Credit Spread Option Trade Produces Quick Profit

| August 25, 2008 | 0 Comments

Are you an experienced trader?  Ever trade options?  I’m sure some of you’ve never traded an option in your life.  I actually started trading options in high school.  I only did this because I didn’t have enough money to buy stocks.

When I started with options trading, brokerage firms had just started allowing touch-tone telephone trading.

That was bleeding edge technology way back then.  No internet.  No streaming quotes.  No real time updates.  No news feeds.  To get a quote on an option, you had to call an automated phone system.  Then you’d carefully punch in the option code.  I’ll tell you this; option trading is much easier in the internet age.

If you haven’t traded an option, you’re missing out on a great way to capture profits.

In my opinion, it’s one of the most exciting trades you can make.  And because you get lots of leverage, the profits can be enormous.

Options have some great advantages over regular stock trading.  For example, options trading provides greater profit potential with lower capital requirements.

What do I mean by that?

It means that if you were to buy stock, 100 shares at $50 would cost you $5,000 total.  By using options, you can control those same 100 shares for only a few hundred dollars.  When the stock moves in your direction, your profits can be huge.

Another benefit is your risk’s clearly defined.  This means you can’t lose more than you invest.  No matter what happens with the stock market or that particular option – you can never, ever lose more than you invest.

And this leads to the next big advantage.  It’s very easy to use options to profit when a stock goes up (call options) or goes down (put options).

So enough about the basics . . . how can we make some money today?

Let’s look at options to put on a spread trade.  This is an advanced concept for experienced traders, but I’ll make it as simple as possible.  A spread trade is simply buying one option and selling another at the same time.

There are many ways to implement spread trades and they can take many forms.  You have horizontal spreads, vertical spreads, calendar spreads, diagonal spreads, bull spreads, bear spreads, credit spreads, debit spreads . . . .the list goes on and on.

We’ll discuss all of these strategies down the road, but today I want to focus on just one – the credit spread.

The credit spread is a great way to capture premium (instant cash) from an option.  And it gives you a favorable risk-to-reward ratio.  (As always, make sure you fully understand the risks and rewards before making any trade.)

Let me give you an example.

The Energy Select Sector SPDR (XLE) is an ETF that tracks oil and natural gas producers, well drillers, and other oil service companies.  The XLE’s traded between $62 and $92 over the last year.  We’ll use this for our example on spread trades.

What we want to do is sell one out-of-the-money call option at a specific strike price and collect the premium.  This is our instant cash profits.  Then at the same time we buy one out-of-the-money call option at a strike price higher than the one we just sold.  This is our insurance policy.

Because the option you sold has a higher premium than the option you bought this is known as a credit spread.  The difference between the prices of the options is your profit.  You get to put this money immediately into your pocket.

Talk about easy money.

So what did we do?  We collected a premium to take on some risk.  Then at the same time we bought insurance to limit our risk.

As I write this, the XLE is trading at about $74 per share.  I’m looking at options about 30 days out.  You could sell the $75 Calls for $2.78 and buy the $76 calls for $2.37.  The difference between the options is a credit of $0.41.  Now remember each option represents 100 shares.  So you put in your pocket $41 per contract.  If you did this with 10 contracts that’s a quick $410 in profits, not counting commissions.

This is a great trade if you expect the XLE to stay below the $75 per share.

So let’s look at what happens 31 days from now.  That’s when the options expire.

If the XLE trades below $75 per share both options expire worthless.  You get to keep your $410 credit and do the trade again if you want.

If the stock trades between $75 and $75.41, you’ve made some money – and at $75.41 you break even.  But like anything in the market this trade isn’t without risk.  If the XLE trades between $75.42 and $76 you lose some money.  But get this.  Because you own the $76 call option, your losses are limited.

For every penny above the $76 level the stock trades your loss in the $75 call option you sold is offset by the gain in the $76 call option you bought.

So a little quick math assuming you do this trade with 10 option contracts.  Your profit over 31 days is $410.  Your maximum risk is $590. Simply the breakeven price $75.42 minus the option you own $76 – then multiplied by 100 for every option contract.

Risk $590 to gain $410 – that’s not a terrible risk/reward ratio on a trade. Clearly spread trades are one excellent way experienced options traders collect profits today in the option markets.

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Category: Options Trading

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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