You may or may not have heard of credit spread option trading but they can be used to profit in bullish, neutral or bearish conditions.
They are a cashflow generating strategy that involves both buying and selling of either calls or puts of different strike prices but same expiration date to establish an overall 'credit' i.e. spendable cash.
It is a great option trading strategy for taking advantage of 'time decay' that option selling provides, but with limited risk.
The amount of potential profit of course is limited to credit received when trade is first made.
Let me give you an example of this powerful, yet underutilized option trading strategy.
Let's say that QQQQ (The Nasdaq 100 tracking unit) is trading at $30.50 and we believe that it will continue to go up in price.
To create a vertical credit spread using puts (selling puts is profitable if market rises), we could do following:
1) Sell $30 put (expiring this month).
2) Buy $29 put (expiring this month).
In my experience, it's always best to sell short-term, 'Out-of-the-money' option premium for 3 main reasons:
1) Out of money options have lower deltas, meaning stock has to move further before value of our sold option increases (remember we want it to decrease).
2) Selling 'current month' options (30 days or less to expiry) is when time decay is at it's most rapid and value of our sold option is eroding away with each day.
3) Contrary to buying options, if stock does moves very little or not at all, we win!
Letís say we received $0.90 cents per contract for selling $30 puts and we paid $0.40 cents per contract by buying $29 puts.
This transaction gives us an overall credit of $0.50 cents per contract ($0.90-$0.40).
If we sold 20 contracts of $30 Put and bought 20 contracts of $29 Put, this would give us a total credit of $1,000 (2000 shares x $0.50 cents).
So basically, if QQQQ expires at any price above $30 we will make our maximum profit, which is initial credit we received ($0.50 cents).
On other hand if QQQQ expires at any price below our breakeven point of $28.50, we will be facing a loss.
Letís look at all possibilities.
Once we have entered trade QQQQ can either:
1)Go up a little bit.
2)Go up a lot.
4)Go down a little bit.
5)Go down a lot.
The beauty of this style of trading is that we will win in four out of five of these situations, and in many instances we can even win in all five!
Let me demonstrate how.
The QQQQ is trading at 30.50, if it moves up a little bit to say $30.80, our sold option ($30 Put) will expire worthless and we will keep all of premium.
If QQQQ moves up a lot to say $32, same will occur and we will get to keep premium.
If QQQQ moves sideways and stays around $30.50, again ($30 Put) will expire worthless and we will get to keep premium.