Option Trading Tip – Credit Spread Cashflow
You may or may not have heard of credit spread option trading but they can be used to profit in bullish, neutral or bearish conditions.
They are a cashflow generating strategy that involves both the buying and selling of either calls or puts of different strike prices but same expiration date to establish an overall ‘credit’ i.e. spendable cash.
It is a great option trading strategy for taking advantage of the ‘time decay’ that option selling provides, but with limited risk.
The amount of potential profit of course is limited to the credit received when the trade is first made.
Let me give you an example of this powerful, yet underutilized option trading strategy.
Let’s say that the QQQQ (The Nasdaq 100 tracking unit) is trading at $30.50 and we believe that it will continue to go up in price.
To create a vertical credit spread using puts (selling puts is profitable if the market rises), we could do the following:
1) Sell the $30 put (expiring this month).
and
2) Buy the $29 put (expiring this month).
TIP:
In my experience, it’s always best to sell short-term, ‘Out-of-the-money’ option premium for 3 main reasons:
1) Out of the money options have lower deltas, meaning the stock has to move further before the value of our sold option increases (remember we want it to decrease).
2) Selling ‘current month’ options (30 days or less to expiry) is when time decay is at it’s most rapid and the value of our sold option is eroding away with each day.
3) Contrary to buying options, if the stock does moves very little or not at all, we win!
Let’s say we received $0.90 cents per contract for selling the $30 puts and we paid $0.40 cents per contract by buying the $29 puts.
This transaction gives us an overall credit of $0.50 cents per contract ($0.90-$0.40).
If we sold 20 contracts of the $30 Put and bought 20 contracts of the $29 Put, this would give us a total credit of $1,000 (2000 shares x $0.50 cents).
So basically, if QQQQ expires at any price above $30 we will make our maximum profit, which is the initial credit we received ($0.50 cents).
On the other hand if QQQQ expires at any price below our breakeven point of $28.50, we will be facing a loss.
Let’s look at all the possibilities.
Once we have entered the trade the QQQQ can either:
1)Go up a little bit.
2)Go up a lot.
3)Go sideways.
4)Go down a little bit.
5)Go down a lot.
The beauty of this style of trading is that we will win in four out of five of these situations, and in many instances we can even win in all five!
Let me demonstrate how.
The QQQQ is trading at 30.50, if it moves up a little bit to say $30.80, our sold option ($30 Put) will expire worthless and we will keep all of the premium.
If the QQQQ moves up a lot to say $32, the same will occur and we will get to keep the premium.
If the QQQQ moves sideways and stays around $30.50, again the ($30 Put) will expire worthless and we will get to keep the premium.
If the QQQQ goes down a little bit to say $30.15, the same will occur and we will keep the premium.
OK, so far so good!
The only way we can LOSE in this trade is if the QQQQ goes down a lot to below $29.50 (which is the higher strike price minus the premium).
If it were the end of the month of expiry and the QQQQ was trading below $30 (our sold option strike price) we would be exercised and our total loss would be the difference between the sold option strike price and the current stock price less the total credit we received.
Our maximum loss will be realized at any price at or below our bought option strike price.
$30 – $29 = $1, less the premium of $0.50 cents = a maximum loss of $0.50 cents per contract or $1000 (20 contracts – 200 shares x $0.50 cents)
However, before it gets to this point, we would intervene. If the QQQQ is falling strongly then we were obviously wrong in our initial analysis.
Before we entered the trade though, we decided that if the QQQQ fell through support at $30 (which it does) we would move to plan B.
At this point we can do a little ‘magic’.
With the click of a mouse through our online broker, we can instantly jump from the bullish camp to the bearish camp!
We do this by buying back the options that we sold which in this case is the $30 puts, and this removes all of our obligation.
At this point though, we have taken a loss BUT, we are still long the $29 puts which would have already increased in value.
If the QQQQ wants to go down, then we are going to let it and just ride the $29 puts as far as they will go.
The more the QQQQ falls in price, the more our option will increase in value.
If it falls far enough, which in this case it does, (falling to $28.50) then we will not only make all our money back, we will start to move into a profitable position.
With credit spreads, we give ourselves the flexibility to change our position mid stream, and the chance to not only recoup some of our losses (if we get it wrong), but to possibly move from a loss into a PROFIT!
And this is just the plan B if things go wrong. Plan A, on it’s own, has statistically, a very high probability of success.
If on the other hand we had the view that the QQQQ would go down, we would simply construct a vertical spread with Out-of-the-money Calls.
We would sell the $31 Call and buy the $32 Call for an overall credit and should the QQQQ close below $31 by the end of the month, the spread would expire worthless and we would simply keep the premium.