Stock Option Credit Spreads: A Low-Risk Monthly Income Technique Used By The Pros

Despite its reputation as a speculative tool for aggressive traders, stock options are also used by professional investors as a conservative way to earn substantial monthly income, typically around 8-10% per month. If we can produce such a rate of return every month, regardless of which direction the market takes, and do it with defined and controllable risk, then clearly we’re talking about a very nice neighborhood.

credit spreads

The vehicle many professionals use to earn a monthly income stream no matter which way the market goes is the Option Spread, the simultaneous buying and selling of a pair of call options (or put options) with different strike prices. that expire the same month. .

When we collect more on the option we sell than we pay on the option we buy, the net amount we collect on the margin is our net premium and represents our trading income. This type of spread is known as a credit spread and is an ideal technique for generating a recurring income stream.

Why they can be so attractive to look for reliable monthly income

  • Credit spreads are not directional; the investor can make a profit no matter which way the market goes.
  • They represent a conservative investment approach. Business risk is defined and controllable. This conservative option position is appropriate even for retirement accounts.
  • A Credit Spread option requires much less capital than the corresponding number of shares of the underlying security. Consequently, collecting spread premiums every month can represent a large return on investment (ROI).
  • The full interim profit on each credit spread is paid to the investor in advance. The gain is fully realized at option expiration.
  • Uniquely, time is on the investor’s side in credit spreads. The passage of time mother plays in favor of the investor.
  • If you have set your spread far enough from the current value of the underlying or index that the price of the underlying does not reach your spread positions, the premium will go to zero at expiration no matter what price changes occur with the stock beforehand. expiration. The expiring worthless option is the perfect desired outcome for a credit spread.

Establishment of a credit spread

This is how this technique can act as a monthly income “machine”, using individual stock options or broader index options.

The three key elements of each margin option are: strike price, premium, and expiration date. Therefore, selecting optimal values ​​for these variables, his entry criteria, is what the investor does to maximize the probability of a successful trade.

Strike Price: Each option has an exercise price, the predetermined price at which the purchaser of a specific future month’s call options is entitled to to buy a fixed number of shares of the underlying stock. (The holder of put options has the right to sell the underlying share at the exercise price of your option). You want your selected strike price to be far enough from the current price of the underlying stock that the share price is unlikely to reach this level before option expiration.

EXPIRATION DATE: The exercise of the right to buy or sell the underlying stock or index at the Strike Price ends on the Option Expiration Date, generally the third Friday of each month.

PREMIUM: This is simply the price at which the option trades when you buy or sell it. If you are buying an option, you are paying the premium; if you are selling the option, you collect that premium. As noted above, when you establish a credit spread, you are simultaneously selling one strike price option and buying a different strike price option that is further away from the current market value of the underlying stock or index. The difference between the two premiums is the net premium and is the “income” credited to the seller from the credit spread when he establishes the position.

Credit Spread Trading Example

Assume that XYZ shares are trading at $85 on March 4.

The March Expiration Option (expires March 18), with a strike price of $100, is currently trading at thirty-two cents ($0.32).

The March expiration option with a strike price of $105 is currently trading at twelve cents ($0.12).

Us sell March 1, 100 Call and collect $0.32, and simultaneously to buy March 1, 105 Call for $0.12. Net, we have raised $0.20 per underlying share (.32 -.12 =.20).

Since each option represents 100 shares of the underlying stock XYZ, we charge a premium of $20 in total ($0.20 x 100 underlying shares = $20).

This then is our position: “short” a March 100 call and “long” a March 105 call for a $20 net premium credited to our account.

We haven’t “spent” any money, but the trading rules require that we have money in our account (margin) when we trade. The margin requirement for this trade is $500.

As long as the underlying shares of XYZ remain below $100 (the strike price of our short strike price option), both options will expire worthless, which is exactly what we want to happen.

Result: We originally sold the credit spread for $20, and the offsetting “buy” transaction never takes place, since the option price at expiration has fallen to zero. So now we figure out, meaning the bank, the full $20 (minus the cost of the commission).

Our return on margin employed is 20/500 = 4.0% just for the two weeks we are in the position!

Obviously, with $5,000 available in our account for margin, we could make 10 of these spreads, and our two-week return of 4% would be $200.

An analogous exchange could have been done using places with Strike Prices of $70 and $65, respectively. The profit result would be the same as long as the final price of XYZ on the expiration day of the option was greater than $70.

Here’s the dessert! A credit spread investor can and often does use BOTH a buy credit spread and an ask credit spread on the same underlying. As long as the stock on the expiration day is below the call spread strike prices and above the ask spread strike prices, the investor keeps both premiums… and at brokers that accept options, margin is only required on one of the spreads, obviously it is impossible for XYZ to hit both calls and puts at expiration.

Note that this doubles the potential ROI because the margin “expense” is the same for both spreads as it is for just one. A trade that establishes a bid spread and an ask spread on the same underlying security is called an “Iron Condor.”

Final Considerations: Commercial Entry Criteria and Commercial Protection

The maximum possible loss on these positions is the difference between the two strike prices used. In practice, however, the prudent investor will manage his trade to ensure that he exits a spread that is going in the wrong direction well before the market price of the underlying stock or index reaches this point of maximum risk.

Credit spreads, properly established, will be successful trades a large percentage of the time (entry criteria that provide a mathematical probability of greater than 90%) can be used. Since the amount of absolute profit on any trade is relatively modest, it is essential not to allow the unavoidable loss on the trade to be large. The Credit Spread trader should always make use of contingent stop loss orders to protect each position “just in case”.

The criteria to identify which credit spreads are especially attractive in any given month involve a number of considerations including (1) selected strike prices the correct % distance from the current market, (2) the current trend of the underlying security, (3) available capital in your account for margin, (4) remove or minimize “principal risk”, etc. Collectively, these will represent your “trade entry criteria” and can be set to produce a 90% or higher probability of success.

The further the strike price is from the current underlying price of the stock or index, the less likely it is to hit before expiration (higher probability of success). But the further that distance is, the lower the premium.

The disciplined credit spread investor should always choose their credit spreads with default values, specific trade entry criteria in mind – not on the basis of hunches. That being said, as with any type of investment, the other half of successful market participation is managing the trade, that is, limiting risk in the event that the position deviates.

However, once the position is established,the deck is clearly stacked in favor of the Credit Spread investor because the passage of time works for him… option premiums decline inexorably (as you wish) as time goes by. This premium time decay option represents a very important advantage for the investor who uses credit spreads to generate a monthly income stream.

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