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Credit Spread Trading
The Smart Profits Report: Issue #364
Friday, October 20, 2006
Credit Spread Trading: How To Be Wrong… And Still Win On Your Trades
By Lee Lowell
Futures Options Specialist, Mt. Vernon Research
Two weeks ago, I jetted off to Las Vegas with the rest of the Mt. Vernon Research team for our first-ever Commodities and Trader Seminar.
While there, I gave a detailed presentation on my favorite investment strategy - option credit spread trading. Simply put, this is a fabulous way to invest - one of the most profitable techniques I know to squeeze gains from just about any market. I execute this type of trade for myself more than any other, and it’s also one that my Triple-Zone Profits Trader subscribers will see time and again.
Before I go over the finer points of option credit spread trading for you so you can see just how profitable it can be, let me start by telling you the biggest benefit of the strategy…
How You Can Be Wrong… And Still Profit
Picking the correct direction of the market is not the driving force behind being profitable.
That’s right.
When was the last time someone told you that? Probably never. I’m sure we’ve all learned over the years that the only way to win on a trade is to get the direction right.
If You Want To Be “In The Money,” You Have To Go Out-Of-The-Money
Well, that’s all going to change when I show how to profit with the option credit spread.
The trick to succeeding with option credit spreads is to use it with out-of-the-money (OTM) options. The option credit spread is an “option-selling” technique that involves selling a more expensive OTM option and offsetting it by buying a cheaper, farther OTM option.
Since we are selling the more expensive option, the buyer will be putting a cash credit into our account. Remember: We’re not paying for this spread, someone is paying us.
There’s just one thing you need to know before you initiate an option credit spread: You must have at least some idea where you think the market may be headed. The market can be anything you want - the Dow… S&P… commodities… bonds… currencies… or an individual stock. You won’t have to be totally correct on the direction, but you must have an idea about it. Once you’ve got that covered, then you can move on to the next step.
How To Grab Gold Profits By Shifting Your Attitude
Take a look at the chart below, which shows Gold futures that expire in February 2007. Even though the price of gold has trended lower over the last few months, you might think that gold will start to head higher in the near future, or at least not go down much farther. This is a bullish attitude and we want to play that directional call with an option spread. So what do we do?
Listen to my next sentence…
We’re not going to try and predict how high or how far gold might go to by option expiration. We’re going to predict where it likely won’t go to by option expiration.
There’s a huge difference in those two approaches. We know gold is going higher, but we’re not sure how high. However, following our technical and fundamental analysis (don’t forget to do that!), we’re more sure that it won’t be going lower than the $530 level.
Since we’ve predicted that gold won’t be going lower than $530, we want to sell an OTM put option credit spread. This is a limited risk/limited reward, bullish type of trade. We want to choose options that correspond to our support levels, so we will sell a February 2007 $530 put option and simultaneously buy a February $520 put option in one single transaction and collect a premium of $1.30 ($130 in real dollars with the $100 Gold multiplier). Someone will be paying us $130 to sell that spread to them. Since we’re selling this option spread, the most we can make on the trade is that $130. There is no chance to make unlimited profits with this trade.
The option credit spread is a type of strategy used to hit singles and doubles and to collect premiums over and over again in as many markets as you want to trade in and as many times during the year as you can.
It’s a slow, steady gainer type of trade with an extremely high probability of profit. That’s why I execute it so much - because the probability of winning is very high. How do we know that…?
Know Your Chance Of Success Before You Trade
Take a look at the probability calculator below - specifically the box in the bottom right-hand corner. It shows us that our probability of being successful on this trade is 88.1%. I like those odds.
What we don’t want is for gold to trade lower than our breakeven price of $528.70 (calculated by subtracting the spread price of $1.30 from the short strike of $530 - $530 - $1.30 = $528.70).
If gold retraces back down to the $528.50 level, that’s where we’ll start to lose money. However, we’re starting with a huge cushion. Gold is $70 above our danger zone. As long as gold doesn’t go back down there by option expiration, we get to keep the whole $130 per spread. And the probability calculator is telling us that there’s an 88.1% chance that gold will not go below our breakeven price of $528.70. That’s sweet!
Make Your Life Easier With Option Credit Spread Trading
Why would you want to make life difficult for yourself by trying to predict where a market/stock might go? That’s a very hard thing to do. Save yourself the frustration by simply figuring out where it likely won’t go. Do that… and you’ll give yourself three chances to win. In our trade above, it works like this…
- As long as gold stays above $528.70, we win.
- Gold could flatline and we’ll win.
- Gold can even move lower, against our prediction, and we can still win.
So get out of the mindset of trying to predict where the market is headed. Give yourself a better chance of being correct by figuring out where the market is not headed. Once you’ve done that, you can sell OTM option spreads and reap many small winners over time.
Good Trading,
Lee Lowell
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Today’s Smart Profits Cribsheet
- I gave a detailed introduction to the option credit spread technique, and explained exactly how you can implement it into your investment strategy today. Check it out in Smart Profits #348, Credit Spreads With Options: How Option Credit Spreads Give You a Better Chance to Win.
Related Articles:
- Out-Of-The-Money Options: Buyer Beware… Seller, Take The Money
- Strike Prices: Increase Your Odds by 99%
- Understanding Options Leverage: The Power of Leverage Is Bigger than You Think
