The Monthly Income Machine

The Monthly Income Machine™

My choice as the ONE BEST investment technique for monthly income!
by Lee Finberg
Former Vice President - Investments
Paine Webber (UBS) and Prudential Securities

Third Edition
Third Printing

Copyright © 2010, 2012, 2013, 2014 by Dorian Products LLC

The Monthly Income Machine, Lee Finberg
All Rights Reserved under all Copyright Conventions

First Edition: July, 2010

Second Edition: August, 2012
st
Third Edition – 1 Printing: February 2013
nd
Third Edition – 2 Printing: August 2013
rd
Third Edition – 3 Printing: March 2014

This publication may not be resold or distributed, copied in total or in part, altered, given to another, stored in a
database or retrieval system, posted online, or transmitted in any form or by any means, without the written
permission of the author.

Notice: You are encouraged to discuss the appropriateness of this investment approach with your own,
competent investment advisor. We have made every effort to provide accurate and complete information, but
cannot guarantee that there are no errors or omissions in this publication, and we reserve the right to make
further revisions to it at any time. Thus, everything provided herein is presented “as is” for informational and
educational purposes. In short, the reader of this book agrees to hold harmless, and without liability, the author,
the publisher, and any distributor of this book with respect to any losses or costs of any kind (monetary or
otherwise) resulting from the use of ideas, suggestions, and recommendations presented in this book.

Dorian Products LLC

The Monthly Income Machine
Sanford, FL, 32771
U.S.A.
www.SaferTrader.com
Contact Author: [email protected]
Contact Customer Service: [email protected]

ISBN-13: 978-0-615-53691-0
ISBN-10: 0615536913
Bar Code: 68946630483

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 The Monthly Income Machine

This book is dedicated to: my dear friend Vivian who encouraged me to

share this blueprint for reliable monthly income; to my eagle-eyed
friend Jerry who spotted and brought to my attention several tangled
thickets of prose needing pruning; to my wife and proofreader
extraordinaire (who holds the North American record for number of
times reading this book in the pursuit of each typo); and to you dear
reader who finds the contents of the book a useful part of his or her
financial life. Thank you.

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 The Monthly Income Machine

Activate All of Your "Machine"

In addition to the book itself, there are three (3) very important companion parts to "The
Monthly Income Machine" that you are entitled to receive at no additional cost.

You need to register now to obtain these related services that include:

1. Direct coaching by the author if you have questions. Lee typically is able to
provide responses to your questions within 48 hours.

2. Lee's ongoing series of "how-to articles" alerts covering "The Monthly Income
Machine" related investment tips, opportunities, expanded explanations and book
updates. The alerts are sent to you, as they are released, at the e-mail address
you specify when you register.

3. Access to the members-only Safer Trader FORUM, where community participants

- including Lee - share trade candidates they have identified, discuss market
opportunities, etc.

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 The Monthly Income Machine

Contents
Activation of Additional (Free) Services 2

Contents 3

About Lee 4

Introduction 6

Chapter 1 Investment Myths and Realities:

Let’s Dispel a Few of Them 8

Chapter 2 Option Basics:

Who Wins, Who Loses, and Why 10

Chapter 3 The Information We Need

and What To Do With It 21

Chapter 4 Greeks, VIX

and Other Option Gibberish 26

Chapter 5 Foundation of “The Monthly Income Machine”

and Why It Works 29

Chapter 6 “The Monthly Income Machine”:

Owners Manual 32

Chapter 7 Entry Criteria:

for “The Monthly Income Machine” Positions 42

Chapter 8 Managing and Adjusting Positions:

When A Trade Is Threatened 63

Chapter 9 Additional Considerations:

… and They Are Important! 75

Disclaimers Risk Considerations 89

Glossary A Option Terms, Glossary by Category 90

Glossary B Option Terms, Glossary Alphabetically 99

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 The Monthly Income Machine

About Lee
Lee Finberg, the creator of “The Monthly Income Machine,” includes a strategy, a book, a
FORUM, an ongoing series of “white paper” articles and tips, direct access to the author when
you have a question, and a separate (optional) screening candidate subscription service.

These features are open to all registered individuals seeking to generate a monthly income
stream from the markets, using the concepts, trade entry "rules," and trade management
techniques presented in this book.

Tellingly, after three decades devoted to participating in the financial markets as a professional
with ContiCommodity, Paine Webber, and Prudential Securities, and trading stocks, bonds,
options, commodity futures, currencies, and precious metals both for his clients and for his
own account, Lee’s own personal accounts are now devoted exclusively to Monthly Income
Machine and covered call trades.

He began his education by entering college at age 16 and earned a B.Sc. in Pharmacy at the
Philadelphia College of Pharmacy and Science and continued his MBA graduate work at
Temple University. Lee then joined pharmaceutical giant Merck as an Economic Research
Analyst and ended that phase of his career as Vice President of Marketing at the American
Optical Division of Warner-Lambert.

In parallel with his first career, he became extremely interested in the financial markets,
successfully trading his own accounts and then launching his second career by joining the
industry as a broker.

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 The Monthly Income Machine

While with Paine Webber (now UBS), he began writing a syndicated column on investing and
also accepted invitations to speak at investment symposia throughout the country and abroad.
Invitations for interviews on CNBC followed and Lee ultimately worked with individual clients
and money managers from all over the world as head of the Finberg Group at Prudential
Securities.

Over the years, his philosophy of personal investing changed from one of high-stress pursuit of
capital gains to one of seeking to comfortably and reliably extracting a significant monthly
income from the markets.

This philosophy culminated in the development of "The Monthly Income Machine."

One of the readers of the book, who faithfully uses the concepts and follows the “rules”
presented in it, wrote that, “It changed my life.”

As you use the blueprint provided herein, Lee invites you to share your own results with him
and other members of the Monthly Income Machine community at www.SaferTrader.com.

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 The Monthly Income Machine

Introduction
The Monthly Income MachineTM
Perhaps the ONE BEST investment technique for
conservatively producing monthly income!
I mean each word of the title and subtitle.

Monthly Income: your net profit income is realized in your account on a monthly basis, in rising,
falling or stagnant markets. Our often achievable target is 4 - 8% return on margin investment
per MONTH.

Machine: an apparatus consisting of interrelated parts with separate functions, used in the
performance of some kind of work. Like any machine, “The Monthly Income Machine” is based
on doing the same thing, i.e., placing the same kind of orders and managing the trades, the
same way, every month.

One Best: From an investment standpoint, there are many markets and techniques for seeking
profits and/or income. Over the past 30+ years I have been involved in stocks, bonds, options,
precious metals, futures, and currencies both professionally and for my own accounts.

This book will show you what I have learned from these decades as a stock broker, investment
advisor, newsletter and syndicated column writer, book author and personal investor to be one
of the best techniques for seeking income from the markets and doing so conservatively and
routinely. It is essentially the only investment vehicle I use personally now, and – along with
covered call writes - the only one I expect to use in the future.

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 The Monthly Income Machine

Reliable: “The Monthly Income Machine” is not intended to produce “home run” capital gains
(nor stomach churning losses) in your account.

It is geared to generating substantial income and it provides me, and can provide you, with
very significant returns most EVERY MONTH with limited time investment and minimal
concern about market direction.

“The Monthly Income Machine” helps provides me with a great deal of free time with my family
(a wonderful wife and our beloved Shetland Sheepdogs) and my life-long hobby (stamp
collecting).

IMPORTANT NOTE

I believe “The Monthly Income Machine” to be a suitable strategy for even the most
conservative investor’s account, including IRA’s and other retirement accounts, even though
the targeted rate of return is relatively large and it employs an often misunderstood (and even
more often misused) investment vehicle. Results, however, cannot be guaranteed and you
should read and heed Disclaimers and Disclosure information at the end of Chapter 9.

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Chapter 1
INVESTMENT MYTHS AND REALITIES
…LET’S DISPEL A FEW OF THE FORMER
Myth: Buy-and-Hold is the “correct” investment strategy.

Reality: Buy and Hold is a favorite TV talking-head mantra. Today, many investors have
learned through experience that buy-and-hold being the "correct" strategy is really an
unsubstantiated generalization. Nevertheless, TV pundits frequently proclaim its merit despite
the fact that it is often a losing strategy resulting from financial upheavals, world events, new
technologies, and new competitors.

Consider what happened with a few highly respected widows-and-orphans stocks of the past:
GM, CitiGroup, Lucent, and near-criminal or over-leveraged enterprises masquerading as
attractive growth companies like Enron and AIG, or even federal government “blessed and
backed” companies like Fannie Mae and Freddie Mac.

If you sadly held on to those “buy and hold” portfolio stalwarts during the last 10-20 years, your
portfolio has truly suffered. Trends change, and fighting trends by stubbornly sticking with your
losers - or worse, buying more to “average down” – can be dangerous to your financial health.

Myth: Purchasing stock options is the way to use a highly leveraged investment vehicle and a
small amount of money to generate mega-profits with low risk. Your only risk is the premium
you pay when you buy options.

Reality: Well the last part about risk being limited to the premium you pay is true. But that’s of
little consolation if you often lose that premium! Be aware of this widely known, repeatedly
proven, and terribly grim statistic: 80-90% of option buyers lose money over the long run. The
fact that most investors who buy options lose money is the primary reason options have the
reputation of being “very risky.”

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 The Monthly Income Machine

That reputation is well deserved based on the way most investors use options (buying out-of-
the-money Calls or Puts outright), but it is not the way “The Monthly Income Machine” employs
them, as you will see. Our approach is a conservative one that profits from the great risk option
buyers take!

…so, if 80-90% of options traders lose money,

WHERE DOES THAT MONEY GO?

Hint: If you employ “The Monthly Income Machine” exactly as I am going to show you, some of
it can go to you. Every month.

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Chapter 2
OPTION BASICS
WHO WINS, WHO LOSES, AND WHY
Even if you are an experienced investor, if you skip past the following “BASICS” Chapter you
will miss some important items. Although you may be familiar with parts or all of the basics,
here we are going to review them using examples and illustrations of what NOT to do, as well
as what to do - and why.

That way, even before we cover the step-by-step details of correctly using the "Machine," you
will gain insight into why I insist “The Monthly Income Machine” is the ideal technique for
making money in up, down, or sideways markets... and why you can have confidence that the
strategy and procedures I explain in later chapters can work for you.

The Key Aspects of Stock, ETF and Index Options

There are five basic aspects of a stock, ETF or index option that we need to understand: (1)
Calls and Puts and their Strike Prices; (2) Distance of the Strike Price from the underlying; (3)
Long and Short; (4) Premium; and (5) Expiration and Last Trading Day Dates. “The Monthly
Income Machine,” in part, is based on selecting the correct combination of these factors and
placing, and then managing, your trades accordingly. We’ll review these five components of all
stock options. But first, let’s be sure we understand what an option is.

Options on Stock, Index, and ETFs (Exchange Traded Funds) are investment vehicles that are
traded, like the underlying instruments themselves, on registered, regulated exchanges, most
notably the Chicago Board Options Exchange (CBOE).

Just as the individual stock option trades in relationship to the underlying stock, Stock Index
Options trade in relationship to the underlying index, a basket of stocks. Actively traded index
options include those on the S&P, the Nasdaq, the Russell 2000, etc. Similarly, ETFs
(exchange traded funds) are typically composed of multiple, related or specialized underlying
instruments.

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 The Monthly Income Machine

As with stocks themselves, options have a “bid” price (what investors are willing to pay for the
option) and an “ask” price (what investors are willing to sell it for).

When an option and its underlying stock or index are actively traded, and/or the underlying
price is close to the option strike price, the bid and ask prices will tend to be closer together
than the bid-ask spread would be for a relatively infrequently traded, or far out of the money,
option. When the “bidders” (buyers) and “askers” (sellers) agree on price, a trade takes place.

The price at which an option is quoted or traded is also known as the Premium, the price the
buyer pays for the option and what the person on the other side of the trade, the seller, collects
for selling the option. Incidentally, you do not need to already own the option when you are
establishing a new position that involves selling an option. We will cover this important concept
– the “short” - in detail later.

Calls and Puts and Their Strike Prices

Now let’s look at the two flavors of options: Calls and Puts. Both types of stock options can be
converted to (usually) 100 shares of the underlying stock, prior to or at expiration, if the owner
wishes. For indices, cash settlement is used since there are no underlying “shares” involved.

The buyer of a Call option has the right, but not the obligation, to buy the underlying stock at
one of a series of specified prices – the Strike Price – any time up to and including the Last
Trading Date of the option (typically the third Friday of each month).

An investor buys Calls if he believes the underlying stock or index is going to rise above his
chosen Strike Price significantly. If the underlying rises far enough above his Strike Price at
expiration day, he could sell the Call for a profit. He could also sell the Call at any time before
expiration, at a profit or a loss, depending on the price of the underlying, how close it is to his
strike price, and the amount of time remaining until expiration.

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 The Monthly Income Machine

But, if the price of the underlying is at or below the Strike Price of his Call Option when the
option expires, the option expires worthless (bad news for the buyers of the option; all smiles
for the folks - like “The Monthly Income Machine” practitioners - who sold them those options).

Therefore it makes absolutely no difference how far the stock price is below the Strike Price of
a Call option on expiration day. Even if the stock price and option Strike Price are identical at
expiration, the buyer of the option loses whatever he paid for the Call option (the Premium) in
its entirety if the underlying has failed to exceed the strike price.

The buyer of a Put option, on the other hand, expects the price of the underlying to go down
significantly. Owning a Put option gives him the right to sell the underlying stock at the Strike
Price of the Put he owns. He would buy a Put with a Strike Price he thinks the underlying stock
will be below when the option expires. If the price of the stock is indeed below the Strike Price
of his put at or before expiration, he could sell the PUT at the Strike Price and immediately
realize a profit.

If, however, the stock’s price remains above the Strike Price of his Put on expiration day, he
loses and the option expires worthless. His loss is the Premium he paid for the Put when he
bought it. As with Calls, the owner of a Put can sell his Put any time he wishes and need not
wait until expiration day.

The Long and Short of it.

Let’s be very clear about “Buying Long” and “Selling Short.”

If an investor expects a substantial rise in a stock or index, he could BUY a CALL (“buy Call
long”) on that underlying stock, ETF, or index. If that underlying does go up enough, and does
it sometime at or before expiration day, he could then sell the Call at a higher price and thus
close out the transaction with a profit.

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 The Monthly Income Machine

If he expects a substantial decline, he could BUY a PUT (“buy Put long”). If the underlying
does go down enough, and does so at or before expiration day, he could Sell the Put at a
higher price and thus close out the transaction with a profit.

Buying (going long) Calls or Puts, as described above, is what most option traders do; they are
seeking highly leveraged profit gains.

If an investor is neutral to mildly bullish, and believes the price of the underlying will remain
above a particular price, he could SELL SHORT a PUT (“sell PUT short”) at that Strike Price. If
the price of the underlying does remain above the Strike Price, the premium (option price) will
decline and he could later buy the Put back at a lower price and thereby close out the
transaction with a profit, or he could simply allow the option to expire worthless in which case
he has made the maximum possible profit on the short sale.

Conversely, when an investor is neutral to mildly bearish, and expects the price of the
underlying to remain below a particular price, he could establish his bearish position by
SELLING SHORT a CALL (“sell CALL short”) at a higher Strike Price. If the price of the
underlying does indeed remain below the Strike Price of his Call, he would be able to later buy
the Call back at what will be a lower price and thus close out the transaction with a profit, or, as
in the short Put scenario, allow the option to expire worthless (at zero) and thus realize the
maximum possible profit on the transaction.

Incidentally, selling a Call option short if you do not also own the underlying stock is extremely
dangerous as will be discussed later.

The only real difference between an outright long vs. an outright short transaction is that in the
Buying Long case the bullish investor buys first and sells later (hopefully at a higher price) to
close out the transaction. While in the Selling Short case, the bearish investor sells first and
buys back later (hopefully at a lower price) to complete the transaction. Only the ORDER in
which the buy and sell takes place is different.

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 The Monthly Income Machine

Example of a “Long” and a “Short” Option Transaction

John is very bullish on Option A, expecting it to go up from its current $5 price, so he Buys that
Call Option:

First: Buys (goes long) Call Option at $5 to initiate transaction.

Second: Underlying does go up and he Sells back Option later at $7 to close out transaction.

Result: Bought at $5; Sold at $7 for a $2 profit.

