Trade with the Odds by Using Credit Spreads
Scott Johnson is the founder of IncomeSpreadTrader.com. Johnson, who traded equities and options for over 20 years, switched to trading with the odds by being an option seller in the 1990s. After perfecting variations to the credit spread (with an extremely high rate of success), he started the newsletter. IncomeSpreadTrader.com in 2005, which focuses on index and stock option credit spreads. Subsequently, Johnson brought together a group of traders who specialize in spread trading gave the website’s members an edge in today’s market.
The goal of this article is to shed light on the little-used strategy of trading credit spreads. First, let’s walk through the advantages and disadvantages of credit spreads and then give some real – life examples of how to make money trading credit spreads.
Professionals are often the traders on the other side of the retail investor’s trade. Because professionals are able to trade with very deep pockets and are given much more leverage than the public, they do not have to make their trade into a spread. Instead, they are simply selling the retail person the call or put. They collect the premium up front and then sit back and wait for the option to expire worthless. Not a bad way to make a living?
The problem is that when you are only selling options, you leave yourself open to a great deal of risk. By turning the position into a credit spread, this risk can be capped. A credit spread is constructed by buying one stock option and selling another of the same type (call or put) in the same expiration month but at different strike prices. The option that we sell is more expensive than the option that we buy, thus resulting in a net credit (deposit) to our trading account. The goal is for both of these options to expire worthless, so that we keep the full credit at expiration.
One of the fascinating things about placing a credit spread is that we are not paying for the spread, someone else is paying us. This is a whole different mindset then most retail investors have. We become the seller by trading three different types of credit spreads: Bull Put Spread, Bear Call Spread, and Iron Condor.
1. There are six main advantages of trading credit spreads:
2. Don’t need a directional move in the stock. The stock can even go against us (to some extent) and we still make the same amount of money.
3. Profit from time decay. The rapid decay in the option’s value works in our favor. Time is on our side.
4. Don’t rely on Market timing to profit. Because we give ourselves a cushion when we place the spread, we can weather a downturn and still profit. Place spreads that are a few strike prices out of the money, which produces a high probability of winning trades.
5. Don’t need to make daily adjustments to the positions. Instead, enter the spread and then let it expire worthless at expiration.
6. Collect the profit upfront. The credit goes into our trading account when we place the spread. As long as the options expire out of the money, we keep our full credit.
After seeing the advantages of trading credit spreads, you might wonder why more people wouldn’t trade them? Probably the reason why they are not widely traded is that people do not understand them. It is difficult for some people to understand the concept of profiting when options expire worthless.
Most investors don’t understand how to trade spreads and most brokers don’t make them easy to trade. As a matter of fact, brokers will have to clear you for the ability to trade them in your account. The other main issue is the management of the spreads. Because you will be “short” one option and “long” the other, it becomes confusing for traders. Perhaps the best way to explain credit spreads is to give real-life examples of our trades.
BULL PUT SPREAD
We use a Bull Put Spread when we have a positive to neutral bias on a stock. As with any credit spread, we take in a credit when we enter the spread and the goal is for these options to expire worthless. If this happens, we keep the premium that we took in at the time we entered the spread.
Let’s look at an example of a credit spread.
Google
(
Goog |
Quote |
Chart |
News |
PowerRating) Bull Put Spread
Sell 10 Jan. puts at 440 strike price
Buy 10 Jan. puts at 430 strike price
Total Credit $0.85 per contract
Potential Profit $850.00
In this trade, we sold 10 contracts (1 contract equals 100 shares of stock) of the January 440 puts for a credit of $3.25 per contract. To figure the total credit that you receive for entering this position, take the number of contracts (10) times the number of shares of stock in a contract (100) equaling 1,000 shares times the price per contract $3.25, which comes out to a total credit of $3,250.00.
If you simply entered this trade without purchasing the January 430 puts, you would leave yourself open to downside risk if the stock fell. This is precisely what happened when I lost over $50,000 back in the 1990s. In order to protect ourselves from an extreme downward move in the stock, we finish the spread by purchasing 10 contracts of the January 430 puts for a debit of $2.40 per contract. To figure the debit that you pay for entering this position, take the number of contracts (10) times the number of shares of stock in a contract (100) equaling 1,000 shares times the price per contract $2.40, coming out to a debit of $2,400.00.
When you enter both of these positions at one time, you are placing a credit spread. In this trade, you would receive the difference between the puts you sold (January 440 puts) and the puts you purchased (January 430 puts) into your account. Your broker would place that $850.00 into your account when you enter the position. As long as Google finishes above $440 at the end of trading on the third Friday in January, you keep the $850.00.
With Google trading at $483 when we enter this position, this gives us a 43-point cushion. By placing our credit that far away from the stock price, we reduce our risk dramatically. This is one of the reasons why we have such a high percentage of profitable trades.
With that large cushion between the stock price and the puts we sold, you might wonder why we purchase the 430 puts. Even though it cuts down on the premium that we collect, we feel that it’s important to limit our risk in case of an extreme move against us. This is the lesson I learned the hard way.
In this case, we have limited our loss to the amount between the puts that we sold and the puts that we bought, minus the premium that we collected.
We then subtract that difference from the premium that we collected when we entered the spread.
We then take that amount, $9.15 times the number of shares, (10 contracts times 100 shares per contract) we get a total risk of $9,150.00.
It is true that spreads in general will have a negative risk to reward ratio. However, by putting on spreads that are out of the money, we are able to have a track record of highly profitable trades month after month.
One thing you will notice when you enter a spread, is that your position window will probably show the spread losing money for the first few weeks. Even if the stock has not moved against you, your broker will possibly show you as having a loss. Your cash balance in the account, however, will show the credit of $850.00 (which will be earning interest if you have the right broker). As the expiration date nears, this loss will turn into a profit as time decay starts to eat away at the value of the options. You may want to enter some paper trades with your broker to see how the time decay and position balances react in a credit spread.
In this trade, Google closed at $489.75 on the third Friday of January. Because this was above our strike prices of 440 and 430, all the options expired worthless. Due to this, we were able to keep the credit ($850.00) that we received when we entered the spread. This is the goal for all of our spreads.
This article has only scratched the surface on credit spreads. But hopefully it has stirred some interest in trading with the odds on your side. There’s so much more to the world of options than just buying and selling calls and puts. With the choppy trading environment that we are now in, why not put the odds on your side.