1



IN/OUT SPREADS

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Risk Disclosure

•       We Are Not Financial Advisors or a Broker/Dealer: Neither TheoTrade® nor any of its officers, employees,
representatives, agents, or independent contractors are, in such capacities, licensed financial advisors, registered
investment advisers, or registered broker-dealers.  TheoTrade ® does not provide investment or financial advice or
make investment recommendations, nor is it in the business of transacting trades, nor does it direct client
commodity accounts or give commodity trading advice tailored to any particular client’s situation. Nothing
contained in this communication constitutes a solicitation, recommendation, promotion, endorsement, or offer by
TheoTrade ® of any particular security, transaction, or investment.

•        Securities Used as Examples: The security used in this example is used for illustrative purposes only. 
TheoTrade ® is not recommending that you buy or sell this security. Past performance shown in examples may not
be indicative of future performance.

•        Return on Investment “ROI” Examples: The security used in this example is for illustrative purposes only. The
calculation used to determine the return on investment “ROI” does not include the number of trades, commissions,
or any other factors used to determine ROI. The ROI calculation measures the profitability of investment and, as
such, there are alternate methods to calculate/express it. All information provided are for educational purposes
only and does not imply, express, or guarantee future returns. Past performance shown in examples may not be
indicative of future performance.

•        Investing Risk: Trading securities can involve high risk and the loss of any funds invested. Investment
information provided may not be appropriate for all investors and is provided without respect to individual investor
financial sophistication, financial situation, investing time horizon, or risk tolerance.

•        Options Trading Risk: Options trading is generally more complex than stock trading and may not be suitable
for some investors. Granting options and some other options strategies can result in the loss of more than the
original amount invested. Before trading options, a person should review the document Characteristics and Risks of
Standardized Options, available from your broker or any exchange on which options are traded.

•        No part of this presentation may be copied, recorded, or rebroadcast in any form without the prior written
consent of TheoTrade ®.

•        No Soliciting. No Recording. No Photography.

Don Kaufman
▪ Co-Founder TheoTrade

▪ Industry-leading options strategist

▪ Derivatives Risk Manager

▪ 18 year trading career

▪ 15 years of thinkorswim® platform experience

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• Implementation of Spread Criteria and Execution of Strategy

• Understanding Probabilities in Your Trading

• Overcoming Time Decay in Options Trades

• Consistency in Trading

• Contrarian Setups

• Trading Binary Events

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Theory. Trade. Logic.

• Probabilities are the law in the markets.

• One trade, good or bad, does not define us.

• Trading goes beyond one trade or one idea, it’s about

thousands of occurrences and having the right logic over
time.
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Start from the Beginning!

• Let’s revisit a few of the basic concepts in options.

• We can buy a call or buy a put to take a directional bias

but what are some of the risks we encounter?
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Risks of Single Options

!
• Let’s assume we BUY a 30 day at the money call option in
stock.

!
• Let’s review the risks:
 8

Time Decay
!
• Time Decay – buying an individual option immediately
puts you “on the clock”. Every day passing sees the
dwindling of your options premium.

!
• Let’s take a moment to review the THETA (time decay)
component of all your existing positions.
Theta Decay
• Let’s review how options decay.

• Options decay at the square root of time.

The
! Power of Time Decay (Theta)
• Options Decay at the √Square Root of Time:

• Option for one month = $1

• Option for two months = $1 x √2 = $1.41

• Option for three months = $1 x √3 = $1.73

Theta is a measure of an option's sensitivity to time decay

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THETA… Feeling the Burn?

• Theta is the daily whittling down of an option’s value.

!
• Oh my THETA BURNS when I am long options!

• What is Your THETA BURN rate?

• Are you Positive or Negative Theta?

 12

Negative Theta and YOU

!
• Negative Theta implies everyday that passes you are
paying to hold a position.

!
• If the underlying DOES NOT make the intended move you
are burning capital waiting for a move to take place.
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Volatility Exposure of Long Options

!
• Volatility Exposure – if volatility goes DOWN and you are
long an option, your option will depreciate in value by an
amount equal to VEGA.