Henry, however, is somewhat bearish and expects Option A to go down in price so he Sells
Short the Call Option:

First: Sells Short (goes short) a Call Option at $5 to initiate transaction.

Second: Underlying goes down and he Buys back Option later at $3 to close out transaction.

Result: Sold at $5; Bought at $3 for a $2 profit.

In both cases, going long, or going short, the outright investor sold the Call for $2 more than he
bought it for, so he profited by $2. Only the order in which the buy and sell were done was
different, not the financial outcome since the sell price was $2 higher than the buy price in both
cases.

The above example transactions are intended to illustrate the difference between going long
and selling short. However, NEITHER of the above outright buy nor sell short transactions
would be executed as part of "The Monthly Income Machine."

Summary: How Bulls and Bears use single option (non-

spread) transactions
If one were quite bullish on an underlying stock, he could Buy the Call outright.
If he were mildly bullish on an underlying stock, he could Sell a Put short outright.

If he were quite bearish, he could Buy a Put outright.

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 The Monthly Income Machine

If he were mildly bearish, he could Sell a Call short outright.

This grid summarizes the four possibilities of a transaction involving a single outright (non-
combination, i.e. non-spread) market position:

BUY SELL
BULLISH Call Put
BEARISH Put Call

“The Monthly Income Machine” does not involve any of these common, single-option outright
strategies, because the likelihood of profiting long-term from buying options is relatively low,
and the risk associated with “naked” short selling of call options is much too high. (A naked
short option refers to a short option that does not have a protective long underlying stock or
option position associated with it.)

Premium: The Price at Which an Option Trades

A stock, ETF or index option Premium price is made up of either one or two components,
depending on where the option’s Strike Price is compared to its underlying’s price.

If the price of an underlying is above the Strike Price of a Call option (that is, the option is “in-
the-money”), the premium the buyer pays or the seller earns is made up of both “intrinsic
value” and “time value” (extrinsic value).

Intrinsic value is just the arithmetic difference between the price of the stock and the Strike
Price of the option. If XYZ stock is trading at $60, the Call with a $55 Strike Price has exactly
$5.00 of intrinsic or “real” value. It is in-the-money to the extent of $5.00. The mere passage of
time has no effect on intrinsic value.

However, when an option is in-the-money, the Premium the option trades at will include both
its current intrinsic value and some amount of “time value.” The additional time value
component of the option’s Premium is referred to as “extrinsic value.”

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 The Monthly Income Machine

A Call option trading at a Premium of $7.00 might be in-the-money (have an intrinsic value of)
$5.00. The extra $2 dollars over and above the $5.00 intrinsic value is for “time value,” since
buyers are willing to pay more than the current intrinsic value because the underlying stock –
and therefore the call option – could go even higher during the time remaining before
expiration.

If the price of the underlying stock, ETF or index is below the Strike Price of the Call, the entire
Premium is for “time value,” since there is no intrinsic value at that time, i.e., the option is “out-
of-the-money.” “The Monthly Income Machine” only deals with out-of-the-money options
where the entire Premium is made up of only time value (extrinsic value).

The Significance of Time Value

“Time value” is constantly declining. It erodes away faster as expiration day approaches, and
really fast during the last 10 trading days prior to expiration. If the Call option expires with the
underlying at or below the Strike Price of the Call, or at or above the Strike Price of the Put, the
premium falls to 0 and the option expires worthless since there is no intrinsic value and no
remaining time value.

Keep in mind that the buyer of Calls or Puts need not keep the option until expiration day. He
can exit from the option whenever he wants (at a profit or a loss) up to and including the last
trading day before expiration. In practice, the owner of an option (Call or Put) almost never
exercises it, i.e. exchanges it for the underlying stock.

Instead, he either sells the option (if he was “long”) or buys it back (if he was “short”) at a profit
or a loss before expiration; or, if the market is moving nicely in his favor, he does nothing and
watches it expire worthless on expiration day if the underlying is still out-of-the-money, i.e.
below his Call Strike Price or above his Put Strike Price.

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 The Monthly Income Machine

The Appeal of Options:

A Successful Stock Trade vs. a Successful Options Trade
Here’s a simple example that illustrates the typical option transaction. Again, it is NOT the kind
of transaction you will employ with “The Monthly Income Machine.” Rather, it represents the
mind-set and resulting actions of many - if not most - non-professional option market
participants.

Joan sees that the stock in XYZ company is trading at $48/share. She thinks the stock price
will reach $55/share in 30 days. She could just buy 100 shares of the stock itself and, if the
stock were at her $55 target in a month, she would have a paper profit of $7/share. She paid
$4,800 ($48 x 100) for the 100 shares of stock, and in this example it’s worth $5,500 next
month if the stock price reaches $55. She has $700 profit at that point. $700 profit on $4,800
investment is a 14.5% rate of return. Not too shabby, but unfortunately this doesn’t happen
very often in such a short time period.

But that’s not what she does. Joan understands the power of “leverage” and instead of
spending $4,800 of her available investment capital, she buys an XYZ out-of-the-money Call
option with a Strike Price of $50, which gives her the right to buy 100 shares of XYZ at
$50/share anytime up to and including the day the option expires next month.

She pays, let’s say, 40 cents for the Strike Price $50 Call option. This is the Premium, and
since the underlying stock price of $48 is currently below the option’s $50 Strike Price, that
$0.40 premium she pays is entirely made up of “extrinsic (time) value.” This Call option costs
her $0.40 premium x 100 potential shares = $40. If, as in this example, the XYZ stock is at
$55 next month at option expiration day, her Call option with the $50 Strike Price would now
have intrinsic (actual) value of $5.00 (compared to the $0.40 she paid for it!) because she
could, if she chose to, exercise her option to buy the stock at the $50 Strike Price, and then
immediately sell the stock for the then market price of $55 to realize a $500 profit.

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 The Monthly Income Machine

She wouldn’t actually exercise the option, of course; she would simply sell the Call option at
the $5.00 premium, which is $5.00 x 100 potential shares = $500, to take her profit on the
transaction.

Now let’s compare the buy-the-stock and the buy-the-Call approaches when the stock goes
from its current price of $48, to the $55 price it’s at when the option expires. Her rate of return
is much, much higher by buying the Call option instead of the underlying stock. Had she
bought the stock itself, excluding commission transaction costs she would be ahead $700 on a
$4,800 investment; instead, by buying the Call option, she is ahead by $460 (she paid $40 for
the call and sold it for $500) on a $40 investment.

That’s 1150% profit on the buy-the-option approach vs. a 14.5% profit on the buy-the-stock
approach. This kind of potential outcome is what tempts most option traders to buy individual
options outright.

You remember of course that this approach of buying out-of-the-money options outright (and
paying the Premium to do so) is exactly what most option traders do, and it is why most option
traders lose money over the long run trying for a home run trade like the one we just
described.

Remember this: according to the CBOE, 80%+ of out-of-the-money options purchased expire
worthless. You will soon learn why this is a very important, and a very desirable, statistic for
“The Monthly Income Machine” investors.

Expiration Day for Options:

A Monthly Occurrence
As noted earlier, a given month’s Stock or ETF Options expire following the close of the 3rd
Friday of that month and the options can be bought or sold up till the end of that Friday’s
trading day. Although Index Options also expire after the close on that Friday, Index Options
cease trading the day before, i.e., on the Thursday before the 3rd Friday of the month.

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 The Monthly Income Machine

Expiration Day: For Some, Smiles; For Others Frowns

In short, seeking large percentage profits by buying out-of-the-money stock options outright -
even though you know the grim statistic that on balance the approach usually doesn’t work
over time – is at least a questionable strategy. In fact, it is this wrong-headed allure operating
with many option traders that provides you with the income from the "Monthly Income
Machine."

In the real world, most of the time the underlying stock does not make the desired move
beyond the strike price, or does not do it in time before the option expires. The buyers’ options
usually expire worthless and the Premium paid for them is lost to whomever sold them the
options.

Incidentally, examples shown in this book do not take commissions into account, but
commissions on both stocks and options traded online are reasonably minimal nowadays and
should not be a major factor unless you are day trading (which you better not be doing!)

What About Weekly Options?

The relatively new "weekly" options that are increasingly available can be quite useful for
certain applications. However, they are usually not appropriate for "The Monthly Income
Machine" or - in my opinion - for credit spreads in general when entered with only a week until
expiration. When there are only 5 or fewer days until expiration, the risk/reward ratio is not
favorable at the distance required between underlying and the credit spread. We'll go into this
in more detail in a later section.

What About Mini Options?

The even newer “mini” option contracts can be employed appropriately with credit spreads and
“The Monthly Income Machine” strategy. As the name implies, these are options that represent
a smaller amount of the underlying stock but currently they are limited to relatively few, very

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 The Monthly Income Machine

actively traded stocks. (See the “white paper” on mini options at http://safertrader.com/mini-
options-do-they-fit-your-income-investment-game-plan.)

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Chapter 3
THE INFORMATION WE NEED
… AND WHAT TO DO WITH IT

The Option Chain: Strike Price, Premium and Expiration

Having reviewed the major components of all options, we’ll turn now to considering how those
components fit into “Machine’s” conservative monthly income trades.

Below is an important tool for a trader in options. It is called the “Option Chain” and it shows
you at a glance where things stand at that moment in time you are looking at it and/or are
contemplating placing your order.

We will focus on three of the key elements we consider with any option trade: Strike Price,
Premium, and Expiration.

Option Chain Example

First, though, we’ll use a hypothetical transaction that assumes the trader has not read this
book and is hell-bent on buying an option outright in hopes of making a big profit.

Trader Joe intends to buy Call Options on Apple Computer because he’s expecting a favorable
earnings report that will lead to a big and rapid jump in the price of the stock .
(Note: the following example is for illustrative purposes only; “The Monthly Income
Machine” would NEVER make this trade since it NEVER buys options outright…
because we know such a strategy is usually a losing proposition over time.)

Apple Computer (symbol AAPL) is selling at $604.30

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 The Monthly Income Machine

Because he is banking on a quick spike in Apple stock based on an upcoming earnings report
due later in August before expiration of August options, Joe elects to use August Calls, whose
option chain table is depicted below. (There are similar option chain tables for September,
October, November, etc. option expirations.)

The more time there is until expiration, the greater the premium cost, all other things being
equal, because there is more time for the hoped for move in the underlying stock to take place.
Recall that “time” (extrinsic value) is really what one is paying for in the Premium for an option
when the option is out-of-the-money, i.e., when the current stock price is below the Strike Price
of a Call or above the Strike Price of a Put.

Here is an actual Option Chain table (courtesy of OptionsXpress):

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 The Monthly Income Machine

The Option Chain table above shows AAPL Calls on the left, and AAPL Puts on the right, for
the range of Strike Prices we are interested in for this example. In the middle of the table are
the various Strike Prices available for the options that expire in August. This table is a
snapshot taken after the market closed the day before.

You will note that the table, always available online at your brokerage firm, identifies the type
of option (Call or Put), the Strike Prices and current Premium prices for each Expiration Month
(August in this case.)

The various available Strike Prices are shown in the middle column, and Joe decides that
Apple stock can jump more than 10% above the current price of the stock ($604.30) on what
he expects (hopes) will be a surprisingly good earnings report, so he decides to use the
August 665 Calls. Because the Strike Price is so far above the current price of Apple stock,
the premium cost is relatively small.

The table tells him under the “Last” column, the price the option closed at the previous day.
With the underlying AAPL stock at $604.30, the August 665 Call finished the trading day with
the "bid" at $3.20 and the "ask" at $3.35; it settled at $3.30, which is the Premium. One call
option would therefore cost Joe approximately $330 ($3.30 x 100 potential shares) +
commission. Joe decides to place an order to buy 10 Apple August 665 Calls at $3.30 which
costs him $3,300 ($3.30 x 100 potential shares x 10 contracts) and, since each call represents
100 shares of the underlying stock, he is controlling 1000 shares of Apple for $3,300 (10 Calls
at $330/call), instead of the $604,300 he would need to buy 1000 shares of the stock itself!

As noted at the beginning of this example, this is decidedly not a "Machine" trade. It can hardly
be categorized as conservative. It's very much an all-or-nothing speculation.

To just break even, excluding commission cost, the stock would have to rise from its current
price of $604.30 to $668.30 by options expiration day... less than a month away (strike price of
$665, plus the $3.30 premium paid for the option).

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 The Monthly Income Machine

Yes, the trade could work out to be very successful. The earnings report might "beat" the street
expectations by a mile and result in a big move in the stock to well above the 665 strike price.
However, as evidenced by many studies, including those of the options exchanges
themselves, buying far out-of-the-money options in hopes of a big move in a short period of
time is a very difficult enterprise if one is aiming for a recurring stream of profits. That's the
polite way of saying that over the long run, most outright buyers of out-of-the-money options do
not make money.

In our hypothetical, if AAPL rose in roughly one month from $604.30 all the way to $668.25 at
options expiration day (just $0.05 short of his break-even $668.30 price), the maximum
possible loss results, i.e. the entire $3,300 investment in the 10 options would be lost.

Nevertheless, Joe plows ahead with his plan to buy AAPL Call options outright.

The Option Chain: Open Interest + Volume = Liquidity

The options chain table also includes an Open Interest (Opint) column, which is the total
number of outstanding long and short option contracts that have not yet been closed out by an
offsetting transaction, and the Volume (Vol) column that is the number of options of that Strike
Price traded during the day.

Joe notes that there is significant Open Interest to provide liquidity in the event that he later
decides to sell his Calls before expiration. The Vol (volume) column shows zeros on this table
because there are no trades as the market is not yet open today.

When the market opens, he goes to his brokerage firm website and looks at this Option chain
table online. Now the bid, ask, and last traded prices, the volume, the price of Apple stock,
etc. will change moment by moment for each Strike Price as trading takes place and he can
decide what Strike Price and associated Premium appeals to him if he wants to place an order.

Just as one is able to do with any stock order, after he places his option order and before it is
filled, Joe can change the Premium (price) he is willing to pay, increase or decrease the size of

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 The Monthly Income Machine

the order, make the order good only for today, or have it “good till cancelled,” or simply cancel
the order anytime he wishes - so long as it has not already been filled, of course. He can also
place and/or modify separate protective stop loss orders, contingent stop loss orders, etc. at
any time as with a stock.

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 The Monthly Income Machine

Chapter 4
GREEKS, VIX
… AND OTHER OPTIONS GIBBERISH

Lastly in this background review section, we will visit briefly with the “Greeks,” Volatility, and
VIX.

“The Monthly Income Machine” does not require that you employ these tools in its operation
(except for one of them: Delta). In any case, the values are easily obtained from an Option
Calculator, on your brokerage firm website, and throughout the Internet in free, downloadable
format.

For the most part these considerations are already built into “The Monthly Income Machine”
rules without the need for the user to work separately with the "Greeks,” other than Delta.

The “Greeks” are the analytical tools that provide insights into the risks associated with a given
option or position.

Delta
is derived from a theoretical pricing model that attempts to measure how much the price of an
option will change as a result of a $1 change in the price of the underlying stock.

Delta also provides insight into the mathematical probability that an option will finish (expire)
“in-the-money” (underlying above the strike price of a Call option, or below the strike price of a
Put option).

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 The Monthly Income Machine

Gamma
is used primarily by professionals managing a large position. Essentially, while Delta measures
change in option price as stock price changes, Gamma measures changes in Delta as the
underlying stock price changes… i.e., changes in the changes.

Theta
measures the impact of TIME on an option’s value. Just remember that the value of an option
declines as time passes. This time deterioration is for all options, especially significant for
those that are “out-of-the-money,” i.e., stock price still below the Call option Strike Price, or
stock price still above the Put option Strike Price.

When an option is out-of-the-money, the premium the option sells for (made up entirely of
extrinsic or time value) is based on several factors, including how much time is remaining until
expiration and how far the underlying stock price is from the Strike Price. While price
movement in the underlying stock, ETF, or index may move in favor or against the value of the
option, the passage of time is always working against the option’s value. It should be noted
that it is this “time value decay,” constantly reducing the value of the option, that tends to kill
the trader who buy options outright. “The Monthly Income Machine" investor is often his
beneficiary.

Rho
Measures changes in option price that would theoretically occur because of changes in interest
rates. This is not particularly useful unless the option has many months to go to expiration,
and even then is considerably less significant than Delta. Because "The Monthly Income
Machine" uses the current option expiration month or the one after it, Rho does not usually
come into play in a meaningful way.

