Back on November 2, I profiled a trade on Microsoft (MSFT).
I included the chart below which was a classic bullish breakout, one in which I surmised would continue to move higher.
And this is how the stock looked at the close of trading on Thursday December 12, 2019:
MSFT finished the day at $153.24, which is about $10 higher per share since the first screenshot.
That's good for about a 7% gain in just over a month. Not bad.
A bullish breakout from a channel like that is pretty powerful, especially when the broader market is bullish as well. I still think it has legs.
How Did Our Trade Perform?
I profiled a limited risk/limited reward bullish put-option credit spread in which I collected $50 for each spread that I sold.
This type of spread would allow me to keep the $50 in three different directional scenarios - even if MSFT stock moved against me (lower).
I could profit if MSFT moved up, stayed flat, and even moved lower. I discussed this very situation last week.
As long as MSFT doesn't move lower than $130 by January 17, 2020 (expiration date), the spread would be a winner.
Here's what the spread looked like on November 2 and what it looked like on December 12:
The spread was sold for $.50 per on November 1, and now it's worth roughly $.08 per.
As stock prices rise, put option prices decline.
Since the spread has lost $.42 of value (84%), it can be bought back now and closed out, locking in the gains. Or, it could be held until expiration to see if the full $.50 profit would be realized. I like to close trades early before expiration (which is allowed) once I've realized at least 80% of the full profit potential. In this case, 84% of the value has been lost, and that allows for the gain to be realized. That's good (for option sellers)!
You see, when you sell an option or option spread as the initial transaction, you want it to decline in value so it can then be purchased back at a later date for less money.
Sell high, buy low (in that order).
It can be bought back for $.08 per spread, which would be a $.42 per spread gain, or $42 for each spread transacted. For ten spreads, the gain would be $420.
As far as the returns go, the calculation is based on how much the "margin requirement" was.
When selling single option contracts or option spreads, a margin requirement is necessary.
A margin requirement is an amount of your free cash funds that will be held aside while the trade is active.
The margin requirement for selling option spreads is calculated by taking the distance between the strike prices and multiplying by 100.
The distance between the $125 and $130 strike prices is $5. Multiply that by 100 and you get $500 margin requirement per spread.
For every spread that is sold, $500 will need to be held aside by your broker. If ten spreads are sold, $5,000 would be held aside.
As of now, the profit is $42. Divide that into the $500 margin requirement and you got yourself an 8.4% return-on-margin (ROM) in about six week's time. Annualize that and you're looking at a fat 72.8% return. Pretty sweet.
You see, even though I was bullish on MSFT, I wanted a more conservative way to play it, just in case my directional assessment or timing were off.
By selling put-option credit spreads, I entered into a bullish type of trade that afforded me a limited-risk/limited-reward opportunity.
Although I didn't gain the unlimited reward opportunity that a straight-up stock or call option purchase would offer, I felt relieved knowing that my downside was limited in case the floor fell out from under the market (and MSFT). It's a trade-off that I was willing to make for safety's sake.
Different strike prices can be chosen to reflect one's risk. Choosing strike prices that are closer to the stock's current price would offer a bigger upfront premium collection, but at the same time, would offer a faster risk as the stock would need less of a drop to move into the danger zone. I always opt for less risk.
We recently launched an option credit spread service this year and it's doing very well. It is run in the exact manner in which I described in this blog post. It's called Vertical Spread Trader and details can be found here. Come join us!
Until next time...