!
• Vega is an option’s sensitivity to changes in implied
volatility.
 14

Sensitive to Vega?
• For example: we buy a call option and the stock goes
UP.

!
• However, as the stock goes up the volatility often
decreases. The crush down in volatility can offset
appreciation of the stock. This is termed volatility crush.
 15

Offsetting Your Risks

• It is essential TheoTraders offset their risks in order to
make trades less susceptible and impenetrable to time
decay and volatility risks.

• Keep this in mind as we move forward to In/Out Spreads!

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Probability Review
• Before diving head-on into spreads and criteria let’s
provide you a comprehensive understanding of
probabilities in trading.

!
• The proceeding examples transcend an individual trading
strategy and can be used in all aspects of your trading.
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Probability of Expiring
• The probability of expiring refers to the probability a stock or index
will be above or below a certain point at an expiration date.

!
• The probability numbers themselves are based on formulas that use
current stock price, the target or strike price, interest rates, days to
expiration and volatility.

!
• Probability of expiring is not defined as making or losing money but
the chance of each unique option falling in the money or out of the
money by one penny or more on the corresponding expiration date.
 18

Buy Me a Low Probability

• When you BUY an at the money option what is effectively
your probability of making one penny or more?
 19

Probability and Buying Options

• When buying options the probability of making one penny
or more is statistically speaking 50% or less.

!
• If your designated brokerage technology does not offer
probability of expiring you can use DETLA in lieu of
probability in the money.

!
• Let’s review a few examples of probability of expiring in
the money.
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Probability of Making Money?

• If you buy the 111 calls what's the approximate probability
of making one penny or more?
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Put/Call Relationship
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50:50 Chance
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Probability of Being Stopped OUT

• Have you questioned what your probability of being
stopped out of the trade might be?

!
• Probability of being “stopped out of a trade” can be
calculated using Probability of Touching.

!
• Be Advised: you may never look at trading quite the same
after this example.
 24

Probability of Touching
!
• Probability of Touching – the probability of an individual
options strike being touched or surpassed ANYTIME
between now and expiration.

!
• Probability of touching has NO directional bias.

!
• Calculations to solve for probability of touching are
implemented from options implied volatility.
 25

Probability of Touching and Stops

• You purchase a stock at $60.00

• You set a STOP ORDER at $59.00

• You set a target price of $62.00

!
• What's the probability in the next 29 days of being
stopped out versus hitting your target price?
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STOP is a Four Letter Word

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STOPS !
• We don’t need no stinking stops!

• Spreads define your RISKS.

• Why would we place a stop order on a trade with defined

risk?

• Entering into a defined risk trade alleviates the need for

stop orders.

• If you are considering a stop order don’t do it!

• Trade less contract size and be comfortable with your risk.

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Spreads Basics
!
!
!
• Future success is largely based on an ability to create
strategies that transcend market conditions.

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Let’s Get Our Spread On

• We are going to consider defined risk vertical spreads
when we want to take directional bias in an underlying.

!
• If your Bullish or Bearish the “In/Out Spread” will provide
you a strong risk/reward without exposing you to time
decay, volatility, or the threat of being stopped out.
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Spread Structure
• We will build or Vertical Spreads with a RISK 1 to make 1
scenario.

!
• Yes we can do trades offering higher probability however,
when we want to be directionally bias we want strong
rewards with the least amount of risk.

!
• In/Out Spreads will provide the equilibrium we seek in our
trading.
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Setting Up an IN/OUT Spread

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Just say NO to RISK

• Offsetting Vega (volatility) and Theta (time decay) is an
important component of In/Out Spreads.
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IN/OUT Spreads Offset Your Risks

!
• In/Out Vertical Spreads offset risk:

• time decay, volatility exposure, and initial capital outlay are all
controlled via using a vertical spread.
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Offsetting Risks Continued

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Risk Graphs
• Risk Graphs on options trades often blur the lines
between theoretical profits and the reality of profitability.

• If you are viewing Risk Graphs attempt NOT to view the

trade at expiration, rather you can often view trades at
multiple points between now and expiration.
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Risk Graphs Continued

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Day Stepping Risk Graphs

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Risk 1 to Make 1 ?
• Do the math: let’s assume you do 1000 trades over a
period of 1 year and you flip a coin to make your trading
decisions.

