Stock Option Credit Spreads – A Low-Risk Monthly Income Technique Used by the Pros

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Despite their reputation as a speculative tool for aggressive traders, professional investors also use stock options as a conservative way to gain substantial monthly income – typically in the neighborhood of up to 8-10% per month. If we can produce such a rate of return every month irrespective of which way the market goes, and do so with defined, controllable risk, we are clearly talking about a very nice neighborhood.

Credit Spreads

The vehicle many pros use to obtain a stream of monthly income no matter which way the market goes is the Option Spread, the simultaneous purchase and sale of a pair of Call options (or of 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 it represents our income from the trade. This kind of spread is referred to as a Credit Spread, and is an ideal technique for generating a recurring income stream.

Why They Can Be So Attractive for Seeking Reliable Monthly Income

• Credit Spreads are non-directional; the investor can profit no matter which way the market goes.
• They represent a conservative investment approach. Trade risk is defined and controllable. This conservative option position is appropriate even for retirement accounts.
• An option Credit Spread requires much less capital than the corresponding number of shares of the underlying security. Consequently, collecting spread premiums every month can represent a large return on investment (ROI).
• The total provisional profit on each credit spread is paid to the investor up-front. The profit is fully realized at option expiration.
• Uniquely, time is on the side of the investor in credit spreads. The mere passage of time works in favor of the investor.
• If you have established your spread far enough away from the current value of the underlying or index, so that the underlying security’s price does not reach your spread positions, the premium will go to zero at expiration no matter what price gyrations occur with the stock before expiration. The option expiring worthless is the desired perfect outcome for a credit spread.

Establishing a Credit Spread

Here’s how this technique can act as a monthly income “machine,” using either options on individual stocks, or options on the broader indices.

The three key elements of every option spread are: Strike Price, Premium, and Expiration Date. Thus selecting optimal values for these variables – your entry criteria – is what the investor does to maximize the likelihood of a successful trade.

STRIKE PRICE: Every option has a Strike Price, the predetermined price at which the buyer of a specific future month’s Call options has the right to buy a fixed number of shares of the underlying stock. (The owner of Put options has the right to sell the underlying stock at the Strike Price of his option). You want your selected Strike Price to be far enough away from the current price of the underlying stock that it is unlikely the stock price will reach this level prior to expiration of the option.

EXPIRATION DATE: The exercise of the right to buy or sell the underlying stock or index at the Strike Price ends on the Expiration Date of the option, usually the third Friday of each month.

PREMIUM: This is simply the price the option is trading at when you buy or sell it. If you are buying an option, you are paying the premium; if you are selling the option, you collect that premium. As noted earlier, when you establish a credit spread you are simultaneously selling one Strike Price option, and buying a different Strike Price option that is more distant 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.

Example Credit Spread Trade

Assume XYZ stock is trading at $85 on March 4.

The March expiration option (expires March 18), with a Strike Price of $100, 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).

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

Since each option represents 100 shares of the underlying XYZ stock, we collect $20 premium altogether ($0.20 x 100 underlying shares = $20).

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

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

So 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 spread for $20, and the offsetting “buy” transaction never takes place, since the option price at expiration has fallen to zero. So we now realize, i.e. bank, the entire $20 (less commission cost).

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

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

An analogous trade could have been done using Puts with Strike Prices of $70 and $65, respectively. The profit outcome would be identical so long as XYZ final price on option expiration day was above $70.

Here’s dessert! A credit spread investor can, and often does, employ BOTH a call credit spread and a put credit spread on the same underlying. So long as the stock on expiration day is below the call spread Strike Prices and above the put spread Strike prices, the investor keeps both premiums… and at option-friendly brokerages, margin is only required on one of the spreads since it is obviously impossible for XYZ to reach both the Calls and the Puts at expiration.

Note that this doubles the potential ROI because the margin “expense” is the same for the two Spreads as it would be for just one. The trade establishing both a Call spread and a Put spread on the same underlying security is called the “Iron Condor.”

Final Considerations: Trade Entry Criteria and Trade Protection

The maximum possible loss on these positions is the difference between the two Strike Prices used. In practice, however, the prudent investor will manage his trade to assure exiting from a spread going the wrong way long before the market price of the underlying stock or index reaches this maximum risk point.

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

The criteria for identifying which credit spreads are especially attractive in any given month involve a number of considerations including (1) selected Strike Prices the right % distance from the current market, (2) the current trend of the underlying security, (3) the capital available in your account for margin, (4) eliminating or minimizing “headline risk,” etc. Taken together, these will represent your “trade entry criteria,” and they can be set to produce 90% or more probability of success.

The further the Strike Price is from the current underlying stock or index price, the less likely it is to be reached by expiration (greater probability of success). But the further that distance is, the smaller will be the premium.

The disciplined credit spread investor should always choose his credit spreads with predetermined, specific trade entry criteria in mind – not on the basis of hunches. That said, as with any kind of investing, the other half of successful market participation is managing the trade, i.e, limiting risk in case the position goes the wrong way.

However, once the position is established,the deck is clearly stacked in the favor of the Credit Spread investor because the passage of time works for him… option premiums inexorably decline (as you want them to) as time passes. This option premium time-decay represents a very important advantage to the investor employing Credit Spreads to generate a monthly income stream.

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Source by Lee Finberg