Tuesday Trading Tutorial - December 23, 2008

Following last week’s discussion of Selling Puts, this week’s article will focus mainly on credit spreads and how options traders can benefit from learning this trading strategy.

What is a credit spread? Well, it is the difference in value of two options on the same underlying security when the value of the option sold exceeds the value of the one bought.

It could also represent the yield difference between Treasury securities and comparable non-Treasury securities such as mortgage-backed bonds, expressed in basis points. Credit spreads widen in recessions and grow tighter in economic expansions.

However, for today, we will be dealing mainly with the options portion of the definition.

A credit spread involves the simultaneous purchase and sale of puts, or calls, that expire at the same time but have different strike prices. Puts are used if you are bullish on the underlying stock, while calls are used for a bearish outlook.

This strategy allows investors to have potentially fixed rewards and manageable risks. This is accomplished by collecting a premium up front and waiting until expiration, when the positions expire worthless, hopefully.

With credit spreads, the effect of time decay is working for you, not against you. Time decay is defined as the ratio in the change of an options’ price to the decrease in its time to expiration.

The two types of credit spreads that we will explore will be Bull Puts and Bear Calls. Each will put money in your pocket at the start of the trade, but one uses puts as the trading vehicle and one uses calls.

A Bear Call spread is a when the investor takes advantage of the market’s decline. Here, a call option is sold (typically out of the money), and a higher strike price call option is purchased for insurance purposes.

An example of a Bear Call Spread would be if a trader anticipates the decline of a stock, say QWE from its current trading price of $40, then the following would take place. The investor could write, or sell, a January 45 call for perhaps $3.00 and buy the January 50 call for $1.00. The spread received would total $2.00, or $200 per contract sold ($2.00 x 100 shares in a contract).

If the stock remains at or below $45 by expiration, then the option would expire worthless and the investor would keep the net credit of $200.

If the stock trades between $45 and $50, your gain or loss would depend upon how much above $45 the stock trades on expiration day. If the stock were trading at $46, you would still show a gain of $100 (you were paid $200, but lost $100 by the stock closing a dollar above $45).

If the stock trades above $47, you will experience a loss on the trade. Your loss will be capped however at $300. This is due to your having bought the $50 Call option. Even if the stock were to go to $60, with the $50 call option you have the ability to buy the call for $50 and turn it over to the person who exercised the $45 you sold.

Ideally, however, you would roll out of the position before your losses mounted. To roll the position into the forward month. The trader would buy back the $45 calls, and sell the $50 calls that were bought. You would then sell an out of the money option for the next month and buy a call at a strike price above the one you sold, essentially entering the trade again but with another month of time value.

On the other side, if a trader believes that the stock is in a bullish position, they would use a Bull Put spread. This is an options strategy that involves using puts to take advantage of a rising market.

For example, if the trader believes that QWE, which is trading at $30, will go up in the near future, then the following could occur. The trader could write, or sell, a January 15 put for perhaps $2.00, and buy the January 10 put for $0.50. The spread received here would be $1.50, or $150 per contract (1.50 x 100).

Here, if the stock were to remain at its current price of $20 or increase in value, then the investor would see the options expire worthless, thus retaining all of the net credit of $150. If the stock were to close between $15 and $10, then the losses or gains would be reduced, depending on the value left in the options at expiration.

However, if the stock were to trade below the $10 mark, then the investor could again roll into the forward month by buying back the January 15 put and selling the January 10 put. There would likely be a loss in the buying and selling of these puts. Subtracting the net credit received at the opening of the trade, the maximum loss on the overall trade would be reduced.

Credit spreads offer two primary advantages over straight put or call purchases. The first, by using out-of-the-money options, an investor can profit from a wide range of outcomes, including the markets moving, to some extent, against your initial outlook.

The second advantage to credit spreads is that no commission costs are incurred to exit your trades when the options expire worthless. Worthless options require no closeout actions, thus do not incur commission costs. This feature increases an investors’ net return on a winning credit spread trade.

Credit spreads are used mainly as a conservative strategy. It gives the investor the potential for modest gains while limiting their overall losses. Whether using Bear Calls or Bull Puts, these strategies can help supplement wages for those traders who study the strategy vigorously.

Some of the more beneficial credit spreads come from investors using index options rather than equity options. If a stock within an index were to gap up or down drastically, it would not have a devastating affect on the index as a whole. However, if you were invested strictly in an equity option and it moved violently, it would give the investor less control over his risk potential, more often resulting in a loss.

Check back after the New Year as we delve into the analysis aspect of the broader markets. Have a safe and Happy Holiday and we hope to see you back here at the first of the year.

For more information on the stock and options markets check out the wealth of information at BetterTrades.