On Tuesday of this week, I covered the basics on constructing a credit spread. I thought that this topic was especially appropriate for this week, given that one could argue the time for premium selling is better now than it has been in a while. Why would premium selling be more beneficial for option traders at this juncture in the market? Well, given that we have had some major price swings this week, volatility has certainly picked up and option prices have increased as a result.
If you do not completely understand how options are priced in the market, then revisiting this blog post from January is a good start. One of the important things to understand is that implied volatility (IV) is a key pricing component in an option, and that out-of-the-money options (OTM) will be made up of entirely time premium—i.e. extrinsic value. IV is embedded in this time premium and when volatility picks up in the market (such as this week) then premium sellers can take in more potential profits (assuming the options expire in the favor, of course).
We can gauge implied volatility in the options market by studying the VIX. Without getting into too much detail, the VIX is an index used to measure “fear” in the market. When volatility is high, the VIX will spike up and the premiums for options will generally be richer. Volatility is considered “mean reverting”—i.e. it tends to revert back to its “normal level” after periods of low or high volatility. If you look at a daily chart of the VIX below, you can see that I have placed Bollinger Bands around the VIX to show periods where it spiked up, only to return to the middle of the bands.
If you have a near-term or immediate bullish bias in the market, then initiating a bullish credit spread (by selling puts) may be a good trade. If your timing is right, volatility could revert back to lower levels in the future, again proving this to be an opportune time to initiate a credit spread. I would be more comfortable playing a credit spread here because should our analysis be incorrect, and the stock we sell puts on moves lower than we anticipated, the option we are long will help to cap our losses.
Let’s examine Green Mountain Coffee Roasters (GMCR) below (as a reminder, none of the examples I give on here are recommendations to make any sort of trade—they are merely for educational purposes). GMCR has had a lot of volatile price action lately, but has still been in a nice uptrend since it broke away in late November, 2012.
GMCR is now trading up near the $55 level, and has shown a slight pullback after approaching $60 (as of the close on 4/18/13). If we remain bullish (to neutral) on GMCR in the near future (let’s say into Max expiration—5/18), then selling puts could be ideal here. Looking at the $50 level, we have determined that this appears to be a potential area of support—GMCR had some previous resistance before going above $50 (previous resistance can turn into support) and it is also a logical round number area. The option chain below (for the May series) shows that the 50-strike put was bid 3.05, ask 3.10. If we want to cap our losses at the 49-strike, we would buy this option at its ask price of 2.74. We would therefore sell at 3.05, and buy at 2.74—taking in a net credit of 0.31. Our broker would require us to post a margin of 0.69 (1-0.31) for each credit spread sold—our profit would therefore be 0.31/0.69=45%. Understanding your breakeven level is also important. Based upon this example, any move GMCR makes below $49.69 would result in a loss on the trade (50-strike minus credit of 0.31).This is a solid return, with a predefined point of support.
There is always a time and a place for different types of strategies in the market. The longer that your trading endeavors continue, then the more you will be exposed to different types of trading environments. Remember that with every potential reward from the market there comes risk, and credit spreads, which can look initially as “safe” trades, can turn against you quickly.