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July 8, 2004
Spread Trading Q&A
by John Brasher, CallWriter Publisher
| We get
a lot of trading questions from our CallWriter members and
free MONEY newsletter subscribers. It often seems that topics
come in waves. Recently we've had a lot of questions concerning
credit spreads. We at CallWriter like spreads. So we thought
we'd take this issue to explore some of the questions and
answers we've addressed on trading credit spreads. |
|
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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