By Dan Passarelli
The great thing about options is their versatility. Traders who learn how to trade options can create strategies that meet their particular criteria for risk, reward and probability of success with a little tinkering (okay, maybe a lot of tinkering). Managing and understanding the relationship between these three factors is one of the most important skills option traders must master.
A vertical credit spread involves selling an option while purchasing a higher or lower strike option (depending on bullish or bearish) with the same expiration month, with the short option being more expensive than the long option. Adding a long option to the short position creates a credit spread, which has a smaller potential profit than a naked option but also limits downside risk.
For example, a bull put credit spread on stock XYZ, which is trading at $26, would consist of selling the July 22.50 put ($0.70) and simultaneously buying the July 20 put ($0.20). The put that was sold is more expensive than the one that was purchased, providing a net credit of $0.50. The maximum profit potential for this trade is the net credit received, or $50 per spread if XYZ finishes above $22.50 at July expiration. The maximum loss is $200 per spread (22.50 – 22 - 0.50 X 100).
Why would anyone want to risk four times what they stand to make? The simple answer is probability. Given an infinite number of permutations of possible outcomes, the trader will make the $50 many, many more times than he or she will take the $200 loss. This was a hypothetical situation, but let's say that the strategy's likely winning percentage was close to 85%. The trader needs to look at prior historical price action of the stock to determine this along with volatility and the Greeks.
Implementing high probability trades like this credit spread is the opposite of what a majority of new option traders do in the market. What most people do when they speculate with options is to buy cheap out-of-the money options and pray for the home run. It's nice when it happens, but it usually doesn't happen nearly enough.
Of course, buying options outright is not necessarily always a bad idea. But if a trader is buying them and hoping to the hit the jackpot most of the time, then realize the odds are probably not on the trader's side.
This credit spread strategy is similar to the insurance business. Insurance companies get to keep premiums if people don't get sick, have accidents, etc. Traders turn themselves into something like an insurance company when they implement credit spreads and keep premium as long as something doesn't go drastically wrong.
Just like an insurance company has to decide if the risk is worth the potential reward, option traders who trade credit spreads have to analyze how much they can collect, how much they can lose, and the probability of having a profitable trade.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.