Credit Spread Strategies

I received a question from Harry yesterday about losses with out of the money option trading. So here are the basics concerning credit spread strategy and how each method affects the bottom line. There are two main ways to trade credit spreads – either a low capital risk trade or a high probability trade.

The low capital risk trade consists of making a trade using in the money (ITM) options or at the money (ATM) options to compose the credit spread. For example a stock trading at $55. You are bearish on this stock feeling that it will fall below $50 and stay there. You create a credit spread using calls called a Bear Call Spread. You would sell an ITM $50 call for $5.75 and then buy an ATM $55 call for $2.00 creating a credit for $3.75. The max value of the spread, the difference between strikes, is $5 (55-50), which makes your max risk is $1.25 (5-3.75). This is the low capital risk your are making $3.75 while risking $1.25 which makes for a 300% rate of return. So a high rate of return a low capital risk, what could be wrong with this trade? The probability of success. The stock needs to be below $50 and stay below $50 at the expiration of the options in order to be a successful trade. You need to be correct in your assessment of the direction of the trade.

The high probability trade consists of making a trade using out of the money (OTM) options to compose the credit. Using the same example of a stock trading at $55 that you are bearish, feeling it will fall and stay below $50, we create a different type of credit spread. To create the credit spread, you would sell an OTM $65 Call for $1.10 and buy an OTM $70 Call for $.50 creating a credit of $.60. The max value is still $5 which makes your risk $4.40, much higher than the previous example. This makes for a high capital risk making only $0.60 while risking $4.40 which makes for a 13% rate of return. This can also make for some pretty rough losses. You need good rules to cut your losses quickly and good money management. The benefit however is in the probability of the trade being successful. The stock will need to close below $60 at expiration of the options and since it already is below $60 and you feel the stock is weak and will be going lower. The probability of it gaining 10 points or 18% is unlikely in comparison to the previous low capital risk trade in which the stock is at 55 and has to fall 5 points and stay below $50 for the trade to be successful, which makes this credit spread a high probability of success.

Low capital risk but also a low probability of success for the beginner or a higher capital risk with a high probability of success makes for the two choices for the credit spread trader. The choice depends on the traders personality – a more involved trader one that really likes to pay close attention to his trade and can make adjustments when necessary may prefer the low capital risk trade. The trader trading part time or is more conservative in their trades one that likes to place a trade and then just monitor it once daily would be more likely to choose the high probability trade. Which type of trader are you?

A Tax on Trading?

Rep. Peter DeFazio, D-Oregon is proposing a tax on trading. A small trading tax on all securities of .25% to try and cover the costs of the $700 billion bailout bill. He suggests that we as small traders are gambling and that the stock market crash was caused by all of us gambling. I usually do not discuss politics on this blog but this really affects me as a trader and it will really affect a trader that trades for a living.

One of the examples displayed in a video from CNBC suggests that a trader with $500,00 that makes 100 trades of $100,000 would be facing a $25,000 tax!

Watch this video from CNBC which has the Congressman explaining how he feels that we as traders should be paying for the bailout bill – Small Trading Tax, Big Impact?

Then call or write your congressman.

I’m sure you have noticed

Just wanted to comment about the other posts in my blog. You know the ones from other authors. I actually am having guest authors now on a regular basis talking about all different aspects of trading and the stock market. The reason is that it will broaden your knowledge base about trading in general. If you know more about a subject in general terms it will help you in your more specific areas such as credit spread trading.

Every post is reviewed by me before it is posted to the site. I hope you enjoy the perspective of these guest authors. Each post will contain a link back to the author or their site that they write for. I will still be posting my own information about option trading focusing on credit spreads, iron condors and diagonal spreads.

I am also sure you have noticed the new format of the blog, if you have not because you are getting these posts via email be sure to check out the new site format… http://www.creditoptionspreads.com

Thank you for being a reader and please comment on anything you like or wish to improve upon this site.

Hollywood to as an indicator to the upcoming BEAR!

Here is an interesting article corrolating Hollywood movies about the stock market and Big Bear drops.

Market Top III: Return of the Gecko by Dominick Mazza and Joe Nicholson. The corrolation is between when the market topped in 1987, in 2000 and right now we are possibly looking at a market top and when the movies Wall Street, Boiler Room and now the upcoming film Money Never Sleeps

It is one of those interesting analogies that probably has no corrolation whatso ever and is merely coincidence – well not coincidence because I really do not believe in coincidence but rather if you look at something then you may just find what you are looking for. Then again who ever came up with the idea of looking at movies vs the stock market???

I guess Kevin Bacon’s movie – “Quicksilver” in 1986 although not entirely about the stock market doesn’t count?

The best explanation is in the article about why this occurs –

Of course, big budget Hollywood producers and A-list celebrities don’t like to take big hedge-fund-style risks. When they invest years of work or $100 million in a project, they’re usually pretty sure there’s going to be an audience or they’d never get on board.

What this actually means is that Hollywood is late to the party. The stock market reaches new unexpected really high highs and starts making waves even with the people on the outside. The attention given makes for an audience to watch a film on the markets, but as we who follow the stock market know the noise just brings in the last of the buyers and once all the buyers are in that are going to get in the market then fails and drops like a stone.

So for me this is just another sign that the hype is almost over and the market will have a correction soon.

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