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Option Credit Spreads

The Smart Profits Report: Issue #267
Thursday, December 15, 2005

Option Credit Spreads: Sell First, Buy Second for 50% Better Odds
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

Much of my own option trading occurs from the short side. I’m not referring to a bearish directional outlook, but rather a trading strategy that involves the selling of options instead of buying them. This involves either selling “naked” options, or initiating option credit spreads.

You see, you don’t always have to be an options buyer, and you don’t have to own something first before you can sell it. The great thing about the financial markets is that you can sell first and buy second, instead of the long-standing philosophy of buy first, sell later.

The reason I like to sell options is because I believe that you gain more margin for error if you are incorrect in your market assessment. But you have to know how to sell them correctly. You can’t just sell any old option and think you’ll have a profitable trade. You have to take into consideration the following:

  • The general direction of the market or stock you’re trading
  • The strike price
  • Time to expiration
  • Volatility of the options

Many people trade options under the assumption that because they think they know where the stock is headed, they can buy cheap out-of-the-money (OTM) options with little time to expiration. This is the downfall of most option traders. How many of us are actually that good at predicting where and when a stock is going to move? I know I’m not, but many investors still trade options that way. You’re giving yourself such a small window to be correct in your assessment since there’s not much time left before the option expires.

Let’s look at why the short side can be more profitable than the long… and how to set up a put credit spread for a 75% chance of winning.

Three Out of Four Chances to Win With A Credit Spread

When you buy an OTM call or put, you only have one way to be profitable, and that’s if the stock moves far enough higher or lower to pass your break-even point in the time allotted. When you sell an out-of-the-money call or put, or an OTM credit spread, you actually have three ways to become profitable.

For example, if you sell an OTM put option or put credit spread, you will be profitable if the stock moves higher, stays flat, or moves slightly lower, but not lower than your break-even. If you sell an OTM call option or call credit spread, you will be profitable if the stock moves lower, stays flat, or moves slightly higher, but not higher than your break-even. The only way to lose is if the stock moves well past your break-even price.

So that’s three out of four scenarios, or a 75% chance of having a successful trade when selling options. When buying options, you really only have a one-in-four chance of winning, or 25%. I like the odds better when selling options - you can be incorrect in your market assessment to a degree, and still have a profitable trade.

Let’s take a real-life scenario and see how I would set up an option trade:

Here’s a six-month daily chart of March 2006 Sugar. We can easily see that sugar has been in an uptrend for quite some time, so why try to rock the boat and trade any other way? Let’s stick with the trend and look for a bullish trade.

Instead of buying call options and trying to predict what level sugar might go up to, we’re going to look at selling OTM put credit spreads instead. Selling put credit spreads is a bullish strategy that lets us take advantage of our directional bias, but also gives us room for error if sugar retraces to the downside somewhat.

How The Option Credit Spread Works

Ideally, we’d like to wait for sugar to pull back a little to one of our trendlines before initiating the trade, but I will show you the strategy so you understand how it works. Since we believe sugar won’t retrace much lower than the $1,270 level, we’ll use that as our support area, and the place in which to pick the strike prices for the put spread. We’d like to sell the $1,250/$1,200 put spread (not a recommendation - educational purposes only!). Let’s check the option prices below.

We can sell the March 2006 $1,250/$1,200 put spread for 9 points. Here’s how it breaks down:

What we’re doing is selling the $1,250 put (for a credit of 21 points) and buying the $1,200 put (which costs us 12 points) as a single trade for a net credit of 9 points. If you look in the “Last” column, you’ll see the prices for each strike. Just take the difference between the two and you get your net price.

In the sugar market, each point is worth $11.50, so our initial credit is $103.50 (9 x $11.50) for each spread we sell. Since we are bullish, we don’t want sugar to go lower than our break-even price of $1,241. In order to figure the break-even, you take the upper strike in this case and subtract the net credit ($1,250 - 9 = $1,241). As long as sugar stays above $1,241, we will retain the net credit and have a profitable trade. Sugar can go higher, stay flat, or go lower, but not lower than $1,241 for us to win. Since sugar is currently at $1,381, we have much room for error and three out of four chances to win.

Based on our technical analysis, I think it’s easier to predict what level the market WON’T get to, rather than the level it MIGHT go to.

Good Trading,

Lee Lowell

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