You may or could not have heard of credit spread option trading but they can be used to profit in bullish, neutral or bearish conditions.
They are a cashflow generating strategy that involves both the buying and selling of either calls or puts of different strike prices but same expiration date to establish an overall ‘credit’ i.e. spendable money.
It is a wonderful alternative trading technique for taking advantage of the ‘time decay’ that option selling provides, but with limited risk.
The amount of prospective profit of course is limited to the credit received when the trade is initial made.
Let me give you an example of this powerful, yet underutilized choice trading technique.
Let’s say that the QQQQ (The Nasdaq 100 tracking unit) is trading at .50 and we believe that it will continue to go up in cost.
To produce a vertical credit spread using puts (selling puts is profitable if the marketplace rises), we could do the following:
1) Sell the put (expiring this month).
and
2) Buy the put (expiring this month).
TIP:
In my experience, it’s often very best to sell short-term, ‘Out-of-the-money’ choice premium for 3 main reasons:
1) Out of the cash possibilities have lower deltas, meaning the stock has to move further prior to the value of our sold alternative increases (bear in mind we want it to decrease).
2) Selling ‘current month’ options (30 days or much less to expiry) is when time decay is at it’s most rapid and the value of our sold option is eroding away with each day.
3) Contrary to buying options, if the stock does moves quite little or not at all, we win!
Let’s say we received .90 cents per contract for selling the puts and we paid .40 cents per contract by buying the puts.
This transaction gives us an overall credit of .50 cents per contract (.90-.40).
If we sold 20 contracts of the Put and bought 20 contracts of the Put, this would give us a total credit of ,000 (2000 shares x .50 cents).
So essentially, if QQQQ expires at any cost above we will make our maximum profit, which is the initial credit we received (.50 cents).
On the other hand if QQQQ expires at any cost below our breakeven point of .50, we will be facing a loss.
Let’s look at all the possibilities.
Once we have entered the trade the QQQQ can either:
1)Go up a little bit.
2)Go up a lot.
three)Go sideways.
4)Go down a little bit.
5)Go down a lot.
The beauty of this style of trading is that we will win in four out of five of these situations, and in many instances we can even win in all five!
Let me demonstrate how.
The QQQQ is trading at 30.50, if it moves up a little bit to say .80, our sold alternative ( Put) will expire worthless and we will keep all of the premium.
If the QQQQ moves up a lot to say , the same will occur and we will get to maintain the premium.
If the QQQQ moves sideways and stays around .50, once more the ( Put) will expire worthless and we will get to maintain the premium.
If the QQQQ goes down a little bit to say .15, the exact same will occur and we will keep the premium.
OK, so far so good!
The only way we can LOSE in this trade is if the QQQQ goes down a lot to below .50 (which is the higher strike cost minus the premium).
If it were the end of the month of expiry and the QQQQ was trading below (our sold alternative strike cost) we would be exercised and our total loss would be the distinction between the sold option strike price and the current stock cost much less the total credit we received.
Our maximum loss will be realized at any price at or below our bought option strike price.
– = , less the premium of .50 cents = a maximum loss of .50 cents per contract or 00 (20 contracts – 200 shares x .50 cents)
However, prior to it gets to this point, we would intervene. If the QQQQ is falling strongly then we had been obviously wrong in our initial analysis.
Just before we entered the trade though, we decided that if the QQQQ fell by way of support at (which it does) we would move to plan B.
At this point we can do a little ‘magic’.
With the click of a mouse by means of our on-line broker, we can immediately jump from the bullish camp to the bearish camp!
We do this by buying back the choices that we sold which in this case is the puts, and this removes all of our obligation.
At this point though, we have taken a loss BUT, we are still long the puts which would have already increased in value.
If the QQQQ wants to go down, then we are going to let it and just ride the puts as far as they will go.
The more the QQQQ falls in cost, the far more our option will increase in value.
If it falls far enough, which in this case it does, (falling to .50) then we will not only make all our cash back, we will begin to move into a profitable position.
With credit spreads, we give ourselves the flexibility to change our position mid stream, and the chance to not only recoup some of our losses (if we get it wrong), but to possibly move from a loss into a PROFIT!
And this is just the plan B if things go wrong. Plan A, on it’s own, has statistically, a very high probability of success.
If on the other hand we had the view that the QQQQ would go down, we would basically construct a vertical spread with Out-of-the-cash Calls.
We would sell the Call and buy the Call for an overall credit and must the QQQQ close below by the end of the month, the spread would expire worthless and we would just maintain the premium.