Spread the Word
Investor’s Daily Edge
August 15, 2007
By Chris Johnson
Over the past few weeks, I’ve been busy putting together a new service that takes advantage of one of my favorite strategies. I like it because it is very forgiving. In fact, it benefits if a stock doesn’t move and can yield a maximum profit even if the stock moves somewhat against your directional view.
The strategy is a credit spread, which involves the simultaneous purchase and sale of either puts or calls with the same expiration. If you believe a stock will stay flat or move higher, the credit spread involves buying and selling puts. If you are neutral to bearish, you do the same with calls. I prefer to use out-of-the-money options, buying the option that is further out of the money and selling the option with a strike price closer to the stock price. Because the near-the-money option has more premium, you collect a net credit when opening this trade.
The goal of a credit spread is for both options to remain out of the money through expiration. If that happens, both options expire worthless and you retain the premium, without incurring any extra commission costs.
Let’s look at an example trade from earlier this week using the S&P SPDR (SPY), which opened at 144.71 on Monday. My thinking was that SPY would stay flat or drop over the next week. I could have opened a bearish credit spread in which I sell the August 149 call for $0.60 and buy the August 150 call for $0.45. The net credit is therefore $0.15, or $15 per pair of contracts. This spread was about three percent out of the money. That is, SPY would have to move three percent higher before the sold call is in the money.
There is a margin requirement for credit spreads equal to the width of the spread (one point in this case) minus the amount of credit collected. So the margin for our example is $0.85 or $85 per pair of contracts. The return on margin is simply the credit received ($15) divided by the margin ($85), or 17.6 percent. That may not sound very attractive for an option strategy, but considering that the trade would be in effect for only a week (August options expire on Friday), nearly 18 percent for a few days is very handsome indeed.
My goal with this trade is for SPY to remain below the sold call strike – 149 – through option expiration (the end of this week). If that happens, both options will expire out of the money (worthless) and I keep the credit for a 17.6-percent return.
This trade points out two important advantages of credit spreads. First, the trade will achieve its maximum return over a wide range of outcomes. Note in my example how SPY can move higher – against my expectations – by more than four points (or three percent) and I still achieve the maximum outcome because the sold 149 call remains out of the money. So I can be wrong about direction (to a certain degree, of course) and still be very successful. There aren’t too many strategies that can make that claim!
The second advantage is that a winning trade involves no extra commission costs. Both options expire worthless, and no additional actions are required. You just pocket your winnings! This increases the net profit, although you also must recognize that two commissions are required to enter the trade.
I prefer to trade credit spreads using front-month, out-of-the-money options. Typically, I’ll trade these spreads with a week or less remaining until expiration (such as this week). Why? Because I’m using out-of-the-money options, their premium is comprised totally of time value. Remember that options undergo time decay such that there is no time value remaining at expiration. Furthermore, this time decay increases as an option approaches expiration.
Therefore, I am trading these spreads when time value is undergoing its greatest decay, which is an advantage to me. I want the options to be worthless, so trading them close to expiration gives me the greatest decay and gives the underlying stock or index less time to move such that my sold option could move into the money.
Before playing a spread, keep these pointers in mind. First, the key is not for the stock to move in your direction, but for it to not move against you to the point where your sold option is in the money. Unlike buying an option, direction and speed of movement are not important. You gain no extra benefit if the stock moves in your favor, as the value of your trade will not increase beyond the credit received. But you can be hurt if the stock moves against you.
Second, understand the variables in play with credit spreads. You can adjust the width of your spread (the difference between the options’ strike prices) to alter the credit received. A bigger spread results in greater credit. But the wider the spread, the less protection you have until the “insurance” of your purchased option kicks in. You’ll also have to put up more margin as the spread widens. The art of playing a spread is to juggle the credit, spread width, and the amount the sold option is out of the money. You’ll of course receive more premium if the option is closer to the money. But the risk of that option moving into the money, and thus of being assigned (having the option exercised), also increases.
As of Wednesday, SPY had sunk below 143, pushing the 149 and 150 calls further out of the money. Both options were bid at five cents, meaning that they are approaching my goal of expiring worthless. Of course, SPY could come roaring back, especially given the current market environment. But I also have the option of closing the spread out, which at this point would probably net me a small profit.
Playing credit spreads is a great way to make small profits with a high win rate. They can be used in any type of market, especially with trading ranges, where directional moves are contained. Try paper trading these spreads for a few months (just before expiration) to get a feel for how they work. Once you’re comfortable with their behavior, they’ll be a great addition to your trading arsenal.
Stay tuned for my new credit spread service that should be launching soon. I’ll tell you more about it in the coming weeks in my IDE columns.
