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Spreading
out your profits...
Question: I
don't understand the difference between debit and credit
spreads. How are they different and how are they each
traded?
Answer: There
are two credit spreads - the bull put spread and
the bear call spread. Here is a simplified chart
illustrating the differences:
| |
Debit
Spread |
Credit
Spread |
| Types |
Bull Call
(bearish)
Bear Put (bullish) |
Bear Call
(neutral
to bearish)
Bull Put (neutral to bullish0 |
| How
created |
You sell a
call/put and buy a more expensive call/put. |
You sell a
call/put and buy a less expensive call/put. |
| Profitability |
Maximum profit
is the net spread, which is the difference
between the total spread and the net debit, assuming
the trade is not unwound for a better profit. |
Maximum profit
is the net credit generated at trade entry,
assuming the trade is not unwound for a better profit. |
| Characteristic |
Generates a
net debit upon trade entry (costs you money).
Limited return, limited risk. The stock has to move
enough for the trade to win. |
Generates a
net credit upon creation, meaning you put a
credit into your pocket. Also limited return, limited
risk. The trade wins if the stock moves the right
direction or just doesn't move in the wrong direction. |
| Example |
Bull Call
When XYZ is $35:
Sell XYZ 40 Call - $1.50
Buy XYZ 35 Call - $2.80
Net Debit =
$1.30
Max. Profit = $3.70 |
Bear
Call
When XYZ is $35:
Sell XYZ 40 Call - $1.50
Buy XYZ 45 Call - $0.40
Net Credit =
$1.10
Max. Profit =
$1.10 |
| Strategy |
The trader
creates the spread on a stock expected to move enough
up (bull call) or down (bear put) by expiration to
make the trade win. |
The trader
creates the spread expecting that the stock will remain
below (bear call) or above (bull put) the short strike. |
Question: Is
there anything particular to puts or can these be used
profitably in bullish situations as exact opposites to
Call credit spreads?
Answer: A bear
put spread (the mirror image of a bear call spread)
should only be used on a stock that you believe is going
up or will hold its price. You don't have to be bullish
on the stock, but you should not be bearish. If the stock's
price falls below your short put strike, the trade potentially
is in trouble. The goal is for the stock price to stay
above the short put strike.
Example: if the stock is $22, the best
bear put spread would be to sell the 20 Put and buy
the 17.50 Put. In this example, the stock does not have
to go up to produce a winning trade, it only has to
stay above $20. If the stock drops below the short put
strike ($20), the trade could be brewing mischief.
Question:
You stress that credit spreads should be constructed out
of the money for safety. Please explain your logic.
Answer: At
CallWriter we believe in writing credit spreads (bear
call and bull put spreads) OTM to allow room for stock
movement. Consider the example above, using the $22 stock.
Instead of selling the 20 Put and buying the 17.50 Put,
you could sell the 22.50 Put and buy
the 20 Put, but the trade would be under water (in
the money) from the outset, because the 22.50 Put is $0.50
in the money. This means that the stock has to actually
move above the 22.50 Put strike to make the trade safe.
In order to get the maximum profit out of a put credit
spread, the stock should remain at a higher price than
the short put strike (in this case $22.50). If the stock
closes below $22.50 at expiration or if the 22.50 Put
is exercised when the stock is below $22.50, the trade
will eat into your credit or actually produce a loss.
Remember that options can be exercised at any time! If
the stock price moves so as to put the short strike in
the money, the trade poses a danger.
Why start out a trade in the hole and force the stock
to work? Write credit spreads out of the money so that
all the stock has to do is stay out of the money. Your
success with credit spreads will be much better if you
construct them OTM at trade entry.
Question:
Is there a rule of thumb for closing out credit spreads?
I have been using the lower strike price plus .50 on call
spreads, vice versa on puts, but wonder if there are any
better general rules about this. I usually do slightly
OTM spreads.
Answer: What
is important is to plan the trade in regards to the profit
level you expect and the risk you are willing to accept.
As long as your trading is generating consistent profits
that are acceptable to you, it doesn't get any better.
You might try watching them and using the CallWriter calculator
to see if better closes are possible.
Question:
I love doing bear call spreads but haven't always succeeded
with them. How can I improve my batting average?
Answer: Pick
lousier stocks. For
even better success with bear call spreads, consider selecting
stocks with these criteria:
| 1. |
Select
stocks that are medium to small cap - preferably no-name
companies the public has never heard of. |
Comment:
It is difficult to let go of the bullish mindset.
But bear call spreads rely on stocks that aren't going
up. Those with little institutional ownership and
public interest are best. |
| 2. |
The stock
should have a low average daily volume. The average
should be below 1,000,000; below 500,000 is even better. |
Comment:
Such stocks have little backbone and retail brokerage
support. |
| 3. |
Look for
low open interest in the call or put series (less
than 200 contracts) and low volume in the calls or
puts themselves.
|
Comment:
Why would lightly traded options on a no-name stock
be expensive? The answer frequently is that these
stocks are going down. |
| 4. |
Look for
weakness in the weekly, daily and 60-minute chart.
|
Comment:
The best candidates will be showing weakness across
the board. |
Question:
My bull put spreads haven't done so well, either. How
can I do better?
Answer: Pick
better stocks! You need a stock that is going up or at
least not going down.
Consider selecting stocks with these criteria:
| 1. |
Select
stocks that are large cap - well known companies that
most people have heard of. |
Comment:
CallWriter's S&P 100 list is the platinum standard
for this, and the NASDAQ 100 list is the gold standard,
but there are many other good stocks, also. |
| 2. |
The stock
should have a strong average daily volume: at least
2,000,000 shares. |
Comment:
Heavily traded stocks have good retail brokerage and
institutional support. |
| 3. |
Look for
high open interest in the call or put series (at least
2,500 contracts) and strong volume in the calls or
puts themselves.
|
Comment:
Even better is when several different call or put
series have strong open interest and volume. |
| 3. |
The weekly
and daily chart are both showing strength.
|
Comment:
If the 60-minute chart is also strong, this one is
golden. |
Question:
I can't seem to find anything about Put credit spreads
on CallWriter.com.
Answer: We don't
offer put data, only covered call trades. However, it
is easy to find call spread trades on the covered call
trades appearing on our lists. Many of these covered call
plays make good bullish or bearish trades using other
strategies. If a play on a list interests you but not
as a covered call, click on the Option Base Symbol,
which pulls up a covered call chain Research Page.
You can select other trade strategies on that page, such
as put or call spreads, or debit or credit spreads, for
that stock. The credit spread
strategies will show you bear call and bull put strategies
for the stock on the Real Time Lists™ that interests
you.
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Disclaimer
We
are not brokers, investment advisers or securities
analysts and do not recommend the purchase,
sale or holding of any security. Your use
of any information or strategy appearing in
this newsletter or on CallWriter.com is solely
at your own risk. We urge our newsletter subscribers
and CallWriter.com website members to do all
requisite and analysis and properly plan each
trade prior to making the trade and to manage
each trade effectively. Covered call and other
potential trades discussed in this newsletter
or on CallWriter.com do not constitute trading
recommendations by CallWriter or any other
person and are presented by solely for informational
and educational purposes. |
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