OPTIONS
Limited Risk With Limited Profit
Option Credit Spreads
by Lee Lowell
Selling options is usually a good idea. Here's a tactic
to do it.
Option trading all comes down to
probability of profit. Statistically, option sellers always have a better
chance of profiting. It's true that when you sell options your profit is
limited, but your chances of walking away with that profit are high. The
reverse is true for option buyers. Their potential profit is limitless,
but the odds of achieving that profit are very small, especially with out-of-the-money
options.
FIGURE 1: OPTION CHAIN. Options Express, one of many
options brokers, provides a full list of market pricing for just about
any credit spread.
Why not put the odds of success on your side and learn how to become a
smart option seller? Naked (uncovered) option selling entails unlimited
risk and limited profit, but there is a strategy of option selling that
has limited risk as well as limited profit. It's called a credit spread.
HOW CREDIT SPREADS WORK
In a credit spread, you sell an option and buy a cheaper option at the
same time to limit your risk. Since you are selling a more expensive option
than you are buying, you get to take an initial credit into your account.
As long as you implement the trade as a spread, you will never be exposed
to unlimited loss, as is the case with naked option selling.
Credit spreads come in two types -- the bear call spread and
the bull put spread. A credit spread is always used with either
all calls or all puts and within the same expiration month. A call credit
spread consists of selling a more-expensive, lower-strike call (say, a
100 call for $5), and buying a less-expensive, higher-strike call (such
as a 105 call for $2). A bull put spread consists of selling a more-expensive,
higher-strike put (a $100 put for $5) and buying a less-expensive, lower-strike
put ($95 put for $2). In both examples, your net credit is $5 - $2 = $3
per contract.
The best outcome of a credit spread is to have all the strikes expire
worthless so you can keep the entire premium you collected at the beginning.
Credit spreads should be initiated using the two closest months to expiration.
This is when time decay starts to accelerate, and it gives the underlying
security less chance to make a move against the position.
Credit spreads can be used with individual stocks, futures options,
or indices such as the OEX, QQQ, Standard & Poor's 500, and so on.
If you are playing the stock market, credit spreads are preferable with
an index such as the OEX or SPX options because there's less chance of
a gap move than there is with many individual stocks.
Credit spread trading is a simple, safe, and stress-free type of trade
that does not require a great deal of monitoring. You just place the trade,
collect the credit, and wait for the options premiums to decrease or expire
worthless. And if the underlying security starts to move against your position,
there's no need to worry; your loss is limited, no matter how far the security
might move. Plus, you can always unwind the spread at a small loss before
expiration occurs. ...Continued in the May 2001 issue
of Technical Analysis of STOCKS & COMMODITIES
Lee Lowell is a former New York Mercantile Exchange (NYMEX) options
pit trader. He continues to trade energy and other derivative options from
his home office in Hawaii. He can be reached via e-mail at syd697@hsa-kauai.net.
Excerpted from an article originally published in the
May 2001 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2001, Technical Analysis, Inc.
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