What I’ve found is that I myself can’t even understand it thoroughly.
Hence why I’ve started this new series to discuss the vast selection of strategies one can venture into when choosing to play options. The key point here, is that all of this will be explored in language that I have created, that I endorse & that I use for my own understanding.
Options, to me, is like selecting which race of women to date. (Yeah I said it!) There are positives & negatives to every culture you choose to mix with & in the modern world, these traits are called ‘stereotypes’. Now, I won’t delve into these stereotypes for fear of receiving anthrax in the mail, but I will say each strategy & female has one thing in common: they are all fucking crazy & you will lose money at some point…
This is one of the risks you must accept when choosing to trade options. Assuming you’ve accepted that risk, let’s talk today about ‘ Credit Spreads’.
Large hedge funds predominantly own equity positions and they ‘hedge’ these by buying options on those same underlying equities. For example, let’s say I own 10,000 shares of XYZ Corp. at $50. I want to hold that position for the long term because I think the fundamentals of the company are great. Let’s also assume, because of the Europe situation, I think the market is going to be super volatile & will most likely go down. WTF do I do?? I would ‘hedge’ my position, by buying some puts. In effect, I’ve locked in the lowest price I’m willing to sell my stock at. The lowest price correlates to the strike price I select for my put option. If I buy the $50 Put, then that means, if in 2012 the Mayans were right and the Earth gets swallowed whole by a giant alien, I sell my stock at $50. All I lose is the premium I paid for my put option at the time I bought it!
That is the beauty of hedging…
Now, it’s not all gravy here people. She may be the most beautiful woman you’ve ever seen in your life, but she’s still fucking crazy. Attraction lasts but so long. The negative side is that often times you limit your potential gains, but you’re protected. (You may not like her that much, but you can still come home and get laid every now and then)
Instead of hedging equity positions, you can have a purely options based strategy where you own options & hedge with even more options, thus creating even more complexities in your life. Being exposed to ONE side of the market can be difficult, folks. Ask yourself, as a trader, when is the last time you’ve correctly predicted the short-term direction of the market AND made money on it? Chances are, many of you will be twiddling your thumbs or whistling dixie right now. With spreads, you can give yourself a little leeway, a little breathing room, maybe even some leg space.
Let’s take a look at an example so you can visualize the differences here. We’ve been chatting up Visa (V) for quite some time now.
Now, after breezing through the above chart, you decide that this stock will NOT be able to reach $100 by December expiration on the 16th. Maybe you also believe the market will sell off due to news out of Europe within the next couple weeks. You consider yourself to be ‘moderately’ bearish in this name. You don’t want to buy puts because you don’t think it can sell off with any kind of conviction. You are satisfied with the perception that the stock will just sit here or push lower back to $95 at the most. In conclusion, you decide to sell a call spread for the December expiration.
We went through some sample margin requirements in our previous installment. We discussed how selling a naked call in a similar type of situation would require substantial cash in your account. Using credit spreads is a way to minimize that margin required.
For your credit spread, you sell the $97.50 Call & buy the $100 Call to hedge your position. This way your broker now sees you’ve covered your max loss against a virtually unlimited loss potential after writing the $97.50. So you have a total credit spread of $.86 ($1.26 – $.40). This means you’ve taken in $86 of premium for every contract you wrote. If your spread is with 10 contracts, you’ve collected $860. Margin requirements tend to vary across different brokers but as a general rule of thumb for credit spreads, you must have in your account the spread between the strike prices. So in this example above, our strikes are $100 & $97.50, giving us a difference of $2.50. Multiply that by however many shares you have exposure to, with 10 contracts you are representing 1,000 shares of Visa. This would require capital of $2,500.
Remember, however, you must be approved by your broker first in order to trade debit/credit spreads. Some brokers require minimum capital of $20K while others have much more relaxes policies. Set up a live chat session with your broker today to find out what strategies you are currently cleared for!
To further our example above, the max potential gain is whatever you took in as a credit, so $860. Your max loss is the difference between the strike prices minus the credit amount of the spread $1.64/contract ($2.50 – .86 = $1.64). Of course, you have the option to sell your spread whenever the hell you feel like. You DO NOT have to wait until expiration!
Many people use short call spreads when they are ‘moderately’ bearish on a stock or they want to take advantage of time decay. Calendar spreads is another great way to take advantage of time decay, and we’ll discuss that strategy in a future part of this series.
Make sure to check in for our next installment in ‘The World of Options’, where we explore debit spreads!
Sang, great post. I remember when you started this site and only focused on the buy/sell plays. It’s cool to see you delving into deeper strategies.
How is the max loss in your above example
” Your max loss is the difference between the strike prices minus the credit amount of the spread $1.64/contract ($2.50 – .86 = $1.64). ”
If you’re hedging with the 100.00 Strike price, isnt the max loss .40 per share?
I mean to say just the difference int sprice prices.. which is 2.50