Selling naked options is a beautiful thing. Your chances of success are incredibly high when you sell naked options. The average win rate for selling naked options is 80%.
But what do you do in the 20% chance that you end up in a bad trade? A really bad trade can easily wipe out months of gains.
A Bad Naked Options Trade Can Be Disastrous
When a naked options trade goes bad, your only option is to keep rolling the naked option until you can no longer roll for a credit. Unfortunately, the latter could come rather quickly with a violent market correction.
What if the stock drops to the point that you end up receiving a margin call? Now you have no choice but to close the position for a big loss.
Sure, this is rare if you are responsible and don’t use too much buying power. But let me ask you this:
What if the fundamentals of the stock completely change and you know that there is no way you are ever making it out of the trade without a loss? I bet you’re going to wish you had protection. Imagine if you could somehow have insurance for your naked option…..
Good news- you can insure your naked options by using credit spreads.
Credit Spreads Are Like Naked Options With Insurance
Credit spreads allow you to cap your losses in the event that your short option goes too far into the money. You can cut your max loss by over 95%! The added benefit is that since your max loss is reduced by so much, the buying power requirement is extremely low.
How does this work? It works by attaching a long option to your short option. You can cap the max loss for your trade by buying an option at a strike of your choice.
Let’s say you wanted to sell an at-the-money put to collect a premium of 8.00. In order to keep your max loss under control, you buy a put so you can sell potentially assigned shares at a predetermined price. Now the short put will have a much smaller max loss.
Of course credit spreads are a bit more complex than that. A credit spread needs to be constructed strategically in order to prevent unnecessary losses and to increase the probability of success.
It’s time for you to learn how to insure your trades by constructing credit spreads!
How To Construct A Credit Spread
Before we venture too far into credit spreads, you need to make sure that you understand what you are doing when selling and buying an option.
- Selling a put gives the seller the obligation to buy 100 shares.
- Buying a put gives the buyer the right to sell 100 shares.
- Selling a call gives the seller the obligation to sell 100 shares.
- Buying a call gives the buyer the right to buy 100 shares.
For more information: check out this guide for selling options and this guide for buying options.
Just to drive the point home, if you are selling a put and buying a put at the same time, you are taking on the obligation to buy 100 shares at one price and the right to sell 100 shares at another price.
Picking The Strikes For Your Credit Spread
It should be rather obvious that you would buy a put at a lower strike price than the put you sold. The opposite is true for calls- you would buy a call at a higher strike than the call you sold.
For example:
You want to sell an at-the-money put for XYZ with a strike of 110 that is trading for 7.00. The put you buy will need to have a strike that is lower than 110. So you decide to buy a put with a strike of 100 for 2.50. The entire trade gives you a credit of 4.50 (or $450). That means your max profit on the trade is $450 if both options expire out-of-the-money.
Here is why you need to buy a put with a strike that is lower:
XYZ is Trading at 70 at expiration. This means that both your short put and long put are in-the-money. Both of your options get exercised.
- Your short put gets exercised and you buy 100 shares of XYZ at a trade price of 110.
- Your long put gets exercised and you sell 100 shares of XYZ at a trade price of 100.
A little bit of math is needed to figure out the max loss of your credit spread at expiration. Let’s look at how it is done:
Calculating The Max Loss Of A Credit Spread
The max loss of a credit spread is calculated by measuring the difference between the strikes and adding the credit received for the trade.
Using the previous example- let’s calculate the max loss of the trade.
- The credit spread gave you a credit of 4.50.
- You bought 100 shares at a trade price of 110.
- You sold 100 shares at a trade price of 100.
The equation looks like this:
(100*100) – (110*100) + (4.50*100) = -$550
Not a bad risk/reward profile! That’s a $450 reward for a $550 risk!
Calculating The Max Profit Of Credit Spreads
Reaching your max profit for a credit spread is the same as reaching your max profit for a naked option- your max profit is reached when the short option expires out-of-the-money.
You max profit is the credit you receive for the credit spread. So if you received 4.50 for your credit spread, your max profit is 4.50.
This gives you a much better risk/reward profile when compared to naked options. Think of it this way:
In the example from earlier, the short call with the strike of 110 gave you a credit of 7.00. If you would’ve only sold the short put, your max loss would’ve been $10,300. Instead, the long put cut your max loss down to $550.
What Happens If You Pick The Wrong Strikes?
Choosing the wrong strikes will set you up for a loss. The only way you could set yourself up for a loss by accidentally creating a debit spread instead of a credit spread.
This happens when you buy an option with a strike that is closer to the money than the strike of the option you sold.
Let’s use the example from before and switch the strikes to illustrate this point:
- You buy a put with a strike of 110 for 7.00.
- You sell a put with a strike of 100 for 2.50.
- 4.50 (or $450) was paid instead of collecting a 4.50 credit.
This is what would happen if both strikes expired out-of-the-money:
- 4.50 was paid for the trade. So you lose that debit amount.
Your loss would be $450.
By choosing your strikes backwards, you set yourself up for a $450 loss!
The good news is that most brokers will show you the type of trade you have just set up on the confirmation screen before your order is sent. So if you see that your trade will result in a debit, cancel that order and set the strike prices properly.
Downside Of Using Credit Spreads
The major disadvantage of using credit spreads is that you cannot manipulate a losing trade into a winning trade without adding more risk to the equation.
With credit spreads, you do not have the option to use the wheel strategy or roll your credit spread to a future date for a credit. Why? You can’t take assignment because of the long option. You can‘t roll the credit spread to a future date for a credit because you will have to lay out more money for the long put.
Realistically, this shouldn’t be an issue for you because you’re only using a credit spread because you want to limit your max loss.
Credit Spreads have the premium collecting perks of naked options and they limit potential losses!
Did you like this post? How often do you use credit spreads? What strikes do you usually pick? Make sure to let me know!