• Trading 101: How to Construct a Credit Spread

    by  • April 16, 2013 7:57 am • Trading 101 with Peter Bryans • 0 Comments

    Spreads in options trading can be done in a variety of ways, and there really is no end to the number of strategies that options provide. Recently, I discussed the way that a debit spread is constructed, and provided an example of when selling an option (to finance the purchase of another) is a good strategy. Credit spreads are a different game and involve taking in premium with the expectation that the option sold will expire worthless.

    Let’s look at a quick example of how to construct a credit spread. Say we are bullish on industrial firm Honeywell (HON), which is featured in the below chart. In order to initiate a bullish credit spread, we would sell puts on this option, and, ideally, the strike that we sold would remain out-of-the-money (OTM) by expiration, allowing us to keep the full premium collected. I’m not one for selling an in-the-money option (ITM) as they provide too much risk and too much leverage for the trader on the other side.

    (courtesy of StockCharts.com)

    With HON, a good (but rather aggressive) trade would be to initiate a credit spread by selling the May 70-strike put, while simultaneously buying the May 67.50-strike put. Looking at the option chain below (this data is as of the close on 4/15/13), we will sell (at the bid) the May 70-strike put for 1.09 and buy (at the ask) the May 67.50-strike put for 0.59—the difference is a net credit of 0.50 (1.09-0.59) for every spread we initiate. Our brokerage account would be credited 0.50 for this trade.

    (data courtesy of eSignal)

    The 67.50-strike put is purchased to act as downside protection if HON drops far more than we anticipated. With this trade, the negative takeaway is that we would lose more than we earn in premium. To calculate the return on this trade, we need to determine the margin that our broker would require us to post, in the event that the sold put option is exercised, and the shares are “put to us”—i.e. we would have to buy the shares at the strike price. Most brokers (not all, but it is pretty standard) will require you to post a margin that is the difference between the two strikes minus the premium collected. For this particular trade, the difference between the strikes is 2.50 (70-67.50), and the premium collected is 0.50. We would post 2.00 (or $200 in margin) for every spread trade we made.

    Calculating the expected return on this trade is simple—you take the premium collected divided by the margin posted. The expected return (should the 70-strike put expire worthless) is 25%–0.50 (credit received) divided by 2.00 (margin posted). We are expecting a 25% return on this credit spread by May expiration—which is May 18th. This is a rather aggressive trade (as mentioned), and it is certainly possible that HON could pull all the way back to the 67.50 mark, thus producing a 100% loser (or 2.00 in margin) on the trade.

    I wanted to mention credit spreads early this week because I think that there is an ideal time to trade them, and (who knows) this could be in the near future. Any form of premium selling can be risky, but you should remember that not every option strategy works in certain market environments. Premium selling can be ideal when volatility is high and you have a bullish bias. This is something that I will cover in more detail later this week.

    About

    Peter Bryans joined the Schaeffer's Investment Research trading team as a Trader in April, 2012. A graduate of the Fisher College of Business at The Ohio State University -- where he concentrated in Finance -- Peter previously held internships with an insurance broker and a wealth-management firm. In his current role, Peter trades a variety of our real-time option services and also hosts our "Options Apprentice" weekly webinar presentations.

    http://www.schaeffersresearch.com

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