The current market reminds me a lot of the price action back in 1994. There's one word for it: CHOPPY. Just when it looks stocks are ready to break out to the upside, they roll over and sell off. Just when things appear to be breaking down, we flip back up. So what's the best option strategy for choppy markets? I believe the answer is what's known as a credit spread.

Most options players think that when bullish, they want to buy calls.  But in less predictable, choppy environments, often a safer strategy results from being a net seller of puts.  The primary difference occurs from the role of time decay, as a call purchase must see the underlying rise to profit, while an out-of the money put sale can profit if the underlying stays flat or even declines somewhat. Yet I'm not a fan of selling "naked" options, as if a position explodes against you, the damage can be quite painful.  So what I do is I purchase another cheaper option as insurance. 

Here's an example (for illustration purposes only).  If you're bullish on the S&P 100 Index (OEX) at 550, and don't think it will drop below 540 by the June expiration, you could sell the June 540 put at 9 and at the same time buy the June 535 put at 8. On a 10-contract spread, this would net you $1000 before commissions.  Your biggest risk is if the index falls under 535 at the June expiration, at which point you would risk losing $4000 on the 10 contracts ($5000 risk between 460 and 455 strike prices minus the $1000 you initially collected).  If you're right about the index not dropping below 460 at the June expiration, you keep the initial $1000 collected, which provides a 25% return on the $4000 margin you have to put up to cover your worst-case risk.

Some people don't like the idea of risking $4000 to make $1000.  I understand that, but the key is what winning percentage you can generate.  Based on the scenarios where the market can rise, stay flat, or even drop by a little over 2% and you still win, you should be hitting on 80% or more of your trades in this approach.  I have seen streaks of 90%+ over some years. 

The risk is that you can lose all of what you put into a given trade, so risk must be managed in situations where the market is moving dramatically against the position. The other key is that you should not pyramid your profits in this strategy, but rather stay with a fixed number of contracts per trade.  This will prevent you from giving back too much of your profits when a loser does occur.

I personally like using the index options on S&P 100 Index (OEX), S&P 500 Index (SPX) and Nasdaq 100 Trust (QQQQ) for credit spreads.  You could use individual stocks with this strategy, but then you increase the company-specific risk that adverse news can cause a gap that takes you out of the game.  The indexes give the increased stability to allow you to apply the proper risk management to your trades. The liquidity in these index options contracts is also excellent overall.  When you place credit spread orders, you want to place them simultaneously and specify a net credit.  This further helps your ability to get filled quickly.

I usually establish a credit spread position on an index just once per month.  The goal is to see both options in the spread expire worthless, allowing the credit spread trader to pocket the initial credit collected.  This is possible due to the passage of time, which works in the favor of the credit spread trader, all other factors remaining roughly constant.  Generally most market conditions are appropriate for credit spreads.  Typically the credit spreads do best in periods when market volatility is relative stable or declining or increasingly slightly.  When volatility is dramatically spiking higher (usually in a sharp downturn), a bullishly-oriented position can get hurt from a quick adverse market move.   I measure the trend in volatility, and will tend not to initiate positions when volatility is trending higher.

Price Headley is the founder and chief analyst of BigTrends.com.