Option Credit Spreads

Option Credit Spreads are a very conservative, low risk options strategy that can put money in your pocket month after month. Even with limited funds you can devise a strategy that will give you consistent monthly gains without big risks.

Making money in the market has always fascinated me, but I was always too scared to invest in anything other than mutual funds. I read every book I could get on the subject, watched CNBC all day long and talked to anyone who would talk with me about the market. Then, I discovered options! The fascination with options was that you could buy an option for a fraction of the cost of the stock, then a small move in the stock produced a larger move in the option. WOW!

Learning to trade options was awesome, especially during the dotcom days. Month after month, raking in the extra cash was like a dream come true. Buying calls and puts, doing covered calls, selling naked puts, doing spreads, it was crazy! At times a real adrenaline rush! To see your naked puts go from up $20,000 to down $10,000, then back up again $30,000 all in one day, was an adrenaline junkies fix. But it was also very stressful.

Then the dotcom bust came and so did my trading account. I never lost my fascination with the market or options. Sitting on the sideline for a few years I reflected on all that I had learned. Because of all the trading strategies, I knew there had to be a way to make consistent monthly income without huge risks. Some things I knew to be true were that with a plan and strategy you could consistently and conservatively make 5% - 10% each month, with low risk and low stress.

But wait! Don't they say that options are exceptionally high risk, with unlimited downside? They do, but there are basically only three things the market can do:

-- Go up
-- Go down
-- Go sideways

With a credit spread, if you are bullish you will profit on your spread if the market goes up or stays the same. If you are bearish you will profit on your spread if the market goes down or stays the same. Here's the bonus with credit spreads, whether you are bullish or bearish if the market moves in the wrong direction you can still profit if your spread is far enough out of the money!

Just like anything else, you make your money when you sell something. Selling naked puts was always my favorite strategy in the dotcom days, now, not so much. They require a huge margin and have to be watched closely. Credit spreads are very similar to naked puts except that you cap your bottom side by buying an option. This limits your downside (lower risk and less stress), brokers like them better and you get to sleep at night.

A credit goes into your trading account when you create a credit spread, that's right, money actually goes into your account when you place this type of trade. Also known as a vertical spread, you sell an option on an underlying stock which is closer to the trading price on the stock, then you buy a farther out option on the same underlying stock, both with the same expiration. The beauty of the credit spread is that the stock can move up, stay the same or move down and you still make money.

Two types of vertical spreads that create a credit in your trading account are the Bull Put Spread and the Bear Call Spread. If you are bullish on the underlying stock you would create a Bull Put Spread by selling a put at one strike price and buying a put at lower strike price on the same underlying stock with the same expiration. Sell the option closer to the underlying stock or index price and buy a farther out option on the same underlying stock or index. FOR EXAMPLE: Say you are bullish on Apple Computer which is trading at $118.51, with a week to go until expiration, you sell the May 115 put at 5.80 for $580. Then to limit your risk you buy the May 110 put at $4.10 for $410. This generates, before commissions, $170 immediately into your trading account:

EXAMPLE: AAPL Stock @ 118.51
Sell 1 MAY 115 put @ 5.80 = $580.00
Buy 1 MAY 110 put @ 4.10 = $410.00
Net Credit 1.70 = $170.00

As long as Apple Computer is above $115 at close on expiration day you keep the credit!

If you are bearish on the underlying stock or index, you would create a Bear Call Spread. Sell the call closer to the underlying price and buy the call farther out with the same expiration.

FOR EXAMPLE: Say you are bearish on First Solar trading at $137.61, with three weeks until expiration, you sell April 160 call at 2.65 for $265. Then to limit your risk you buy the April 170 at 1.40 for $140. This generates $125 into your trading account immediately, before commissions.

EXAMPLE: FSLR Stock @ 137.61
Sell 1 APR 160 call @ 2.65 = $265.00
Buy 1 APR 170 call @ 1.40 = $140.00
Net Credit 1.25 = $125.00

As long as First Solar closes below $160 at close on expiration day you keep the $125!

Advantages of Credit Spreads:
Low risk
Low stress
Great Returns
High probability of success

Of course, if you don't know much about the market or options you need to do your homework. The Chicago Board Options Exchange (CBOE) is a fabulous resource, http://www.cboe.com. The CBOE website has a great learning center and trading tools. Credit spreads require careful planning, paper trade until you know your strategy inside and out. When you are comfortable with your strategy, develop a plan that gives special attention to risk management. Then start small, trade small while you continue to fine tune your trading plan.