Wouldn’t it be nice to know the MAXIMUM loss-potential if an options trade completely flops??? Credit spreads enable one to do so, and if used wisely, they can be great sources of consistent income. This is a GREAT strategy for the so-called ” base-hit ” investor that acquires wealth steadily, as opposed to recklessly ( or not at all ). The strategy involves selling an option contract for a price ( X ) and then buying a lower priced option for loss protection. Since the premium earned from the sale exceeds the cost of purchasing protection, a net credit of money is allocated to the trader. I’ll use a call option to emphasize the point.
A call option gives one the right ( but not the obligation ) to buy 100 shares of an asset at a predetermined ” strike price “. For example, let’s say that a stock is currently trading at $50.00, but we think that it may rise to $60.00 in a month. In order to capitalize on the upside movement of the stock, we purchase a call option with a strike price of $52.00. A single contract costs $0.20 cents, but because options contracts are sold in groups of 100, the net cost of the investment is $0.20 cents x 100 = $20.00 ( totally made up numbers that may not correspond to meaningful examples ).
Let’s now assume that the contract goes ” in the money “, because as predicted, the stock price rises above $52.00. How high must the price rise before we earn back the money paid for the contract??? EACH INCREMENTAL PRICE INCREASE ABOVE $52.00 MUST BE MULTIPLIED BY 100 TO DETERMINE THIS. $20.00 broken into 100 parts equal $0.20 cents, so we actually begin making money when the stock price rises above $52.20. This is referred to as the ” breakeven price “. If the stock actually rises to a price of $55.20 as opposed to the $60.00 we assumed, we’re still good to go. $55.20 represents a $3.00 move above the breakeven price. For this reason, upon expiration, the options contract will have earned us $300.00.
What if we’d decided to exercise the contract when the stock price rose to $55.20??? Well, we’d have to have $52.00 x 100 = $5,200.00 in capital to purchase 100 shares that are now worth $55.20 x 100 = $5,520.00; thus, we’d be getting the 100 shares at a great discount equal to $5,520.00 – $5,200.00 = $320.00. Since our initial investment was $20.00, our net gain realized by exercising the contract ( as opposed to selling it for its value ) is…$300.00.
Now, let’s suppose that we SELL the contract above on the open market. This would earn us a premium of $20.00, which would be deposited into our trading account. The contract-holder ( which could be an individual, a bank, a…who knows ) has the right to buy 100 shares of the stock at $52.00 a share. We must have 100 shares of the stock in our possession to provide to the buyer if things go their way. If the price rises to, let’s say, $57.00…and the contract holder exercises the option, even though the 100 stocks we’re holding as collateral would be worth $57.00 x 100 = $5,700.00, we’d still be obliged to sell the 100 shares for $52.00 x 100 = $5,200.00 for a net LOSS of $500.00.
If we wanted, we could limit our loss-potential by purchasing a call option with a $55.00 strike price as upside protection. SINCE THE STOCK IS INITIALLY TRADING FOR $50.00/share, A CALL OPTION WITH A $55.00 STRIKE PRICE WILL BE LESS EXPENSIVE THAN ONE WITH A $52.00 STRIKE PRICE. This will enable us to purchase the upside protection for less than what we earned by selling the contract with the $52.00 strike price. THIS IS WHERE THE ” SPREAD ” TERMINOLOGY COMES INTO PLAY. Let’s say that the call option that we buy ( $55.00 strike price ) costs us $0.10 cents x 100 = $10.00. Since we earned $20.00 by selling the contract with a $52.00 strike price, we earn a net credit of $20.00 – $10.00 = $10.00.
Since the call option sold has a strike price of $52.00, and the one we purchased for upside protection has a strike price of $55.00, the price range of interest to us represents a $300.00 spread. Since we initially earned a premium of $10.00 when the credit-spread trade was enacted, our maximum loss will be $300.00 – $10.00 = $290.00. We would begin losing money if the stock price rises above $52.10 cents. The range between $52.10 and $55.00 is $55.00 – $52.10 = $2.90 cents, and as seen before, this range represents a potential loss of $290.00.
With this credit spread, it would be advantageous to us if the stock price FALLS. If this occurs, we keep the entire value of the premium allotted to us in the beginning. FOR THIS REASON, A CALL CREDIT SPREAD WILL BE PURCHASE WHEN WE BELIEVE THE MARKET IS HEADED DOWNWARD.
One last note: Options do come with risks, but selling them has some potentially disastrous consequences, one of which involves a possible ” early assignment ” that catches the seller off guard ( MENTORS PLEASE, OOOH!!! ). This could occur when the holder of a contract we sold has determined that the dividend awarded on some date would make a normally unfavorable trade a favorable one. Additionally, I heard of an instance where a credit spread expired, and a trader was supposed to earn about $5,000.00 on a Tesla ( TSLA ) trade. Instead, the option bought for protection expired, but the one sold remained valid for a short period of time after the expiration date had passed ( literally, a couple of hours ). During this time, Tesla stock surged, and without upside protection, A TRADE THAT WAS SUPPOSED TO NET $5,000.00 TURNED INTO A $30,000.00 LOSS!!!
Buyer beware!!! Get a mentor!!!
RENAISSANCE PHYSICS 