VOLATILITY: SIGNIFICANCE
The volatility of individual stocks, indices, and the markets they comprise, are very important in
working with options. In general, volatility refers to how much price movement is taking place,

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 The Monthly Income Machine

or is expected to take place, in the underlying stocks, ETFs or indices associated with the
related options.

There are two common measurements of “volatility” that we should understand.

VOLATILITY: BETA
Beta is a measure of a stock, ETF or index’s price volatility in relation to the rest of the
market.

The higher the Beta, the more volatile the price gyrations and, therefore, options based
on “high” Beta stocks or indices will typically have relatively bigger premiums than “low”
Beta ones.

VOLATILITY: VIX
VIX stands for Volatility Index and is a measure of market expectations with respect to
volatility and whether or not current market sentiment is excessively bullish or bearish. It
is often referred to as the “fear index.” VIX values greater than 30 are generally
associated with a large amount of market volatility as a result of investor fear or
uncertainty, while values below 20 generally correspond to less stressful, even
complacent, times in the markets. VIX values are quoted throughout the trading day on
the Dow, S&P, Nasdaq, Oil, etc.

In general, the higher the VIX, the greater the Premiums on related options will be.

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 The Monthly Income Machine

Chapter 5
THE FOUNDATION OF “THE MONTHLY INCOME
MACHINE” … AND WHY IT WORKS

Now let's dig into “The Monthly Income Machine" itself, beginning with why and how it works,
followed by a step-by-step explanation of the simple, specific rules for using it properly to work
at reliably generating monthly income.

I posed this question earlier regarding stock, ETF, and index options: “If 80-90% of options
traders lose money, WHERE DOES THAT MONEY GO?”

The Answer, as you surely have already deduced, is that the losses go to the option
SELLERS! They are the ones to whom the option buyers pay those premiums. Many, if not
most professionals and market makers are SELLERS, not BUYERS of options.

But there is more we need to understand in order to put the “Machine" to work. Simply selling
options outright – called “naked shorting” - and collecting the premiums the outright option
buyers so willingly and often foolishly pay, not only will not work over time, it is as we
discussed in an earlier chapter the most dangerous thing you can do short of a swan dive off
the top of what used to be the Sears Tower.

Never, under any circumstances, should you sell a Call short “naked,” because the profit
potential is small, while the risk is mathematically unlimited.

Key Principles Summary:

1. We don’t want to buy out-of-the-money Call or Put options outright because the
statistics are overwhelming that those traders who do, lose money over time. They lose
it because “time value decay” continually drives option premiums lower and buyers can

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 The Monthly Income Machine

only profit if the underlying stock or index goes up or down enough and does so fast
enough, before option expiration. When you Buy a Call or a Put, you are fighting a
losing battle against time decay and must live with the reality of having bought a
depreciating asset… one that depreciates very fast!

2. But we don’t want to sell short Call options outright either (unless we already own the
stock) because if we do sell them “naked,” we are risking financial annihilation. (Note:
there is one strategy, not part of the "Machine," where it does make perfect sense to
Sell a PUT short1.)

3. There’s the conundrum. How do we somehow safely sell options, because that is the
route to collecting rather than paying premiums, and thus be an option seller who
makes the money the option buyers lose?

4. We understand that we ESPECIALLY want to sell “out-of-the-money” options and

collect the premium because then the immutable effect of “time value decay” works for
us, driving the premium down toward zero at expiration as we desire. The deck would
truly be stacked in our favor if we were able to sell an out-of-the-money option, whose
premium is by definition entirely made up of depreciating time value, without assuming
the huge risk of naked short selling.

1
See "white paper" on the naked put trade at: www.SaferTrader.com/sell-the-put-option-youll-
get-paid-while-you-wait.

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 The Monthly Income Machine

The solution to this dilemma is the foundation of "The Monthly Income Machine."

A “The Monthly Income Machine” trade involves holding BOTH an out-of-the-money short
option position at a particular Strike Price AND a protective long option position whose Strike
Price is further out-of-the-money. This is a Credit Spread.

It’s called a Credit Spread because you will RECEIVE money (your account will be credited)
when your order is filled, rather than spending money). It’s also referred to as a type of
Vertical Spread.

A properly positioned credit spread – one that follows the “Entry Criteria” rules covered in
Chapter 6 - allows us to safely “short” (sell) a call or a put (it will not be naked), because we
will also have a related long position that eliminates the unlimited risk potential - and high
margin requirement - of a naked short position.

Thus, although we are also “buying” an option as a necessary part of “The Monthly Income
Machine” credit spread, we use the option we are buying only to protect our short position and
to greatly reduce our margin requirement. Accordingly, we are not making the mistake most
option traders make, i.e., the outright purchase of out-of-the-money options that are not part of
a spread.

Combination Options Strategies (Spreads)

There are a myriad of option strategies employing credit spreads and various other
combinations of options, and options in tandem with stocks, that investors can use. They often
have rather colorful names: butterflies, condors, straddles, collars, strangles, (hmm, how about
a collar that strangles?), vertical spreads and ratio spreads to name a few. If time lies heavy on
your hands, you could look into all of them, but we will only refer to one of these exotics in
particular - the Iron Condor - since it applies directly – and very advantageously - to "The
Monthly Income Machine."

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 The Monthly Income Machine

Chapter 6
“THE MONTHLY INCOME MACHINE”
OWNER’S MANUAL

Overview of the Process

1. Select specific, monthly stock, ETF or index options that conform to all of our
“Entry Criteria.” (Time-wise, this identification step is 95% of the Process.)
2. Establish a particular type of position called a CREDIT SPREAD, or its glorious
subset: the IRON CONDOR.
3. Record date, price, etc. at which order is filled.
4. Check on closing prices of your positions occasionally until expiration/last trading
day: the 3rd Friday, or in the case of indices on the 3rd Thursday, of the month.
5. You should also place protective stop loss orders to protect your positions
against an adverse move that could go beyond your maximum acceptable risk
limit level for the trade.
6. Make adjustments to the position along the way, if necessary.
7. Smile!
8. Repeat process for the next month.

The Credit Spread and the Iron Condor – the Foundation of

“The Monthly Income Machine”
1. The Bear Call Credit Spread

As discussed earlier, we know we want to collect the premium that will be our monthly income,
and that the investor collects the premium when he is the SELLER of an option. We also know
that selling an option (selling short) “naked” is a major no-no. As noted, the solution to the

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 The Monthly Income Machine

dilemma is to simultaneously SELL an option at one Strike Price and BUY a related option at
an even further from the underlying Strike Price.

Here’s how it works. Assume that, based on Apple's 604.30 closing price on Friday, 7/20/12,
we wanted to consider a credit spread using Apple options. We consider it unlikely that Apple
would get as high as 695 by expiration day on 8/17/12. So we are again looking at the Option
Chain for August 2012 Apple options.

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 The Monthly Income Machine

We see that the Call for the 695 Strike Price last traded at a $1.28 premium. And two strike
prices higher, the 705 Call last traded at $0.83.

The net “spread premium” between the two is $1.28 paid - $0.83 received = $0.45 net
premium.

If that were to meet our “Entry Criterion” for distance from the current market (and it does) -
and all other entry criteria requirements that we will be covering are also met - we could place
a credit spread order as follows:

Sell to Open 1 Aug 695 AAPL Call

Buy to Open 1 Aug 705 AAPL Call
… day order,
… for a credit of $0.45

In order to place this order, we need to have at least $1,000 in our account to meet the
brokerage firm's margin requirement for the trade.

As soon as the order is filled, if and when it is, $45.00 will be credited to our account ($0.45 x
100 potential shares the option represents = $45.00). That, of course, is why it’s called a
“credit spread.” No money (except about $1.50 commission) leaves our account. Instead, our
account value increases by the amount of the net premium we collected. If our account started
at, say $4,600, our account value is now $4,645.

In case you didn’t notice, if all goes as planned, that $45 will be earned on our $1,000 margin
in one month, for a 4.5% return in one month, which will be fully “banked” when and if the
option expires worthless at the end of the option month.

In order to do a credit spread, we must have enough money in our account to meet the
“margin” requirement. The required margin is based on the difference between the two Strike

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 The Monthly Income Machine

Prices, which in this case is $705 - $695 = $10.00. That $10.00 difference between strikes
equates to $10.00 x 100 potential shares of stock = $1,000 margin required.

So, for any credit spread on any stock, ETF or index option with Strike Prices $10.00 apart, the
margin is $1,000/spread. (Actually, a little less is required because the net premium that was
credited to your account is subtracted from the required margin figure.) Predictably, the margin
requirement on any option whose Strike Prices are $5.00 apart would be $500 ($5.00 x 100
potential shares = $500).

The funds that must be in our account to meet the margin requirement represent the
theoretical maximum amount - except in one very unusual situation a SaferTrader would never
find himself in - that could be lost on the trade if for some reason we took no corrective action
and instead allowed the price of AAPL stock to rise to, or above, $705. Above $705, there are
no additional losses because every additional dollar we lose on the short Call (the 695 Call),
we would gain on the long Call (the 705 call).

Of course, we can exit from our credit spread any time, with some profit or loss, and should do
so long before a trade that appears to be going very much the wrong way is in danger of
reaching the theoretical maximum loss.

Thus, the credit spread net premium is the difference between the premiums of the two Strike
Prices when we enter a credit spread trade. When correctly establishing a credit spread, the
premium we receive on the option we sell will always be greater than the premium we pay for
the option we buy.

Just remember that the credit spread margin requirement is based on the difference between
the two Strike Prices that comprise the credit spread…

and that you need to have at least $500 in your account to collect the premium on a credit
spread with Strike Prices $5 apart, and $1,000 if the strike prices are $10 apart.

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 The Monthly Income Machine

Our “entry criteria,” tracking what is happening to prices along the way to expiration, and taking
corrective action if needed, are both geared to enhancing the likelihood of banking our
premium if the trade goes as expected… and preventing or minimizing a loss if it doesn’t.

So, unlike the unlimited risk associated with a “naked short” option, because we have a spread
that includes both a short and a long option, our maximum theoretical risk is defined and
limited... and manageable. Our maximum profit is also defined; it is the net premium credit we
collected up front.

Remember: we have collected the net premium since the option Strike we sold brought in
more premium than the cost of the Strike we bought. (That’s why it’s called a credit spread.)

Once we sold the credit spread, we want the net premium on the spread to decline, hopefully
expiring worthless on expiration day. And it will expire worthless at expiration as long as the
underlying stock, ETF, or index price does not reach the short Strike Price leg of our credit
spread.

The credit spread in this example is called a Bear Call Spread, because we are using calls and
are “bearish” on the likelihood of Apple stock reaching our nearest Strike Price (the short 695
Call) prior to expiration. It makes no difference whether the Apple stock in our credit spread
example stays where it is, or goes down, or goes up, as long as it is under 695 on option
expiration day.

NOTE: Options “last trading day” for stock and ETF options is the third Friday of the month.

Understand that it is the short option in the credit spread – the 695 Call - that we are really
concerned about. We must stay below that 695 strike price.

If the bear call credit spread trade is not working out, because the underlying is rising rapidly, it
is because the premium on the 695 short leg of the spread will rise against us faster than the

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 The Monthly Income Machine

protective 705 long leg will rise in our favor, thus widening the premium spread rather than
contracting it as we want.

In essence, the very important purpose of the long leg is simply to prevent us from being in a
“naked short” position (with its unlimited risk).

Having the long 705 leg also provides another very valuable benefit: it keeps our margin
requirement low! If we were to just be naked short the 695 Call, and didn’t have the long 705
Call with it, the margin requirement would be much greater than $1,000.

2. The Bull Put Credit Spread

Everything we just covered under “The Bear Call Spread” works exactly the same way for the
"Bull Put Spread." Only now, we are doing a credit spread with Puts rather than with Calls. We
use a Bull Put Spread to collect our spread net premium when we expect the price of the
underlying to remain above a particular strike price, i.e., we are bullish on the underlying
remaining above a particular price at expiration. We would place the “short” leg of our spread
at that strike price and the protective “long” leg at a strike price below it (i.e. the long leg will be
further from the underlying thus further out-of-the-money).

As before, we collect a premium on the Put we sell, and we pay a smaller premium for the one
we buy. The net difference in the premiums is what we earn when both options expire
worthless, which they will so long as the price of the underlying is at or above the strike price of
our “short” put leg at expiration.

Let’s turn again to the Option Chain we used in defining our Bear Call Credit Spread. This
time, our focus will be on the Puts side of the chain.

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 The Monthly Income Machine

Assuming our Entry Criteria (the next section of the book) indicate the proper Bull Put Spread
could involve the short 510 and long 500 strike prices, we see that with Apple stock (the
underlying) at $604.30, this Put option credit spread closed this day at a net premium of $0.36
($1.60 - $1.24). If we were able to enter this spread at the net $0.36 premium, we would have
a $36 profit potential on our $1,000 margin, or a 3.6% return on our margin investment in just

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 The Monthly Income Machine

one month, so long as the underlying Apple stock was at any price at or above $510 on
expiration day.

3. The Wondrous, Fantastical IRON CONDOR

We said that with the Bear Call Credit Spread, all we care about is that at expiration day
Apple’s price be below the Strike Price of the short leg of the Call spread ($695), and that with
the Bull Put Spread, our only concern is that on expiration day Apple be above the short leg of
the spread ($510).

Obviously, we can do both spreads - and bank both net premiums - so long as Apple stock
finishes between the two short legs, i.e., below $695 and above $510. What’s more, at an
“options-friendly” brokerage firm, we do not need to use additional margin for the second
spread!!

The reason: Remember that sufficient margin is required to be in an account to cover the
possibility, no matter how remote, of a spread moving the maximum possible amount against
you (the difference between the strike prices x 100 = $1,000/spread in these examples). Well,
it’s clearly absolutely impossible for Apple to be both above $695 and below $510 at
expiration, so only one margin should be required. (Nevertheless, option un-friendly
brokerages often require margin on both spreads.)

This is the beauty of the Iron Condor. So long as Apple - currently trading at $604.30 in this
example - stays between $695 and $510 at expiration in less than a month, we bank the net
premiums on both the Bear Call Spread and the Bull Put Spread, a total of $45 + $36 = $81.
That, boys and girls, is an 8.1% return in one month on the single $1,000 margin. And, yes,
this is in line with what we are seeking every month.

Note: It is very important that your options account be housed at a brokerage firm that is
options-friendly with respect to Iron Condors, etc. (There is a “white paper” article that reviews

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 The Monthly Income Machine

brokerage firm considerations and recommendations at www.SaferTrader.com/options-

friendly-brokerage.)

Here is a graphic representation of the Iron Condor. This is just an illustration; as you will see
when we get to “Entry Criteria,” the Strike Prices shown in this example do NOT actually meet
our entry rules.

Keep in mind that the Iron Condor is usually established by “legging into” the two spreads.
Typically, the bull put spread and the bear call spread that comprise an Iron Condor will not
both meet all the entry criteria at the same time and allow establishing the Iron Condor with a
single order (a 1-step Iron Condor).

Usually, both of the necessary spreads do not offer at least the minimum required net premium
at the same moment in time. Instead, you might put on the bear call spread one day, and then
later – after the market goes down a bit – the bull put spread premium at the correct distance
from the underlying might now conform to the minimum premium as well as the rest of the
entry requirements. When it does, if you place a bull put spread order at that time that is filled,
you then have the Iron Condor in place (a 2-step Iron Condor).

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 The Monthly Income Machine

When establishing an Iron Condor, whether in 1 or 2 steps, both spreads must independently
meet all the entry requirements.

Important: Note, above, that the short leg of a credit spread (whether a Bear Call Spread or a
Bull Put Spread) is always the closest Strike Price to the price of the underlying stock, ETF, or
index.

Two Critical Steps on the Road to Recurring Profits:

It comes down to this:

1. Rigorous adherence to the Entry Criteria “The Monthly Income Machine" uses in selecting
Bear Call Credit Spreads, Bull Put Credit Spreads, and wherever possible the two of them
established in the same option month as an Iron Condor.

2. Managing the positions, if needed, prior to expiration.

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 The Monthly Income Machine

Chapter 7
ENTRY CRITERIA
FOR MONTHLY INCOME MACHINE POSITIONS

THE ENTRY CRITERIA - Selecting the Credit Spreads

These are the nuts and bolts of the "Machine." As with any machine, each part is needed for
smooth operation.

