Credit Spreads With Options

The Smart Profits Report: Issue #348
Monday, August 28, 2006

Credit Spreads With Options: How Option Credit Spreads Give You a Better Chance to Win
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

If you think the only way to make money in the markets is to always pick the correct direction of your securities, then I have news for you: Think again.

While it might seem odd that you don’t have to be right on your market call in order to still enjoy a winning trade, hear me out… because today, I’m going to give you one of the best options strategies that relies more on picking where the market won’t go, rather than where it will go.

Say, for example, you enter a regular options trade. Over the course of the trade, you begin to consider where the market won’t get to by the time the option’s expiration date, rather than where it will get to. It’s a natural thought, but there’s actually a big discrepancy between those two approaches - one that can make a world of difference in the future profitability of your options trades, because there’s a unique, invaluable way you can trade options that produce a profit - even if the market moves against you. Let me explain credit spreads with options…

Harness the Increased Probability of Option Credit Spreads

You do it by selling close-to-expiration, out-of-the-money option credit spreads that rely on the time decay factor to yield a profit. Here’s how it works…

When many options traders buy calls, they usually pick a strike price above the current price of the stock or commodity and hope it will get to that price by expiration. Similarly, when they buy puts, they choose options with a strike price below the current price of the stock or commodity, hoping that it will get to that price by expiration.

What they’re doing is buying out-of-the-money (OTM) options that have a low probability of turning a profit.

So what we do is take advantage of that and sell those options to them with a high probability of profit. Simple.

Specifically, here’s what you do:

If You’re Bullish: You sell an options spread below the current price of the stock or commodity.
If You’re Bearish: You sell an option spread above the current price of the stock or commodity.

This strategy is called “option credit spreads,” and it’s my favorite way to play the options market.

How You Can Benefit Three Times Over From an Option Credit Spread

The beauty of option credit spreads is that they allow you to profit in three different market scenarios, compared to the regular options buyer who can only profit from one scenario.

Cushion for Error: When you sell OTM option credit spreads, you gain a large cushion for directional error. This means you can still profit if the market goes up, down or sideways. The object of the option credit spread is to have both strike prices expire worthless so you can keep the option premium you receive upfront, or you can buy the spread back cheaper and lock in an early profit.

Receive Cash: The mechanics of the option credit spread is to sell the more expensive OTM option and buy a cheaper, further OTM option in one single transaction. Since you’re doing this, you’ll receive a cash credit in your account.

Limited Risk/Limited Reward: The option credit spread is a limited risk/limited reward type of trade that has a very high probability of profit. The most you can make is the amount of money you receive upfront from the buyer, and the most you can lose is capped and known ahead of time. There’s no possibility of unlimited losses with this kind of trade. The maximum you can lose is the difference between the strike prices, less the amount you collected upfront.

Although it might seem a little unconventional at first, once you see how this little-used strategy works in practice, you’ll find it can be very lucrative. Take a look at this chart of Orange Juice Futures for an example.

Orange Juice Futures Daily Chart

How an Option Credit Spread Helped Me Squeeze Profits From the Orange Juice Market

As you can see, the Orange Juice market was looking pretty bullish, following a strong rise from mid-July. I needed an option strategy that would take advantage of my directional outlook, but also protect me from possible downside in what is a volatile market. So here’s the key:

Instead of trying to pick an area higher on the chart where I thought OJ might go to, I picked a lower area that I thought OJ would not penetrate over the course of the option’s life. At the time of the trade on July 14, 2006, OJ Futures were trading around 15,500.

I opted to sell an OTM put option credit spread, selling the 14,000 put option for 300 points and buying the 13,500 put option for 200 as a spread in a single transaction. That gave me a credit of 100 points.

In the OJ market, one point equals $1.50, so I collected $150 ($1.50 x 100 = $150) at the outset of the trade. This is the most I can ever make on the trade, no matter where OJ ends up at expiration. The most I can ever lose is $600. This is calculated by taking the 500-point difference between the strike prices (14,000 - 13,500 = 500) and subtracting the 100-point credit, which gives you 400 points. In dollar terms, this equals $600 (400 x $1.50 = $600).

Since I was bullish on Orange Juice, I had a pretty good idea that it wouldn’t go below 14,000 by expiration - hence the reason I sold the 14,000 put option. As long as it never moved below 14,000, it was a winning trade. As each day passed, the options lost value and moved closer to expiring worthless. Thanks to this time decay, as well as OJ moving higher, I ended up buying back the spread early for 25 points ($37.50) and locked in a profit on August 1, 2006.

Three Chances to Win, With a 75% Chance of Success

With option credit spreads, all you need to do is shift your mindset from trying to figure where the market might go, and instead focus on where you think it won’t go. It’s a very different way of playing the market, but it gives you three winning scenarios for producing consistent, profitable trades. Alternatively, a regular buyer of an OTM spread would not only need the market to go higher, he’d also need it to happen in the time allotted to win on his trade.

In this specific OJ trade, for example, there was a 75% chance of all strikes expiring worthless. That’s high enough for me to take it. But the buyer of the spread only had a 25% chance. I like my odds better.

Good Trading,

Lee Lowell

Today’s Smart Profits Cribsheet

Generate consistent income… at someone else’s risk. Read my complete guide to trading out-of-the-money options and find out how this reliable strategy can ease the stress of buying regular options. For details, check out Smart Profits #255: “Out of the Money Options: Buyer Beware; Seller Take The Money.”

But before you get started, make sure you give my quick, six-step checklist for trading options a look. It gives you six great tools you can use for every options trade to increase your chances of coming out on the winning side in Smart Profits #213, Options Trading Tools: Six Key Tools for Trading Options.

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