Anatomy Of An Option Credit Spread
Anatomy Of A Credit Spread Hello Smart Option Sellers! While we wait for yesterday's buy-back trade on ORCL to get filled (kind of surprised it hasn't yet) and wait for new put-sell trades to appear, let's take a look at how an option credit spread trade works to give you an idea of what's possible for the future if we roll out a new service. Netflix (NFLX) I love NFLX, as I'm sure many of you do, as well. And so do millions of other viewers, who use such services as a way to "cut the cord" on traditional cable television. NFLX has absolutely killed it over the last few years, going from $50 per share in 2015 to an all-time high of over $400 back in June & July. It is now trading near $365, and I can only see it moving higher again over the next few months (and years!). Since we don't like to use stocks much higher than $50 per share in The Smart Option Seller, we can absolutely play these higher-priced stocks if using limited risk/limited reward type of strategies such as option credit spreads. To get you familiar with how to trade an option credit spread, there's no better way than to walk through an example. An option credit spread will entail using two different option contracts within the same individual trade. Each option within the spread is called a "leg". Since we will be receiving money from selling the spread, it is classified as a "credit spread". The more expensive option will be sold, and is called the "short leg". The cheaper option will be bought, and is called the "long leg".
Above you will see a partial option chain for January 2019 NFLX put options. Since we are bullish, and want to collect money (credit spread), we will only concentrate on selling put option credit spreads, which is also known as a "bull put spread". With NFLX stock trading near $365 per share, we still want to get some downside cushion, so it is imperative to use a spread that consists of out-of-the-money (OTM) strikes. If you key on the $245 and $250 puts above, you can start to formulate a potential spread trade. Those strike prices are over $100 below the current price of NFLX. That is a nice cushion to have for a four-month trade, which equates to about a 30% buffer. Safety first! The $245 put has a bid/ask market of $2.53 bid/$2.67 ask, which is $.14 wide. The $250 put has a bid/ask market of $2.84 bid/$2.98 ask, which is also $.14 wide. It's best to use options that have similar bid/ask width, as it can help figure out where to place your spread price. The next step is to calculate the difference between both the bid and ask prices. $2.84 - $2.53 = $.31 $2.98 - $2.67 = $.31 This is telling you right off the bat that the spread trade is worth roughly $.31 per spread. So how do you execute it? Here's how to construct the trade within your broker's platform: Since the spread involves two different options contracts, you do not want to make two separate transactions. You will be making one single transaction. Some of you who are new to spreads would most likely figure to just buy the $245 put option at the ask price and then turnaround and sell the $250 put option at the bid price (2 separate trades). You do not want to do that! Your broker allows you to trade both options at once in a single option credit spread transaction, which can look something like this:
This is an order page using Schwab.com You will notice that each leg is inputted into the order form with the $250 put as the "sell to open" leg, and the $245 put as the "buy-to-open" leg. Both options will be an "opening" transaction. Since we will be collecting money by selling the spread, we enter the price in the "Limit/Credit" field. I arbitrarily put $.50 as the price, but from our calculations above, we know the spread is worth roughly $.31, which should be the price to place if you want a fighting chance of getting filled. Some brokers offer the capability to view the spread itself with a bid/ask price. The picture below is from Interactive Brokers.
The screenshot above shows the price of NFLX stock along with the price for both the spread itself and each leg. You can see the spread is quoted with a bid/ask market of $.17 bid/$.42 offer,giving a fair value mid-line price of $.29 or $.30 per spread. Obviously the prices have changed from my earlier screenshots above, as NFLX has rallied from $365 to $367, which has put slight downward pressure on the spread. Remember, when stock prices go up, put option prices (and put option spreads) will go down. Using Interactive Brokers (IB) in this case makes it very easy to trade the spread, as the trader can just click on either the bid or ask price of the spread to start the set-up process. For those of you who may ask - can we trade this spread right now if we wish? That's up to you. I'm in no way recommending this spread nor endorsing it, but you can certainly look into if you wish as a viable trade for yourself. If we had the credit spread service up and running today, this would definitely be a spread I would endorse. The instructions would look as follows (unofficial): Sell (sell-to-open) the NFLX January 2019 $250/$245 put option credit spread for a limit spread sell price of $.30 per spread or better, GTC, as an opening transaction (sell-to-open). If filled at $.30 per spread, what happens next? Well, you would be short the $250 put option and long the $245 put option. But since it was entered as a spread, your margin requirement would be fixed, as well as your potential maximum risk and reward. To calculate the risk per spread, you take the width difference between strikes and multiply by $100. ($250 - $245 = 5) x $100 = $500. Not only is $500 the maximum you can lose, but it also is your required margin for the trade. Compared to selling naked put options outright, which theoretically has an open-ended unlimited risk feature and a 20% margin requirement, selling the put spread can give peace of mind and a much smaller margin requirement. This would be extremely beneficial to smaller accounts. What's the potential monetary and percentage gain? If NFLX stock remains above $250 (the short leg) by January expiration, both legs will expire worthless and the profit will be the $.30 per spread ($30 per each spread sold). When selling options (or spreads), the maximum gain is always what you initially received. The return on margin (ROM) would be $30/$500 = 6% in four months (18% annualized). If NFLX stock finishes below $245 (the long leg), then both options will finish in-the-money and the spread will realize the maximum loss of $500 per spread. IF NFLX finishes somewhere in between $245-$250 per share at expiration, then the spread will incur varying amounts of profit or loss. As mentioned above, one of the best features about the spread trade is its limited risk. You can sleep soundly at night knowing no matter how low the stock may go, you can never lose more than $500 (for this trade). That's helpful. Remember, this is just an example of what you can do. It is not an official trade. You can certainly use different strike prices of varying widths and different expiration months to construct the ideal trade. Lots of stocks have $.50-wide strikes, $1-wide strikes, $2.50-wide strikes, $5-wide strikes and $10-wide strikes. Don't forget though, if you want to collect a bigger credit, you'll have to use strike prices that are closer to the current stock price, which yields less downside cushion. It's a trade-off and something to think about. Whew, that's a lot of information for one day. Take some time to digest it. Oh, and lastly, for those of you who are technical, this type of spread is also called a "vertical" spread, as you're using options within the same month but at different strike prices. A " horizontal" spread uses the same options but in different months. That's all for now. Continue to hold all other positions as-is. Let me know your thoughts on this as it will help me make a final decision on launching the service. Contact me here Regards,
Lee Let's Grab That Cash!