How do credit spreads work?

How do credit spreads work?

There are two different types of basic option positions (calls and puts). It is that simple. Traders will be using both calls and puts in utilizing credit spreads. Traders sell calls when the market is going down or sideways and they sell puts when the market is going up or sideways. It’s really no more difficult than that. Choosing the right time to execute the trade is what takes expertise!

Option prices are referred to three different ways:

  • OTM – Out of the Money (these are the options we will focus on)
  • ATM – At the Money
  • ITM – In the Money

Call Options – Investors buy calls when they are bullish (think price will rise) on a particular stock. Profitable trade prefer to be selling call options (Bear Call Spread) when the stock is falling in price. Otherwise known as a downtrend. In a Bear Call Spread, traders will be putting the odds in their favor the minute they take this trade by selling the Out of the Money (OTM) call options to speculators (donors), who are hoping for the price to reverse trend and head higher.

Put Options – Investors buy puts when they are bearish (think price will drop) on a particular stock. Profitable traders prefer to be selling put options (Bull Put Spread) when the stock is rising in price. Otherwise known as an uptrend. In a Bull Put Spread, traders will be putting the odds in their favor by selling the OTM (out of the money) put options to speculators (donors), who are hoping for the price to reverse trend and head lower.

I think it is important that you read up a little to understand definitions, but do not get caught up in all the technical jargon, and certainly do not let that hold you back from taking action. There is an untapped stream of cash in selling options. Do not let the nitty-gritty stop your forward momentum. The quickest way to learn this strategy is to paper trade. It only takes a couple of months to feel confident to start making your own investment decisions. This is no different than anything else you’ve done in life, after a few weeks of paper trading, your confidence will grow like never before.

Remember how I talked about selling time? Here is what I mean by that. When options are OTM, they have no real value (also called “intrinsic value”). They only have time value. The time value is the amount of time left until option expiration. On the third Friday of every month all options for that month expire worthless, provided they are not ITM. That is the goal… ALWAYS sell the OTM options and let them expire worthless.

Below is the formula for option pricing:
Time Value + Intrinsic Value = Option Premium (Price)

Example:

ABC Current Stock Price $99.00
$80 Call Premium (Price) $20.95
Intrinsic Value of $80 Call Option
(Current Stock Price $99 – the Option Strike Price $80)
$19.00
Time Value for Option expiring in 45 days
(Premium $20.95 – Intrinsic Value $19)
$$1.95

Notice that when you add the intrinsic value with the time value you get the call option premium. This is the price you would have to pay for that $80 call option on ABC. Spread trades always focus on selling monthly options with time value only. Spread traders are trying to take advantage of the speculators who are hoping for the market to run up or down by buying near term OTM options (options that have an expiration date of 45 days or less). Doing this, combined with the use of probabilities, gives us a huge advantage over the donors.