SMF Credit Spreads Options Trading
Spreading the Risk for Greater Rewards
One of the best ways to exploit the positive attributes of options is through the use of various combinations of long and short positions, typically known as spreads. A spread is a strategy that involves buying and selling simultaneous but opposing positions in different option series. There are many types of spreads however those used by retail options players generally have lower risk and limited profit potential when compared to outright long or short positions. From a theoretical standpoint, one of the options is a hedge that either makes the other option cheaper or reduces the potential loss in a short position. By using this approach, the trader attempts to offset the (adverse) effects of unexpected market movement thus allowing the combined position additional time to become profitable.
The primary goal of the conservative spread trader is to construct option combinations that offer a high probability of achieving an acceptable gain while maintaining adequate downside protection. One of the strategies used to achieve this objective is the credit spread. A credit spread involves simultaneously buying and selling the same type of options with different strike prices. When the option sold is more expensive than the option bought, a net credit results.
Credit Spread
Buy XYZ OCT-$22.50 Put at $0.25
Sell XYZ OCT-$25.00 Put at $0.75
Credit = $0.50 Cost Basis (break-even point)= $24.50
A credit spread is a type of "vertical" spread because the long and short options involve higher or lower strike prices in the option chain, but with the same expiration cycle. A similar directional position can be created by purchasing a call (or a put) and simultaneously selling a further out-of-the-money call (or put) thus establishing a spread with an initial debit.
Debit Spread
Buy XYZ OCT-$22.50 Call at $3.00
Sell XYZ OCT-$25.00 Call at $1.00
Debit = $2.00B Cost Basis (break-even point)= $24.50
Both debit and credit spreads have the same risk-reward outlook however there are distinct advantages to the latter approach, especially when the resultant position is very conservative (using out-of-the-money options). Another important advantage of credit spreads is they can be funded with portfolio collateral (such as stocks held in a margin account) while debit spreads need an investment of actual cash. In addition, credit spreads have lower commission costs because both options (in a successful position) are simply allowed to expire.B However, some traders favor positions that have no margin requirement and that's one reason debit spreads are popular. The primary disadvantage to in-the-money debit spreads (which are equivalent to out-of-the-money credit spreads) is the potential profits are slightly lower at the same cost basis, due to the characteristics of option pricing. For example, it is rare to find an in-the-money put debit spread that will provide the same risk to profit ratio as the equivalent out-of-the-money call credit spread. The same situation exists with in-the-money call debit spreads and out-of-the-money" put credit spreads. Let's examine this concept further with some hypothetical examples.
Suppose a trader wants to initiate a vertical spread on his favorite technology stock: ABC Technologies (ABCT). A quick review of the front-month options reveals that with the stock trading near $49.25, he can purchase the following in-the-money call debit spread:
Buy ABCT OCT-$45.00 Call at $5.10
Sell ABCT OCT-$47.50 Call at $3.00
Cost = $2.10B Break-Even = $47.10
Maximum Profit = $0.40B ROI = 19%
This position offers reasonable risk versus reward potential and based on the current technical character of ABCT, it appears to be a viable trade. But, a quick glance at the out-of-the-money put options exposes the following (bullish) put-credit spread:
Buy ABCT OCT-$45.00 Put at $0.60
Sell ABCT OCT-$47.50 Put at $1.10
Margin = $2.00B Break-Even = $47.00
Maximum Profit = $0.50B ROI = 25%
So, a brief comparison of the two plays suggests the credit spread offers slightly more profit potential in the event of a successful outcome.B In addition, the break-even or basis in the credit spread is slightly ($0.10) lower, thus resulting in reduced risk.
Those who are curious about the effects of current market trends may be wondering if this concept prevails with bearish issues. The answer is a resounding "YES" and to prove the point, we can examine the option prices for a bear-call credit spread previously offered in the Monthly Cash Machine portfolio. The name of the underlying issue is not important, so we'll call it XYZ Industries (XYZA). Since the issue was in a downward trend near $65, it's a good candidate for this illustration. The most favorable combination for a conservative (bearish) debit spread was:
Buy XYZA OCT-$75.00 Put at $9.90
Sell XYZA OCT-$70.00 Put at $5.80
Debit = $4.10B Break-Even = $70.90
Maximum Profit = $0.90B ROI = 21%
While this in-the-money put debit spread certainly was feasible, a more favorable profit/loss scenario was available using out-of-the-money calls. Consider this option combination for a trader with a bearish outlook:
Buy XYZA OCT-$75.00 Call at $0.70
Sell XYZA OCT-$70.00 Call at $1.70
Margin = $4.00B Break-Even = $71.00
Maximum Profit = $1.00B ROI = 25%
By selecting this spread, a trader would be rewarded with a higher return on investment in the event of a successful outcome. In addition, the break-even point would be slightly higher and the entire position could be funded with portfolio collateral, rather than an outlay of cash.
Credit or Debit - Which is Best?
The moral to this story is: Traders who favor low risk, high probability (vertical) spread strategies will almost always find better profit potential in out-of-the-money credit spreads than in the equivalent debit spreads. The primary reason is that in-the-money options have very little extrinsic value (premium) when compared to out-of-the-money options, which generally are all premium. In addition, the bid/ask spreads are larger with in-the-money strikes so you pay more for long options while the options you sell bring in less money. Think about these facts and review all the alternatives before you initiate your next vertical spread.