1. Stocks, ETFs or Indices?

Any of the three classes of underlyings can conform and each has its entry criteria. Since an
individual stock is normally more volatile than an index or ETF based on a basket of stocks, we
like our stock-based credit spreads to be a little further away from the underlying stock than an
index or ETF spread from their underlyings.

In other words, index and ETF basket credit spreads generally are less subject to dramatically
large percentage moves or overnight “gaps” (which could work against us) than are individual
stocks.

This is because stocks can spike powerfully up or down on such things as a surprise in an
earnings report, a rumor or announcement of a take-over offer, a development involving a
competitor, or one involving the market as a whole.

While market indices like the S&P (SPX), the Nasdaq (NDX), and the Russell 2000 (RUT) can
move sharply on news developments that impact the entire market, such moves are usually
smaller, percentage-wise, than those that occur when a major stock-specific development
takes place.

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 The Monthly Income Machine

An individual stock can rocket up 30% or more in one day on a surprisingly good earnings
report or takeover bid. Similarly, a substantial earnings “miss” can cause a stock to plummet.

Indices, which are comprised of multiple stocks, could theoretically experience such gigantic
percentage moves in one day, but that would be very rare. (The largest percentage move I am
aware of for a major index occurred on October 19, 1987 – Black Monday – when the Dow fell
22.61%.)

Another significant index matter: there is a tax benefit (in a non-retirement account) to income
earned that results from index trades as opposed to individual stock trades. Under Section
1256, the IRS gives favorable tax treatment to contracts that are “non-equity options,” a
category that includes index options.

The IRS recognizes broad based stock index options to be non-equity options and thus profits
and losses on them can be treated as 60% long-term and 40% short term, even if they are
held for less than a year.

The significance of this rule is that long-term capital gains or losses enjoy lower marginal tax
rates. You should discuss this with your accountant to confirm that this is favorable in your
situation.

2. Option Month of Credit Spread

The "Machine" is based upon employing either the current option month or the next expiration
month option chain. These months will have a substantial amount of time value built into the
premium of out-of-the-money options we use, and time decay of the premium works powerfully
in our favor.

Credit spreads could be done using weekly-expiration options, but “The Monthly Income
Machine” technique does not employ these very short-term options with less than 6 trading
days remaining until expiration. Weekly options can be used if entered with more than 6

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 The Monthly Income Machine

trading days remaining before expiration, but the disadvantage of using them rather than the
monthly option expiring at about the same time is that the weeklies are generally less actively
traded and thus may be carrying a wider bid-ask spread.

This is because by the time an option has only a week’s life left before expiration, much of the
“time value” associated with the premium is long gone. Capturing the extrinsic value (time
value) built into out-of-the-money option premium is critical to the way – and why - the
“Machine” works. Note that although some very active options appear on the option chain as
“available” a week or two before weekly option expiration day, these usually have relatively
little activity at that time and thus can be very difficult to trade with rational premiums and/or
decent order fills.

Please note that our objection to weekly options – when there is a week or less remaining until
expiration -refers to their use with credit spreads. There are situations where a weekly option
does make sense. Such a situation could be when an event is known to be coming – an
example would be an earnings report – within the time frame covered by a particular weekly
option. If the investor wanted to speculate with an outright option purchase (not a credit
spread) on the outcome of the event whose timing is known, a weekly option might make
sense. This is because if buying an out of the money option, it’s an advantage to have little
time value built in that must be paid for.

3. Stock Disqualifiers

We eliminate stocks from Credit Spread consideration immediately on the basis of:

 Price of the Stock

“The Monthly Income Machine” entry rule for individual stock credit spreads
is: the underlying stock must be trading at $50 or more. This is because
options on lower priced stocks generally will not provide sufficient Premium at
the Strike Price distance from the market that we require.

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 The Monthly Income Machine

We particularly like stocks trading at $100 or more, because the Strike Prices
we will want to use will often provide spread Premiums well above our
minimum entry criteria amount ($0.25).

 Lack of Trading Volume/Open Interest

A stock that is only thinly traded will generally display both poor Option
Volume and minimal Open Interest. This is manifest in wide bid-ask spreads
that can be terrible for either entering or exiting a position at a fair price. Low
volume and open interest mean the option is not very liquid, which could be
a problem both when entering or exiting from a trade.

We generally want to see the short option Strike Price we are considering to
have an open interest of 250+ contracts, when there are between 25 and 10
trading days (non-holiday weekdays) until expiry. This should be viewed as
an optional consideration, not an entry “rule.” It’s not a rule because Open
Interest is not a stable indicator; it varies widely depending on how much time
remains to expiration and how far the Strike Price is from the underlying.

Average Daily Volume of the Underlying, however, is much more stable as an

indicator of overall liquidity. Our entry rule (and this one is a rule) is that
average daily volume of the underlying must be 1,000,000/day or more.

 Lack of Volatility

A stock with a history of relatively little volatility (i.e., stock trades in a

narrow range for extended periods of time and is often referred to as a “low
beta” security) will offer unsatisfactory premiums at the distance from the
underlying Strike Prices we will want to use. Accordingly, no separate entry
criterion (other than the confirmation afforded by the Delta entry requirement)
is needed re: volatility.

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 The Monthly Income Machine

 Earnings Report Prior to Expiration

A stock is immediately disqualified from consideration for Credit

Spreads if there will be an earnings report prior to expiration day.

Your options-friendly brokerage firm will show the date of the next earnings
report when you pull up a quote on the stock. Violent moves following
surprises in earnings reports occur frequently. We have no interest in violent
moves.

Although not an earnings report, I would recommend (not a “rule”) that one
avoid retail stocks if Black Friday or CyberMonday occur prior to expiration.
This is because credit card and market research agencies often release
preliminary sales data for retailers before the day is even over!

Markets can react to these data as they would to pleasant or unpleasant

surprises in an earnings report.

 Actual or Rumored Takeover Offer Has Occurred

Stocks will rarely offer sufficient Premiums at the Strike Prices we want to use
if there is already a take-over offer on the table to acquire the stock. There
are also additional risks of sudden strong moves based on offer turndowns,
revisions, withdrawals, etc. If there is a take-over issue involving the stock, it
is disqualified.

When you look at a quote on a stock, there is usually a place to “click” to see
recent news developments on the stock.

4. Trade-off between Premium and “Distance”

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 The Monthly Income Machine

When you analyze and select credit spreads, there is always a trade-off between the premium
you collect, and the distance your spread Strike Prices are from the underlying stock, ETF, or
index.

The further away a Strike Price is from the “market” (the current price of the underlying), the
less the premium will be, all other things being equal.

This is because buyers correctly assume the underlying is less likely to reach that more distant
Strike Price before expiration, and therefore are willing to pay less premium than for a Strike
Price closer to the market.

“The Monthly Income Machine” is adamantly in favor of establishing the greatest possible
distance from the price of the underlying, consistent with our minimum premium goal, rather
than trying to capture the greatest possible premium.

The old Wall Street adage applies: “bulls make money, bears make money, pigs get
slaughtered.”

5. How Far To Be From the Market (the Distance criterion)

A. Individual Stock credit spreads:

The "Machine" rule is that the Strike Price of the short leg of the spread (the one closest to the
current price of the underlying) should be at least 15% above the current price of the
underlying stock if it’s a Bear Call Spread, and at least the same 15% below the current price
of the underlying if it’s a Bull Put Spread. (Exception: See “C” below)

B. Index and ETF credit spreads:

Here the rule is the Strike Price must be at least 12% above the current price of the index for
Bear Call Spreads, and 12% below for Bull Put Spreads. (Exception: See “C” below)

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 The Monthly Income Machine

There is no guarantee that the underlying will not reach the closest Strike Price prior to
expiration day, but I have found that the options will cooperate and expire worthless
approximately 85% of the time using this rule along with the other "Monthly Income Machine"
entry criteria and considerations.

C. Distance Rule When Close to Expiration (10 trading days or less):

Bearing in mind that a conforming "Machine" trade must meet ALL the entry criteria rules, a
moderate relaxation of the distance rule may be considered when we are approaching
expiration.

The entry distance requirement with between 10 and 6 days remaining to expiration is reduced
to 11-12% for stock spreads, and 9-10% for index spreads as the distance requirement. (No
less please; remember that I will be looking over your shoulder!)

6. Validating the Distance - Delta

As a further confirmation that our spread Strike Prices are sufficiently far from the current
underlying, given the current volatility, time decay situation, and underlying price, we check the
current “Delta” for the short leg of the spread. (Your options-friendly brokerage firm website
should provide a table of current Delta values for all option strike prices.)

You will recall from the discussion of the “Greeks” in Chapter 4 that Delta is an estimate of how
much the price of an option will change as a result of a $1 change in the price of the underlying
stock or index.

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 The Monthly Income Machine

Delta can also be used as an estimate of the mathematical probability that an option will
expire “in the money” (above the strike price of a Call option or below the strike price of a
Put option).

I recommend that the Delta value for the short Strike Price of a spread be .08 or lower, which
means there is only an 8% probability that the underlying will be “in the money” at expiration.

This is an entry “rule.”

Personally, I like it even better when the Delta is .06 or lower. Obviously, the lower the better.

7. Validating the Distance – Support and Resistance

Our entry rule for Distance from the underlying, and the use of Delta, help provide a position
where the mathematical indications suggest our spread should behave nicely and expire
worthless in about a month. Still, things can - and will - occasionally go wrong.

When that happens, we will take steps – called “managing the trade” – to minimize or even
overcome the impending loss on the trade. This subject, the MRA (Maximum Risk Amount) is
discussed in detail in the next chapter.

However, we can both increase the likelihood of a successful trade at the outset, and lay the
groundwork for later managing the trade if it becomes necessary, by looking at chart support
and resistance levels before placing our order.

As the names imply, “support” refers to a price level where previous declines have stopped
and then reversed, and “resistance” refers to a price level where previous rallies have stalled
and then reversed.

Ideally, we want to place the Strike Prices of our conforming Bear Call Spreads above recent
resistance levels, and our conforming Bull Put Spreads below recent support levels.

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 The Monthly Income Machine

If the underlying penetrates the support or resistance level associated with our credit spread,
that may provide us with a signal that the underlying has now established a trend going the
wrong way, and represent a rationale for exiting from the trade even before our maximum risk
amount (MRA) is reached.

These levels are easily seen on a daily price chart. Charts of stock, ETFs, and indices are
available over time frames ranging from minutes to 10-year and longer periods. I generally use
the 3-month and 6-month charts, where each bar represents one day, for support/resistance
when evaluating potential credit spreads.

Consider the price chart on the following page for the RUT 2000 index back in 2009. If we had
been considering a Bear Call Spread on the RUT in mid-June of that year, we saw that each
time the RUT rose to about 535, it would bounce off that price level and fall back. So we would
have liked to have our Bear Call spread Strike Prices as far above the 535 resistance point as
possible.

Establishing our bear call spread at Strike Prices above the then 535 resistance level would
give us an early indication that the market had "changed" in a way unfavorable to our Bear Call
position if the RUT price broke significantly through that previously well-established resistance
point. That might induce us to take some corrective action rather than hoping the breakout
was a "false" one and simply waiting for expiration. In point of fact, the breakout above
resistance was very real and the RUT continued trending higher.

Similarly, if we had been looking at the following RUT Support and Resistance chart in terms of
considering a Bull Put Spread later in August, we see clear support at 550. If we were
considering a Bull Put spread at that time, we would have liked to have entered our Put Strike
Prices as far below 550 as possible. That way, a significant downside penetration of that 550
support would alert us to a potential problem with our Bull Put spread, since a clearly bearish
chart development would have occurred.

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 The Monthly Income Machine

Consequently, if we were considering several different credit spreads based on underlying

stocks or indices, and several potential credit spreads met all of our Price, Distance, Premium
and other Entry Criteria, all other things being equal we would probably favor a credit spread
whose Strike Prices could conveniently be located above a major resistance level or below a
major support level.

REMINDER: It is always the short Strike Price – the part of the spread closest to the
underlying stock, ETF, or index price – that we care about. The long Strike Price is just along
for the ride to provide protection and a lower margin requirement as explained on page 34.

8. Minimum Acceptable Spread Premium

Certainly we want as much premium as we can get. Realistically, though, at the distance from
the market we demand for the short member of the spread as discussed above, I require at
least $0.25, and hopefully closer to a $0.50 Premium. If I cannot get at least $0.25 premium

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 The Monthly Income Machine

($0.25 x 100 underlying shares = $25.00/spread), I don’t enter the order. Note that every
spread must meet at least the minimum premium requirement. Therefore, a conforming Iron
Condor has two credit spreads, each of which must offer at least a $0.25 net premium (and
each must also meet the distance-from-the-underlying criterion) when established.

Fundamentally, premium - the price for buying or selling an option or an option spread - is
nothing more than buyers and sellers agreeing on how much that right to buy or sell is worth.
Whether we are buyers or sellers we are, of course, operating with imperfect knowledge as to
the future outcome of the transaction.

However we do know what factors are most important in determining whether our potential
credit spread will expire worthless (as we wish it to) and thus deliver the spread’s net premium
to us as banked income.

The key factors affecting the final outcome, and what premium buyers and sellers arrive at,
are: (1) how far the price of the underlying is from our (short) Strike Price, (2) how much and in
what direction investors believe the news/rumor "headlines" acting on the general market and
on our stock or index will drive prices, (3) how volatile will the price action be along the way,
and (4) how much time remains before expiration.

We can't control the "headlines," but we can - and do - evaluate the strike price’s volatility
(delta), distance from the underlying, the net premium available, and the time remaining until
expiration when we decide on a credit spread position.

A. “Multiple Choice” Distance vs. Premium

If the RUT 610/620 bear call spread we were discussing is 12% above the
underlying RUT index, and has a net premium of $0.48, that would meet our
distance and our minimum premium requirements. The next higher Strike Price
pair, the 620/630, might have a $0.35 premium and would therefore also qualify
with respect to distance and minimum premium.

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 The Monthly Income Machine

It would be up to the individual "Machinist" to decide between the two conforming

spreads. For the record, I would opt for the 620/630 to give my spread Strike
Prices even more distance from the underlying RUT index and thus greater
"safety." A somewhat less conservative investor might prefer taking a little more
distance risk in order to snag a bigger premium and he could go with the 610/620
since it also conforms to the Distance entry rule.

B. Wideness of Your Credit Spread (How Wide Apart Should the "Legs" Be?)

First: the answer. Then we'll discuss the reason for it.

"The Monthly Income Machine" rule for the interval between credit spread strike
prices is this:

(A) If the option chain for the underlying offers strike prices that are $1, $2.50, or
$5 apart, we can use a spread where the strike price of the long leg of the
spread is up to $15 from the strike price of the short leg.

(B) If the option chain for the underlying offers strike prices that are $10 or more
apart, we can use a spread where the strike price of the long leg of the
spread is up to $30 from the strike price of the short leg.

Now we will consider the rationale for the entry requirement concerning the
interval between the long legs of the spread. The minimum acceptable Strike
Price of the short leg is "fixed" by the distance-from-the-underlying entry
requirement, but we may have choices to make with respect to establishing the
Strike Price of the long leg.

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 The Monthly Income Machine

Those choices (assuming they conform to minimum net premium and all other
"entry requirements") are among adjacent strike price legs, or legs wider apart up
to the maximum described in (A) and (B), above.

The further away the long leg is from the short leg of the spread, the greater will
be the premium available.

But the trade-off is that the further away the long leg is from the short leg of the
spread, the less rapidly the long leg will gain to help offset loss in the short leg
when the underlying is moving in an unfavorable direction.

Since we want the net spread premium to decline to zero (both legs of the spread
expire worthless), any increase in net spread premium once our order has been
filled is counter to our wishes. And the wider apart the legs of the spread are, the
more significant is the widening of the spread premium during an adverse
underlying move.

Remember, too, that as the legs are further and further apart, the margin
requirement gets larger and larger which materially affects our rate of return on
margin employed.

