Option Credit Spread Strategy: An Opportunity For Success

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By Greg Jensen
Founder and CEO, OptionsANIMAL

Every trade has a personality. Every trade represents an opportunity for success and an opportunity for failure. The choices you make about what, when, and how much define your success. You make those choices based on the personality of the particular trade. Options are perhaps the most personality driven of all trading instruments.

Understanding the different strategies available for use in options trading is like a golfer understanding the different clubs in his/her bag. A driver in a very useful club, but should not be used in every situation on the golf course. It is awfully hard to putt with your driver. It is equally as hard to chip out of the sand with a putter. Let us look at a pretty common personality for options—a bullish credit spread—and how that personality should be played in the market: just like the right club should be played on the golf course.

A bullish credit spread should not be used in every scenario in the market. It is important for you, as a trader, to know the different trading tools available for any market scenario. Meet a bullish credit spread here, and understand its personality.

                                         Profit/Loss Diagram of Bull Put Spread

 

 

One of the key tradingtools I employ regularly is the bullish put vertical, or Bull Put.This trade is applied in a stagnant or stagnant-to-bullish trend. The bullish trend can be slight, moderate, or accelerated. You will be selling a Put and buying a Put simultaneously. The Put that you short (sell) will be at a higher strike price than the Put that you long (buy), and therefore you will generate a credit to your account. This credit is your maximum profit. The strategy with this trade is to capture the effects of time decay on the option sold, as well as take advantage of a bullish move in the stock. The put option that you long (buy) is your hedge, in case the stock moves quickly in the other direction.

Primary and Secondary Exit Strategies

As with all trades it is important to have both a primaryandsecondaryexitstrategy. If you miss the green on the golf course, what will you do to save par? The primary exit strategy for the Bull Put trade is to let both the long put and the short put options that you hold expire worthless. The added benefit to this exit strategy is that you will eliminate the commissions on the back end of the trade by simply allowing the options to expire worthless. The secondary exit strategy can involve either closing out the position for a small pre-determined loss or convert the trade into a collar trade. Let’s take a look at an example.

 

Example:

1. You “sell to open” a July 50 Put for XYZ Corp. @ $1.50 per share;

2. You “buy to open” a July 45 Put for XYZ Corp. @ $0.50 per share;

3. Your net credit for the trade: ($1.50 - $0.50) = $1.00;

4. With one contract per leg (a total of 2) you would generate a profit (credit) of $100.

 

Rules of the Game: Basic Rules to Follow When Applying Credit Spread Trades

1.  Use Out of the Money (OTM) options. Credit spreads can be written At The Money, but have a higher risk of assignment. By structuring this trade in a way where you are writing an option far from the current stock price, it increases your probability of success with the trade.

2.  Lookforoptionshighinimpliedvolatility. Overpriced options are generally a good thing to sell. Oftentimes there is a reason why implied volatility is high, so make sure there is not significant fundamental risk in the stock before placing.

3.  Use strike prices that are side by side. Try to stay to 5-point spreads when using short-term credit spread trades. You can go smaller if they are available. The closer together your spread, the lower your risk.

4.  Trade with the market trend. Do your due diligence. This is a trade that truly does follow the old saying, “The trend is your friend”.

5.  Where is the risk in this trade?

a. We have an OBLIGATION to buy the equity at the strike price of the short put;

b. We have the RIGHT to sell the same equity at the strike price of the long put;

c. Our risk is the difference between those two actions;

d. (However, we do get to keep the net credit.)

6.  Short Put is best placed at or below support.

7.  Do not place this trade during an option series where a scheduled news event (like earnings) could cause the equity to change its direction rapidly.

8.  Set a minimum and a maximum credit needed based on the time until expiration and your tolerance for risk.

9.  Time decay is an ally (this is a credit trade).

10. Long Put is used to minimize and control risk.

     a. You can use spreads as small as $1.00, when available, if you wish.

There is an old saying, “You’ll never go broke taking a profit.” This is the strategy behind credit spread trades. Put money in your pocket. It may not be a significant amount of money but, when structured correctly, these trades have a very high ratio of success. Winning more consistently is the single most important thing a trader can do. Understanding the personality of the trade will allow you to make the right decisions on how to play it, and increase your profitability. Trading, like golf, is a game of practice, discipline, and skill.

For more information on how to structure other trades like the Bull Put and how to adjust losing trades into winning trades, visit www.optionsanimal.com.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Options , Investing Ideas

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