If you trade options frequently you will tend to find that they are very high in risk. But I’m telling you the risk can be lowered, while also not taking a big hit to profit potential. Buying traditional calls and puts is arguably the riskiest way to capitalize in the markets. In fact, almost 70% of contracts expire worthless, leaving you the buyer with only a 30% chance of profiting on expiration day. The seller of the contract seems to always win, while the buyer loses. Much like the casino vs. the gambler. I’m here to say you can be the house and put the odds on your side. The strategy is utilizing credit spreads. This method is when you buy and sell calls & puts with the same expiration date, but different strike prices. Let me explain a call credit spread. This is used when you have a bearish outlook on a stock.
Lets say stock $abc is trading at $30 and we think the price will fall by November 6th.
- Sell a call with a strike of $32 at 1.50 & buy a call with a strike of $33 at 1.10.
- We are automatically given a credit premium of $40 (difference in premium of the two contracts x100). This $40 is yours to keep, you can do whatever you want with it.
- But we must give the brokerage collateral of $100 in case we lose the trade. (Difference in strike price x100) (33-32=1, 1×100=100)
- The max loss is your collateral minus the premium you were given to open the trade. (100-40= 60) So $60 is our max loss.
3 outcomes, you win, lose or roll over your spread.
- You win if by the end of the day on November 6th if stock $abc is trading below $32. So you will collect your premium of $40 and get your collateral back.
- You lose if $abc is trading at or above $32 by the end of the day November 6th. You fork up your collateral of $100, but keep the premium given.
- You can roll over by closing your initial position and opening a new one with more time. I’ll cover more of this in future posts.
The reason I like credit spreads as opposed to buying calls or puts so much is because if a stock trades sideways you will win in the scenario I presented. If you had bought a put, time decay would have killed your contract and you would be at a loss. There are other factors and strategies like improving your risk to reward ratio within a credit spread and put spreads. For now this is how a credit spread is set up and used. Be on the lookout for more tips on credit spreads in my next few posts!!