Stock Option Credit Spreads – A Low Risk Monthly Income Technique Used By The Pros

Despite its reputation as a speculative tool for aggressive traders, stock options are also used by professional investors as a conservative way to earn substantial monthly income, typically in the neighborhood of up to 8-10% per month. If we can produce that rate of return every month, regardless of market direction, and do so with defined and controllable risk, we are clearly talking about a very nice neighborhood.

Credit spreads

The vehicle that many professionals use to obtain a monthly income stream regardless of which direction the market goes is the Option Spread, the simultaneous purchase and sale of a pair of call options (or put options) with different strike prices that expire the same month. .

When we collect more for the option we sell than we pay for the one we buy, the net amount we collect for the spread is our Net Premium and represents our operating income. This type of margin is known as credit margin and is an ideal technique for generating a recurring income stream.

Why They Can Be So Attractive To Find Reliable Monthly Income

• Credit spreads are not directional; the investor can benefit no matter which way the market goes.
• They represent a conservative investment approach. Business risk is defined and controllable. This conservative option position is appropriate even for retirement accounts.
• A Credit Spread option requires much less capital than the corresponding number of shares of the underlying security. Consequently, charging spread premiums each month can represent a large return on investment (ROI).
• The total provisional benefit of each credit spread is paid to the investor in advance. The profit is realized in its entirety at the expiration of the option.
• Unusually, time is on the investor’s side of credit spreads. The mere passage of time works in favor of the investor.
• If you have set your spread far enough away from the current value of the underlying or index so that the price of the underlying security does not reach its spread positions, the premium will go to zero at expiration, regardless of price changes that occur with the underlying security. action before. expiration. The option that expires worthless is the perfect outcome desired for a credit spread.

Establish a credit margin

This is how this technique can act as a monthly income “machine”, using individual stock options or broader index options.

The three key elements of each option margin are: strike price, premium, and expiration date. Therefore, selecting optimal values ​​for these variables, their entry criteria, is what the investor does to maximize the probability of a successful trade.

EXECUTION PRICE: Each option has a strike price, the predetermined price at which the buyer of the call options of a specific future month is entitled to to buy a fixed number of shares of the underlying share. (The owner of the put options has the right to sell the underlying share at the exercise price of your option). You want the selected strike price to be far enough away from the current underlying share price that the share price is unlikely to reach this level before the option expires.

EXPIRATION DATE: The exercise of the right to buy or sell the underlying shares or indices at the exercise price ends on the option’s expiration date, generally the third Friday of each month.

PREMIUM: This is simply the price at which the option is traded when you buy or sell it. If you are buying an option, you are paying the premium; If you are selling the option, you charge that premium. As noted above, when you establish credit spread, you are simultaneously selling a strike price option and buying a different strike price option that is further from the current market value of the underlying stock or index. The difference between the two premiums is the net premium and is the “income” credited to the seller of the credit spread when he establishes the position.

Credit margin trading example

Suppose XYZ’s stock is trading at $ 85 on March 4.

The March expiration option (expires March 18), with a $ 100 strike price, is currently trading at thirty-two cents ($ 0.32).

The March expiration option with a strike price of $ 105 is currently trading at twelve cents ($ 0.12).

Us sell March 1, 100 Call and collect $ 0.32, and simultaneously to buy March 1, 105 Call for $ 0.12. Net, we have raised $ 0.20 per underlying share (.32 -.12 = .20).

Since each option represents 100 shares of XYZ’s underlying shares, we charge a premium of $ 20 in total ($ 0.20 x 100 underlying shares = $ 20).

This, then, is our position: “short” a call from March 100 and “long” a call from March 105 for a net premium of $ 20 credited to our account.

We have not “spent” money at all, but the trading rules require that we have money in our account (margin) when we perform the trade. The margin requirement for this trade is $ 500.

As long as the underlying XYZ stock remains below $ 100 (the strike price of our short strike price option), both options will expire worthless, which is exactly what we want to happen.

Result: We originally sold the credit margin for $ 20 and the offsetting “buy” transaction never takes place as the option price at expiration has fallen to zero. So now we find out, that is, from the bank, the total of $ 20 (minus the cost of the commission).

Our return on employed margin is 20/500 = 4.0% just for the two weeks we hold the position!

Obviously, with $ 5,000 available in our account for margin, we could make 10 of these spreads, and our 4% return in two weeks would be $ 200.

An analogous exchange could have been performed using Places with strike prices of $ 70 and $ 65, respectively. The profit result would be identical as long as the final price of XYZ on the option’s expiration day was above $ 70.

Here’s the dessert! A credit spread investor can, and often does, employ BOTH a call credit spread and a put credit spread on the same underlying. As long as the stock on the expiration day is below the strike prices of the buy margin and above the strike prices of the sell margin, the investor keeps both premiums … and in the brokerage houses Option-friendly, margin is only required on one of the spreads, as it is obviously impossible for XYZ to reach both Calls and Puts at expiration.

Note that this doubles the potential ROI because the margin “spend” is the same for both spreads as it is for just one. The operation that establishes both a buy margin and a sell margin on the same underlying security is called “iron condor”.

Final Considerations: Trade Entry Criteria and Trade Protection

The maximum possible loss in these positions is the difference between the two Strike Prices used. In practice, however, the prudent investor will manage his trade to ensure that he exits a spread that goes the other way long before the market price of the underlying stock or index reaches this point of maximum risk.

Credit margins, properly established, will be successful operations a large percentage of the time (entry criteria that provide a mathematical probability of more than 90% can be used). Since the amount of absolute profit on any trade is relatively modest, it is essential not to allow the inevitable losing trade to be large. The Credit Spread investor should always make use of contingent stop loss orders to protect each position “just in case”.

The criteria to identify which Credit spreads are especially attractive in any given month, involving a number of considerations including (1) selected strike prices at the correct% distance from the current market, (2) the current trend of the underlying security, (3) the capital available in your account for margin, (4) eliminate or minimize “holder risk”, and so on. Together these will represent your “business entry criteria” and can be configured to produce a 90% or higher probability of success.

The further the strike price is from the current underlying stock or the index price, the less likely it is to be reached to expiration (the greater the likelihood of success). But the greater the distance, the lower the premium.

The disciplined investor in credit spreads should always choose their credit spreads with default values, specific entry criteria to trade in mind, not on the basis of hunches. That said, as with any type of investment, the other half of successful market participation is managing the trade, that is, limiting the risk in case the position goes the wrong way.

However, once the position is established,the deck is clearly stacked in favor of the credit spread investor because the passage of time works for him… option premiums inexorably decrease (as you wish) as time goes on. The decay time of this option premium represents a very important advantage for the investor who uses credit spreads to generate a monthly income stream.