Here's an illustration of our “interval between legs of a credit spread" rule:

XYZ stock at 60
[From the current month XYZ Option Chain Table]

Call Strike Price Premium

65 0.95
70 0.50
75 0.15
80 0.06

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 The Monthly Income Machine

85 0.01
90 0.01

The above table provides easily arrived at conclusions -

a. The short 65 does not meet the 15% distance from

underlying rule for the short leg, so it's off the table.

b. The 70 Strike Price does meet the 15% distance rule, so

it's the first possible short leg of a conforming credit
spread.

c. Thus, the 70/75 spread also conforms to the minimum

premium rule ($0.35 net premium for the 70/75 is above
the entry criterion $0.25 net premium requirement).

d. The 75 Strike Price as a possible short leg more than

meets the minimum 15% distance requirement, but the
75/80 spread does not meet the $0.25 minimum premium
requirement, so it's a non-starter. The 75/85 (1)
intervening Strike) and the 75/90 likewise fail the
minimum premium test, so a short leg of 75 won’t work.

e. Our short leg of the credit spread must therefore be the

70 Strike Price.

Now you will note that while the short 70/75 spread delivers $0.35 net premium
($0.50 received for the short leg less $0.15 paid for the long leg) and meets both
rules (distance => than 15%; premium at least $0.25), the 70/80 also meets the
entry criteria... and delivers a bigger net premium to boot.

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 The Monthly Income Machine

The reason for the bigger net premium, of course, is that with the wider 70/80
spread we would pay less - only $0.06 - for our protective long 80 Strike Price
option.

The 70/85 provides an even greater net premium because the long leg would
only cost us $0.01, and it too meets the distance between legs criterion (up to
$15 between strike price legs when available strike prices are $5 apart).

Bottom line, we can decide on the long leg of the spread based on how we view
the trade-off between premium and safety... how conservative we are in weighing
reward against risk.

For me, the 70/85 would not be acceptable (even though it met the entry rules)
because the extra risk and extra margin for the small premium increase
compared to the 70/80 would not interest me.

Finally, let’s look at a different example where the option chain for ABC stock
only has available strike prices that are $10 apart.

ABC stock is trading at $60

Option Chain:

Call Strike Price Premium

70 0.62
80 0.35
90 0.15
100 0.01

The 70/80 has strike price legs $10 apart and meets the premium and distance
criteria.

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 The Monthly Income Machine

The 70/90 and the 70/100 also meet the minimum $0.25 premium and the $30
maximum interval between strike price legs of the spread.

The problem with the 70/100 is that the long leg is so far from the underlying that
the market is only assigning a value of a penny to it. That long 100 leg will
provide practically no net premium protection, or reasonable margin, for the
spread because it will not rise in value nearly as fast as the 70 short leg, hence
the spread net premium will widen very considerably and very fast in the event of
an adverse move. Consequently, I would not consider the 70/100 favorably.

Given the above hypothetical data, only the 70/80 and 70/90 are in the running
as for "Machine" entry. The choice between those two is a function of your
degree of conservativeness. Comparing the two, we know that the 70/80 gives
somewhat less premium income, somewhat more safety during an adverse move
in the underlying, and a more favorable (lower) margin requirement. The 70/90
conforms as well, but offers considerably more net premium, somewhat higher
risk and margin requirement. But either would be rational, conforming choices.

Summary of Entry Criteria, Step-By-Step

I've listed the entry criteria ("The Monthly Income Machine" trade entry rules) in the order in
which I check them each month when investigating potential credit spread trades. You can
check the criteria in whatever order you find efficient, but please make sure every criterion is
met before you conclude that the trade you are contemplating is a conforming one.

1. Earnings Report: There must be no earnings report due prior to expiration (not
applicable to “basket” EFTs and indices).

2. Merger: There must be no take-over activity rumored or "on the table" involving the
underlying stock.

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 The Monthly Income Machine

3. Time Remaining to Expiration: Option can be a "current month" option or one expiring
the following month.

The “sweet spot” for entering a trade for the current option month is when there are 10
to 6 trading days until expiration; this often offers an attractive balance between amount
of premium and "wait time" to expiration.

In periods of unusually low overall market volatility, it can be more difficult to identify
potential current month trade candidates that offer the minimum necessary premium at
the "Machine" entry requirement distance-from-the-underlying. It is perfectly acceptable
- i.e. within the rules - to go out to the next expiration month to find sufficient premium at
the right distance from the market.

The downside to this is that your monthly rate of return potential may be lower because
it will take longer to realize your profit on longer-duration trades. It is also obviously true
that if you are in a trade longer, there is more time for something untoward to occur.

The upside of establishing the spread with more time to go is that because there is
more "time," there will be more premium... perhaps enough to offset the effect on
monthly rate of return of the longer trade duration.

4. Current Price: The underlying stock, ETF or index must trade at $50 or more.

Among the $50+ candidates, the most promising - those that represent the "usual
suspects" - are the stocks with significant volatility and investor interest. Without decent
volatility, we would not have useful premiums.

Note: To obtain a copy of my own current list of "usual suspects" for stock credit
spreads, contact Customer Service at [email protected].

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 The Monthly Income Machine

5. Liquidity:

Rule: “Average Daily Volume” of the underlying must be at least 1,000,000/day.

Optional: Like to see “Open Interest” for the options to be above 250, but that is
often not feasible when the option is far from the underlying and/or the option
month has just recently begun.

No matter what number of Open Interest contracts exist at the time, I would
not be comfortable if my order would result in my Strike Price options
representing more than 10% of that Strike Price’s total Open Interest.

6. Distance From Underlying:

(a) For STOCK underlying credit spreads:

The Strike Price of the short member of the Bear Call credit spread (the leg closest to
the underlying stock price) must be at least 15% above the current price of the
underlying stock.

Similarly, the Strike Price of the short member of the Bull Put credit spread (again, the
leg closest to the underlying stock price) must be at least 15% below the current price of
the underlying stock.

Note: When there are between 10 and 6 trading days remaining until expiration (the
“sweet spot”), you can reduce distance from underlying stock requirement from 15%
down to 11-12%.

(b) For ETF and INDEX underlying credit spreads:

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 The Monthly Income Machine

The Strike Price of the short member of the Bear Call credit spread (the leg closest to
the underlying index price) must be at least 12% above the current price of the
underlying ETF or index.

Similarly, the Strike Price of the short member of the Bull Put credit spread (the leg
closest to the underlying index price) must be at least 12% below the current price of
the underlying.

Note: When there are between 10 and 6 trading days remaining until expiration, you can
reduce distance from underlying ETF/index requirement from 12% down to 9-10%.

Important: Remember that once you establish what the Strike Price of the short member
of the credit spread must be to meet the "distance" and premium criteria, you can then
select the long member of the credit spread, up to the maximum entry criteria rule for
strike price spread interval, based on the trade-off between net spread premium vs.
safety during an adverse move.

7. Maximum Spread Width (interval between strike prices of long and short leg of spread):

Our maximum Strike Price spread interval rule is:

for option chains with strike prices $1, $2.50, or $5 apart, difference between
long and short leg of spread can be up to $15.

for option chains with strike prices $10 or more apart, difference between long
and short leg of spread can be up to $30, although more conservative investors
may wish to limit the distance between long and short leg to a more narrow
interval.

8. Net Premium: The net premium received on the spread meeting the preceding
requirements should be at least $0.25 (of course, more is better!).

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 The Monthly Income Machine

9. Delta: The Delta value for the short member of the credit spread must be .08 or lower
(meaning an estimated 92% probability that the underlying will not reach that Strike
Price by expiration day).

10. Chart: Although not an absolute “entry requirement,” I always look at the 3-month and 6
month charts of any underlying I am considering for a credit spread.

I greatly favor a situation that allows me to establish the short Strike Price of my bear
call spread above a resistance level, and below a support level if it is a bull put spread.

I can then use the breaching of that support or resistance as a signal to either exit from
the position or to employ an adjustment technique (explained in the next section)
because such breakouts suggest my spread’s short Strike Price is, or may soon be,
threatened.

I also look at a stock’s chart to see at a glance if it is currently in a strong trend, or is

more or less “range-bound.” I prefer not to establish a bull put spread in a sharply
falling market, or a bear call spread in an explosively rising one, unless I have very
strong indicators1 that the market in question is very much oversold or overbought.

11. The “Conforming Credit Spreads Service” Subscription (optional):

Everything needed to successfully use “The Monthly Income Machine” program is

explained step-by-step in this book, supplemented by the ongoing series of “white
paper” article alerts, access to the members-only Forum, and one-on-one coaching by
the author if you ever have any questions.

However, for investors who wish to have a provisional list of fully-conforming “Machine”
trade candidates routinely delivered to them for further consideration, SaferTrader offers
a separate, optional, subscription service at about the proverbial “cost of a cup of coffee

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 The Monthly Income Machine

a day.” Again, the investor can arrive at exactly the same list of “conformings” doing his
own screening as outlined in the book, but the Service does offer a substantial saving of
time in identifying and choosing trade candidates for further evaluation.

1
There are several widely used overbought/oversold indicators; the one I use frequently (with an
additional filter) is discussed in detail in the SaferTrader "white paper" located at:
www.SaferTrader.com/overbought-oversold-market-how-to-recognize-and-profit-from-them/.

The “Conforming Credit Spreads Service” is available only to current, registered owners
of “The Monthly Income Machine.” Because the conforming trade candidates provided
by the service after Friday’s close must be confirmed by the user before placing orders
(once trading begins again on Monday, prices, etc. can change), it is essential that
subscribers fully understand and be able to implement the “Machine” entry criteria and
trade management details as spelled out in the book.

If you wish to review more information about the Service, or obtain a sample copy of a
current report, contact Customer Service ([email protected]) or go to
http://SaferTrader.com/screening-service-sales-page.

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 The Monthly Income Machine

Chapter 8
MANAGING AND ADJUSTING POSITIONS
IF TRADE IS THREATENED

MANAGING AND ADJUSTING POSITIONS

Clearly, the purpose of "The Monthly Income Machine" is to seek a reasonable Premium, over
a very short time period (usually about a month), and to do so with a high degree of reliability.

Following the exact entry rules of “The Monthly Income Machine," it is reasonable to expect
that approximately 85% of the time you will capture this premium income on each credit spread
or Iron Condor.

Typically, the underlying stock, ETF or index will bounce around, the inexorable power of time
decay will work its magic for us, and the underlying will not reach our credit spread’s short
Strike Price prior to expiration day. Accordingly, our credit spread or Iron Condor will expire
worthless and, as we hoped, we will bank our entire premium income for the trade.

But, approximately 2 times out of 10 the underlying will not cooperate and we MUST make
adjustments in our positions. We must do our best to NEVER allow a losing trade to be large
and thereby undo all the good work of our successful trades.

Let’s refer back to an earlier graphic of an Iron Condor position, this time on XYZ stock trading
at 155.

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 The Monthly Income Machine

Assume that these two related credit spreads (an Iron Condor) each met all the “Entry
Criteria”, having received a $0.45 premium on the September 180/185 bear call spread and a
$0.40 premium on the September 130/125 bull put spread. If XYZ stock remains between 130
and 180 at expiration on the third Friday of September, we bank the total $0.85 premium. That
means we would earn $85 ($0.85 x 100 potential shares an option represents) on our $500
margin, for a 17% rate of return on margin employed in one month.

Everything starts out fine. Then a problem arises when XYZ announces a new whiz-bang
product and the stock starts moving strongly upward and threatens our Bear Call Spread even
though it started out a full 15% above the then-current price of XYZ.

We may need to adjust our position or simply exit from the Bear Call Spread with a relatively
small loss if the stock continues to move even higher. (Note that the other half of our Iron
Condor, the Bull Put Spread, would actually be in great shape if this very strong rally
occurred.) But in no case would we want to suffer a large loss on either component of our Iron
Condor.

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 The Monthly Income Machine

Our best-case scenario results if the stock ultimately finishes below 180, the short Strike Price
of our Bear Call Spread, and we do bank the $0.45 premium we collected for it at the outset.
Our worst-case scenario would occur if we – insanely – stood by and allowed the stock to
climb all the way to above the higher, long Call Strike Price (185) at expiration.

Then the maximum possible loss would occur. Since the Strike Prices are $5 apart, that loss is
$5, minus the $0.45 premium we received = $4.55. Obviously, we would not ever want to risk
$4.55 to make $0.45, so we need to do our best to make sure that outcome, or anything close
to that, does not occur.

Fortunately, we have a number of techniques for dealing with a credit spread if we are
threatened by a powerful move against us by the underlying stock, ETF or index.

The first, and most important, consideration is, “what is the maximum amount we allow a
position to move against us before we make an adjustment?” In other words, what is our
Maximum Risk Amount (MRA)?

That we do set a MRA on every trade is a “rule.” What the MRA should be, however, is up to
each investor to decide based on his objectives and risk tolerance.

A suggested MRA follows next.

Maximum Risk Amount (MRA)

While this could vary depending on the investor’s risk tolerance, my risk tolerance is low, and
my MRA on a credit spread is:

A loss of 1.5 to 2 times the premium I initially collected on the trade is the
maximum amount I am willing to risk on any spread position.

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 The Monthly Income Machine

For our example, let’s use the value of MRA = 2 times premium received.

In the XYZ example, I received a premium of $0.45 on the threatened Bear Call Spread of my
Iron Condor. 2.0 times my original premium is $0.90. Therefore, if the rise in XYZ stock pushes
the Bear Call Spread to a premium of $1.35, I exit the threatened spread with a $0.90 loss
(paid $1.35 to exit from the spread, minus $0.45 I collected on the spread as up-front premium
= $0.90 loss).

So, in this example, I would place a “stop order” to exit from my credit spread if the premium
widened to $1.35. Note: a stop order is always placed on the net premium of the spread, not
on the individual long and short legs of the spread.

When setting the protective stop based on your MRA, please keep in mind that there is a
difference between the maximum loss risk that is acceptable to you, and the price at which the
stop is placed. In the above example, the investor is willing to risk a loss of $0.90 (his 2.0 times
premium received MRA), but the stop is placed at a net premium of $1.35 in order that the loss
calculation also account for the premium received when the trade was established.

A handy shortcut for determining where to place the stop on a spread if using a 2 X initial
premium MRA, is to set the stop at 3 X initial premium.

Returning to our example, I leave my Bull Put Spread alone, since this net spread premium will
have moved even further down in my favor toward zero as the stock rose. The $0.90 loss on
the Bear Call Spread I exited is not ruinous.

I still have my increasingly likely potential $0.40 profit on the Put spread I’m keeping, and I
could make back the net loss on the entire Iron Condor ($.90 bear call spread loss and $.40
bull put spread profit = $0.50 Condor loss) on my next trade or two.

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The purpose of having a MRA on every credit spread, and sticking to it, is to assure that when
a loser comes along – and it will – our account and long-term profit are not jeopardized by a
large loss.

Using 1.5 to 2.0 times original premium received as the MRA strikes a reasonable balance
between risking too much on a trade, and not allowing the spread enough “breathing room” to
work as the underlying stock or index moves around.

These numbers were not pulled out of a hat; there is a mathematical basis to them.

Consider this: if we experience 8 out of 10 trades as winners (this is our actual estimated
outcome), and we gain only the minimum entry criterion premium profit ($0.25) on each, we
gain $2.00 on those 8 trades. If on the 2 out of 10 losing trades in our hypothetical, we lose
2.0 X premium received, we will lose $0.50 on each loser, or a total of $1.00.

That works out to an account profit over the 10 trades of $1.00 ($2.00 total profit from 8
winners - $1.00 total loss from 2 losers). In other words, the account value grows.

Before leaving the “adjustment” involving simply exiting from the position and accepting the
pre-determined MRA loss on the trade, we’ll take a moment to define how we “exit,” i.e., close
out, the transaction.

It’s simply doing the opposite of what we did when we entered the trade originally, and thereby
offsetting the position.

Since we entered the Bear Call Spread with the order:

Sell to open 1 XYZ September 180 Call
Buy to open 1 XYZ September 185 Call
… day order
…at a net credit of $0.45

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 The Monthly Income Machine

To offset this trade (exit from it), we could enter a “stop” to buy back the 180 Call and sell the
185 Call with this order:

Buy to close 1 XYZ September 180 Call

Sell to close 1 XYZ September 185 Call
STOP
… at a net debit of $1.35
… day order

If the stop price of $1.35 were reached, our order would be filled “at the market,” and we would
then have no XYZ Calls left. We have taken our $0.90 loss (our MRA) on the Bear Call Spread
leg of our Iron Condor. Note: Conventional stop orders, when the trigger price is reached or
exceeded, are filled at the market – meaning the best price the brokerage firm can get for you
at that moment. The “fill” might be somewhat above or below the actual trigger price, but the
investor will be “out” if his stop point is reached.

