Using the Free Trade Calculator to Profit on Credit Spreads
It’s the last week of July, which means it’s our last blog post giving out a free trade calculator. Some people are wondering why they should use the free trade calculator or why it should matter to them.
The answer is simple: It helps improve investors’ understanding on options. The calculators are free and they work in Excel, Numbers and various other spreadsheet applications. Some readers are subscribers to Option Party and can get vastly more powerful number-crunching features as part of the subscription. (There’s a free 30-day trial, here). So they can either disregard the free trade calculators or use them to better understand how the formulas work.
If readers are not Option Party subscribers, then the free trade calculator is an excellent tool. It can help investors calculate the probability of profit, probability of target return and probability of maximum loss. By entering a few different strikes, investors can quickly get a feel for which trade is the best.
What’s not to like? So far, we’ve had a free trade calculator for:
The links above go to the stories that contain a downloadable link for each free trade calculator. Below is the one for credit spreads, both bear call spreads and bull put spreads:
Option Party’s Free Trade Calculator — First Steps
For those that downloaded the free trade calculator for credit trades, you should see a similar image to the one below. There are two tabs in the spreadsheet and the first one is for bear call spreads.
Just like in prior iterations, we need to fill in some key data points to complete the equation. The first set is on the left under “Inputs.” We need to include the stock price, implied volatility and expiration date. For us, the date is July 31st and we’re looking at the regular September expiration, some 45 days away. The other set of data goes under the “Call Inputs” column.
Once we fill that in with the correct strike prices and their respective bid and ask, we get our probabilities. By using the inputs above, it should look something like the chart below:
According to the numbers, there is an 85% chance of achieving our full profit. This would mean the trader keeps the entirety of the premium collected, or 60 cents per share. There is just a 3.5% chance of total loss, which would require a close above $65 on expiration.
Aside from providing the probabilities, the calculator also tells investors what prices the stock needs to exceed or be below for specific outcomes.
Free Trade Calculator — Bull Put Spread
If you head to the second tab, you’ll see the free trade calculator for the bull put spread. For this example, we’re going to use Micron again. Remember, this isn’t a trade suggestion, it’s simply an example. In this case, the left column will stay the same and we’ll only need to input new option data under “Put Inputs.”
By now you should have a pretty good idea of how the inputs work on the calculator. But we want to show readers how they can be used to investors’ benefit. That’s by comparing two different trades side-by-side. The below example is for $50/$45 bull put spread expiring in 45 days.
Now using the same expiration date and stock price, below is an image for selling the $45/$40 bull put spread. The probability for each is highlighted with a red box.
In the first example with the $50/$45 put spread, you can see we collect a much more attractive premium, with a net credit of $1.21. In the second one, we only collect a net credit of $0.50. But would we rather safely pick up nickels and dimes on a deserted rural road or dollar bills on a highway?
Traders might escape getting hit on the freeway at first, but after a long enough time they’ll get pegged. You can see this analogy in the probabilities. In the first example there’s a 12.4% chance of total loss vs. just a 2.9% chance of total loss in the second, more conservative strategy.
Furthermore, in the first example, there’s just a 66% chance of hitting our target return and collecting the full credit. In the second trade though, that probability swells to almost 88%.
The Bottom Line on Option Party’s Free Trade Calculator
Do you now see the power of these free trade calculators? Within seconds we can calculate actual, tangible data to help determine which setup is a better trade. Aggressive investors may decide the first setup is best for them, while conservative traders may opt for the second. Neither is incorrect.
But by taking just a few extra seconds to run the numbers we can get a much better idea for what trades will work best for each trader. That’s why there’s so much value in these free trade calculators. If you’d like, feel free to bookmark this page or the other trade strategy pages outlined above. If you feel that some can benefit from them, feel free to share as well!