Definitions:
Buy Call Option: Buying Call options give the owner the right to buy the underlying asset at a strike price on or before expiration
Buy Put Option: Buying Put options give the owner the right to sell the underlying asset at a strike price on or before expiration
Sell Call Option: Selling Call options give the owner the obligation to sell the underlying asset at a strike price on or before expiration
Selling Put Options: Selling Put options give the owner the obligation to buy the underlying asset at a strike price on or before expiration
Roll: Rolling a spread works much the same way as rolling an individual option. You will most likely be moving out in time and moving the strike prices either up or down or retain the same strike prices, depending on the market trend. The difference is you will be trading four different options in one trade instead of two. In other words, you’re closing two existing options and opening two new ones.
When an option is bought it is subjected to time decay, meaning it loses value over time. Therefore, when you buy an option and the market moves sideways not only do you not make any money but lose money as well due to time decay. So it is better to be on the other side, the house so to speak to benefit from time decay even if the market moves only sideways. But, selling a naked call (short call) has unlimited risk if the market moves substantially against you and selling a naked put (short put) has large finite risk because the asset can only go to zero. So what we do? The answer is to use a credit spread which limits the risk while limiting the profits to some extent.
Put Spread and Call Spread
Put credit spreads (sometimes referred to as bull put spreads) and call credit spreads (sometimes referred to as bear call spreads) are vertical credit spreads that involve selling an option while purchasing a higher (call) or lower (put) strike option (depending on a bullish or bearish bias) with the same expiration and with the short option being more expensive than the long option. Adding a long option to the short position creates a credit spread. When the spread is created, it has a smaller potential profit than a naked option, but it also dramatically lowers the overall risk.
The most an option trader can make from selling a vertical credit spread is the initial credit. This is true no matter how much the underlying moves away from the credit spread. Maximum profit is capped. The call or put spread will expire worthless if the underlying is trading above the short put strike, or below the short call strike at expiration.
The most the spread can lose is the difference between the long and short strikes minus the credit received. The maximum loss would be realized if the stock is trading below the long put at expiration for the put spread and above the long call at expiration for the call spread.
Breakevens for the spreads are determined by subtracting the premium received from the short put for a put spread and adding the premium received to the short call for a call spread. Ultimately, the trader’s goal is to buy the spread back for less or have the spread expire worthless in order to profit.
For example, imagine a trader sells an 85 – 90 put spread for 0.75. The 90 strike put was sold for a credit of 2.50 and the 85 put was bought for a debit of 1.75. In this scenario, the maximum profit of $0.75 would be reached if the underlying were trading at or above $90 at expiration. The maximum loss would be $4.25 (5 – 0.75). That is the difference between the sold and bought strikes (90 – 85) minus the credit received. The maximum loss would be realized if the stock is trading at $85 or below at expiration. Breakeven would be at $89.25 (90 – 0.75) for this put spread. If the trader buys back the spread for less than 0.75 or if the spread expires worthless, he profits.
Risk – Reward Ratio
Often novice option traders tend to stay away from credit spreads because of the disparate risk‐reward, without considering probability of success. Depending on how the spread is implemented, a trader is usually going to risk more than they can make especially then the spread is set‐up out‐of‐the‐money (OTM). But generally, even though they are initially risking more on the trade than they are willing to make, the odds of profiting are prohibitively in their favor.
Rubber meets the Road. How did I do with real money in real time?
The two indices SPX (S&P 500) and RUT (Russell 2000) are picked for their volatility (hence more premium can be collected) during the months of March through May of 2016 when both remained relatively flat, conducive to playing the credit spread options.
Please take a look at the charts for SPX and RUT from March 18 2016 to April 15 through May 20 2016. Please take a look at my journal of option trades comprising 11 SPX trades and 22 RUT trades amounting to a total of 33 trades. There were 19 calls and 3 puts for RUT consisting of 2 bull put spreads and 8 bear call spreads. There were 11 SPX calls consisting of 4 bear call spreads. There were 13 rolls each consisting of a pair of credit spreads. 7 credit spreads could have been avoided that would have increased the return on investment. There was only one bear call spread (trades 3 and 4) that resulted in some loss in May 2016 roll over trade RUT 1100/1090 because of the up trending market.
Total Fund invested = $66,000
Profit in one month after commission = $7813.41
Profit in one month before commission = $8265.00
Hypothetical Annual Income after commission = $93,760.92
Hypothetical Annual Income before commission = $99,180.00
Return on Investment (30 days) after commission = 12.60%
Annualized rate of return after commission = 153.33%
Annualized rate of return before commission = 162.19%
Commission paid = $451.59
Commission paid as a percentage of profit = 5.46%
Hypothetical Scenario
The beauty of options is that it is scalable. Scaling up the fund invested by 10 folds to $660,000, using the same trades, the hypothetical annual income is close to a Million! There you have it the road map to a possible Millionaire in one year! That is too aggressive. How about in 5 years? Doable?
Options are not the complicated instrument many would have you believe.
In Wall Street they use an old proverb regarding arbitrage which has been reworded:
“Give a man a fish and you feed him for a day. Teach him how to arbitrage and you feed him forever.” – Warren E. Buffett.
The cave you fear to enter holds the treasure you seek. – Joseph Campbell.
U.S. Government Required Disclaimer – Forex, futures, stock and option trading is not appropriate for everyone. There is a substantial risk of loss associated with trading these markets. Losses can and will occur. No system or methodology has ever been developed that can guarantee profits or ensure the avoidance of losses. No representation or implication is being made that using the strategies or tactics, or the information in this website or accompanying material will generate profits or ensure avoidance of losses.