Credit Spreads
Basics
Credit spreads have a maximum profit potential.
Credit Spreads require level 3 options trading authority
Tip: If you think the stock is going to make a dramatic move up, you would be better playing a long call
But what is really cool is that you can make money with a credit spread even if the stock stays flat and may even take a small profit even if it goes down only a little bit
Spreads have a max loss potential
Spreads have a max profit potential
When playing options, you should ALWAYS have your stop set as soon as you place your order
The are two different types of Credit Spreads
Bull Put
i. Bull Put= stock should be trending up or at least sideways
ii. So the same rules would apply to playing a bull put spread as if you were buying a bullish stock (You would want to enter the trade at support and exit at resistance)
iii. You will most likely achieve the max profit in a Bull Put spread if the stock is trending up.
iv. Because one of the two positions in a bull put spread is naked, you should enter the long side first
v. You can then enter the short side without needing naked option writing approval
vi. many platforms allow you to make a single credit spread now where both are executed simultaneously
How to play a Bull Put spread
Buy a put on a bullish stock, with a strike price below the current trading price of the stock.
Sell a put on the same stock with a strike price above the strike price that you bought the first put.
Example
a) Lets say a stock is bouncing off support at $54
b) You buy the 50 put and sell the 55 puts
c) When you buy the 50 puts- you pay .25
d) When you sell the puts at 55 you bring in 2.50
e) 2.50-.25=2.25/sh
f) Your max profit is your credit, so the max profit=225/contract
g) Max Loss = Difference between the spread less the net credit
h) 55-50=5.00
i) 5.00-2.25=$2.75/sh or -$275.00 /contract
j) If the stock closes 55.50 on exp date
i. Both puts expire worthless
ii. and you keep max gain of 225/contract
k) If the stock closes at 35
i. You would assume the max loss of $ 275/contract
l) The reason you get max gain is because both options expire worthless= $0.00 in commissions
m) Breakeven= Higher Strike price - Net credit= 55.00- 2.25=$52.75 assuming all options are worth their intrinsic value at expiration.
How to exit a trade early because we have made a profit
a) When we exit early, we have to physically close the trades=commissions
b) So let’s say the stock we spread traded is sitting at 55.00 within two weeks to expiration.
c) Now we have a profit, and even though it isn’t max profit we still grabbed 35-50% of our max profit
d) We should look to exit because the risk reward ratio starts to turn against us
e) We are holding something that might bring another 10-15% more but holding 50% gain to make that 10 –15%gain
f) I am not willing to give up a gain for the small added value it would bring
g) We entered the spread with a 2.25 credit, and we want out
a. so we buy back the $55 put and it costs us $1.00 ($1 is the ask price we bought the $55.00 put we sold earlier)
b. and we sell the $50 put for +.15
c. this gives us a profit of 1.40 or 140/contract
$2.25 - $1.00 +$0.15= $1.40/sh or $140/contract
Bear Call
i. Bear Call Credit spread=Stock should be trending flat to down
ii. You want to enter when the stock is bouncing off resistance (just as if you were shorting a stock)
How to play a Bear Call
1. You Buy a call above the current share price
2. And you sell a call below the strike price you bought.
3. This will bring a credit into your account, just like the bull put spread did
Example
1. imaginary stock ZILL is trading at 76.00/share
2. You buy the $80 call for -.50
3. You sell the $75 call for 3.00
4. Net credit= 3.00-.50=2.50
5. Net credit is you MAX GAIN= 2.50
6. Assume ZILL drops dramatically to 60 on exp date, you would get the max gain.
7. MAX LOSS= Difference between the Strike Prices-Net Credit
8. max loss=$250/contract 80 – 75 =5 – 2.50 = 2.50/sh
9. Breakeven= Lower Strike Price+credit recieved= 75+2.50=$77.50 assuming all options are worth their intrinsic values at expiration.
Debit Spreads
1. Basics
a. These are very similar to credit spreads with a couple of exceptions
i. In a debit spread we pay out $$$$$$ first and collect after the trade is closed
ii. You buy a higher priced option while simultaneously selling a lower priced option
iii. Some debit spreads must be closed manually by expiration date.