However, we also have other choices.

1. Early Profit Exit Prior to MRA

An investor might choose to exit from a then-profitable spread prior to expiration because he
wishes to free up margin for another spread opportunity.

He might also simply decide that he has a nice potential profit right now, and rather than risk a
later adverse move that could turn the trade into a loss, he might prefer to exit from the spread
early at some immediate profit, rather than risk waiting for expiration and the maximum profit
that would be achieved if the spread expires worthless on expiration day.

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2. The Roll
The roll represents a powerful trade adjustment technique that, when the situation warrants,
can substantially reduce the over-all loss on a single credit spread or Iron Condor, and in fact
may turn a potentially losing trade into a profitable one.

A roll up or a roll down is simply first exiting from a threatened credit spread and then
establishing another one at higher Strike Prices (if a Bear Call Spread) or at lower Strike Prices
(if a Bull Put Spread), so long as the new spread meets the usual entry criteria.

If at least 6 trading days remain prior to expiration, the roll up might be done in the same option
month as the threatened spread. At the lower end of acceptable minimum time remaining,
however, it may be quite difficult to obtain sufficient premium at the necessary Strike Price
distance. However, the roll can usually be established at the desired Strike Prices at a greater
premium using the next expiration month.

In this example, the sharp rise in XYZ stock increased the net premium on our 180/185 Bear
Call Spread to the stop loss trigger price of $1.35, causing us to exit the trade. But it also
increased the premium on those Strike Prices ABOVE our previous 180/185 Strikes.

Therefore, after we exit the XYZ Bear Call Credit Spread because our MRA has been reached,
we could employ “The Roll Up.”

As noted, when there are at 10 to 6 trading days left before expiration, we may be able to use
the option chain for the current month with the “sweet spot” lesser distance requirement. Using
this reduced distance-from-the-underlying entry requirement as discussed earlier, and the
usual minimum premium criterion, we can look to roll up into another Bear Call Credit Spread
with higher Strike Prices. We might employ, for example, the 190-195 credit spread which is
trading at a $0.50 premium after the move higher in the underlying.

Alternatively, we might want to (or have to) go out to the next option month and take
advantage of the even larger premium that having more time-remaining affords us. If

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successful this time, we will be able to reduce or even completely offset the loss on the original
trade.

As discussed earlier, we are always dealing with out-of-the-money options, so all of the
premium in the option is "extrinsic," i.e. the option's entire value is based on the amount of time
remaining till expiration. That extrinsic time value declines at an ever increasing rate as we
approach expiration. The decay rate, as seen in the illustration below, occurs especially rapidly
during the last two weeks prior to expiration.

Therefore, again as noted earlier, for credit spreads based on an underlying stock with about
10 days or less left until expiration, I can reduce my short Strike Price distance requirement to
11-12% from the underlying, rather than the usual 15%. Similarly, I can reduce my ETF or
index option distance requirement to 9-10% .

When I am rolling into a new spread in the same expiration month, I need no additional margin
to enter this trade because I still have the now profitable, much safer Put Credit Spread part of
my Iron Condor working; in effect I am simply re-establishing an Iron Condor with a new Bear
Call Spread component.

So, in the above example, I then place my new credit spread order to Sell the 190 Call and
Buy the 195 Call at a net premium credit of $0.50 or more.

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 The Monthly Income Machine

As long as XYZ remains below 190, I will bank this $0.50 premium. Now let’s look at our
Adjusted Iron Condor arithmetic at expiration:

Original Call Credit Spread 0.90 loss

Rolled Call Credit Spread 0.50 gain
Original Put Credit Spread 0.40 gain
Adjusted Iron Condor 0.00 break-even

Just remember that the roll into a spread of the same expiration month is used only when there
are at least 6 trading days remaining until expiration. NEVER do any adjustments in the same
option month, other than exiting from a position, with 1 week or less remaining until expiration.
There simply is rarely enough time-related premium to produce a trade at an acceptably safe
distance from the underlying. In fact, if there is sufficient premium with less than 6 remaining
trading days at the required distance, I would be somewhat suspicious as to why there was so
much premium under large distance/near expiration conditions. Does somebody know
something?!

And, of course, you can do exactly the same thing as described for a CALL spread if the PUT
credit spread leg of your Iron Condor is the one in trouble. You would exit from your PUT
spread, and then roll into a new PUT Credit Spread with Strike Prices below your original ones
to re-establish the Iron Condor.

In some situations it is possible to do a roll that retains one of your initial strike prices.

Assuming there is sufficient time remaining in the current option month, we might wish to roll
our threatened 180/185 call spread into a 185/190 call spread rather than the 190/195 roll
discussed previously. Of course, doing so would provide more premium (and is somewhat
more aggressive) since the new 180/185 spread is closer to the current market than the new
190/195 would be.

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To do this roll, you would:

Buy back your 1 short 180 call,
Sell 2 185 calls (1 to offset your existing long, and 1 to establish a new short
position at 185),
Buy 1 190 call to establish the long position to go with your new short 185 call.

You end up “out” of your original 180/185 call spread, and rolled into a new 185/190 call
spread.

Finally, if there isn't enough time left in the current expiration month (less than 6 days
remaining), you can establish your roll-out spread for the following month's expiration period.
There you will find that the premium available will be substantially higher than the premiums
available for the current month close-to-expiration options of the same Strike Price.

This is the case, of course, because next month's options have more time value.

To do this “roll,” you simply exit from this month’s spread that reached your MRA, and
establish a new spread in the next month.

3. Early Adjustment Trigger – Violation of Support or Resistance

Recall that in the “Entry Criteria” we discussed the desirability of placing the Short Strike of
your Bear Call credit spread above resistance, or below support with a Bull Put Spread. These
levels are easily identified by looking at 3-month and 6-month or longer period charts of the
underlying (page 51).

One purpose of pre-identifying support and resistance levels is to provide you with a “trigger”
for possible early exit, or early exit with roll, when important price levels of the underlying are
breached and you are nearing, but haven’t reached, your MRA (Maximum Risk Amount).

4. Early Adjustment Trigger – Rise in Delta

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 The Monthly Income Machine

When we enter a credit spread, one of our entry criteria is that the Delta for our short
component of the spread (the one whose Strike Price is closest to the market) must be .08 or
less (meaning that the estimated probability of the underlying reaching the Strike Price prior to
expiration is only 8%).

Once we have established our trade, the delta value of our credit spread’s short option
continually changes as the price of the underlying changes and as time passes.

If the underlying should be making a fairly strong move in the “wrong” direction and we are
uncomfortable with our position, we could use a higher Delta - say of delta = 0.50 for example -
as an early exit trigger… and simply exit the position with a loss well below MRA, or exit and
also employ the Roll.

4. Early Exit - Just Before Expiration Day for Index Options

Often, investors stay with a profitable position through expiration and allow the spread to
expire worthless, providing them with the maximum profit on the trade. This is fine when the
underlying is far from the short Strike Price of the spread.

NOTE: With Index Options: if the underlying index is even remotely close to the short Strike
Price of the index credit spread on the Thursday before expiration, you MUST exit from the
spread at least by Thursday, the last trading day for Index Options, rather than hoping for the
best when it actually expires the following day.

If one were to remain in the index spread until after the close on Thursday, and the market
opened on Friday such that the underlying moved your spread “into-the-money,” there is
nothing you can do since trading ended the day before.

Repeating: you MUST exit from a threatened index spread no later than the Thursday before
expiration Friday, unless the underlying is so far from the Strike Prices of your spread that the
premium is down to 5 or 10 cents. You will incur a commission when closing out the trade, but
it’s a very small price to pay for peace of mind and protection from ulcers.

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Bottom line, you should not be in any index positions on expiration Friday unless the Short
Strike Price of your spread is so far from the underlying that the premium is almost non-
existent and is almost certain to disappear completely on expiration day.

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Chapter 9
ADDITIONAL CONSIDERATIONS
…AND THEY ARE IMPORTANT!

Up to this point, everything we discussed is geared to understanding the “Why” and the
specific “How-To-Rules" entry and trade management considerations associated with ”The
Monthly Income Machine.”

Now I’d like to go over some additional considerations that you as an investor will want to
employ in establishing and managing your credit spreads and Iron Condors. Rather than
“rules,” these are techniques that you may want to use depending on your degree of
conservativeness, your available capital, and, of course, your income target.

But keep in mind as you read this final section – and the Disclaimers that follow – if there is
one paramount “rule,” that rule is to never intentionally allow a losing position to exceed your
Maximum Risk Amount (MRA).

We are dealing with a strategy geared to producing reliable monthly income based on
relatively small profits on each position, so we must not allow what we bank from a series of
winners using “The Monthly Income Machine" to be jeopardized by one large loss.

A. "Weekly" Options

All "Machine" trades involve the use of monthly expiration options. As mentioned earlier, the
increasingly available "weekly" options have a place in the conservative investor's world. But
in my judgment, that place is not in credit spread country if the investor is considering
establishing a credit spread with a week or less to go until expiration.

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The reason is this: The major advantage "Machinists" have with their credit spreads is that
time decay - an inherent element of all options - works for them and against the outright
options buyer.

Furthermore, time decay of the premium value of an out-of-the-money option is not linear. The
rate of decay accelerates markedly toward the end of an option's life - especially during the
week before expiration.

Since we are selling credit spreads, it is accurate to say that we are essentially selling time.
You will recall that in all our discussions of using “The Monthly Income Machine," we
specifically say "no" to establishing trades during the last week prior to expiration since the
small amount of remaining time typically means a very small premium at "safe" distances. It
would not be worth taking any risk at all under these conditions.

A week-4 weekly option would be exactly the same vehicle as the last week of a monthly
option. In fact, weekly options are not even available for the last week of a monthly option's life
because it would be a duplicative product.

That said, although weekly options are not suitable for credit spreads when there is less than 6
days remaining prior to expiration, because most of the benefit of time decay is gone, the
absence of time premium represents an advantage to an investor who happens to want to buy
an option under a particular circumstance.

The bottom line on weeklies: They are fine for speculating on a known upcoming event by
BUYING options outright or BUYING debit spreads because the premiums will be relatively low
so close to expiration.

Conversely, weeklies are NOT FINE during the final week before expiration for credit spreads
because the premiums are too low at reasonably "safe" distances since time decay has greatly
reduced the premium relative to distance.

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Although weekly options with more than 6 days left before expiration can be used with credit
spreads, they generally will offer less liquidity than the monthly option and thus are more likely
to sustain less attractive fills when orders are triggered.

B. Number of Spreads

You are well advised to “paper trade” the "Machine" for a while to experience entering, exiting
when necessary, and adjusting positions. For the sake of simplicity, the examples in this book
involve a single credit spread or Iron Condor.

But, realistically, the $25 - $100 or so income from a successful trade using a single credit
spread with a $0.25 to $1.00 premium hardly qualifies as significant monthly income.

Depending on your account size, and income objectives, you will undoubtedly do multiple,
identical spread contracts for an underlying each month, employing exactly the same rules and
controls you would for a single spread.

When doing more than one contract of your credit spread, you will also be able to take
advantage, if and when you wish to, of several additional techniques like the "ladder entry"
discussed in section "D" below.

Finally, a few words about “diversification.” There is absolutely nothing wrong with intentionally
diversifying a credit spread portfolio among various underlyings and between put spreads and
call spreads (so long as all spreads meet all the “Machine” entry requirements, of course!), but
diversification need not be looked upon as having the same degree of urgency as with outright
long or short positions.

This is because credit spreads are essentially non-directional in nature (up to a point). We do
not really care whether the underlying is trending upward or downward so long as it doesn’t go
too far in the adverse direction. Personally, I consider diversifying credit spreads as possibly
desirable, but not a deal killer if not done.

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 The Monthly Income Machine

If one chooses to build diversification into his credit spread “portfolio,” I feel it most useful for
credit spreads with stocks as the underlying.

For the purpose of guarding against a surprise market-wide development, one might also look
favorably on diversifying by favoring a series of conforming spreads that include both bull put
spreads and bear call spreads so long as all spreads used are conforming ones.

C. Number of Spreads vs. Margin Available

Recall that for Credit spreads, when the Strike Prices are $5 apart, the margin requirement is
$500, and when they are $10 apart, the margin requirement is $1,000.

But realistically you actually need a bit more than that in your account to place the trade.

On the SPX (S&P 500 Index) for example, the margin requirement for a spread with strike
prices $5 apart is $500/spread because that is the theoretical maximum possible loss on one
such spread, but there is also transaction cost (commission), so you need a bit more than
$500 in your account to place a single credit spread trade, or the two credit spreads of an Iron
Condor trade.

Also, in the event that a spread were temporarily going against you, the "paper loss" would be
reflected in a lowered account value, but you would still need sufficient available funds to meet
the margin requirement for your position.

Therefore, if you were doing 10 SPX spreads with strike prices $5 apart, you would need to
have a little more than $5,000 in your account, and so forth. Whether you plan to trade 10
spreads at a time or not, I would not recommend having a "The Monthly Income Machine"
account with less than about $6,000 in available margin.

That's the arithmetic. Although you could theoretically employ all the money in your account as
margin at any one time, that would be too aggressive a posture for me.

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As a practical matter, I personally “earmark” (remember: we are not “spending” margin; it just
has to be in the account), a maximum of 50-75% of my available margin for credit spreads and
Iron Condors each month.

You may elect to employ more or less of your margin, depending on your comfort level with the
program and with the trades you are considering.

D. Ladder Entry

One of the excellent techniques we can use with multiple spread positions is the “ladder entry.”
It represents a kind of averaging-in approach.

Assume we intend to end up with 6 ABC Bull Put Spreads. Instead of entering all 6 at once,
using for example the 110/105 Bull Put Spread strike prices, we might initially only do 3 of
them.

Perhaps early in the life of the trade, the market moves lower, but not enough to worry us that
it is likely to reach too close to our short Put Strike Price. Now we could do the other 3 110/105
spreads at an even more attractive premium, or at more attractive (lower) Strike Prices.

Suppose, instead, the underlying makes a sharp early move down, and we are concerned that
it is getting within shouting distance of our MRA.

Then we would forgo the other 3 spreads and, in fact, now only have the original 3 to deal with
in terms of exiting with a loss, rolling, etc.

Lastly, suppose the market moves up early in our spread’s life, and we are very confident that
the original 3 Bull Put spreads we have on are going to be winners.

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We could simply add the additional 3 spreads at the same Strike Prices as originally (although
the premium will be smaller now because the underlying has moved away from those Strike
Prices
…or we could add the additional 3 spreads at higher Strike Prices and thus more premium.

In short, laddering gives the investor additional flexibility in establishing multiple credit spread
positions.

E. Timing Your Entry

We noted earlier in the Entry Criteria discussion that we want there to be at least 6 trading
days (non-holiday weekdays) left until expiration when we establish a credit spread (10 to 6
trading days is the “sweet spot” for entry timing).

This is so there is enough time value in the options to produce at least $0.25 premium
opportunity at an adequate distance from the underlying.

Within those remaining-days-until-expiration parameters, we have flexibility as to exactly which

day we enter our order.

Consider this: markets rarely go up day after day, or down day after day, even when there is a
strong trend underway. This is obvious when looking at the chart of any underlying stock, ETF
or index. The underlying may go up three days in a row, and then have a down day or two due
to profit taking, news that affects the entire market, etc.

If I am interested in establishing, for example, a XYZ Bear Call Spread, I would prefer to enter
my order after XYZ has been going up for several days in a row. Then I would enter my credit
spread order using, of course, strike prices that meet all of our entry criteria.

F. "Legging" Into An Iron Condor

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Most option-friendly brokerage firms allow you to enter your Iron Condor orders as a single
order. I rarely do this, needing instead to “leg into” the Bear Call Spread and Bull Put Spread
parts of the Condor at different times in order to meet the premium and distance requirement
on each spread.

Suppose, for example, we are planning to do 10 Iron Condors on the Russell 2000 (symbol:
RUT), when the underlying RUT is at 770.

Using the Entry Criteria, we see that the premium on the Bear Call Spread that meets our
criteria is $0.25, i.e., we can sell the 860 Call and buy the 870 Call for a $0.25 net premium.