• Theoretically you would be right about 50% of the time

without ANY real trading strategy or management.

• However, with a Risk 1 to make 1 scenario and no

management; after transaction costs and slippage (bid/
offer spread) you would likely take minimal percentage
loss.
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What You Do Not Want to Hear

• No one likes to hear about breaking even or taking mild
losses but I differ vastly in that regard.

!
• I need to get you to a point in which you will not and are
not exposed to large losses.

!
• Individual trades are minuscule pieces of a much larger
probability puzzle termed “markets.”
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Making You Consistent

• The risk 1 to make 1 idea at the very least positions you to
make effective and consistent trades without substantial
risk in any one underlying.
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Go Ahead, Use Charts

• Ok so I’m a QUANT (math geek) and any strategy I present
has some mathematical logic and based on probabilities.

• But I've come to the realization you may not be a Quant

and I’m willing to accept you anyway ☺
• If you look at charts and follow trade setups you may be
accurate on selecting directional bias over 50% of the
time.

• Anything over 50% accuracy produces positive expected

returns with a Risk 1 to make 1 logic.
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Do Not Overthink Direction

• Directional Bias can torment traders.

• Do not overthink your bias…

• Think about many of the trades you may have embarked

upon in the past.

• Were you directionally accurate?

• Or maybe you bailed out of the trade only to watch the

underlying move your intended direction thereafter?

• We can help!
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Probability of Touching: Revisited

• There was a method to the madness of our earlier
discussion on Probability of touching.

• We are about to create a spread trade whereby the

Probability of Touching is higher on profitability side of
trade rather than loss.

• If constructed properly we should hit our Profit Target prior

to our loss exit.
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The Cart and the Horse

• Don’t put the cart before the horse.

!
• Picking direction is important for producing positive
returns but strategy and trade logic trump all.

!
• Can you mathematically solve for your positive expected
returns in your trading strategy?

!
• Today we can and will…
 45

Principles of Building a Trade

!
1. Trade Logic

!
2. Capital Allocation

!
3. Directional Bias
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IN/OUT VERTICAL SPREADS ENTRY

CRITERIA
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Liquidity is King
1. Liquidity
• Underlying must have massive liquidity. Liquidity is
ESSENTIAL.

• Tight bid/offer spreads, and high open interest.

• Weekly Options availability in the product you intend to

trade.

• Liquidity is variable but generally you want to be the

smallest fish in the largest pool in order to achieve viable
trade execution and pricing.
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Your Directional Bias

2. Selecting Directional Bias
• We are going to BUY a call spread if Bullish

• We are going to BUY a put spread if Bearish

• Today’s class focuses on more the logic, criteria, and

execution of the trade rather than an individual “trade or
chart setup”.

• But we shall disclose a few nice chart setups!

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Strike Price Selection

3. Strike Price Selection.

• We are buying a debit spread:

• Strike Price we BUY is IN THE MONEY.

• Strike Price we SELL is OUT OF THE MONEY.

!
• Think of the spread as an IN/OUT SPREAD, buying one strike
ITM and selling one strike OTM.

!
• Buying an ITM option and selling an out of the money option
offsets theta and vega risks.
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Strike Price Continued

• Strike price selection Continued
• You are seeking a trade with approximately a 1 to 1 risk/reward
ratio.

• Select Spreads $2 wide minimum, this would lead to a $1 debit

spreads.

• In higher dollar value underlying's spreads can be $2.50 or

even $5 wide dependent upon available strike price increments.

• Do NOT exceed a $5 wide spread, it is reasonable to do more

contract size rather than a wider spread.

(wider spreads push your break-even point further away!)

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Strike Price and Spread Examples

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Strike Price and Spread Examples

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Time
4. Time Horizon of the In/Out Spread
• Via using an IN/OUT SPREAD, we have offset our time
exposure (theta risks).

• Having offset theta risk we are enabled to select a variety of

expiration cycles WITHOUT being impacted by time decay.

• Look to buy the debit spread with a minimum of 9 days

remaining until expiration, maximum expiration not to
exceed 50 days.

