Don’t Forget About Put Options When Getting Long
The stock market is often compared to the casino. All too many times, some traders have found themselves wildly speculating about a potential stock or move in the broader market. This speculation essentially boils down to a bet on whether stocks will go up or go down.
When it comes to the options market, there can be a far more choices as opposed to simply, long or short. But when it comes to the casino, “the house” metaphor still holds up.
Many refer to the casino as the one selling option trades and the traders are considered the buyers. While the actual number varies, it is said that about three-quarters of option positions expire worthless.
Of course, this data varies and one could argue that a large chunk of positions are closed before expiration, leaving a smaller sample size largely containing worthless positions. But we’re not here to debate the merits of these studies. Instead, we’re here to look at credit spreads using options.
I bring up the casino reference because many investors have a hard time shifting from buying options to selling options. Because buying an option has unlimited reward and limited risk and selling an option has limited reward and unlimited risk, many traders are inclined to perform the former: buying options.
But selling options, while seemingly less rewarding, can really add up over time when executed correctly and done with an aversion to risk. Of course, picking out those rewarding, low-risk trades is the tricky park.
So What Is a Credit Spread?
Simply put, a credit spread still involves a trader taking a market position – either long or short. But instead of buying a call spread when we’re bullish, we’re going to sell a put spread.
That also means that instead of buying a put spread when we’re bearish, we’re going to sell a call spread. But to keep things simple for now, we’re just going to focus on the first one: Bull put spreads.
Additionally, when the underlying security doesn’t move at all or moves very little, our trade will often times end up profitable as well. This is a distinct advantage over buying option spreads as opposed to selling them.
A bull put spread involves a combination of selling a higher priced put option and simultaneously buying a lower priced put option. An example would look like this:
Shares of ABC are trading at $100 and we’re bullish on the stock. To perform the trade, we sell 1 February $95 put for $1.00 and buy 1 February $90 put for $0.25.
By only selling the $95 put, we would collect a $1.00 credit for assuming the risk of the stock’s decline. Unfortunately, we open ourselves up to a big risk (a maximum of $9,400 technically) should the stock suffer a massive pullback.
We are at risk once the stock falls below our breakeven price of $94, which is the strike price minus the collected credit, ($95 strike – $1.00 credit = $94 breakeven).
But because we purchased the $90 put option for $0.25, our maximum loss is now capped at that level. So even if the stock falls below $90, our maximum loss is only $425, ($95 – $90 = $5.00; $5.00 – $0.75 credit = $4.25 per share as our maximum loss).
So what exactly is our goal with this trade? The theory is that shares of ABC will close above $95 per share on February expiration and as a result, we will get to keep the $0.75 credit we collected by selling the spread.
If the stock rallies, stays flat, or even pulls back slightly, the value of our spread will dwindle, which in turn actually shows a profit for us, as we’re looking for both options to be worthless at the time of expiration.
To picture it visually, look at it from the flip side. Imagine you are looking to buy protection for shares of ABC. For the $95/$90 put spread, it costs $0.75. We pay that price to insure that our stock has some protection. But for the seller, their goal is see the stock continue to trade higher, or at least flat, so that insurance plan ends up worthless and he gets to keep his $0.75 credit.
So What’s a Real World Credit Trade Look Like?
Conveniently, instead of pouring through countless options chains of various stocks, we can simply scan for our strategy using OptionParty.
For this particular scan, I wanted to skew my results to the more conservative side, as the market has been a bit complacent and I’d rather avoid a big loss rather than go for a big gain. Using the Party Rank feature allows for this type of discrepancy.
As you may remember, there’s three very important probabilities to understand when it comes to options. Below are my criteria for this trade:
- Minimum Probability of Target Return: 65%
- Minimum Probability of Profit: 75%
- Maximum Probability of Total Loss: 5%
- Minimum Return: 4%
- Expiration: Within 10 Weeks
In total, 150 entries were returned from this criteria. Thankfully though, it’s ranked. Below are the top 10 results.
While typically the individual stock trade – in this case, GOOGL – is more appealing to me than an ETF or index, the sub-1% total loss probability and 4.1% return on risk from the third-ranked SPY trade is too enticing.
It involves selling the March 3rd $212.50 put option and buying the $202.50 put option for a net credit of $0.41.
According to the results, there is a 93.7% chance the SPY will close above $212.50 on expiration, leaving us to collect the entire net credit. Likewise, there is a 94.2% chance the stock closes in profitable territory, which means the SPY would close above $212.10 on expiration.
Finally, there is only a 0.4% chance of total loss, which would mean the SPY closes below our long put strike price of $202.50.
While a trader could surely up the stakes here – that is, take on higher risk in order to collect a higher credit – it seemed that a more prudent, conservative approach was warranted given the market conditions.
As the markets change though and volatility rises and falls, it will continually change the landscape for those looking at credit spreads in the options market. There will be times to be aggressive, times to be conservative and times where no trading at all is warranted.
Just remember, the return may seem small. But when accumulated over several months or an entire year, the gains can be impressive.