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If QQQQ goes down a little bit to say $30.15, same will occur and we will keep premium.
OK, so far so good!
The only way we can LOSE in this trade is if QQQQ goes down a lot to below $29.50 (which is higher strike price minus premium).
If it were end of month of expiry and QQQQ was trading below $30 (our sold option strike price) we would be exercised and our total loss would be difference between sold option strike price and current stock price less total credit we received.
Our maximum loss will be realized at any price at or below our bought option strike price.
$30 - $29 = $1, less premium of $0.50 cents = a maximum loss of $0.50 cents per contract or $1000 (20 contracts - 200 shares x $0.50 cents)
However, before it gets to this point, we would intervene. If QQQQ is falling strongly then we were obviously wrong in our initial analysis.
Before we entered trade though, we decided that if QQQQ fell through support at $30 (which it does) we would move to plan B.
At this point we can do a little ‘magic’.
With click of a mouse through our online broker, we can instantly jump from bullish camp to bearish camp!
We do this by buying back options that we sold which in this case is $30 puts, and this removes all of our obligation.
At this point though, we have taken a loss BUT, we are still long $29 puts which would have already increased in value.
If QQQQ wants to go down, then we are going to let it and just ride $29 puts as far as they will go.
The more QQQQ falls in price, more our option will increase in value.
If it falls far enough, which in this case it does, (falling to $28.50) then we will not only make all our money back, we will start to move into a profitable position.
With credit spreads, we give ourselves flexibility to change our position mid stream, and chance to not only recoup some of our losses (if we get it wrong), but to possibly move from a loss into a PROFIT!
And this is just plan B if things go wrong. Plan A, on it’s own, has statistically, a very high probability of success.
If on other hand we had view that QQQQ would go down, we would simply construct a vertical spread with Out-of-the-money Calls.
We would sell $31 Call and buy $32 Call for an overall credit and should QQQQ close below $31 by end of month, spread would expire worthless and we would simply keep premium.
For more information on how to profit by using credit spreads from someone who is a 'specialist' at credit spread option trading, click here.
James Thomas is a successful private option trader and has created http://www.option-trading tips.com as an informative no-nonsense resource full of useful tips and information designed for option traders to improve their trading results.