Credit Option Spreads: Great Tools for Income Investors
In almost any business, the quality of your tools determine how successful you’ll be. Credit option spreads can be great tools for income investors. Using credit option spreads, investors can collect cash payments up front, while strictly limiting the amount of risk on every trade.
Editor’s Note: This is part one of a multi-part series on credit option spreads.
- Part II – Bull Put Spreads: Income From Stocks Moving Higher
- Part III – Bear Call Spreads: Profit From Stocks Trading Lower
- Part IV – Spread Trade Permission: A Must for Income Investors
- Part V – When Should I Close Credit Spread Trades?
Stay tuned for future articles on this specialized tool for generating investment income.
What About Credit Option Spreads?
Earlier this year I took a trip to Chicago with a handful of readers. We toured the floor of the Chicago Board Options Exchange (CBOE) which was an incredible experience.
After the tour, I had a conversation with one subscriber who wanted to know about credit option spreads. This surprised me a bit because very few investors really understand how these trades work — or how profitable they can be.
Last week, a similar question popped up after we discussed the pros and cons of weekly option contracts. Reader Mel asks:
“Why don’t you do option spreads, which would tie up less cash and would allow us to trade higher priced stocks like Apple or Google?”
The short answer is that I DO use option spreads in my own account. And I believe these are excellent tools for income investors who are willing to put a little effort into learning how they work.
Today, I want to talk about four reasons to consider using credit option spreads in your account. Then, over the next few days, we’ll cover specifics of how to use this tool in your own account.
Option Spreads Generate Income On The Spot
An option spread trade always has two parts. The spread trades I like to use follow this format:
- Investors sell a put or a call contract for a particular price.
- Simultaneously, they buy a similar put or a call for a different price.
The difference between what is received (for selling one option) and what is paid (for buying the other option) is called a “spread.”
A credit option spread is created any time the contract sold gives you more cash than you pay for the contract you buy. In other words, your net price for entering this trade is a “credit” to your account.
I like credit option spreads because they allow you to collect this income instantly. This is much like our strategy of generating instant income from selling put contracts. There are just a few key distinctions as you’ll see over the next few days.
Option Spreads Help You Manage Risk
A second reason I like credit option spreads is that these trades can significantly reduce your risk.
Remember, each credit option spread has two parts. And these two parts are essentially opposites of each other. When I set up a credit option spread, I typically sell a call contract, and buy a different call contract.
Here’s how the two contracts work to limit your risk:
If our stock moves significantly in one direction, it may hurt one side of our trade. But that same stock movement will help the other side of our trade. So between the gain on one side of our spread trade, and the loss on the other side, our risk is strictly limited.
Knowing that there is a clearly defined limit on how much could possibly be lost is very helpful. When you know your maximum risk, you can better determine how much capital to put in each trade. And in many cases, you’ll have more capital available to invest in other opportunities (making your money work harder for you).
Option Spreads Let You Use Higher-Priced Stocks
As Mel mentioned in his question, credit option spreads can make it easier to collect income from high-priced stocks.
Think about it for a second…
If you were to sell a put contract on a stock like Chipotle Mexican Grill (CMG), you’ll need to set aside a lot of cash for each contract. That’s because each put contract represents 100 shares, and CMG is currently trading near $440. That means you’d need more than $40,000 for each CMG contract that you sell!
But when you set up a credit option spread trade with limited risk, you won’t need to sed aside the full $40,000 for this trade.
Instead, you could set up a spread trade that risks a smaller amount (for instance, maybe only $5.00 per share). Your broker will be able to recognize that this is a limited risk trade and will only allocate enough cash to cover your potential loss.
Since you’re now able to generate income from higher priced stocks, there is a much wider universe of potential opportunities available to you!
Option Spreads Let You Benefit From Rising or Falling Stocks
The fourth thing I like about credit option spreads is that this strategy allows you to benefit both from stocks that are rising and stocks that are falling.
Have you ever looked at a stock and thought:
“That company is in trouble and the stock is going to trade lower”
Better yet, were you correct??
Most investors only know how to make money when stocks are moving higher. And then other investors understand how to bet on stocks trading lower, but they’re concerned about taking too much risk. Shorting shares of stock (betting they will trade lower), or buying put contracts (to profit from a drop), can be risky plays.
Fortunately, as you’ll see in the next few days, you can use a specific kind of credit option spread to profit from shares of stock moving lower. And just like our other spread trade opportunities, you will be able to generate income on the spot. Plus, your risk will be strictly limited.
Please note: at this point, I don’t write a specific newsletter or trading service that covers credit option spread opportunities. So far, I’ve found that there just aren’t enough readers who are interested in learning to use this tool.
If this is something you’re interested in learning more about, I’d love to hear from you! Feel free to shoot me an email (Zach@ZachScheidt.com) and tell me if you would like to see specific credit option spread trade opportunities.
I’ll be back to you tomorrow with more specifics on how these trades work!