I has been a difficult environment for stock traders — especially those who are focusing on the tech- and growth-oriented Nasdaq, which has tried and failed multiple times to get back above technical support. Even investors who have stuck with the blue chips in 2014 have little to show for it: Dow stocks are up just 0.5% for the year-to-date, and are yielding just 2.7% for buy-and-hold dividend investors.
But there is an alternative strategy that offers income-oriented investors better gains and more consistency, and it involves selling options. There’s a specific way to do so that involves much less risk than the more popular strategies … one that is so conservative that just about anyone — even beginners — can do it: credit option spreads.
Credit Spreads 101
The first step of a credit-spread trade is to “sell to open” (short) an option you think is going to decline in price. Next, you “buy to open” (go long) a similar option that costs less than the one you sold, and your profit is the difference between the two option prices.
Obviously, this is a bit different than a basic option trade, in which you simply buy an option, hoping that it will increase in value and allow you to sell it for a profit. Here, the moneymaker is your short option; the income you get from “selling to open” it is yours to keep, regardless. The role of the second, long option is to provide you with protection in case the short option goes against you.
A key benefit of this method is that, compared to other trading strategies, you’ve got much less at risk in a credit spread: generally only $250 or $500 per contract, if you use inexpensive options. That’s because the short option is “covered” by the long option, which is what makes this a much more conservative trade than shorting stock, shorting naked options, or even a long stock or options trade. Unlike those methods, you’re getting paid up front and taking advantage of the wasting nature of options (via the short option), while still protecting your downside risk (via the long option).
In addition, spreads can be used to profit from either bullish or bearish market moves and can be very profitable during a fast-moving market when traders are particularly uncertain.
How Do Credit Spreads Work in Practice?
You can implement a credit-spread trade using either call options or put options, depending on whether you’re bullish or bearish on the underlying stock.
Typically, you buy call options when you’re bullish on the stock, and you buy put options when you’re bearish on the stock. But keep in mind that in option-selling strategies like these, you’re taking the opposite side of that trade. For our purposes, we’d want “sell to open” a call option if we’re bearish on the stock, and conversely we’d “sell to open” a put option if we’re bullish on the stock. Then, of course, to complete our credit spread we’d “buy to open” a similar call or put option, thereby protecting our downside.
When the stock makes the move we expect, the market value of our options will go down to zero; since we’re on the opposite side of the trade, that’s great for us. It allows us to keep all of the option premium we got from our short option (minus the cost of the long option).
Now that you understand the strategy, let’s look at some examples…