Option Credit Spread Strategy: An Opportunity For Success

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.

OptionsANIMAL is here to help you get a handle on each of those personalities. Understanding the different strategies available for you to use in options trading is like a golfer understanding the different clubs in his/her bag. A driver is a very useful club, but it should not be used in every situation on the golf course. It is awfully hard to putt with your driver, and it is just as hard to chip out of the sand with a putter. You need to be familiar with all the clubs in your bag in order to know which one will likely bring you the best results when you’re on the golf course.

In the same vein, one option strategy may not be the right choice for a trade while, in another trade, it is the perfect fit. One trade may seem like a lost cause, but when you apply the proper strategy, it suddenly becomes profitable. Let’s take a closer look at a fairly common personality for options—a bullish credit spread—and how that put strategy should work in the market—just like the right club should be played on the golf course. At OptionsANIMAL, we can teach teach you the best ways to maximize your investments for optimal results. We’ll list a few tips below, but for more in-depth instructions, you can sign up for one of our webinars.

A bull credit spread should not be used in every scenario in the market. It is just one of many tools in your arsenal, and before selecting it, you should be clear on how it will work within the current market. It is important for you, as a trader, to know the different trading tools available for any market scenario. Take a closer look at a bullish credit spread here, and get a good feeling of its individual “personality” and just where it should fit in your trading work.

Profit/Loss Diagram of Bull Put Spread

 

Bull Put Spread Profit/Loss Graph

One of the key trading tools I employ on a regular basis is the bullish put vertical, or Bull Put.This trade is best 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), which means the net result will generate a credit to your account. This credit is your maximum profit. The idea behind a Bull Put Spreads strategy is to capture the effects of time decay on the option sold, as well as to 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 (and all rounds on the golf course), it is important to have both a primary and secondary exit plan as a part of your put strategy. If you miss the green on the golf course, what will you do to save par? If you land in the sand trap or the water hazard, how can you correct for your mistake? Is it better to play the ball wear it lies and hope you can recover, or would you be wiser to simply accept your losses and take the extra stroke rather than risk worse results?

The primary exit strategy for the Bull Put trade is to let both the long put and the short put options that you hold simply expire, worthless. The main benefit of this exit strategy is that you will eliminate the commission costs you would accrue on the back end of the trade by simply allowing the options to expire. The money you save on those commissions is higher than the money you would make on the sale. 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: 10 Basic Rules to Follow When Applying Credit Spread Trades

  1. Use Out of the Money (OTM) options. A credit spread can be written At The Money, but they will 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. Look for options high in implied volatility. Overpriced options are generally a good thing to sell. Oftentimes there is a reason why implied volatility is high, so make sure there is no 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 use a smaller spread if it is available. The closer together your spread, the lower your risk.
  4. Trade with the market trend. Do your due diligence. Options spread strategies focus on trades that truly follow the old saying, “The trend is your friend”.
  5. Where is the risk in this trade?
    1. We have an OBLIGATION to buy the equity at the strike price of the short put;
    2. We have the RIGHT to sell the same equity at the strike price of the long put;
    3. Our risk is the difference between those two actions;
    4. (However, we do get to keep the net credit.)
  6. The 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. The Long Put is used to minimize and control risk.
    1. 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.” Credit spread trades are based upon this logic. Your end goal is to put money in your pocket. It may not always be a substantial amount of money, but when structured correctly, these trades have a very high ratio of success. Winning more consistently, even if you are winning a small amount, is the single most important thing a trader can do. It may not be impressive or dramatic, but a gradual rise means that your fortunes are increasing.

Understanding the personality of the trade will allow you to make the right decisions on how to play it and increase your profitability. Remember that trading is more than just a string of lucky guesswork. Like golf, trading is a highly-nuanced game of practice, discipline, and skill.

For more information on what OptionsANIMAL can teach you, give us a call! We’ll give you a free consultation and give you a clear picture of the benefits you can enjoy. Contact us at 1-888-297-9165.

Read more: http://community.nasdaq.com/News/2012-02/option-credit-spread-strategyan-opportunity-for-success.aspx?storyid=118517#ixzz1nhjuof3P