Credit Spreads -- The Favorite Strategy of Successful Option

Leefe Poche Credit Spreads Defined

The two most widely used credit spreads are the bull put spread and the bear call spread.

Bull Put Spreads are used when the investor is neutral to slightly positive about the prospects for the underlying stock or index. They are constructed by purchasing one or more puts at a certain strike price and then immediately selling short an equal number of puts at a higher strike price.

Bear Call Spreads are used when the investor is neutral to slightly negative about the prospects for the underlying stock or index. They are constructed by purchasing one or more calls at a certain strike price and then immediately selling short an equal number of calls at a lower strike price.

The Best Time to do Credit Spreads

Which type of credit spread works best depends on the condition of the market.

Market Uptrends If the major indexes (the Dow Jones Industrial Average, the S&P 500 Index and the Nasdaq Composite) are locked in strong uptrends, then the investor would want to focus on bull put spreads, since three out of four stocks tend to move in the same direction as the major indexes. The credit spread investor would probably want to have at least 75 percent of his or her trades in bull put spreads.

Market Downtrends If the major indexes are locked in strong downtrends, then the investor would want to focus more on bear call spreads, for the same reason that three out of four stocks will usually move in the same direction as the major indexes. While the investor would want to use bear call spreads for some of his or her trades, the amount would usually not approach 75 percent. The reason for the lighter weighting is because the indexes have a tendency to eventually get through bearish periods and move higher over the long run as the economy expands and stocks of companies with new products and services become available for trading.

Flat or Choppy Markets When the major indexes have been trending sideways and are showing no strong trend in either direction, the credit spread investor would want to have a mix of bull put spreads and bear call spreads. Since, as noted above, the indexes have a tendency to move higher over time, the mix of trades will usually be biased towards the bullish side.

How to Structure a Credit Spread Trade

Out-Of-The-Money Bull Put Spreads are our favorite trades during market uptrends or choppy market periods.

In this example, say it is March 11 and the underlying stock is trading at 40. We would look to use April puts, which have five weeks of time remaining before expiration. When initiating credit spreads you normally want to use options that are as close as possible to expiration, but there has got to be enough time left for the options to have some premium, so we have chosen April.

With the stock at 40, we would purchase the April 32.50 puts and sell short the April 35 puts. The ask (the amount we would have to pay to buy them) on the April 32.50 puts is 0.50, or $50 per option. The bid (the amount we would receive for selling them short) on the April 35 puts is 0.90, or $90 per option.

In this example, our account would receive a net credit of $40 if one April 35 put is sold short and one April 32.50 put is purchased (to protect the position against a big drop by the underlying stock).

While a $40 credit in an investor's account is not much, if he or she does 5 of these, then $200 is deposited into the account. Doing this credit spread with 10 of each option would bring in $400, and so forth.

Since the spread between the put options sold short at 35 and the put options bought for protection at 32.50 is 2.50 points, the maximum risk is $250, minus the $40 credit received, or $210 per spread.

You figure out the yield for the trade by dividing the amount of credit received ($40) by the amount of risk ($210) if the stock were to close below 32.50 on the third Friday in April.

In this example, the yield would be 19 percent. Not bad for a five-week trade!

What Are The Possible Outcomes?

Here's our favorite part:

If the stock moves higher during the five-week period up until expiration, the investor gets to keep the entire amount of premium that he or she received when the trade was opened. No further commission costs are incurred because both sets of puts will expire worthless on the third Friday in April and the investor has earned the maximum credit possible in the trade.

If the stock moves sideways, the results are the same. The investor earns the maximum credit.

If the stock moves lower, but is above $35 on the third Friday in April, the investor still gets to keep the full amount of credit.

I don't know about you, but any trade that lets you earn a full profit when your stock moves higher, when it moves sideways, or even when it moves lower by more than 10 percent over a period of 5 weeks, seems like a pretty good deal!

What are the Risks Associated With a Bull Put Spread?

The risks, like the rewards, are known and limited from the time the trade is first opened.

In this case, the risk is $210 per spread. It's the most that can be lost no matter how far the stock might drop during the five-week period.


How to Find Suitable Stocks for Credit Spreads

We pretty much use the same method for finding credit spread stocks as we use for finding covered call candidates for our newsletter at our Covered Call Of The Week website.

As a matter of fact, almost any stock that is suitable for covered calls can be used for bull put spreads.

The great thing about bull put spreads is that the yield is usually higher than a covered call trade using the same stock, while the amount of risk is lower.


Finding Stocks for Bull Put Spreads

1. Market Direction

If you are doing bull put spreads, you want the major indexes to be trending higher, or at least moving sideways. It does not make sense to be opening a bunch of bullish trades if the indexes are collapsing.

2. Fundamental and Technical Rankings

For bull put spreads, we want the company to have an Earnings Per Share ranking that places it in the top 25 percent among all companies with publicly traded stocks.

The 12-month Relative Strength ranking should also be in the top 25 percent.

By insisting that these standards are met, an investor is stacking the odds in his or her favor right from the start when doing bull put spreads.

3. Proper Entry Point

For bull put spreads, you want the stock to be in an uptrend and preferably above both its 200-day (long-term) moving average and its 50-day (intermediate-term) moving average. If the stock has recently pulled back some on light volume, it makes the trade even more appealing since some of the risk has been taken out.


Finding Stocks for Bear Call Spreads

1. Market Direction

If you are doing bear call spreads, you want the major indexes to be trending lower, or at least moving sideways.

2. Fundamental and Technical Rankings

For bear call spreads, we look for companies with weaker Earnings Per Share rankings, preferably ones below 50 percent when compared to all companies with publicly traded stocks.

The 12-month Relative Strength ranking should also be below 50 percent, but neither one of these cutoff points are set in stone.

By using these guidelines, an investor is only considering doing bearish trades on stocks that are already showing weakness and at times when the market is struggling, or at best, muddling along.

3. Proper Entry Point

For bear call spreads, you want the stock to be in a downtrend already and preferably below its 200-day moving average and its 50-day moving average -- with both of those moving averages pointed lower. If the stock has recently advanced on below-average volume, it makes the trade even more appealing since the stock may be unable to sustain its weak rally attempt.

About the author:

Leefe Poche is editor and co-founder of http://www.covered-call-of-the-week.coma FREE weekly newsletter that provides one carefully screened covered call trade every week.

He is also editor and co-founder of
http://www.thirdfriday.neta site dedicated
entirely to credit spread trades.