A Quick and Easy Guide to Option Credit Spreads

10/15/2009 12:01 am EST


Kenneth Trester

Editor, Maximum Options

In my Maximum Options trading service, we employ a strategy where we not only expect options prices to drop to zero, but we strive for it and position ourselves to take advantage of it with option credit spreads. Why? Because someone else's loss becomes our gain!

Simply put, credit spreads work by simultaneously writing (or selling) a call or put option and buying the same type of option with a lower strike price on the same stock and expiration date. When you employ a credit spread, you are simply buying one option to "cover" the risk you take when you write the other option.

We've had a lot of success with credit spreads over the years, but we hit some home runs recently while everyone else was flailing. One of our latest wins used a credit spread on a pair of Dow Jones Index calls.

Specifically, we recommended that readers sell the Dow Jones calls at the $142 strike price and buy the Dow Jones calls at the $138 strike at the same time for a spread credit income of 40 cents or higher. Both of these calls were in the same expiration month, which was August.

Let's walk through the trade as though you were executing it. For illustrative purposes, we'll say the August 142 calls were priced at $1 and the August 138 calls were priced at 60 cents.

The reason we're choosing prices for example purposes is because when you enter a spread trade, the price you pay for the individual parts of the trade doesn't really matter, just as long as your broker gets you into the trade for a set price. In this case, as long as you collected at least 40 cents when you initiated the spread, you were starting off on the right foot.

If we wrote (or sold) the August 142 calls, our account would be credited with $100 (the $1-per-share price multiplied by 100 shares in a contract). Then we would buy the August 138 calls, which would be a debit to our account of $60 (60 cents x 100).

Our goal, then, was for both the $142 calls and $138 calls to expire worthless, so that we could keep our $40 credit. (Or a $100 credit from the sold calls minus the $60 debit to buy one call contract.)

The savvy investor might ask, "Why even bother with buying the calls for a debit at all?" The answer involves reducing risk.

If we did not buy the $138 calls, we would have otherwise been writing a "naked" call. This means that if someone who was a buyer of the calls we sold for upfront profit decided to exercise them, then we would be obliged to come up with 100 shares of Dow Jones Index stock—and there's no telling how much we'd have to pay for each share. We could easily lose our initial investment 100 times over.

With the calls we purchased, they served as an inexpensive insurance policy. In this trade, we were betting that the stock would stay below $138, the level of the lower strike price (and the call option that we bought). If the stock traded up through the higher strike price ($142), the call buyer would have likely chosen to exercise his or her right to buy stock at that price.

Our long calls at the $138 strike, then, would give us the right to buy stock and turn around to sell it (for a loss) at $142 a share. However, those long $138 calls would have helped us to cap our losses at $5 per share (or $500 per contract).

If we didn't have them and the stock traded up to $150, then we would have had to buy shares at $150 and been forced to sell them at $142. And that's assuming we had enough money in our trading accounts to cover that kind of expenditure. Ouch!

This trade worked wonderfully in our favor since the Dow dipped just as we expected it would. Thus, the call options did in fact expire worthless.

In order for the trade to have moved away from us, the Dow would've had to have risen 2.5% before expiration Friday. But as you may remember, the Dow didn't start rising again until that day, and it didn't move enough to make a difference insofar as our trade.

Bottom line: If you'd bought ten contracts, you would have made a cool $400 in less than two weeks. Any way you slice it, it's a nice 100% return as you got to keep the money you collected at the outset of the trade.

This trade is a great illustration of why options investing really is an all-seasons strategy, and credit spreads in particular can pave a path to profits no matter how challenging the overall trading conditions may be.

By Ken Trester, owner of MaximumOptions.com

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