Credit Spreads for low risk directional trading…

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Yesterday’s article on selling puts received a great deal of attention on several forums.  In fact, I submitted a edited copy of the blog posting to Seeking Alpha for a future, featured article.   In the realm of Options Trading and it’s complexities, there are several stages, with a little more experience or expertise required at each stage.  I recommend visiting this site to gain basic knowledge: CBOE Education . There’s also a link at the bottom of this page for two books I highly recommend reading.  The Options Machine introduces the reader to put selling.  I learned how to sell put premium as an alternative to owning common stocks, by reading this book!  The other book, Stock Market Insurance Trader (see links below or on sidebar by clicking my “Menu” on the right.  This latter book provides an introduction into the complex stage of Credit Spreads Trading.  A third book I have studied and learned a great deal about options trading from is the “Options Playbook,” which offers dozens of options strategies and covers Stage I, II & III options trading.

Stage I is simply purchasing premium.  You are bullish on a stock or index, you can purchase a call option and your only risk is the amount you paid for the premium.  Same goes for your bearishness, you’d purchase a put option on the stock or index.  Quick story; A friend of mine Eduardo Mirahyes of Exceptional Bear recommended put options on Bear Sterns in early 2008.  He had pinpointed a very negative Elliott Wave count on his charts of the stock.  Eduardo recommended to his friends to take a very contrarian position in puts when Bear Sterns was trading over $80/share!   Who knew?!!! bsc2

In Stage I you’re a buyer of premium.  In Stage II you’re a seller (proper parlance is “writer”) of premium.  I gave an example of writing premium in yesterday’s article, when I went into a hypothetical trade in Kimberly Clark (KMB).

Today I want to present to my Dear Readers, Stage III which is Spread Trading.  There several types of spreads, Bull, Bear, Butterfly, Debit, Credit, Vertical, and the list goes on and on.  CNBC even has a30-minute options trading show on Friday afternoons that you should watch one time….  Enough said.

The type of spread I personally trade and the only one I’ll explain or write an article about is called the Credit Spread.  When you purchase an option in Stage I you’ll be debited the premium plus a small commission.  If you purchase a call option on Netflix (NFLX) and the option is priced at 6.00, you’ll be debited $600. + commission.   Stage II involves a credit premium.  I explained yesterday’s article that if you sell a put on a certain stock, let’s use Netflix again, you’ll receive a credit the amount of option premium.  If the put is priced at $6.00, you’ll receive an immediate credit of                 $600. – commission.

A Credit Spread involves simultaneously buying a low-priced option and selling a higher-priced option at the same time (you’re charged only one commission), resulting in your brokerage account receiving a credit.  This can be a potentially lucrative and limited risk option trade.  With spreads you have a maximum gain and maximum loss involved.  I’ll leave the detailed explanations (including how to calculate the gains/losses) to the lessons learned in the book “Stock Market Insurance Trader.”  The author does a much better job explained this system than I ever could.  I understand it and I’ve master it, but I admit, I’m no teacher.  (I have a degree in Physical Education and Drivers Education, yet I never even pursued a teaching certificate, what does that tell you! LOL!) 

Here’s a hypothetical example (NOT a recommendation!) of a credit spread that a trader might do if he/she is bearish on the QQQ:

This trader selects the QQQ Calls for September expiration; the trader might place a spread order to buy to open 20 QQQ Sept. 21st calls with a 200 strike price while simultaneously selling to open 20 QQQ Sept. 21st calls with a 190 strike price.  The cost of the 200 call might be .45 (or $45.ea) and the 190 strike calls might cost $1.40 or ($140. ea) The cost of the purchased call is subtracted from the premium received on the sale of the lower strike call, providing the trader a credit of .95 ea ($95.) x 20 contracts = $1900.  This is the total credit received minus commissions.  The trader is bearish and betting that by September option expiration the underlying QQQ will close below 190.  If it does, the spread expires worthless and all of the credit is kept.  If the QQQ trades above 190 before expiration the trade will be losing money.  But due to the fact that the trader is Long a 200 call, the risk is limited on this trade and that’s why I mentioned earlier that these spreads have a maximum gain (which is premium collected, i.e. $1900) as well as a maximum loss (the maximum loss is the difference between the strikes, less the credit received when putting on the position).

Before you shake your head and poo-poo Credit Spread trading , and say “no but Hell no!”  Allow me to share an analogy with you.  The reason the recommended book is called, “Stock Market Insurance Trader” is because the insurance business and credit spread trading are similar.  A homebuyer purchases homeowners insurance to mitigate any risk, fires, flooding, tornadoes, etc.  Every year for as long as the home owner resides in the house, he/she will pay the insurance company a premium.  What’s the likelihood that the homeowner will lose the home due to a catastrophic event?  Sure, things happen, but consider this; if the home is located near the coast (or in the midwest), the insurance premiums will be much higher.  You see, the insurance company is a winner each time it receives the premium.  On occasion the insurance company pay claims, some minor like a new roof from a hail storm and some major, tragic events like a fire or a hurricane.  Regardless, between the homeowner paying the premium and the insurance company collecting the premium, who comes out ahead?  Most of the time the insurance company.  For this very reason, I engage in credit spread trading.  Credit spread trading like cash-covered put writing, generates passive income for me.  The more sources of passive income, the sooner I can be on FIRE (financially independent and retired early)!

DISCLAIMER:  THIS IS NOT ADVICE!  I am not an investment advisor, nor a professional in the financial services industry.  Options trading and stock market investment do have risks.  This blog is for informational purposes only and the reader is 100% risk responsible for any and all trades and investments made.

For further education on options trading I have links to recommended books,  I do not personally know nor related to any of the authors but nonetheless, I have profitably traded options and based my own trading on the lessons contained within these three books.

 

 

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