• (Exception for time: shorter trades are viable during earnings

announcements and binary trading events)
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Time Selection Examples

• Below is an example of several identical strike spreads in
multiple expiration cycles. Note there is little to no
variation on spreads price in the longer dated expiration
cycles.

• Select a time frame most appropriate for your directional

bias.
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The Right Time

• Selection of a spreads time frame is of utmost
importance; you want the underlying above or below
(depending on directional bias) the short strike at or near
expiration.

• The In/Out Vertical Spread will NOT mature to full value

until closer to the expiration cycle selected OR the spread
goes deep in the money.
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Size Matters
5. Position Sizing
• Size the trade according to the $$$ you are willing to risk.

• Accept the trade will have little or no salvage value and a

loss will be near 100% of the risk in the trade.

• Traders only defend trades when they are taking large

losses. We will enter the trade with a defined risk and
comfortable capital at risk.

• Comfortable position size allows us to sustain the trade.

What we shall henceforth term: “Duration over Direction.”
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Execution of the In/Out Spread

6. Execution of the Spread.

• Review the Vertical Spread order.

• You are BUYING the Debit Spread to OPEN the trade.

• Route (send) the order at MID-PRICE of the bid/ask.

• In/Out Spreads are At the Money Spreads and have a

high

probability of executing (filling) at or near mid-price.

• Work the Order!

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IN/OUT VERTICAL SPREADS EXIT

CRITERIA
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Exit Profitability, Take the Money

• If the underlying trades in your intended direction:

• Close the Spread if or when profitability reaches 55% to

65% of initial risk.

• For example: You buy an In/Out spread for $1.00 debit. If

or when the spread reaches a value of 1.55 to 1.65 or
above close the spread immediately.

!
• A debit spread is closed via SELLING the spread.
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Using GTC Orders

• Exit Good Till Canceled (GTC)for profitable trades

!
• After placing and executing your initial order to BUY a debit
spread you can set a SELL ORDER to exit Good Till Canceled
Order (GTC).

!
• Example: You BUY to Open a $2 wide debit spread for $1.00
debit. You can set a SELL ORDER GTC @ 1.60 LIMIT. This
enables to set the profit exit shortly after inception of the trade.
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Exiting on Middle Ground

• Middle Ground is when the spread is coming close to
expiration and has not hit your profit target.

• When a spread has 4 days or less left until expiration consider

closing PART or ALL of the position win, lose, or draw.

• Spreads can be sustained until expiration however, in order to

mitigate risk close a portion or entire spread prior to expiration.

!
• CLOSE IN THE MONEY SPREADS PRIOR TO EXPIRATION
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Exit Criteria PUSH Trade

• In the event the underlying doesn’t move significantly OR
the spread is trading at or near your initial debit you have
the ability to Push the Spread to future expiration via a
ROLL.

!
• Alternatively you can close out the trade for near break-
even.
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Exit Criteria Rolling

• Rolling is moving the spread from one expiration into a
longer duration expiration.

!
• Rolling an In/Out Spread should ONLY be done IF the
trade is profitable OR at break-even.

!
• We do NOT roll losing In/Out Spreads as this only
increases our risk within a losing position.
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Exit Criteria Rolling Cont.

• Rolling is a trade procedure whereby we SELL our current In/
Out vertical spreads (spread we bought) and simultaneously
BUY another In/Out Spread in a further dated expiration.

!
• Rolling In/Out Verticals is typically using the same strike vertical
in a future expiration.

!
• Rolling can be done for a MINIMAL credit or debit.

!
• Minimal is defined as less than .10 to .15 cents in ANY product.
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Exit Criteria It’s a LOSER

!
• At times we are wrong in the markets. Your directional
bias is not impenetrable however, the spread logic allows
you to sustain trades longer while defining your risk.

!
• Our war cry is “Duration over Direction!”
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Losing Trades Cont.

• In/Out Spreads can be left on into expiration IF completely
out of the money and will expire worthless.

• If there is even the slightest chance the long leg of the

spread may be in the money on expiration you MUST
close the trade.