2. Bull Call
a. Bull Call spreads allow you to make money on stocks that are trending up or remain sideways.
b. We enter the trade on a bounce off support and exit at resistance or exit once we make our spread profitable
c. The max profit is equal to the spread between the two strike prices minus the initial debit
d. Select an expiration date of 20-40 days away.
e. As a rule, if the maximum profit potential is at least 30% to 50% of the maximum loss potential, the spread is acceptable. To determine the Return on an investment you divide the maximum potential profit and divide it by the nest debit (max potential loss).
f. When volatility rises, buying an out of the money spread may be less attractive because premiums are higher.
g. You would attain the max profit at expiration if the stock closes above the sell call strike price ($37 in example below).
h. An out of the money spread unlike a bull put spread will only be profitable if the underlying stock price increases. Conservative investors should buy In The Money options. Aggressive investors should buy Out of the Money options.
i. The max profit would be the difference between the strike prices less the net debit.
j. If the stock closes in between the strike prices, you must exit the In The Money call manually. Do not expect your broker to sell your in the money option on expiration date
k. The max loss is the net debit
l. You can also exit early if your profit target has been reached
m. Assume the stock rises to 36.80 with a week or two until expiration (see example below)
i. The differences in the long and short call premiums will have changed
ii. We would buy back the 37.00 call for -.0.10
iii. And we would sell the 36.00 call for +0.85
iv. or a profit of .10
v. or 10.00/contract
vi. -.65 +.85 -.10=.10
How to Play a Bull Call Debit Spread.
If you cannot do this trade as a single transaction, always enter the BUY (LONG) side before selling the call.
1. We sell a call above the current trading price
2. We buy a call below the strike you sold
3. ENTER THE BUY FIRST OR YOU ARE NAKED
4. ALWAYS ENTER THE LONG SIDE FIRST
Example
1. Current stock price is at $36.70
2. We sell a 37 call for .20
3. We Buy a 36 call for -.85
4. This results in a -.65/share debit, or -$65 per contract
5. Max profit = 36 – 37 = 1, 1-.65 = .35 or 35/ per contract. Max profit occurs when the stock closes above the 37 strike price on expiration. Both calls expire in the money.
6. Max loss = 65/ contract= Net Debit
7. Assume Stock is at $34 on expiration date…
a. Both calls expire worthless and you assume max loss
8. To determine the breakeven point, take the net debit, multiply it by –1 and add it to the lower strike price.
In this case:
-.65 x –1= .65.
36.00 + .65=36.65
Exiting the Spread
1.Same Day Substitution- his describes the process that takes place when the option buyer exercises the short option, causing your broker to immediately exercise the long option to offset your obligation in the trade. This means you wil not have to buy the stock. Your broker will automatically liquidate your position. Always contact your broker prior to playing credit spreads to make sure they offer same day substitution.
2.If the stock closes through the spread (above the higher strike price) on expiration date, both calls will expire In The Money and you will achieve max profit and will need to take no other action if your broker offers same day substitution.
3. If on expiration date the stock closes between the two strike prices, the spread could break even or even be slightly profitable.
Bull Call Spread Review
*Find optionable stocks in a bullish to neutral trend with good fundamentals
* Conduct TA on those stocks. Concentrate on support and resistance.
*Buy a call option option (either in or out of the money) with a strike price close to the current trading price of the stock. Then sell a call with a strike price above the strike price that is higher than the call you purchased. This transaction will create a debt. An extremely bullish investor would buy the call with a strike price above the current trading price of the stock.
*Enter the spread with a “buy to open” for the call with the lower strike price and a “sell to open” for the call with the higher strike price. If possible, enter the trade as a single position instead of legging into the trade one side at a time.
*Monitor the trade daily. Watch the price of the stock. If it drops unexpectedly, consider exiting the trade.
*Exit the spread by entering a “But to Close” order to exit the short call and a “sell to Close” order to exit the long call, by letting both options expire worthless, or by allowing the spread to be exercised.
Bear Put Debit Spreads
you sell call at a strike above the current trading price
you buy a call below the strike price you bought
:the stock should be trending UP or at least sideways
we are talking vertical spreads
You play a vertical spread for 20-40 days
its a short term trade
Bear = trending down
With a spread, you can make a profit even if the stock trends sideways
And may even break even if it the stock moves up a small amount
You would use a Bear Put spread in the same conditions you would play a
long Put.
