The Best Way to Get Started With Options

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.

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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…

Let’s take a look at a past trade of mine as a working example: an Anadarko Petroleum (APC) put credit spread. Here, we “sold to open” the APC Mar 80 Put, then “bought to open” a put that was a little closer to the money — the APC Mar 77.50 Put — for a spread credit of 30 cents or higher.

When we recommended the credit spread, the APC Mar 80 Puts were trading around 70 cents and the APC Mar 77.50 Puts were trading at around 40 cents. When you’re entering a spread order, most options brokers will ask you to put in the two options and will ask the price you want. Again, in this case, we were hoping to collect 30 cents or more, so with one APC option at 70 cents and the other at 40 cents, that goal was achievable.

Know Your Potential Risk and Reward

Before initiating a trade like this, it’s important to first calculate the maximum amount you stand to lose on each contract. For the trade above, our maximum risk was $220 per contract.

Why wasn’t the maximum risk $250, to match the 2.5 point spread between our $80 strike and our $77.50 strike? Because the spread was offset even further by the money we collected from the option we “sold to open.” In the APC trade, we were aiming to collect 30 cents upfront ($30 per contract), which means our maximum risk was $250 (the 2.5 point spread x 100) – $30 = $220 for every contract. So, in the “worst case” scenario, you would have to pay $220 per contract sold to exit a credit spread if the stock moves against you.

If the starting value of the APC Mar 80 Puts is 70 cents, as APC stock continues to trade higher than $80, that “right to sell shares at $80” becomes worthless. Why would someone exercise an option to sell the shares at $80 when he/she could just sell them on the open market at $82?

Similarly, if the starting value of the APC Mar 77.50 Puts is 40 cents, as APC stock continues to trade higher than $80, that “right to sell shares at $77.50” becomes worthless. Again, why would someone exercise an option to sell the shares at $77.50 when he/she could just sell them on the open market at $82? So, the goal is for each option to expire at or near 0 so we can keep 100% of that $30 per contract we collected at the start of the trade.

What happens if APC hits a wall and drops below $80, and it doesn’t look to recover before expiration? We would “unwind” the trade by doing the opposite of what we did to open them. So, that means we would “buy to close” the APC Mar 80 Puts at, say, $1.50, and “sell to close” the APC Mar 77.50 Puts for, say, 80 cents … making for a net loss of 70 cents.

But remember, regardless of what happens, you get to keep all of the premium we collected at the very start ($30 per contract). If you had done our hypothetical credit spread as a five-contract trade, you’d close for a $350 loss that is offset by your $150 in upfront premium, for a true net loss of only $200. Risking $200 to realize a $150 gain? That’s a pretty good risk/reward picture in our book.

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