Option
Strategies:
Bernie
Schaeffer on Credit Spreads
ALSO: Strategies for the Aggressive Portfolio
By Bernie Schaeffer, editor
Option Advisor
One
of our favorite strategies is credit spreads. As with all investments,
the name of the game is risk versus return how much bang for
the buck you can achieve for a given level of risk. For many
option-buying strategies, higher risk takes the form of lower
winning percentages; in fact, winning on less than half your
trades is quite normal. The payoff, of course, comes from the
much higher profits you can achieve with these strategies, often
in excess of 100 percent. With credit spreads, the risk/reward
paradigm is reversed, such that you can reach winning percentages
of 80 percent or higher using out-of-the-money options. However,
the return per win will be much lower, most often in the range
of 10 to 25 percent.
A credit spread involves
the simultaneous purchase and sale of puts (or calls) that expire
at the same time but have different strike prices. Puts are used
if you are bullish on the underlying stock or index, while calls
are used for a bearish outlook. For out-of-the-money credit spreads,
the strike price of the sold (or written) option is closer to
the underlying's market price than the purchased option and therefore
has a higher premium. This results in a net credit. The goal
of a credit spread position is to retain this net credit by having
both options expire worthless.
Let's take a look at
an example from our OA Wealthbuilder service, which trades
credit spreads using S&P 100 Index (OEX) options. Amid an
overall OEX decline last fall, we were looking for signs of a
possible reversal, as overall market pessimism was building.
The CBOE equity put/call ratio had impressively high daily readings
(high put volume relative to call volume), trading volume on
Nasdaq-100 Trust shares had been rising rapidly (indicative of
increased shorting activity), and the OEX downdraft appeared
to be finding support at the 700 century mark. As such high pessimism
amid a sharp pullback to potential technical support is often
a bullish combination, we opted to trade a bullish credit spread
using OEX puts.
With the OEX at 709,
we recommended selling the October 690 put and simultaneously
buying the 670 put for a credit of 3.50. The maximum gain on
this trade was the premium received, and would be achieved if
the OEX stayed above 690 by expiration. The maximum loss would
occur if the OEX dropped to 670 and would amount to the difference
between the two strike prices (20) minus the amount of credit
initially received (3.50). A margin account is required to cover
a potential maximum loss, which in this trade was 16.5, or $1,650
per pair of puts. The maximum return on margin would therefore
be the credit divided by the margin, or 21.2 percent.
Editor's Note: Bernie Schaeffer is editor of the Option Advisor, 1259 Kemper Meadow Drive, Cincinnati, OH 45240, 1 year, 12 issues, $200.
Since its inception in 1993, the OA Wealthbuilder service has achieved a win rate of nearly 85 percent and an average return per trade of 9.4 percent. Learn how credit spreads and OA Wealthbuilder can help your portfolio by calling 1-800-448-2080 or go to www.SchaeffersResearch.com/markets/weathbuilder.asp.
