 Eliminating the Risk of Naked Call
One of the key advantages of implementing the Jade Lizard strategy is its ability to eliminate the risk of a naked call. Naked calls carry the potential for unlimited losses if the underlying asset’s price rises significantly. With the Jade Lizard strategy, the combination of the short put option and the bear call spread ensures that there is no risk to the upside.
2.5 Adjusting Strikes for Neutral Configuration
In a neutral configuration of the Jade Lizard strategy, the strikes need to be adjusted to create a riskless position to the upside. By fine-tuning the strikes, traders can ensure that there is no risk of loss if the underlying asset’s price increases. This adjustment is crucial for maintaining the risk-reward characteristics of the strategy.
2.6 Pushing the Short Put Side Up Slightly for Bullish Configuration
For a bullish configuration of the Jade Lizard strategy, the short put side is pushed up slightly to reflect a bullish bias. By adjusting the strike of the short put option, traders can align the strategy with their bullish outlook while still benefiting from the defined risk component of the bear call spread.
2.7 Constructing the Bearish Jade Lizard Strategy
The bearish Jade Lizard strategy aims to have the call spread take a larger percentage of the total premium. This configuration is more challenging to construct as it requires careful consideration of strike selection and premium distribution. Traders implementing this strategy have a bearish outlook and want the call spread to generate a significant portion of the strategy’s profitability.
2.8 Aim of Having Call Spread Take a Larger Percentage of Premium
In both the neutral and bearish configurations of the Jade Lizard strategy, the aim is to have the call spread take a larger percentage of the total premium. This allows traders to potentially maximize their profits if the underlying asset’s price remains within a certain range or decreases.
3. Implementing the Credit Spreads Strategy
3.1 Analyzing Exit Points
When implementing the credit spreads strategy, it is crucial to determine exit points. These are predetermined price levels or profit targets where traders may choose to close the position to secure profits or limit losses. By analyzing market conditions and the performance of the credit spread position, traders can make informed decisions on when to exit their trades.
3.2 Determining Maximum Loss
To manage risk effectively, it is essential to determine the maximum loss that a credit spread strategy can incur. This is typically calculated as the difference between the strike prices of the options involved in the spread, minus the net credit received. Understanding the potential maximum loss allows traders to assess the risk-reward ratio of their positions.
3.3 Calculating Initial Buying Power Requirement
Before entering a credit spread position, traders need to calculate the initial buying power requirement. This requirement represents the amount of capital that must be held in the trading account as collateral to support the credit spread position. By calculating the initial buying power requirement, traders can ensure they have sufficient funds to maintain the position.
4. Examples of Successful Credit Spreads Strategies
4.1 Case Study 1: Neutral Jade Lizard Configuration
In a case study of a neutral Jade Lizard configuration, let’s consider an investor who sells a short put option with a 16 to 20 Delta and implements a bear call spread with a 30 to 35 Delta. By adjusting the strikes and premium distribution, the investor creates a riskless position to the upside while aiming to generate consistent income from the call spread side.
4.2 Case Study 2: Bullish Jade Lizard Configuration
In a bullish Jade Lizard configuration, let’s imagine a trader who pushes up the short put side slightly to reflect their bullish outlook. By doing so, they can align the strategy with their market view while still benefiting from the defined risk component of the bear call spread. This configuration allows the trader to potentially generate income while limiting the risk to the upside.
4.3 Case Study 3: Bearish Jade Lizard Configuration
For traders with a bearish outlook, the bearish Jade Lizard configuration offers an opportunity to profit from downward price movements. By constructing the strategy in such a way that the call spread takes a larger percentage of the total premium, traders can maximize their profitability if the underlying asset’s price remains within a certain range or decreases.
5. Tips and Best Practices for Credit Spreads Strategy
5.1 Effective Risk Management
Implementing effective risk management techniques is crucial when using the credit spreads strategy. This includes setting appropriate position sizes, placing stop-loss orders, and diversifying strategies to mitigate potential losses.
5.2 Monitoring and Adjusting Positions
Traders should regularly monitor their credit spread positions and be prepared to make adjustments as market conditions change. This may involve rolling the options contracts, closing the positions early, or adjusting strikes to maintain the desired risk-reward profile.
5.3 Identifying Market Trends
Being able to identify market trends is essential for successful credit spread strategies. Traders should analyze market indicators, technical analysis, and fundamental factors to gain insights into potential price movements and adjust their strategies accordingly.
5.4 Understanding Volatility
Understanding volatility and its impact on options pricing is crucial for credit spread strategies. Traders should consider implied and historical volatility levels when entering trades and adjust strike prices, spreads, and premiums accordingly.
5.5 Diversifying Strategies
Diversifying strategies can help reduce risk and enhance overall portfolio performance. Traders can consider implementing credit spreads on different underlying assets, using various strike prices, and adjusting the strategy configurations to align with their market views.
5.6 Following News and Events
Staying informed about market news and events can provide valuable insights for credit spread strategies. Major announcements, earnings reports, and economic indicators can impact the underlying asset’s price movement and influence the success of credit spread positions.
6. Conclusion
The credit spreads strategy, including the Jade Lizard strategy, offers options traders a versatile and flexible approach to generate income and manage risk. By combining both undefined risk and defined risk strategies, traders can take advantage of market inefficiencies and potentially profit from a variety of market conditions. However, it is essential to thoroughly understand the strategy, adjust strikes and premiums accordingly, and practice effective risk management to maximize the potential benefits of credit spreads.