Common Misconceptions About Credit Spreads You Should Know

Posted on May 13th, 2011 admin No Comments

The options market has been very busy lately. The volume of options being trades is growing rapidly with more and more investors jumping in. And as the audience grows, so do the articles about how “risky”options trading is for beginners. And it’s completely true if you trade blindly, but there are 3 very common misconceptions about Credit Spreads in particular that I wanted to cover.

1) They Are Used For Day Trading

The most common misconception is the ignorant comparison to day trading. Day trading and Position trading with Credit Spreads are completely different. Unlike day trading, Credit Spreads derive their income from a low risk strategy.

Day trading however involves extreme intra-day risk, massive amounts of capital, nearly constant attention and huge commission costs. It can be extremely time consuming. On the other hand, many investors choose to use Credit Spreads as their primary income vehicle for any market.

2) You Will Get Rich Overnight

I don’t care what seminars you have been too or what books you have read, Credit Spread trading is income oriented and will not make you a millionaire overnight. It’s not a “Get Rich Quick” strategy and you had better understand that right now.

As Warren Buffett says:

Risk comes from not knowing what you are doing.

Learning any options trading strategy involves a certain amount of personal discipline and education. Once you grasp the basics of Credit Spreads you will have a very solid and consistent strategy in your trading arsenal.

3) Credit Spreads Are Only For “Professional” Floor Traders

The reality is this strategy is for anyone looking to make consistent income returns on their money minimized risk. Whether you are a professional or a beginning trader doesn’t matter to the market, so long as you know the in’s and out’s of the strategy. Great trades make money and bad ones lose money; regardless if you are a professional or not.

Actually, most traders use credit spreads because of the relatively low capital needed to start profiting. Unfortunately, many people never even get started because they think they need to have thousands of dollars saved up. This is a far more costly mistake.

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Bull Put Spread: Strategy Risks

Posted on March 17th, 2010 admin No Comments

It is important to always be aware of the strategy risks. The primary risk when placing a bull put spread is when the share price decreases past the sold put and an ever greater concern is if the share price decreases below the bought put (protection). Since you receive a premium to enter this trade there is a required margin. This margin can increase to as much as 1.2 times your maximum loss. For example if you were risk $2,000 the cash margin required in the account can increase to $2,400 (2000 *1.2) which includes the premium received. So it is important to know your maximum risk and make sure there are enough funds to cover the worst case scenario.

Another risk inherent with selling options is volatility. When you open the bull put spread you want the volatility to be high so you can sell the put options for as much value as possible. Once the trade is placed you want the volatility to drop off and time decay to kick in. So even if the share price stays still but volatility increases the position may not profit in the short-term. Increased levels in volatility mean to close out it will cost more to buy back the sold put. If the share price decreases below the sold put prior to expiry there is potentially a risk of exercise.

Exercise

The main risk of credit spreads is the risk of being exercised. If the sold put is exercised it means that you are obligated to buy shares at the exercise price of the sold put. This can have a negative impact in terms of you have bought shares you do not own which means you need to sell them back at the lower level and therefore locking in a loss on the share position. If the share price is below the bought put (protection) when exercised then you can sell the put option which will reduce the loss from being exercised. It is still not possible to lose more than the maximum risk before entering the trade. Another disadvantage of being exercised is the brokerage on the share purchase and sale so it is a good idea to try an avoid exercise. To avoid being exercised you need to monitor your position and more importantly the delta on the sold put. If the share price is below the sold put an indication of the likelihood of being exercised can be identified by the delta. If the delta on the sold call is below -0.95 there is a chance being exercised. If the delta is below -0.98 then it is necessary to implement one of your exit strategies.

To avoid exercise there are two options. If you think the share price will keep decreasing you can close the trade for a loss. If you think you view is correct and the share price will rise from this level and want to keep the position you can roll out to the next month. What this means is you can close the positions you have an open the same position for the next month and do this for no cost or a small credit. Therefore if the share price then increases above the sold put by the next month you can still make maximum profit.

To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

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Bull Put Spread: Trade Analysis – Risk vs. Reward

Posted on March 17th, 2010 admin No Comments

Trade Analysis

Analysing your trade is essential before placing the trade. You need to make sure you have the necessary detail and go through the following checklist:

  1. Stock Selection: Double check your analysis on the stock and make sure your outlook on the share price reflects the bull put spread.
  2. Determine max loss and check that that is suits your risk profile and how much of your trading account you are risking.
  3. Determine premium received when entering trade, most important as it is also your maximum profit.
  4. Make sure you risk vs. reward suits the trading strategy.

