As a trader, you probably know you can buy to open, or go long, a call option as a proxy for buying a stock. And you can buy to open a put option instead of shorting a stock. If you're ready to take your trading to the next level, one of my time-tested strategies is options spreads that combine two or more long and short options to collect options premium while lowering our risk and capital required.
Options spreads don't carry the same risks that a "short" option does, and, in fact, provide some additional benefits to just buying stocks and options such as getting paid up front and taking advantage of the wasting nature of options.
In addition, options spreads can be used to profit from either bullish or bearish market moves and can be very profitable during a fast-moving market when traders are particularly uncertain.
When you open a spread you are buying to open one option and then selling to open another with a strike price that is a little further out of the money than the put you purchased.
For example, let's use a current short-term bearish recommendation my Maximum Options members have open in Campbell's Soup Co. ( CPB ) - and it's a spread that you can establish today, too.
First, a little background as to why I'm bearish on CPB in the near-term. Look at CPB's chart, and you'll see it's been in almost a parabolic move upward, which tells me that a top is coming. In my opinion, CPB is overvalued, but the reason a lot of investors are in the stock is because it is a defensive name that pays a good dividend.
But with CPB at all-time highs, it's really at a point where there is not much more value there, so it should find resistance at this level. And, if it does fail at resistance, investors will likely start to take their profits and bail out. Essentially, CPB is due for a correction based on its technicals.
You could short CPB shares, or buy a put option against it, but I chose a call credit spread because it's a strategy where you get paid to trade. Even though we're using call options, this is a short-term bearish trade, and we'll explore why later. First, let's look at my recommendation and see how this works.
Call credit spread recommendation: Using a spread order, buy to open the CPB April 15th $70 call and simultaneously sell to open the CPB April 15th $65 call for a credit of about $0.55 or more.
The short call is "covered" by the long call so, in the eyes of the broker, this as a much more conservative trade than shorting stock or shorting naked options.
The primary advantage of the credit spread is that the premium you collect from the short put eclipses the premium you have to pay for the long put, which lowers the overall cost of the trade. Let's do the math using Tuesday's closing prices.
You could buy to open the CPB April 15th $70 call for about $0.16. That is, you would pay $0.16 per contract.
A spread order allows you to simultaneously sell to open the CPB April 15th $65 call for approximately $0.83 cents. That is you would collect $0.83 per contract.
$0.67 credit per contract to your account
By achieving a $0.67 credit in this transaction, you have adhered to my recommendation to get a credit of about $0.55 or more. The best part is that the specific prices you pay don't matter, as long as you are able to get at least the credit you're aiming for.
Again, usually traders will enter both legs of this position all at the same time. Good options brokers allow you to enter an order for a spread with a combined price rather than having to break it into two positions. You can usually sell to close the trade as a single position as well.
Setting Yourself Up for Success with Credit Spreads: Using Margin
The good thing for beginning options traders is that as long as you have the permission from your broker and you have the cash to purchase the calls or puts, you are good to go. It's a fairly straightforward affair and works in the very same way you would buy a stock.
But because options spreads are a little more advanced, they do require some additional conditions to your account. While there is no way to carry out options credit spreads without using margin, the amount of money you need to begin using margin is surprisingly low: just $2,000 in cash that is not allocated to any other assets.
Yes, that's right. If you can deposit just $2,000 into your brokerage account, you can be eligible to use margin and carry out my most winning strategy, credit spreads. This is known as regular or "Reg T" margin. And, generally speaking, that $2,000 will give you enough trading power to execute all of the credit spreads we recommend at any given time.
I've heard from a lot of traders in my four decades as a professional trader that they worry they're on the hook for buying hundreds or thousands of stock shares when they trade options. That isn't at all true for our single options calls and puts, nor credit spreads. You do not ever need to worry about having money to buy the stock. You only need enough money to close the spread in a worst-case scenario.
This dramatic risk reduction works hugely in your favor - it dramatically reduces the amount of cash you need on hand for collateral.
Calculating Your Costs for Each Credit Spread
Margin requirement for each spread varies depending on the point spread between the strike prices. What I mean by "point spread" is the difference between the two strike prices. Let's look at this CPB credit spread to learn about point spreads.
Recommendation: Using a spread order, buy to open the CPB April 15th $70 call and simultaneously sell to open the CPB April 15th $65 call for a credit of about $0.55 or more.
The point spread for this trade is 5.0 because the difference between the strike prices of the CPB April 15th $70 call and the CPB April 15th $65 call is $5.00. Hence a 5.0 point spread.
Of course, with options, you multiply prices by 100 as one options contract corresponds to 100 shares of the underlying stock, so a $5.00 point spread means $500 in real-dollar terms.
A quick, easy estimation for your potential loss per contract in a credit spread is the point spread. So, if you open one contract of the CPB call credit spread, you know right off the bat that your absolute worst-case scenario is losing approximately $500 on the trade.
