Playbook #065: Options - Credit Spreads
🖼️ The Big Picture
If you like the idea of trading stocks or options and value “certainty,” then credit spreads may be the strategy you’ve been looking for.
It's a proven way to generate extra income without needing to invest a lot of money to get started and that has built-in risk control.
A credit spread uses options to create a ceiling (maximum amount you can make) and a floor (maximum amount you can lose). There is also a "break-even point" somewhere between those two values.
If the price of the particular stock finishes above the break-even point when the option play expires, you make money. If the price finishes below the break-even point, you lose money.
The skill involved is creating a spread that will more than likely finish in the profit zone.
The advantage is that you will always pocket your maximum profit immediately after the trade is made. Another advantage is that you always know what your maximum loss will be (even if the stock you are trading goes down by a lot more).
The downside is that if the stock price shoots up, you will only participate in profit you already received. You won't get any more, even if the stock doubles in value.
Another important feature of credit spreads is that you can use this strategy profitably in most market conditions: when the stock market is soaring — and when the market is tanking.
You see, there’s 2 ways to create the spread depending on whether you’re bullish (think the price will go up) or bearish (think the price will go down) for the particular stock you are trading. Both involve selling a “near the money” option and buying an “out of the money” option at the same time.
Here are examples of how the scenarios play out, which you can play with yourself using this options strategy calculator.
#1: Bullish (you’re betting the stock stays the same or goes UP in value)
If you think the price of a stock has the best chance of going up during your selected time frame, you would trade what is known as a Bull Put Spread.
Put options give the owner the right, but not the obligation, to sell a certain amount of a stock at a set price within a specific time. Options contracts are for 100 shares of the underlying stock.
Assuming the current stock price is $98, you can create a "Spread" between $95 and $100. If the stock tanks, the most you can lose is $300. Here's how that might look:
- Sell 1 “Short” Put Option with Strike Price of 100
- You earn $3.20 premium x 100 shares = $320
- If you were 100% certain the stock price would go up during the timeframe of this trade, you could stop here and pocket the entire $320. But to protect yourself in case something unforeseen happens and the stock price nosedives, you create a floor of your spread in order to minimize any potential loss.
- Buy 1 “Long” Put Option with Strike Price of $95
- You pay $1.30 premium x 100 shares = $130
- You are immediately in possession of $190 ($320-$130) - and you will keep all this profit as long as the stock remains above the “Short” Put Option you sold at $100
- Your maximum loss is $300 - and this will happen only if the stock falls below the “Long” Put Option you bought at $95
- Your breakeven point is if the stock is at $98.10 when the options expire
- If the stock is above $98.10, you make money
- If the stock is below $98.10, you lose money
Here's how it looks on a chart:
#2: Bearish (you’re betting it stays the same or goes DOWN)
If you think the price of a stock is more likely to go down during your selected time frame, you can trade what is known as a Bear Call Spread.
Call options give the owner the right, but not the obligation, to sell a certain amount of a stock at a set price within a specific time.
This works the exact same as the example above, except you’re betting the stock goes the other direction. So let's say the stock has soared to $102, but all indications are that it's overpriced and you are expecting it to go down in the next 2 months. Here's how you would play that:
- Sell a Call Option with Strike Price of 100 at $3.30
- You immediately receive a $330 premium (100 shares x $3.30)
- Buy a Call Option with Strike Price of 105 at $1.50
- You pay out $150 (100 shares x $1.50) to protect yourself in case the price keeps going up.
Here's how the Bear Call Spread looks on a chart:
Credit spread options trading is a great way to get your feet wet with trading because you’re locking in the amount of risk you’re willing to take, so you will never have massive, unexpected losses.
Once you get good at it, you have the potential to create spreads that work in your favor more often than not, and it can be a great way to generate extra income without needing to invest a lot of money.