Have a great trading week.
Over the past few weeks, I’ve been busy putting together a new service that takes advantage of one of my favorite strategies. I like it because it is very forgiving. In fact, it benefits if a stock doesn’t move and can yield a maximum profit even if the stock moves somewhat against your directional view.
The strategy is a credit spread, which involves the simultaneous purchase and sale of either puts or calls with the same expiration. If you believe a stock will stay flat or move higher, the credit spread involves buying and selling puts. If you are neutral to bearish, you do the same with calls. I prefer to use out-of-the-money options, buying the option that is further out of the money and selling the option with a strike price closer to the stock price. Because the near-the-money option has more premium, you collect a net credit when opening this trade.
The goal of a credit spread is for both options to remain out of the money through expiration. If that happens, both options expire worthless and you retain the premium, without incurring any extra commission costs.
Let’s look at an example trade from earlier this week using the S&P SPDR (SPY), which opened at 144.71 on Monday. My thinking was that SPY would stay flat or drop over the next week. I could have opened a bearish credit spread in which I sell the August 149 call for $0.60 and buy the August 150 call for $0.45. The net credit is therefore $0.15, or $15 per pair of contracts. This spread was about three percent out of the money. That is, SPY would have to move three percent higher before the sold call is in the money.
There is a margin requirement for credit spreads equal to the width of the spread (one point in this case) minus the amount of credit collected. So the margin for our example is $0.85 or $85 per pair of contracts. The return on margin is simply the credit received ($15) divided by the margin ($85), or 17.6 percent. That may not sound very attractive for an option strategy, but considering that the trade would be in effect for only a week (August options expire on Friday), nearly 18 percent for a few days is very handsome indeed.
My goal with this trade is for SPY to remain below the sold call strike – 149 – through option expiration (the end of this week). If that happens, both options will expire out of the money (worthless) and I keep the credit for a 17.6-percent return.
This trade points out two important advantages of credit spreads. First, the trade will achieve its maximum return over a wide range of outcomes. Note in my example how SPY can move higher – against my expectations – by more than four points (or three percent) and I still achieve the maximum outcome because the sold 149 call remains out of the money. So I can be wrong about direction (to a certain degree, of course) and still be very successful. There aren’t too many strategies that can make that claim!
The second advantage is that a winning trade involves no extra commission costs. Both options expire worthless, and no additional actions are required. You just pocket your winnings! This increases the net profit, although you also must recognize that two commissions are required to enter the trade.
I prefer to trade credit spreads using front-month, out-of-the-money options. Typically, I’ll trade these spreads with a week or less remaining until expiration (such as this week). Why? Because I’m using out-of-the-money options, their premium is comprised totally of time value. Remember that options undergo time decay such that there is no time value remaining at expiration. Furthermore, this time decay increases as an option approaches expiration.
Therefore, I am trading these spreads when time value is undergoing its greatest decay, which is an advantage to me. I want the options to be worthless, so trading them close to expiration gives me the greatest decay and gives the underlying stock or index less time to move such that my sold option could move into the money.
Before playing a spread, keep these pointers in mind. First, the key is not for the stock to move in your direction, but for it to not move against you to the point where your sold option is in the money. Unlike buying an option, direction and speed of movement are not important. You gain no extra benefit if the stock moves in your favor, as the value of your trade will not increase beyond the credit received. But you can be hurt if the stock moves against you.
Second, understand the variables in play with credit spreads. You can adjust the width of your spread (the difference between the options’ strike prices) to alter the credit received. A bigger spread results in greater credit. But the wider the spread, the less protection you have until the “insurance” of your purchased option kicks in. You’ll also have to put up more margin as the spread widens. The art of playing a spread is to juggle the credit, spread width, and the amount the sold option is out of the money. You’ll of course receive more premium if the option is closer to the money. But the risk of that option moving into the money, and thus of being assigned (having the option exercised), also increases.
As of Wednesday, SPY had sunk below 143, pushing the 149 and 150 calls further out of the money. Both options were bid at five cents, meaning that they are approaching my goal of expiring worthless. Of course, SPY could come roaring back, especially given the current market environment. But I also have the option of closing the spread out, which at this point would probably net me a small profit.
Playing credit spreads is a great way to make small profits with a high win rate. They can be used in any type of market, especially with trading ranges, where directional moves are contained. Try paper trading these spreads for a few months (just before expiration) to get a feel for how they work. Once you’re comfortable with their behavior, they’ll be a great addition to your trading arsenal.
Stay tuned for my new credit spread service that should be launching soon. I’ll tell you more about it in the coming weeks in my IDE columns.
Have a great trading week.
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