I know I rant to an audience of mixed experience. Some know how this trade works, while others might not. In any event, let's discuss Credit Spreads.

A credit spread is created when you buy and sell calls or buy and sell puts within the same month of expiration. This is also called a vertical spread. Let's use the Google trade I mentioned a minute ago as an example...


If you had entered this trade where you are buying a put for 5.70, and selling a put for 8.70 you would be left with $3.00 in your account. This is why it is called a credit spread. You are paid for this trade upfront. You won't get to use this money at first, but as the trade expires or as you close out the funds then become yours.

For basic option students it is complicated to think of puts as being bullish. This is due to us not seeing the other side of the put trade. Here is why we are bullish...

Upon selling a 500 put, you are entering an obligation to buy this stock (have it put to us) for 500. Since we don't like the unlimited risk this trade would carry, we are also buying a 490 put, giving us the right to sell the stock at 490. If you think about it, we have locked in a transaction here. We are obligated to buy for 500, and have the right to sell at 490.

As the seller of the 500...we are in a bet with the put buyer. A bet that basically bets on whether or not the stock will end up above or below 500. Since we are the seller, we are betting it will remain above 500. This is why the trade is bullish. If the stock closes at 510 (example) the buyer of this option, having the right to sell the stock to us for 500 would not exercise. Why would they sell us the stock at 500, when they could sell it to the market at 510? Our incentive here is that juicy $8.70 premium. If the stock remains above 500, we keep that premium. But what if the stock price falls?

This is why we trade a spread rather than just selling the naked option. Sometimes we are wrong, and we don't want to carry unlimited risk. Since we are also buying the 490, if the stock plummets to 480, we can sell the shares put to us for $500 back to the seller at $490. This means we would lose $10 on the trade, but that is offset by the $3 credit we receive. Max loss is $7.

I know this is a lot of numbers being thrown out. Sorry if that was hard to read. In this particular trade, we would enter this trade under the assumption that Google won't break 500. If it doesn't we collect $3. If it falls, we could lose up to $7 worst case scenario.

Why would you trade this?

Income. Pure and simple. You can also create very conservative high probability trades here. What if you entered the 460/450 spread. You could collect $.50 cents and as long as Google does not fall below 460, you keep this premium. Sounds like free money doesn't it? Do you anticipate Google falling that much? Me neither.

Why would you not trade this?


Limited upside potential. The $3 premium received is the most you will make. What if the stock makes a run at $550? You are limited to a $3 profit. Also, without exit strategies in place you could lose a lot more than you make. Risk 7 Reward 3. Not so good, right?

In closing, I only trade spreads in situations like this. To be brutally honest I hate spreads. Don't tell the company this since they have me teaching this strategy in our advanced options trading rooms. The reason why I do teach them is because I want the people that want to trade this strategy to have all the facts and to know when it is appropriate to trade them, and when it is not. I think I am one of the best suited for this job. Since I only trade them in certain situations, wouldn't you want to know when these situations are?

I am not wildly bullish on Google, but I am relatively certain that 500 will hold. I am willing to risk that by taking this trade. Options are expensive, and time decay is starting to heat up on the Dec options. Jeff says:

I would like to take an advanced look at this trade next week. We will analyze the greeks in spreads and talk about the sensitivity these have to time, price, and volatility. Until then, have a great holiday. I will post on Friday so stay tuned. If you are real bored, join Master Talk tonight...session 1.

Posted by Option Addict on 11/22/2006 at 4:41 PM | Permalink