Risk vs. Reward

The risk vs. reward will be different for every strategy. Credit spreads have a lower risk reward meaning the maximum profit (reward) is quite low relative to the maximum loss (risk). This trade can be positioned to risk $0.50 to make a $0.50 this is when the bull put spread is traded at-the-money. The trade can be more cautious by selling out-of the money options where you risk $0.80 to make $0.20. Both trades work well at the right time but the first example only requires a 50% success rate to break even while the second example requires an 80% success rate to break even.

Author: Matthew Gartrell

To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

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Bull Put Spread: Identifying Trades – The Greeks

Posted on March 16th, 2010 admin No Comments

Delta

When identifying trades it is essential to look at the delta of the option legs. In particular it is important to calculate the net delta of the bull put spread. The net delta is calculated by the delta of the sold put option minus the delta of the bought put option. The net delta will always be negative. The net delta indicates if the share price increases quickly what the value of the bull put spread will be worth. For example, if a bull call spread had a net delta of -0.20, and the share price decreased by $1.00, the bull put spread would have decreased by 20 cents. Therefore to close out the position you buy back the position for less than the premium received to enter the trade.

Vega

The volatility affect on a bull put spread is positive. When looking to enter a bull put spread you look to sell an out-of-the-money put option. The idea is to sell a put option which has a relatively high volatility and therefore trading above its theoretical value. The bought put even further out-of-the-money and you want to buy this option with low volatility. When entering the trade you want to volatility to be high and decrease throughout the trade.

Theta

Credit spreads are set up to take advantage of time decay. The effect of time decay on this strategy varied with the underlying share price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the higher strike price of the sold put, profits generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the lower strike price of the bought put, losses generally increase at a faster rate as time passes.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

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Bear Call Spread: Trade Analysis – Risk vs. Reward

Posted on March 10th, 2010 admin No Comments

Trade Analysis

Analysing your trade is essential before placing the trade. You need to make sure you have the necessary detail and go through the following checklist:

1. Stock Selection: Double check your analysis on the stock and make sure your outlook on the share price reflects the bear call spread.

2. Determine premium received when entering trade, most important as it is also your maximum profit.

3. Determine max loss and check that that is suits your risk profile and how much of your trading account you are risking.

4. Make sure you risk vs. reward suits the trading strategy.

Risk vs. Reward

The risk vs. reward will be different for every strategy. Credit spreads have a lower risk vs. reward meaning the maximum profit (reward) is quite low relative to the maximum loss (risk). Bear call spreads can be positioned to risk $0.50 to make a $0.50 this is when the bear call spread is traded at the money (Risk vs. reward 1:1). The trade can be more cautious by selling out-of-the-money options where you risk $0.80 to make $0.20 (Risk vs. reward 4:1). Both trades work well at the right time but the first example only requires a 50% success rate to break even while the second example requires an 80% success rate to break even.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

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Bear Call Spread: Identifying Trades – The Greeks

Posted on March 9th, 2010 admin No Comments

Delta

When identifying trades it is essential to look at the delta of the option legs. In particular it is important to calculate the net delta of the bear call spread. The net delta is calculated by the delta of the bought call option minus the delta of the sold call option. The net delta will always be positive. The net delta indicates if the share price decreases quickly what the value of the bear call spread will be worth. For example, if a bear call spread had a net delta of 0.20, and the share price decreased by $1.00, the bear call spread would have decreased by 20 cents.

Vega

The volatility affect on a bear call spread is varied. When looking to enter a bear call spread you look to sell an out-of-the-money call option. The idea is to sell a call which has a relatively high volatility and therefore trading above its theoretical value. The bear call spread can be traded when volatility is high on the call option which allows the spread to be higher above the current share price so the stock would have to increase further before affecting the trade.

Theta

Credit spreads are trades that take advantage of the time decay nature of options. The effect or time decay is a positive for this trade. When the share price is below the sold call if the share price and volatility remain constant this value of the position will reduce and therefore increase your profit. If the stock price is closer to the lower strike price of the sold call, profits generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the bought call, profits generally decrease at a faster rate as time passes.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

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Option Spreads: The Strategy

Posted on February 23rd, 2010 admin No Comments

The option spreads are divided into two categories debit spreads and credit spreads. These refer to the cash positions that can result from this transaction, positive (credit) or negative (debit) cash flow.

Debit Spreads

A debit spread is when the trade is set up for a cost and you have to pay a certain premium. If you are paying more for the bought option than receiving for the sold option it is a negative cash flow position. The strategies that are debit spreads are Bull Call Spread and Bear Put Spread.

Credit Spreads

A credit spread is when you initially receive a premium. If you are receiving more for the sold option than paying for the bought option it is a positive cash flow position. The strategies that are credit spreads are Bull Put Spread and Bear Call Spread.

A bull spread is profitable when the share price increases while a bear spread is profitable when the share price decreases.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

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