Vertical Credit Spread Option TradingUsing a Bull Put or Bear Call Spread as a High Probability Stock Option Trade
The vertical credit spread is a limited risk option trade involving the simultaneous purchase and sale of two differing option contracts. This trading strategy is designed to produce an immediate cash credit to the trader's account and typically does not rely upon directional movement of the underlying stock for profitability.
A profit can be realized from a credit spread if the underlying security moves in the direction anticipated by the trader, remains at the same price, and even if the security moves against the position slightly. Profitability is achieved through theta decay. As the options used to construct the credit spread near expiration their time value evaporates, making the spread less expensive to repurchase.
If the options are out-of-the-money as expiration approaches, the spread need not be repurchased but can simply be allowed to expire worthless through the options expiration process. Allowing a credit spread to expire worthless allows an option trader to keep the full credit and pay no commission to close out the trade.
A vertical credit spread can be constructed with calls or puts, and can be designed so as to provide a high probability of profit. The high probability nature of a credit spread combined with the fact that the trade produces a net credit to the trader’s account, makes the credit spread well suited for monthly cash flow generation.
To construct this option position, one option contract is sold for a credit while a second, less expensive option is purchased at a more distant strike price. The options must both be calls or both put options, and they must have the same expiration date. The only difference between the two options will be their strike price. This second option is purchased slightly further out-of-the-money and serves as a hedge that limits the risk created by selling the first option. As such, the credit spread is a limited risk, option selling strategy.
The objective of the credit spread trader is to position the trade so that the option being sold expires worthless, or at least at diminished value. As such, if constructing the trade with call options, the trader wants to sell the short call option at a strike higher than the underlying stock is expected to trade during the lifetime of the option. This is called a 'bear call spread' and carries a bearish bias to the extent you do not want the market to move much higher.
Conversely, if using puts, the trader wants to sell his or her short put contract at a strike lower than the underlying stock is expected to trade. This 'bull put spread' has a bullish bias because you want the market to trade higher and away from the strike of the short put option.
By selling an option contract, the trader as incurred an obligation to buy (in the case of a short put option) or sell (in the case of a short call option) the underlying stock at the selected strike price. As such, the risk of selling options is that the underlying stock may trade higher (in the case of a short call option) or lower (in the case of a short put option) than the strike at which the option was sold. In that case, the trader may be obligated to fulfill the obligations imposed by the option contract that he has sold.
The risks associated with those obligations are limited by he purchase of the second option, which effectively caps the exposure we have in the market. The purchased option will be at a higher or lower strike, depending upon whether we are using calls or puts. This “long” option acts as insurance on the trade. It serves to limit our potential loss. Like an insurance policy on your home or automobile, we hope to never have need for it. Also, just like an insurance policy, we are required to pay for the insurance and gladly do so with the understanding that the insurance will protect us from catastrophic loss.
Calculating the Maximum Loss and Maximum Potential Profit of a Vertical Credit Spread
Before placing a credit spread trade, we need to be aware of what we are getting ourselves into. The maximum risk of the trade must be understood, as well as any potential profit.
Our maximum potential profit is equal to any credit that we receive when opening the trade. This is not a guaranteed profit, as we can earn less or even sustain a loss if the trade goes against us. While our profit is limited to the credit received, our risk in the trade is also limited.
Maximum risk is the difference between the strike prices of the option contracts that were bought and sold, less the net premium received on the trade. Let us assume that our spread consists of option contracts purchased and sold at strikes that are $5.00 apart, in exchange for which we received net proceeds of $1.00.
Diff. Between Strikes - Net Credit = Maximum Risk
$5.00 - $1.00 = $4.00
Having defined the maximum profit and risk for the trade, we can then turn to our calculation of our maximum expected return on risk. The maximum return is equal to the net credit received divided by the maximum risk of the trade.
In the case of the above hypothetical spread, our maximum return would be as follows:
$1.00 / $4.00 = 25%
What these calculations have told us about our trade is that the most we can lose is $4.00, the most we can gain is $1.00, and the best return that we’ll experience is 25%. While at first look these numbers may not overly excite, consider that if these trades are implemented well, they are high probability trades and can be placed each month as part of an income strategy.