: You would want to enter the trade at a bounce off resistance or a break of
Remember with any spread, one side of the trade is SHORTor NAKED
So you should ALWAYS enter the trade on the Long Side(Buy) first if you use
a single entry platform
You can then enter on the Short (Sell) side without needing Naked Option
Writing approval
The Long side will COVER the short side if the contract is assigned
unexpectedly
You can use spread stategies in any market condition, but remember, if you
are expecting your stock to move violently in either direction, you may be better off playing straight
calls or puts
How to Play a Bear Put Spread:
You buy a Put option on a bearish stock. This option should have a strike price that is higher than the strike price of the Put that will be sold in the next stepThen you sell a Put option with a strike price that is lower than the current trading price of the underlying stock.
example
Stock price= 49.12
Buy a put for 50.00 = -2.10
Sell a 47.50 Put= +.85
Net Debit= -$1.25/share or -$125.00/contract 2.10- .85= 1.25
Max Profit Potential= Difference between the spread minus the initial net debit
50.00 - 47.50 - 1.25 = 1.25/share or $125.00/contract
Maximum Loss= Net Debit
[n this case Max. Loss= 1.25
: No matter how far the stock rises, you cannot lose more than 125.00/contract
Breakeven Point= Upper Strike Price-Net Debit= $50-$1.25=$48.75
As a rule, if the max potential profit is at least 100% of the max potential loss , the spread is acceptable
When volatility rises, buying an out of the money spread will bring in higher premiums
Be careful though,
Volatility often rises prior to any major news. and the stock could move against you lightning fast and you lose
Lets assume the stock falls to 48 with 20 days till expiration
The premiums for both the long put and the short put wil have changed
If the difference between the two premium prices is larger than the net debit, you can close the trade for a profit
Its a good idea to have an optional profit target of 30-50% of the maximum potential gain
Exiting early lets you take gains sooner and enter another trade
Because a Bear Put Spread is a Debit spread, you pay up front so you must have the funds available in your account to make the trade
But there is no margin requirement as there is in a credit spread
stock is at 48.00
We buy back the 47.50 put = -$0.50
and we sell the 50.00 put for +$2.65
We entered the spread with a net debit of -1.25
2.65 - .50 - 1.25= +.90 or $90.00/contract
example 2:
Current stock= 72.45
We Buy the 70.00 put for -2.50
We sell the 65.00 put for +0.95
Net Debit= -1.55
Max Profit- 70.00 - 65.00 - 1.55 = 3.45
Lets assume the stock drops drastically to 58.00/share on exp date- you would get the max profit
Max Loss
The max loss is equal to the net debit
in this case tha max loss would be 155.00/contract
Return on Investment:
ROI= Max potential profit/Max potential loss
3.45/1.55=233%
which is well above the acceptable 100% ROI mentioned earlier
Assume the stock rises to 72.00 unexecpectedly and stays there until expiration
Since the stock closed above both strike prices, both options will expire out of the money : and the spread will realize the maximum loss : because both puts expire worthless
Exiting at Expiration
If the stock closed "through the spread" (below the lower strike price) on exp. date, both calls will expire In The Money, you will achieve max gain and will not need to exit the trade. That is how you make the max profit, because there are no commissions
Exiting If the Stock Moves Higher by Expiration:
[f on expiration day the stock closes below the higher strike price, but above the lower strike price, the spread could still break even or even be a little profitable
Break Even Price
Subtract the net debit from the higher strike price
70.00-1.55=68.45. As long as the stock fallss below 68.45 you can break even or make a small profit
Whenever the stock closes in between the stock prices you need to close the trade manually. This is very important:
To capture any value from the spread, you will have to sell the option you purchased (70) with a "Sell To Close" order and allow the lower strike price (65) to expire worthless
DO NOT EXPECT YOUR BROKER TO AUTOMATICALLY SELL YOUR IN-THE-MONEY OPTION SIMPLY BECAUSE IT STILL HAS VALUE ON EXPIRATION DATE
You must manually close the trade
