Options Strategies: Credit Spreads

The market's up, the market's down. The constant fluctuation of the market as it searches for a direction has left more than one seasoned investor scratching his head in frustration. Yet, options can help to alleviate some of that anxiety. They can easily make money in bull or bear markets, and can serve as hedges on existing positions. Furthermore, the capital outlay for an options trade tends to be less than a traditional stock purchase. In this day and age, you can't afford to ignore the potential of equity options.

Risk and Reward

Today, I will briefly walk you through the credit spread options-trading strategy. Nullifying the prevalent (and erroneous) theory that all options trades are risky and frequently losing propositions, credit spreads can be profitable the majority of the time. In fact, the risk/reward profile of the credit-spread strategy can average a winning percentage around 80% or higher when out-of-the-money options are employed. Of course, there is naturally a tradeoff. With the reduced risk comes a reduced profit. Most credit-spread trades will bank profits of less than 20%.

The Mechanics of the Credit-Spread Strategy

A credit spread consists of the simultaneous purchase and sale of puts (or calls) with matching expiration dates but different strike prices. An options player who is bullish (to neutral) on the underlying stock, index, or exchange-traded fund (ETF) would employ put options; a bearish trader would use call options. When using out-of-the-money options (which we recommend), the strike price of the sold option is closer to the underlying stock's market price than the purchased option, and therefore carries a higher price tag. Selling a higher-priced call or put contract and purchasing a lower-priced contract as a hedge results in a net credit in one's account. The ultimate goal of a credit spread is simply to retain this credit with both options expiring worthless.

Those with options experience limited to call and put purchases may wonder why bullish investors use puts and bearish investors use calls for the credit-spread strategy. This is because the goal is for both traded options to expire worthless. Put options will lose value on a rally in the stock (or no move at all, since the options traded are out of the money to begin with). Likewise, call options will expire worthless on a decline in the stock.

Example: Bullish Credit Spread

Suppose a trader is bullish-to-neutral on XYZ, which is trading around the 110 mark. There is short-term chart support in place at 100 and nothing scheduled on the calendar that could cause a volatile swing in the shares (earnings report, etc.). With just two weeks until options expiration, a credit spread is opened by selling a front-month 100-strike put and buying a front-month 95-strike put. With the stock at 110, the sold 100-strike put is closer to the money and is therefore more expensive. (Also, because both are out of the money, XYZ could fall as much as 10 points - 9% - and the credit spread would still be a winner). The 100-strike put is sold for 0.75 and the 95-strike put is purchased for 0.25. The initial credit is 50 cents per share, or 0.75 collected minus the 0.25 paid. The trader can keep this premium as long as XYZ advances, stays flat, or even drops to the 100 level. Both sides of the trade would then expire worthless, keeping the credit in the trader's account.

A Note about Margin

In order to trade credit spreads, a margin account must be established with one's broker. The minimum required in margin is equal to the difference between the strike prices of the spread's two options, less the credit pocketed at the outset of the trade. (This value is then multiplied by 100). In the above example where a 100-strike put was sold for 0.75 and a 95-strike put was bought for 0.25, the spread of five points (100 - 95) and the resulting credit of 0.50 equals to a margin of $450 per pair of contracts.

Credit-Spread Pros

Profitable outcomes. As mentioned above, the likelihood of a credit spread being profitable is very good. Through the use of out-of-the-money options, a credit-spread trader can profit from a wide range of outcomes. If a bearish credit spread is opened with the sold call option 3% out of the money, the entire premium will be retained if the underlying stock moves lower, stays flat, or even rises by 3%. Only when the sold option moves into the money is the position at risk of a loss.

Predictable losses. Typically, losses are capped at the difference between the strike prices of the options minus the originally collected premium. (The maximum loss usually corresponds to the margin required). Even credit-spread losses compare favorably to a stock trade (long or short), which can suffer unpredictable and steep losses if it moves in the wrong direction.

In rare circumstances, it is possible to lose more than this amount. This phenomenon can occur near expiration, when the sold option consists almost entirely of intrinsic value. If the underlying stock, index, or ETF moves contrary to expectations and the entire spread is in the money, the trader runs the risk of his sold option being exercised. If this happens, the purchased option holds value as well, and can be sold to offset the loss incurred by the sold option, or exercised side of the spread.

No Commissions to Close Successful Trades. The goal of a credit spread is for both the sold and the purchased option to expire worthless, allowing the trader to keep the full credit. Worthless options of course require no fees to be closed and hence do not incur commission costs. This element means increased net return on winning credit-spread trades.

Credit-Spread Cons

Limited Gains. Credit spreads are a conservative strategy with a hedging element to protect against major moves in the underlying vehicle. Because of this reduced risk, reward is also capped. Typically, a credit spread's profit is limited to the amount of the premium (or net credit) received at the outset.

The Rare Loss Can Be Costly. In the instance of a loss, if the trader decides to close out the credit spread prior to expiration, he can incur up to four commission costs (two commissions to enter the trade and two commissions to exit the trade) on the entire position, which adds to his loss.

Conclusion

If you are intrigued by the world of options but worried about supposedly high "risk," credit spreads offer a tame and attractive alternative. Credit-spread returns may not be as great as straight call or put purchases, but the high winning percentage can be rewarding in bull, bear, and even range-bound trading environments.

Bernie Schaeffer is Chairman and CEO of Schaeffer's Investment Research, Inc.