• Long options in the money by one penny or more on

expiration will be auto-exercised making you long the
stock and susceptible to larger losses.
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DON AND MARKET DIRECTION

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800 Pound Gorilla

• How does Don look for and decide to take contrarian style
trades?

• I’m a contrarian, it’s what I know, it’s where I live, it’s what
makes me smile.

• That means all things being equal…

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Contrarian Criteria
• Filter through Indices, ETFs, and Stocks having WEEKLY
Options availability.

!
• Limiting our search candidates to underlying's with Weekly
Options weeds out less liquid products.

!
• Say it with me “I will only take trades in Liquid Products”.

!
• Weekly's are NOT always liquid yet, they are a viable start point.
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Contrarian Criteria Upside Breakout

• Avoid earnings announcements within your trade horizon.

!
• Earnings will take an upside breakout and make it a
gamble.

!
• Earnings can take a stock from 52 week highs and
explode to all new highs.
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Contrarian Criteria Upside Breakout

• Price is within 2% of the 52 week high.

!
• On a 1 year price chart set to percentage view. Look for
the underlying to be within 2% of the 52 week high.

!
• All-time underlying highs is viable.
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Contrarian Criteria Upside Breakout

• Recall we are looking for an upside breakout in order to
get SHORT with a defined risk trade.

• Price change in underlying is 3.0% or greater from the

previous 10 day period.

• Use percentage view on charts to assess a 3%+ move in

the most recent 10 day period.

• Scanning technology or radar screens can assist in

discovery of candidates.
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Contrarian Criteria Upside Breakout

• Earnings can drastically impact an upside breakout.

• Stocks can see continuation of a move or follow-through

after an earnings announcement.

• Make sure your candidate is earnings date PLUS 6 trading

days.

!
• Exclude all candidates having earnings in the previous 6
day period.
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Contrarian Criteria Upside Breakout

!
• Exclude ALL takeover or buyout announcements.

!
• Takeovers candidates may have soared but they are
prohibitive in potential for a downside move.
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Additional, NOT required Criteria

• In effort to further your search for contrarian upside breakouts
you can use expected move.

• View the expected move (ATM straddle) with 4-10 days

remaining till expiration.

• Has the underlying moved double (2 or 3 times) the expected

move from LOW to HIGH in the same period as the expiration
selected?

!
• Disregard a move directly following an earnings announcement
(within 6 days of earnings).
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Expected Move Example

 77

Expected Move Example

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In-Depth Criteria
• You will NOT and are not expected to find these underlying
contrarian opportunities in every market condition.

!
• I recognize some of this criteria is rather in-depth however,
if you want to find opportunity in our markets you need to
be thorough and precise.

!
• Additionally, I want to make sure in every course I deliver
you find value far exceeding expectations.
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BINARY EVENTS AND IN/OUT SPREADS

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Binary Events and In/Out Spreads

• Do you like binary events such as Earnings
Announcements, product launches, or the occasional
FMOC meetings?

!
• In/Out Spreads can be an effective means to trade these
announcements without substantiating massive risk due
to increased volatility surrounding the event.
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Place Your Bets!

• Place your In/Out Spread on the day or day prior to the
scheduled news related event using the SHORTEST
EXPIRATION date available!

!
• Example 1, earnings are due out on JPM Tuesday morning.
You would look to place your In/Out Spread Monday prior to
the market close.

!
• Example 2, GOOGL earnings are on a Thursday after the bell.
Look to place your trade on Thursday prior to the close.
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Earnings Direction?
!
• So how does one determine direction surrounding an
earnings announcement?

!
• Data supports regardless of what the earnings
announcement is… the underlying is likely to trade with
the general trend of the markets.
 83

Does it Matter what Firms Say?

• For example, markets may be in a steep uptrend.

!
• There is statistical significance whereby more equities
trade higher after releasing earnings results (regardless of
those results) in an up trending market.

!
• The opposing has also been found to be statistically
significant during periods of down trending markets.
• Implementation of Spread Criteria and Execution of Strategy

• Understanding Probabilities in Your Trading

• Overcoming Time Decay in Options Trades

• Consistency in Trading

• Contrarian Setups

• Trading Binary Events

84
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