At the same time, we see that the premium on the Bull Put Spread that meets the entry criteria
is $0.30. In this example, we could sell the 670 Put and buy the 660 Put and collect a net
premium of $0.30.

We could enter our order on the entire Iron Condor, seeking a total $0.55 net premium ($0.25
+ $0.30) as follows:

Sell to open 10 Oct 860 Calls

Buy to open 10 Oct 870 Calls
Sell to open10 Oct 670 Puts
Buy to open 10 Oct 660 Puts
… day order
… net premium of $0.55

I refer to the above scenario – entering both the bull put spread and the bear call spread of an
Iron Condor at the same time – as a 1-step Iron Condor. Except with very active/volatile
underlyings, it is usually not possible to establish an Iron Condor in the current expiration
month as a 1-step Iron Condor. One or the other of the two spreads need for the Condor will
often not provide sufficient premium. Remember: BOTH spreads of an Iron Condor must
EACH fully conform individually to all the entry rules.

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Since each spread of the Iron Condor must offer at least $0.25 premium to qualify, an Iron
Condor must provide at least $0.50 premium in total… but we cannot have a Condor where
one spread provides $0.35 and the other only $0.15 – even though the total is $0.50.

It would be fine to enter that spread with the $0.35 premium now, and hope to establish the
other spread later based on price movement in the underlying bringing the spread premium up
to at least $0.25.

That would represent a “2-step Iron Condor,” wherein we could “leg into” the Iron Condor, i.e.,
establish half of the Iron Condor now, and the other half later. This is the most common
method of establishing an Iron Condor.

For example, let’s assume that the underlying RUT had been down for each of the past 3 days,
and we decided to now enter only the Bull Put Spread at the $0.30 premium available on the
670/660 Put credit spread.

A couple of days later, we find that the underlying RUT has bounced up somewhat and is now
at 781, $11 higher than when we had entered the Bull Put Spread. At this point, we are
“ahead” on our existing Put spread, because the rise in the underlying – and the passage of
some time – have reduced the premium on our existing spread… which is what we want, of
course. In other words, our Bull Put spread is now even further away from the underlying price
than when we established it.

Furthermore, because the underlying RUT has risen $11, we might now be able to do our Bear
Call Spread at higher Strike Prices (of course, at the required distance from the underlying)
and still collect a minimum $0.25 premium. In this example we might find that instead of the
860/870 spread, the 870/880 now meets all of our entry criteria, and thus we could enter our
Bear Call Spread order accordingly.

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Now we have our complete Iron Condor, but are better off than we would have been had we
established the entire Iron Condor at the outset with a single order. The distance apart
between the Call Spread and the Put Spread is greater, and we already are ahead on the Put
Spread.

G. Protecting Your Credit Spread From the Unexpected

Obviously, the various entry criteria concerning distance, premium, absence of earnings
reports, delta, and relative liquidity are all focused on identifying spread candidates with a high
probability from success. Limiting risk once in the spread position is the key trade management
responsibility and using a MRA (maximum risk amount) is a key to limiting risk on each
position.

But there can be occasions, albeit infrequently, when the underlying makes an overnight or
sudden intraday mega move in the wrong direction and blows right through our MRA stop loss
order and can result in a much bigger losing trade than the MRA called for. Of course, the
theoretical maximum loss based on the interval between the strike prices would stop the
bleeding, but we could still be well beyond the risk we identified as our risk “limit” at the outset
of the trade.

Is there a solution for preventing a so-called “black swan” event? No, there is no perfect
defense against a giant adverse move that leaps past our stop loss trigger. However, there are
steps we can take before an unforeseeable headline event wrecks a conforming spread trade.

Extra, Extra, Read All About It

Additional “long” option of the spread

This technique involves adding one or more “extra long" options to a Credit Spread,
e.g., we might SELL 10 Strike Price 860 RUT Calls, and BUY 11 or 12 (instead of 10)

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Strike Price 870 RUT Calls for our Bear Call Spread, or sell 10 Strike Price 670 RUT
Puts and buy 11 or 12 Strike Price 660 RUT Puts.

Why buy the extra long option(s)? Because in the case of the Bull Put spread, we might
be a little concerned that even though a contemplated Bull Put spread meets all the
“entry criteria,” there is something in the news that’s nagging at us. Perhaps we’re
hearing that there is saber rattling going on between the Republic of Last Tuesday and
the Duchy of Hortense and there’s an outside chance we could be drawn into the
fracas. Maybe China suddenly devalues its currency, or North Korea does something
terminally stupid.

By adding the extra Puts, if the market does make a sharp move down (which is
certainly not what we want with a Bull Put Spread), that extra long Put or Puts can offset
some or even all of our loss on the 10 spreads, because it will be gaining in value on its
own. Of course, buying the extra Put reduces our net premium somewhat, but we can
look upon the expenditure as insurance.

Extra unrelated option(s)

If looking to protect a bull put positions from a “black swan” market collapse, the
investor could use an insurance policy made up of some long SPY puts. These would
bring separate profits into the account if the market tanked and would thus serve to
offset all or some of the loss on conforming put spreads that suffered in the downdraft.

A similar approach can involve purchasing some VIX calls along with the conforming
bull put credit spreads. Since the VIX is an instrument that represents a “fear index,” we
can expect it to increase in value when the market is falling hard (taking our bull put
spreads with it in the general decline) no matter what is causing the fear. Again, the
profits from the long VIX calls can offset losses in bull put spreads we have in the
market.

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As noted, extra long positions established to protect spreads from an extreme,

unforeseeable down move is an insurance policy in every sense of the word. We hope
nothing happens and our spreads expire worthless giving us our maximum profit, or if a
spread goes the wrong way, we are able to exit at or near our pre-determined stop loss
point.

But if the worst case, rare, very abrupt move occurs, we’d be very happy that we bought
the insurance even though most of the time the insurance we purchased will not be
used.

H. Freeing Up Margin

Here is an excellent move you can make in the following specific situation:

The market has moved strongly in the direction you want and, with at least 2 weeks left until
expiration, you see that you could exit from a credit spread (not part of an Iron Condor) at a
premium of only 5 or 10 cents.

You might want to do that, even though you are: (1) giving up some of the potential profit you
would earn if you waited until the spread expired worthless, and (2) are incurring an extra
commission.

The reason you might consider exiting earlier is that the margin requirement disappears when
you exit from a spread (not part of an Iron Condor), and you could now put on another spread
(employing the usual entry criteria) and earn an extra premium from the same margin during
the same month.

Obviously, you also remove any possibility, no matter how remote, of having to eventually exit
from the original spread at a loss.

I. Stop Loss and Contingent Stop Loss Orders

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The purpose of a stop, or contingent stop, order is to have your position automatically offset
(exit from the trade) if the price moves against you and reaches a certain predetermined point.

The order is “resting” in the market and will automatically take you out of the position if the
specified price is reached. When you place the order, you indicate if it is to be a “day only
order” or a “good till cancelled” one.

You don’t have to be there, watching, or take any additional action once the order is placed. Of
course, you are free at any time (as long as it has not been filled) to cancel the order, change
the trigger price, change from day order to good till cancelled order, or vice versa.

I sometimes prefer to initially place my protective orders as “contingent stop orders,” on the
underlying stock or index rather than as “stop orders” on the options themselves.

Because options are less liquid than the underlying, their prices tend to bounce around more
than that of the underlying. Consequently, a stop loss order placed directly on an option
spread might get filled because of unrealistic bid/ask prices even though the price of the
underlying doesn’t warrant the option moving that much. The risk of such an "unwarranted" fill
is greatest during the opening minutes of the trading day.

Instead, you can place a “contingent order,” that says – in effect – if the price of the underlying
stock or index reaches a specified price, take me out of my option spread.

Keep in mind that when using a contingent stop on your credit spread – based on the
movement of the underlying – you are working with an estimate of where the option spread
premium will be if the underlying reaches the trigger value. The calculation of what option
premium is associated with what price of the underlying is subject to change as delta changes
and as we near option expiration. Accordingly, the investor needs to recalculate the underlying
trigger price when the underlying makes a significant move up or down and as time passes.

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This contingent stop based on the price of the underlying is useful if placing good-until-
cancelled orders, but it is not as accurate as setting the “day only” MRA stop on the option
spread itself.

J. Option-Friendly Brokerage Firms (a Critical issue)

All brokerage firms are not equal, and I am not just talking about such obvious considerations
as commission rates.

While most substantial brokerages offer stock, bonds, and options trading support, the level of
option support, and their option policies, and their options trading platform vary widely.

Options-friendly brokerages do offer especially attractive commissions rates.

They also are more likely to have options experts available to answer telephone or e-mail
inquiries.

Predictably, trade/quote/information screens at options-friendly brokerages are typically

exceptionally user-friendly. They provide real-time streaming stock, ETF, Index, and option
price quotes, with their associated Greeks and other data, as part of their trading platform.

Perhaps most importantly, brokerages differ on margin policy. By far the most important
margin policy issue is the “recognition” of Iron Condors. It is a critically important selection
criterion in evaluating where to have your account.

As discussed in detail earlier, it is absolutely impossible for an option on an underlying to

expire in-the-money on both your Bear Call Spread and Bull Put Spread components of an Iron
Condor. The price of the underlying at expiration cannot be in two places at one time. Period.

Therefore, you should only have to post margin for one side of the Iron Condor, because only
one side can be at risk at expiration.

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 The Monthly Income Machine

Despite this, some major brokerages do not recognize this indisputable fact, and their software
demands margin for both the bull put and bear call spreads of the Iron Condor… which cuts
your potential rate of return in half!

Since you have a choice of several top-notch options-friendly brokerages, you should use one
of them for your "Monthly Income Machine" account. You can leave your other accounts where
they are if you wish, although the recommended firms also handle stock, bond, mutual fund,
etc. trading.

There are several options-friendly brokerages that I recommend you look into. Please check
with Customer Service ([email protected]) to check if any of them are currently offering
any special bonus to members of the SaferTrader community.

For a discussion and “naming names” of our list of recommended options-friendly brokerages
see the “white paper” http://safertrader.com/options-friendly-brokerage/.

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K. Disclaimers and Disclosure

Please read the author’s disclaimer, as well as the following required disclaimers.

Author’s Disclaimer:
We emphasize that you should not invest more than you can afford to lose in any investment –
including "The Monthly Income Machine;" that there are no guarantees of profit using any
method or technique; and that there are particular risks associated with leveraged investment
vehicles like options and futures.

Other Required Disclaimers:

U.S. Government Required Disclaimer - Commodity Futures Trading Commission: Futures and Options trading 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 futures and
options markets. Don't trade with money you can't afford to lose. This is neither a solicitation nor an offer to Buy/Sell futures or options.
No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this web site.
The past performance of any trading system or methodology is not necessarily indicative of future results.

CFTC RULE 4.41 - HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL
PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN
EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS
LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE
BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES
SIMILAR TO THOSE SHOWN.

All trades, patterns, charts, systems, etc., discussed in this document and the product materials are for illustrative purposes only and not
to be construed as specific advisory recommendations. All ideas and material presented are entirely those of the author. No system or
methodology has ever been developed that can guarantee profits or ensure freedom from losses. No representation or implication is
being made that using the Monthly Income Machine methodology or system will generate profits or ensure freedom from losses. Each
individual's success depends on his or her background, dedication, desire, and motivation.

MATERIAL CONNECTION DISCLOSURE: You should assume that there is an affiliate relationship and/or another material connection to the
providers of goods and services mentioned in this writing and may be compensated when you purchase from a provider. You should
always perform due diligence before buying goods or services from anyone via the Internet or offline.

THE PERFORMANCE EXPERIENCED BY USER COMMENTS AND TESTIMONIALS, ON THIS PAGE AND/OR OUR WEB SITE, IS NOT WHAT
YOU SHOULD EXPECT TO EXPERIENCE. ALTHOUGH SAFERTRADER.COM ACCEPTS THE TESTIMONIALS IN GOOD FAITH,
SAFERTRADER.COM HAS NOT INDEPENDENTLY EXAMINED THE BUSINESS RECORDS OF ANY OF THE PROVIDERS AND THEREFORE HAS
NOT VERIFIED ANY SPECIFIC FIGURES OR RESULTS QUOTED THEREIN. THESE RESULTS ARE NOT TYPICAL, AND YOUR INCOME OR
RESULTS, IF ANY, WILL VARY AND THERE IS A RISK YOU WILL NOT MAKE ANY MONEY AT ALL. HOWEVER, NONE OF THE USERS HAVE,
BEEN INCENTIVIZED TO SUBMIT THEIR COMMENTS.

MATERIALS FROM OUR PROGRAM AND ON OUR WEBSITES MAY CONTAIN INFORMATION THAT INCLUDES OR IS BASED UPON
FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE SECURITIES LITIGATION REFORM ACT OF 1995. FORWARD-LOOKING
STATEMENTS GIVE OUR EXPECTATIONS OR FORECASTS OF FUTURE EVENTS. YOU CAN IDENTIFY THESE STATEMENTS BY THE FACT THAT
THEY DO NOT RELATE STRICTLY TO HISTORICAL OR CURRENT FACTS. THEY USE WORDS SUCH AS "ANTICIPATE," "ESTIMATE,"
"EXPECT," "PROJECT," "INTEND," "PLAN," "BELIEVE," AND OTHER WORDS AND TERMS OF SIMILAR MEANING IN CONNECTION WITH A
DESCRIPTION OF POTENTIAL EARNINGS OR FINANCIAL PERFORMANCE. ANY AND ALL FORWARD LOOKING STATEMENTS HERE OR ON
ANY OF OUR SALES MATERIAL ARE INTENDED TO EXPRESS OUR OPINION OF EARNINGS POTENTIAL. MANY FACTORS WILL BE
IMPORTANT IN DETERMINING YOUR ACTUAL RESULTS AND NO GUARANTEES ARE MADE THAT YOU WILL ACHIEVE RESULTS SIMILAR
TO OURS OR ANYBODY ELSES, IN FACT NO GUARANTEES ARE MADE THAT YOU WILL ACHIEVE ANY RESULTS FROM OUR IDEAS AND
TECHNIQUES IN OUR MATERIAL.

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Glossary of Option Terms

(A) ORGANIZED BY CATEGORY

Some very basic terms you may have heard before:

Bearish- an investor view that the stock market, or a stock price, will fall.

Bullish- an investor view that the stock market, or a stock price, will rise.

Neutral- an investor view that is neither bearish nor bullish.

Stock Options- give the holder the right to buy or sell particular shares at a fixed pre-
determined price within a fixed period of time. Stock options can be traded in the same way
that the underlying stock can be bought and sold.

Underlying Security- is the stock or index that an option taker has the right to buy or sell if
they choose to exercise.

Some terms that relate to the mechanics of stock options:

Bear Call Spread- This strategy is constructed by selling one call option while simultaneously
purchasing another call option with a higher strike price. The goal of this strategy is realized
when the price of the underlying stays below the lower strike price, which causes that
short option to expire worthless, resulting in the investor keeping the premium.

Bull Put Spread- This strategy is constructed by selling one put option while simultaneously
purchasing another put option with a lower strike price. The goal of this strategy is realized
when the price of the underlying stays above the higher strike price, which causes that
short option to expire worthless, resulting in the investor keeping the premium.

Call Options- give the holder the right to buy the underlying stock or index at a fixed pre-
determined price within a certain, fixed period of time.

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Contract Size- The amount of underlying stock covered by an option contract. In the U.S this
is normally 100 shares.

Expiry (Expiration)- This is the date at which the option contract expires. This cannot be
changed throughout the life of the option, and thereafter the contract is worthless.

Exercise- The process of fulfilling the put option contract and buying or selling the shares. This
can be done any time up to and including the option expiry date.

Iron Condor- This strategy is accomplished by establishing both a Bear Call Spread and a
Bull Put Spread with the same expiration date on the same underlying stock or index.

Margin- The amount of money the brokerage firm requires be available in your account to take
a particular position.

Premium- The amount you pay for the option contract. Each stock has set strike prices for
trading. Where the strike price is in relation to the current share price influences the amount
you pay. Premium is the sum of the option’s intrinsic value and its time value.

Put Options- give the holder the right to sell the underlying stock or index at a fixed pre-
determined price within a certain, fixed period of time.

