Credit: Shutterstock photoVolatility has been the name of the game on Wall Street during the past couple of weeks. In fact, from its high near 11,258 to its low of 9,869, the Dow Jones Industrial Average ( DJIA ) has traded in a 1,389-point range since April 26. What's more, the CBOE Market Volatility Index ( VIX ) tagged an annual high of 42.15 not too long ago. Aside from the market gyrations, this activity ultimately means higher options prices due to the rise in implied volatility. This means that when you go to buy that XYZ Communications Inc. ( XYZ ) 50-strike call, it will likely be more expensive. For the savvy options trader, however, there are ways to take advantage of elevated options prices.
One such strategy is known as the credit spread. Compared to other option plays designed to take advantage of elevated prices, this one is relatively tame, and allows you to benefit from a wide range of outcomes, including a modest move in the wrong direction. In fact, you start to lose money on a credit spread only when the sold option moves in the money. Even then, your losses on the position are limited to the difference between the sold and purchased options, minus the premium collected upon entering the position. But, I am getting ahead of myself.
Before we go any further, I want to preface today's column with a warning that credit spreads are limited-reward, limited-risk strategies. As such, you shouldn't enter into the trade expecting massive returns, as your initial credit is the most you will ever receive from the position. That said, the fact that these are limited-risk strategies makes them perfect for options traders who are still a little wet behind the ears.
With our expectations now appropriately set, let's explore this strategy a bit further. Let's say that you have followed XYZ shares for some time, and that you have seen the stock repeatedly bounce off support near $50 per share for the past several months. In fact, the stock even failed to breach this round-number level during the market's now infamous "flash crash." Furthermore, you've noticed that implied volatility on the stock's options is tracking significantly above XYZ's historical volatility. With the recent market volatility contributing to the mix, the equity's put options are considerably pricey, even as the shares near a solid level of technical support
The Credit Spread
Given this setup, you could initiate a credit spread position on XYZ. To do so, you would sell one front-month, out-of-the-money put at the 50 strike (home to the long-term support you have witnessed while following the shares), and buy one deeper out-of-the-money front-month put. You want to focus on the option series that is the closest to expiration in order to limit the time remaining in which the stock could move against your position. Remember, you want the shares to remain above the sold put, thus allowing time value to erode. This is why your knowledge of the underlying stock is important, especially if you are attempting to take advantage of historically high levels of volatility.
Assuming that XYZ is trading at $54 per share, you sell the 50 put and buy the 48 put for a combined premium of $1. This is the maximum profit attainable on this trade. You can adjust your maximum profit by moving the purchased put deeper out of the money, but doing so increases your risk. For example, with the strikes above, your maximum loss is $1 -- the difference between the two strikes (50 - 48) minus the credit received. However, if you purchased the 45-strike put instead, you may end up with a combined premium of $1.50, but your maximum loss would increase to $3.5 -- (50 - 45) - 1.5.
Finally, breakeven on this position is $49 per share, and is calculated by subtracting the net credit from the sold strike. Below is a graph of the potential profit/loss scenarios for this example:
Margin Requirements
Since the bullish credit spread involves selling an option, your brokerage firm could require you to maintain a margin account. The minimum margin requirement represents the most the position could lose. In this case, the minimum required in margin equals the difference between the strike prices of the sold and purchased options, less the credit received. This value is then multiplied by 100. In our example, the margin requirement would be $100 per pair of contracts ([50 - 48] - 1 x 100).
Knowing your margin requirement is also key to calculating your overall return on a credit spread position. Typically, such returns are calculated by dividing the credit pocketed by the margin requirement. In this example, the return on the credit spread would be 10%.
Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
