Credit Spreads

As stated before, I will focus on selling credit spreads because I think they fit me best. Selling credit spreads is designed to benefit from the premium paid and the decay of options. Most options expire worthless so being on the sell side of the trade puts odds a little more in one’s favor. A credit spread is almost like selling naked options, which expose one to unlimited risk, except the risk and reward are capped by simultaneously buying a further out-of-the-money option, creating the credit spread.

Bull Put Spread

Definition: Sell a put and buy a further otm put to hedge. This trade would be executed if one is bullish or neutral on an underlying. If neutral, further out-of-the-money strikes work best.
Stock: IWM
Current Price: $79.72
Trade:  Sell Feb 77 Put @ $1
Buy Feb 76 Put @ $0.68
Result: Credit of $0.32 or $32

Above is the risk profile for selling this bull put spread. The red line represents the profit and loss at expiration while the white line represents the current profit and loss for various stock prices. It is curved because it still has extrinsic value as represented by the greeks. As long as the stock is above $77 at expiration, me, the seller, gets to keep the premium paid of $32. My downside risk is also capped near $70. The risk for reward seems unreasonable but is justified because this strategy has high odds of success. It profits from up and sideways movement along with option premium decay that will be discussed in a later post.

Bear Call Spread

Definition: Sell a call and buy a further otm call to hedge. This trade would be executed if one is bearish or neutral on an underlying.
Stock: IWM
Current Price: $79.72
Trade: Sell Feb 80 Call @ $0.90
Buy Feb 81 Call @ $0.46
Result: Credit of $0.44 or $44

Above is the risk profile for selling this bear call spread. This trade is exactly the same as the bull put spread except money is made when the price stays below a certain level. In the example illustrated, if the stock stays below $80, the seller makes the premium paid of $44 and the risk is capped near $50. Again, like in the bull put spread, the risk seems unreasonable but the probability of winning is high, justifying this trade.

Part 2: Credit Spread Greeks