I mentioned credit spreads when discussing iron condors. As a reminder, an iron condor consists of one call credit spread and one put credit spread, each expiring on the same day.
I didn’t take the time to discuss why you may want to trade credit spreads, and this is a good time to rectify that omission.
When you sell a credit spread:
- Cash is collected. That cash represents your maximum profit for the trade.
- The options that comprise the spread are almost always out of the money (OTM).
- The option bought is further OTM than the option sold.
- You have a position with a market bias.
o When you sell a call spread, you are ‘short,’ and profit when the underlying stock moves lower.
o When you sell a put spread, you are ‘long,’ and profit when the underlying stock moves higher.
- The option bought has a smaller delta* than the option sold. That means your short option
changes price by more than the option you own. If the stock moves in the right direction, you profit. If it moves in the wrong
direction, you lose.
Here’s an example of how this works
Let’s say you believe YZX is overpriced at $43 per share, and is not likely to move higher anytime soon.
One way to benefit from that market outlook is to sell a call spread. Another is to sell the shares short.
Buy1 YZX Sep 50 call
Sell 1 YZX Sep 45 call
Collect $2.00, or $200 for the spread. That $200
represents your maximum profit.
If the stock is below 45 when expiration arrives (close of business, 3rdFriday of September), then both options expire worthless and you keep the $200 premium.
If you are wrong, and the stock moves higher, but only to 44 or 45, you still collect your profit. That’s one advantage for sellers of credit spreads. If you are ‘slightly’ wrong, you can still win.
If the stock moves beyond 45 (at expiration) you must pay some cash to close your spread position. How much do you pay? $100 per point for every point the stock is above the strike price (45). Thus your break-even price is 47 and if the stock moves above 50, you lose the maximum possible for the position – or $300 (pay $500 to close
and you collected $200 to open the trade).
This is a limited loss and limited profit strategy. Although profits are limited to the cash collected, this is a good strategy to learn because it limits losses and allows you to make a profit even if the market moves against you. Traditional stock market investments have unlimited gains and losses (ok, the stock can only go to zero), but to earn a profit, the stock must move your way. Thus, it’s much more likely that selling a call spread will be profitable when compared with selling stock short.
The same rationale applies to selling put spreads. You are more likely to earn a (limited) profit when selling a put spread than by buying stock.
Delta is one of a series of Greek letters (‘The Greeks’) used to quantify specific risk characteristics of options. Delta measures the rate at which the price of an option is expected to change when the underlying stock or index moves one point. Calls have a positive delta and increase in value as the stock movers higher. Puts have a negative delta and increase in value when the stock moves lower. If you sell an option that has a delta of 0.40, you can expect to see the value of that option increase by $0.40 if the stock moves one point higher today. That represents a loss of $40. Other factors play a role in an option’s value, but that’s beyond today’s discussion.
Credit Spread is a position consisting of two options (both calls or both puts) that expire on the same day. You sell the higher priced option and buy the lower priced option, collecting a cash premium.