Most traders know the basics with stock options. You buy an option, and if all goes right the option will quickly increase in value, at which time you sell the option and pocket your profit.
You may not be familiar with spreads. Spreads turn the options world upside down and in this case you WANT the option to expire worthless. Of course when you buy an option you want it to expire in the money.
Personally I call this tactic “Investor Jiu-jitsu” and here’s why…
You’ve heard of jiu-jitsu. It’s a Japanese form of combat the primary tactic is to use your opponent’s strength against him and, at the same time, find a weak spot that is unprotected.
That’s what this strategy is all about — using the market’s momentum against itself. It’s about taking advantage of leverage and piling on the profits month after month. It’s about the individual trader — like you — taking money that the big guys aren’t protecting.
Too Good to Be True? Not at All
The Investor Jiu-Jitsu trading tactic is technically called a credit spread. I have used this technique over the years to profit with more than 88% of the time.
Credit spreads help me make profits while others are losing money because it puts me on the opposite side of losing trades, and on the side of winning trades. A credit spread takes an option’s negative and turns it into a positive.
So why are credit spreads shunted off to the corner of the options market? Primarily, because they don’t stand up and scream, “Look at the big profits I just made!”
Another reason credit spreads operate in relative obscurity is because many of the pros who trade them like it that way. Credit spread traders like to stay under the radar.
The Mechanics – How to Do It
All investing involves one simple premise — you sell something for more than you bought it. Credit spreads are no different in that regard.
The difference between what you buy an option for and sell it for is your profit. The premise of buy low and sell high remains.
With a credit spread, all you are doing is selling an option that you think is going to decline in price. If the price does indeed decline, you make a profit. If the price falls to zero, you make 100% of your expected profit.
How many stocks actually fall to zero? Not too many, but more than 80% of option prices do exactly that so you can make 100% per trade.
The Protection of a Spread
The first order of business when you open a credit spread is to “Sell to Open” an option you think is going to decline in price.
Your second step when building a credit spread is to “Buy to Open” a similar option.
The option you “Buy to Open” will cost less than the one you “Sell to Open.” The difference between the prices is your potential profit for the position.
With a credit spread, when you “Buy to Open” an option to complete the position, you dramatically reduce your risk. In fact, your risk is the amount of the spread, generally only $250 or $500 per contract.
You do not need to worry about having money to buy the stock. You only need enough money to close the spread in a worst-case scenario.
Risk Reduction Works in Your Favor
This dramatic risk reduction works hugely in your favor — it dramatically reduces the amount of cash you need on hand for collateral. In fact, the collateral you need is the amount of the spread.
For example, with a 5-point spread, you will need $500 to close a worst-case scenario. And in all likelihood, you will close a losing position well before it reaches its maximum loss.
Don’t worry if the option you “Buy to Open” expires worthless–that is part of the plan. The “Buy to Open” option’s role is to provide you with protection. The option you “Sell to Open” is your moneymaker. And the income you receive from “Sell to Open” is yours to keep regardless of what might happen later.
Some Examples
Credit Spread Trading Examples
Put Credit Spread – Sell to Open the Freeport McMoRan Copper & Gold () Feb 7.50 Puts () and Buy to Open the FCX Feb 5 Puts () for a spread credit of 30 cents or higher.
A put option profits when a stock price falls. So this is a bullish position in which you want FCX to stay above 7.50 until February expiration.
If that happens, the price of the Feb 7.50 Put will fall to zero. The price of the FX 5 Put that you Buy to Open will also fall to zero, but that doesn’t matter. Its job is to provide protection and lower margin requirements.
This position generates a 12% return on margin (144% annualized) for a one-month holding period. Plus, you will not only be opening one contract, but several. It is not unusual to open 10 contracts of the same credit spread.
And it is likely that you will open more than one credit spread every month, involving several contracts with each spread. In fact, the greatest danger with credit spreads is not the tactic itself, but that you might open too many positions. As with any investment tactic, it is best not to go overboard.
Here’s Another Example:
Call Credit Spread — Sell the PowerShares QQQ Trust () Dec 33 Calls (QAVLG) and buy the QQQQ Dec 38 Calls () for a spread credit of 40 cents or higher.
This credit spread was recommended as a speculation on the bear market continuing as the dominant trend. QQQQ mirrors the Nasdaq 100 Index, which is dominated by large technology stocks. QQQQ was in a trading range at the time of the recommendation, with the top of that range at $33.
This position generates an 8% return on margin, that’s 48% annualized. (The return on margin amount for a credit spread is calculated as the amount of the spread times the 100 shares an option contract represents–$38 minus $33 = $5, times 100 = $500.)
No doubt you have noticed the relative low profit amount in these examples. That is my preference. I want a credit spread to expire worthless, and to achieve that I go as far out of the money as possible with my Sell to Open option.
Don’t Get Greedy
More-aggressive traders might want to Sell to Open closer-to-the-money options. You can certainly produce greater percentage profits that way, but you will also be more exposed to having the Sell to Open option going in-the-money and creating a loss.
That’s all there is to it. Stay disciplined, don’t open too many credit spreads at one time, maintain the attitude that a lot of a little is better than a little or nothing of a lot, and you will find yourself making some of the easiest money there is to be made trading options.
