Spreading Options Allow You a Trader to Control Risk, While Assuming an Advantageous Position in the Market.

The Bull Put Credit Spread

As the name implies, the Bull Put Spread carries a bullish bias and is constructed with put options. Let us assume that XYZ Company is currently trading at $30 per share, has been on a sustained upward trend, and we expect XYZ to continue in that trend.

We might look at a chart of XYZ and notice that the stock price is near its 50-day moving average, which has consistently provided support from which XYZ renewed its upward assent. Of course, there is no guarantee that the 50-day line will continue to serve as support and there is no certainty that XYZ will continue in its upward trend. There is, however, a good probability that it will.

Credit spreads have a good probability of returning a profit because profit is derived if the market moves as anticipated, stays flat, or even if it moves against our position slightly. This high probability characteristic of this trade can be further enhanced by selling our short put option at, or behind, an area of market support. As such, the short put is out-of-the-money with some measure of distance between the short option’s strike and the actual stock price.

Let us assume that we are selling the $27.50 strike price contract. Even though we now have the odds in our favor, we want to protect ourselves from a catastrophic loss. We are willing to risk some loss, but we do not want it to be of devastating consequence.

In order to provide this protection against a devastating loss, we will purchase a put contract at a strike lower than our $27.50 strike. The lower we go on the option chain, the less money we will have to pay for this insurance but we will also be receiving less protection.

For this trade, we want to be conservative and will move just one strike down, purchasing a $25.00 strike put. Let’s assume that we receive a net credit of $.70 for this spread trade.

Diff. Between Strikes — Net Credit Received = Max. Risk ($27.50 — $ 25.00) — .70 = $1.80

Maximum Return / Maximium Risk = Yield $.70 / $1.80 = 38.9%

What we have done is place an option trade that is capable of returning 38.9% if XYZ continues in its trend or, if it does pull back, holds support at its 50 day moving average. We are not asking for a big move. All we are asking is that XYZ hold support at its 50-day moving average until our options expire.

The Bear Call Credit Spread

The market does not always go up!

Sometimes, the path of least resistance for a stock, or the market in general, is down. Let us assume that XYZ has now reached an area of upper resistance near the area of $50 per share. Each time the stock approaches this price level, selling ensues and the stock falls back under the pressure of higher volume trade. Rather than adopting a bullish bias by selling puts, we decide that XYZ is more likely to retrace in a downward direction or, at the very least, remain below the resistance at the $50 level.

The Bear Call Spread is a spread trade comprised of both a short call and a long call, creating a bearish bias. With the XYZ example, we might consider selling the $50 strike call option based upon our observation that the selling has been heavy at that level. We expect that the resistance will hold and the stock will not cross above that level before our short call option expires. However, acknowledging that we could be wrong and that XYZ could break out to the upside, we also buy a $55 call option as insurance against a catastrophic loss.

Diff. Between Strikes — Net Credit Received = Maximum Risk ($50.00 — $55.00) — .80 = $4.20

Maximum Return / Maximum Risk = Yield $.80 / $4.20 = 19%

By selling the call at the $50 strike level, we have created a trade that will return 19% so long as XYZ does not break through resistance to the upside. It can continue to consolidate in sideways trade, it can adopt a downward direction, or retrace to an area of prior support. We are only asking that resistance hold until such time as the short option expires.