Spread Margin- Is the amount of money you must have available in your account to take a
spread position like those employed with the Monthly Income Machine. At options-friendly
brokerage firms, the margin requirement represents the maximum theoretical possible loss that
could be realized on a spread if the investor remained in a position until the underlying stock or
index exceeded the strike prices of both parts of the spread.

When the strike prices are $5 apart, the margin is $500; when they are $10 apart, the margin is
$1,000, etc.

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Strike price- This is the fixed, pre-determined price at which you can buy or sell the shares.
This cannot be changed throughout the life of the option contract.

Taker- is a trader or investor who buys an option.

Writer- is a trader or investor who sells an option.

Some terms that relate to the pricing and values of stock options:
At-the-Money- when an options strike price is the same as the current stock price, it is said to
be at-the-money.

Fair Value- is used to describe the value of an option as calculated by a mathematical model.
Also used to indicate intrinsic value.

In-the-Money- A call option is in-the-money when the underlying stock price is higher than the
strike price of the call, and a put option is in-the-money when the stock price is below the strike
price. The option would have intrinsic value.

Intrinsic Value- is the difference between the current stock price and the option’s strike price.
This is the amount by which an option is in-the-money, and indicates the value of an option if it
were to expire right now.

Out-of-the-Money- A call option is out-of-the-money when the stock price is below the strike
price, and a put option is out-of-the-money when the stock price is higher than the strike price.
The option would have no intrinsic value.

Theoretical Value- The price of an option as calculated by a mathematical model.

Time Decay- Options are made up of time value and intrinsic value. As you get closer to the
expiry date, the option value diminishes. This is called time decay. When you buy an option,
you are buying time.

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Time Value- is the difference between an options current value and the intrinsic value.

Overvalued- describes a stock trading at a higher price than it logically should.

Undervalued- describes a stock that is trading at a lower price than it logically should.

Some terms you will run into when talking with a broker or when
placing orders online:

Ask Price- is the price at which an option seller (writer) is willing to sell. We buy option
contracts and stocks at their ask price.

Bid Price- is the price at which an option buyer (taker) is willing to buy.

Bid/Ask Spread- is the difference in price between the bid and ask price of an option contract.
Option contracts that are heavily traded (liquid) tend to have a tighter Bid/Ask Spread and
option contracts that are thinly traded (less liquid) have a wider Bid/Ask Spread.

Buy To Close- is an order to close your position. It simply means you are buying back an
option contract that you have previously sold short.

Buy to Open- is an order in option trading to open a position through buying that option
contract. You are said to be long that option.

Closing Order- is an order placed to close an open position, whether it be a sell to close or a
buy to close order.

Day Order- an order that expires at the end of the trading day if it is not filled.

Day trading- is the process of making multiple trades that are opened and closed all within the
same trading day.

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Discount Broker- is a brokerage firm that offers low commission rates.

Early Exercise- is the exercise of an option contract before its expiry date.

Full Service Broker- is a broker you deal directly with to execute all transactions and orders.
They come with higher fees, but typically provide more “hand holding.”

Good Until Canceled Order- is an order that remains effective until it is cancelled or filled.

Leg In- is a technique of establishing part of a position now and the rest of the position later.

Limit Order- is an order to buy or sell options at a certain, or limited price.

Long- to be long is to own a stock or option.

Mark- specifies the broker is to use the midpoint between the bid and ask, rather than the bid
or ask itself, in determining price at which an order is to be triggered.

Market Order- is an order to buy or sell options at the current market price.

Naked Short Option or Uncovered Short Option- is when an investor writes (sells) an option
he does not currently own AND he does not own the underlying security. This is an
EXTREMELY DANGEROUS position.

Online Broker- many brokerage firms offer an online trading platform that allows you to
control your orders with the click of a mouse. The fees are usually a fraction of the full service
brokers’.

Options-Friendly Brokerage- is critical to the maximum profitability of the Monthly Income

Machine. Refers to a brokerage firm that offers low commissions, powerful and easy to use

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trading platform, cost-free quotes and other real-time data needed for analyzing potential
trades. Most importantly, requires margin on only one side of an Iron Condor.

Position- used to describe the number and strategy currently open. i.e. if you had bought 12
November $20 call option contracts on XYZ Company, your position would be “long 12 XYZ
Nov $20 calls.”

Sell To Close- is an order to close out an open position through selling that option contract.
This really means you are selling an option contract that you own.

Sell To Open- is an order to open a position by selling (writing) an option contract to a buyer.
You are said to have sold short that option.

Short- to be short means to sell (or write) to a buyer an options contract you don’t currently
own.

Short Term Options Trading- to buy and sell stock or index options within a period of time no
more than 4 weeks in total.

Some things that may affect our decisions when to enter or exit a
position:

Fundamental Analysis- is the study of a company’s financial structure and results in order to
form an opinion as to future share price movements.

Greeks- are a set of mathematical criteria used to calculate stock option prices.

Liquidity- is the ease at which a purchase or sale can be made. Heavily traded stocks have
better liquidity.

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Open Interest- is the total number of outstanding open contracts in a particular option series.
Opening transactions increase the open interest, while a closing transaction reduces it.

Resistance- is a term used in technical analysis to recognize a price level, or ceiling, that is
higher than the current stock price and where the stock has previously traded and then fallen
back.

Return on Investment- is the percentage of profit that you make on an investment.

Reward / Risk Ratio- is a measure of how risky a position would be. Divide the maximum
profit potential by the maximum loss potential, and a ratio of above 1 means that the potential
reward is greater than the potential loss.

Stop Loss- is a pre-determined price at which you have decided to exit a position once it is hit.

Stop Order- is a traditional stop loss where your broker will close a position when a
predetermined price is hit.

Support- is a term in technical analysis indicating a price level, or floor, lower than the current
price of the stock, where demand is thought to exist. This indicates that the stock may stop
declining when it reaches this level.

Technical Analysis- is the study of price movements in order to form an opinion of future
possible price movements. The use of stock or index price charts is a common example of
technical analysis.

Trend- the direction of a stock or index price movement.

Volatile- a stock market or stock price that fluctuates significantly up or down over a short time
span is referred to as volatile.

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Volatility- is a measure of the amount by which an underlying stock is expected to vary or

fluctuate in a given period of time.

Volume- refers to the number of transactions that took place in a trading day. This indicates
the number of buyers and sellers in the market.

VIX- stands for Volatility Index and is a measure of market expectations with respect to
volatility and whether or not current market sentiment is excessively bullish or bearish.

And a few strays:

American Style Option- is an option contract that may be exercised at any time up until and
including the expiry date. Most exchange-traded options are American-style.

Derivatives- are financial instruments whose value is derived in part from the value and
characteristics of another financial instrument. Stock Options are derivatives of the underlying
stock

European Style Option- is an option that may only be exercised at expiry and not before.

Hedge- to protect against potential losses.

Index- is a compilation of the prices of companies related in size, type, or other criteria into a
single number, such as the S&P 500, the Russell 2000, the Nasdaq, and the Dow Jones.

Index Option- is an option whose underlying security is an index. Generally index options are
cash-based.

Leverage- is the power to achieve greater profit potential with a smaller amount of money.
Options offer high leverage.

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Market Maker- is a member of the exchange whose purpose is to aid in the making of a
market, by making bids and offers when there are no public buy or sell orders.

Realize- once you have closed an open position you will realize a profit or loss.

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Glossary of Option Terms

(B) ORGANIZED ALPHABETICALLY
American Style Option- is an option contract that may be exercised at any time up until and
including the expiry date. Most exchange-traded options are American-style.

Ask Price- is the price at which an option seller (writer) is willing to sell. We buy option
contracts and stocks at their ask price.

At the Money- when an options strike price is the same as the current stock price, it is said to
be at the money.

Bear Call Spread- This strategy is constructed by selling one call option while simultaneously
purchasing another call option with a higher strike price. The goal of this strategy is realized
when the price of the underlying stays below the lower strike price, which causes that
short option to expire worthless, resulting in the investor keeping the premium.

Bearish- an investor view that the stock market, or a stock price, will fall.

Bid/Ask Spread- is the difference in price between the bid and ask price of an option contract.
Option contracts that are heavily traded (liquid) tend to have a tighter Bid/Ask Spread and
option contracts that are thinly traded (less liquid) have a wider Bid/Ask Spread.

Bid Price- is the price at which an option buyer (taker) is willing to buy.

Bullish- an investor view that the stock market, or a stock price, will rise.

Bull Put Spread- This strategy is constructed by selling one put option while simultaneously
purchasing another put option with a lower strike price. The goal of this strategy is realized

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when the price of the underlying stays above the higher strike price, which causes that
short option to expire worthless, resulting in the investor keeping the premium.

Buy To Close- is an order to close your position. It simply means you are buying back an
option contract that you have previously sold short.

Buy to Open- is an order in option trading to open a position through buying that option
contract. You are said to be long that option.

Call Options- give the holder the right to buy the underlying stock or index at a fixed pre-
determined price within a certain, fixed period of time.

Closing Order- is an order placed to close an open position, whether it be a sell to close or a
buy to close order.

Contract Size- The amount of underlying stock covered by an option contract. In the U.S this
is normally 100 shares..

Day Order- an order that expires at the end of the trading day if it is not filled.

Day trading- is the process of making multiple trades that are opened and closed all within the
same trading day.

Derivatives- are financial instruments whose value is derived in part from the value and
characteristics of another financial instrument. Stock Options are derivatives of the underlying
stock

Discount Broker- is a brokerage firm that offers low commission rates.

Early Exercise- is the exercise of an option contract before its expiry date.

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European Style Option- is an option that may only be exercised at expiry and not before.

Expiry (Expiration)- This is the date at which the option contract expires. This cannot be
changed throughout the life of the option, and thereafter the contract is worthless.

Exercise- The process of fulfilling the put option contract and buying or selling the shares. This
can be done any time up to and including the option expiry date.

Fair Value- is used to describe the value of an option as calculated by a mathematical model.
Also used to indicate intrinsic value.

Full Service Broker- is a broker you deal directly with to execute all transactions and orders.
They come with higher fees, but typically provide more “hand holding.”.

Fundamental Analysis- is the study of a company’s financial structure and results in order to
form an opinion as to future share price movements.

Good Until Canceled Order- is an order that remains effective until it is cancelled or filled.

Greeks- are a set of mathematical criteria used to calculate stock option prices.

Hedge- to protect against potential losses.

Index- is a compilation of the prices of several common entities into a single number, such as
the S&P 500, the Russell 2000, the Nasdaq, and the Dow Jones.

Index Option- is an option whose underlying security is an index. Generally index options are
cash-based.

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In the Money- A call option is in-the-money when the underlying stock price is higher than the
strike price of the call, and a put option is in-the-money when the stock price is below the strike
price. The option would have intrinsic value.

Intrinsic Value- is the difference between the current stock price and the option’s strike price.
This is the amount by which an option is in-the-money, and indicates the value of an option if it
were to expire right now.

Iron Condor- This strategy is accomplished by establishing both a Bear Call Spread and a
Bull Put Spread with the same expiration date on the same underlying stock or index.

Leg In- is a technique of establishing part of a position now and the rest of the position later.

Leverage- is the power to achieve greater profit potential with a smaller amount of money.
Options offer high leverage.

Limit Order- is an order to buy or sell options at a certain, or limited price.

Liquidity- is the ease at which a purchase or sale can be made. Heavily traded stocks have
better liquidity.

Long- to be long is to own a stock or option.

Margin- The amount of money the brokerage firm requires be available in your account to take
a particular position.

Mark- specifies the broker is to use the midpoint between the bid and ask, rather than the bid
or ask itself, in determining price at which an order is to be triggered.
Market Maker- is a member of the exchange whose purpose is to aid in the making of a
market, by making bids and offers when there are no public buy or sell orders.

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Market Order- is an order to buy or sell options at the current market price.
Limit Order an order to buy or sell options at a certain, or limited price.

Naked Short Option or Uncovered Short Option- is when an investor writes (sells) an option
he does not currently own AND he does not own the underlying security. This is an
EXTREMELY DANGEROUS position.

Neutral- an investor view that is neither bearish nor bullish.

Online Broker- many brokerage firms offer an online trading platform that allows you to
control your orders with the click of a mouse. The fees are usually a fraction of the full service
brokers’.

Open Interest- is the total number of outstanding open contracts in a particular option series.
Opening transactions increase the open interest, while a closing transaction reduces it.

Options-Friendly Brokerage- is critical to the maximum profitability of the Monthly Income

Machine. Refers to a brokerage firm that offers low commissions, powerful and easy to use
trading platform, cost-free quotes and other real-time data needed for analyzing potential
trades, knowledgeable and responsive customer service, etc. Most importantly, requires
margin on only one side of an Iron Condor.

Out of the Money- A call option is out-of-the-money when the stock price is below the strike
price, and a put option is out-of-the-money when the stock price is higher than the strike price.
The option would have no intrinsic value.

Overvalued- describes a stock trading at a higher price than it logically should.

Position- used to describe the number and strategy currently open. i.e. if you had bought 12
November $20 call option contracts on XYZ Company, your position would be “long 12 XYZ
Nov $20 calls.”

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Premium- The amount you pay for the option contract. Each stock has set strike prices for
trading. Where the strike price is in relation to the current share price influences the amount
you pay. Premium is the sum of the option’s intrinsic value and its time value.

Put Options- give the holder the right to sell the underlying stock or index at a fixed pre-
determined price within a certain, fixed period of time.

Realize- once you have closed an open position you will realize a profit or loss.

Resistance- is a term used in technical analysis to recognize a price level, or ceiling, that is
higher than the current stock price and where the stock has previously traded and then fallen
back.

Return on Investment- is the percentage of profit that you make on an investment.

Reward / Risk Ratio- is a measure of how risky a position would be. Divide the maximum
profit potential by the maximum loss potential, and a ratio of above 1 means that the potential
reward is greater than the potential loss.

Sell To Close- is an order to close out an open position through selling that option contract.
This really means you are selling an option contract that you own.

Sell To Open- is an order to open a position by selling (writing) an option contract to a buyer.
You are said to have sold short that option.

Short- to be short means to sell (or write) to a buyer an options contract you don’t currently
own.

Short Term Options Trading- to buy and sell stock or index options within a period of time no
more than 4 weeks in total.

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Spread Margin- Is the amount of money you must have available in your account to take a
spread position like those employed with the Monthly Income Machine. At options-friendly
brokerage firms, the margin requirement represents the maximum theoretical possible loss that
could be realized on a spread if the investor remained in a position until the underlying stock or
index exceeded the strike prices of both parts of the spread.

When the strike prices are $5 apart, the margin is $500; when they are $10 apart, the margin is
$1,000, etc.

Stop Loss- is a pre-determined price at which you have decided to exit a position once it is hit.

Stock Options- give the holder the right to buy or sell particular shares at a fixed pre-
determined price within a fixed period of time. Stock options can be traded in the same way
that the underlying stock can be bought and sold.

Stop Order- is a traditional stop loss where your broker will close a position when a
predetermined price is hit.

Strike price- This is the fixed, pre-determined price at which you can buy or sell the shares.
This cannot be changed throughout the life of the option contract.

Support- is a term in technical analysis indicating a price level, or floor, lower than the current
price of the stock, where demand is thought to exist. This indicates that the stock may stop
declining when it reaches this level.

Taker- is a trader or investor who buys an option.

Technical Analysis- is the study of price movements in order to form an opinion of future
possible price movements. The use of stock or index price charts is a common example of
technical analysis.

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Theoretical Value- The price of an option as calculated by a mathematical model.

Time Decay- Options are made up of time value and intrinsic value. As you get closer to the
expiry date, the option value diminishes. This is called time decay. When you buy an option,
you are buying time.

Time Value- is the difference between an options current value and the intrinsic value.

Trend- the direction of a stock or index price movement.

Underlying Security- is the stock or index that an option taker has the right to buy or sell if
they choose to exercise.

Undervalued- describes a stock that is trading at a lower price than it logically should.

VIX- stands for Volatility Index and is a measure of market expectations with respect to
volatility and whether or not current market sentiment is excessively bullish or bearish.

Volatile- a stock market or stock price that fluctuates significantly up or down over a short time
span is referred to as volatile.

Volatility- is a measure of the amount by which an underlying stock is expected to vary or

fluctuate in a given period of time.

Volume- refers to the number of transactions that took place in a trading day. This indicates
the number of buyers and sellers in the market.

Writer- is a trader or investor who sells an option.

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Notes

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