But it's actually less than that because, remember, we already got paid to open this trade. In this example, we collected $0.67, or $67, for one contract. That money is yours to keep no matter what happens.
So, in reality the most you stand to lose per contract is $433. Here's how:
$500 point spread - $67 premium collected = $433 total potential loss per contract
No one likes losses, but you can see it's not outrageous. For this position, a loss would occur if CPB trades above the lowest strike price in the spread. So, if CPB trades above $65 prior to April expirations, that would typically be my signal to exit the spread by doing the opposite of what we did to open the trade.
So, to exit the spread would mean selling to close the CPB April 15th $70 call and simultaneously buying to close the CPB April 15th $65.
Even in the "worst case" scenario, you would have to pay only $433 per contract sold to exit a credit spread if the stock moves against you. And what's more, that $433 comes from that $2,000 margin fund, not out of your pocket.
How You Make Money from a Credit Spread
Let's look at the CPB example again to determine how you profit from credit spreads:
Using a spread order, buy to open the CPB April 15th $70 call and simultaneously sell to open the CPB April 15th $65 call for a credit of about $0.55 or more.
When you're entering a spread order, your broker will ask you to put in the two options and will ask the price you want. In this case, we were hoping to collect at least $0.55 or more. With the short CPB option at $0.86 and the long option at $0.16, that goal was achievable and we hypothetically ended up with a credit of $0.67 per contract.
Now, the exact prices you pay for either option don't really matter, as long as you can get a $0.55. Any combination of prices to get you the $0.55 credit is fine.
So perhaps we sold to open the CPB April 15th $65 call for $0.80 and simultaneously bought to open the CPB April 15th $70 call for $0.25 to get that $0.55. Whereas, another trader may have sold to open the CPB April 15th $65 call for $0.88 and simultaneously bought to open the CPB April 15th $70 call for $0.31 to get $0.57. Still another trader might have sold to open the CPB April 15th $65 call for $0.79 and simultaneously bought to open the CPB April 15th $70 call for $0.23 to get $0.56.
Any case would have been OK.
Is Your Position is Working?
Let's walk through the steps to show you how you profit.
Using our example prices from Tuesday's close, if you used a spread order and bought to open the CPB April 15th $70 call and simultaneously sold to open the CPB April 15th $65 call, you would see $0.67 ($67) appear in your brokerage account for every contract you opened.
If you opened 1 contract of each option, you would see $67 appear in your account.* If you opened 2 contracts of each option, you would see $134 appear in your account.* If you opened 3 contracts of each option, you would see $201 appear in your account.* If you opened 4 contracts of each option, you would see $268 appear in your account.* If you opened 5 contracts of each option, you would see $335 appear in your account.*
Remember that based on the point spread minus the credit we collect, your worst-case potential loss is $433 per contract. So, if you open one contract, you would be risking $433 and you stand to make $67.
Maybe it doesn't sound like a lot at first, but that's a healthy 13.4% return on margin in a matter of weeks.
The ideal scenario is that at options expiration, you keep 100% of that $67. Let's walk through how that happens.
*Not including your broker's commission fees.
When Worthless is Worthwhile
Just as a reminder, my recommendation was using a spread order, buy to open the CPB April 15th $70 call and simultaneously sell to open the CPB April 15th $65 call for a credit of about $0.55 or more.
Again, the whole premise of this call credit spread is that CPB is going to trade lower before the April 15, 2016, options expiration. That's the key to our profit with this spread.
To realize full profit by April expiration, we want CPB to be trading below the strike price of the short option, which is $65. Why?
If the starting value of the short CPB April 15th $65 call is $0.83, as CPB stock continues to trade lower than $65, that "right to buy shares at $65" that the call option offers becomes worthless. Why would someone exercise an option to buy CPB at $65 when he/she could just buy shares on the open market at CPB's market price, which is lower than $65?
Similarly, if the starting value of the long CPB April 15th $70 calls is $0.16, as CPB stock continues to trade lower than the $70 stroke, that "right to buy shares at $70" becomes worthless. Again, why would someone exercise an option to buy the shares at $70 when he/she could just buy them on the open market at a lower price?
So, the goal is for each option to expire at or near zero ($0.00) so we can keep 100% of that $67 per contract we collected at the start of the trade.
And don't worry if the option you buy to open expires worthless. That is part of the plan. Its role is to provide you with protection and to lower your costs.
The option you sell to open is your moneymaker. And the income you receive is yours to keep regardless of what might happen later. Ideally, you want each leg of the trade to expire worthless so there will be no cost to close the trades and no further action you need to take.
I hope I've given you a good look at why I love credit spreads and why I want you to get involved, but let me know your thoughts and questions.
Ken Trester has been trading options since the first exchanges opened in 1973 with a winning streak that goes back to 1984 with money-doubling average annual profits since 1990. To receive further updates on this trade , try Maximum Options today.