How many times have you bought a call option only to see the stock moving in the wrong direction? When you are bullish on a stock and buy a call option, you need to be right three times: about the direction of the move, about the size of the move and about the timing. This is a very difficult task and not many traders can do it consistently.
There might be a better way. We want to take the other side of the trade and sell options to those high-risk buyers. We are going to use a strategy called a credit spread. This is a limited risk, limited reward, directional strategy. If you are bullish, you will sell a put credit spread. If you are bearish, you are going to sell a call credit spread. This trade has more than one way to win. You don’t have to predict where the stock will go to, but where the stock likely won’t go to. You win if the stock goes in the right direction, stays unchanged or goes in the wrong direction but not too strongly.
Let’s take a look at hypothetical trade using the SPDR SP&P 500 (NYSEARCA:SPY) as an example. If you think that SPY will stay above $120 by January 2012 expiration, you can place the following trade:
- Sell 10 SPY January 2012 120 puts.
- Buy 10 SPY January 2012 119 puts.
With SPY currently trading at $126.05, the trade can be done for $0.22 credit. By selling ten contracts, you will get $220 credited to your account. This is the maximum profit. The margin requirement for this trade is $780, so the maximum return on margin is 28.2%. This return is realized if by January 2012 SPY stays above $120. It gives you a 5% downsize caution.
Based on the delta of the short options, this trade has 70% probability of success. You can go with lower strikes (for example, sell 118 put, buy 117 put) to increase the probability of success, but this will reduce the credit and the potential maximum gain.
What is the exit strategy? I like to exit when I can buy back the spread for 20% of what I paid. In this case, it would be about 4 cents. The last few cents are not worth the risk. On the downside, one reasonable exit plan would be to buy back the spread when if SPY goes down and touches the short strike. Depending on when it happens, the loss can be in 10-20% range. If it happens after few weeks, the trade can even make money.
I ignored commissions in all my calculations. Make sure you are using the right broker if you are going to trade options, otherwise commissions will eat a significant portion of your trading account. Even with the right broker, some trades will be more commissions consuming than others.
Like I mentioned, there is more than one way to win with this trade, and time is on your side. The trade is theta positive, which means that it makes money from the time decay. The time decay will accelerate the closer you get to expiration.
How does it compare with buying a straight call? Let’s compare it with buying At The Money (ATM) options with the same expiration. SPY January 2012 126 call will cost $3.87. That means that you need SPY to be at $129.87 at January expiration just to break even. To make the same 28% as with the credit spread, you need SPY to be at $131. That’s an increase of 4%. Of course if SPY makes a quick and sharp move up, the call will make bigger gains, but the opposite is true as well. The probability of success is about 50% since this is ATM option.
The bottom line: if you like the odds of making 28% in five weeks with 70% probability, the credit spread strategy is for you.