A Next-Level Way To Profit With Less Risk…
Capital preservation and minimizing losses should be the most important objectives of any investor or trader. Warren Buffett is credited with the saying: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”
Oftentimes, investors are drawn to options as a way to limit risk while still offering huge potential profits. This is true in theory, but the reality can be a different story.
An option is a wasting asset. It has a limited life span. Every day it draws closer to expiration, its value erodes as the chances of it being profitable diminish. This is known as time decay.
Imagine swimming in a race against a current in which you must cross the finish line within a defined time period. If you do nothing, the current will push you backward. If you swim at the same speed as the current, you will run out of time to cross the finish line. The only way for you to cross the finish line in the allotted time is to swim faster than the speed of the current working against you.
Types Of Options, And Outcomes
There are two types of options. You can be a buyer or seller of either…
A call option gives the buyer the right but not the obligation to buy shares of the underlying stock at an agreed upon price (the option’s strike price) within a certain period of time.
The seller of a call option (also known as the writer) sells the right to the buyer for a payment known as a premium. In doing so, the seller assumes the obligation to deliver the shares at the strike price should the buyer choose to exercise her or his right. The call buyer will do so if the market price is higher than the option’s strike price.
A put option gives the buyer the right but not the obligation to sell shares of the underlying stock at the option’s strike price within a certain period of time.
The put seller receives a premium and assumes the obligation to purchase the shares at the option’s strike price should the buyer choose to exercise her or his right. The put buyer will do so if the market price is lower than the option’s strike price.
There are five possible outcomes for the underlying stock:
1. The stock goes up a lot
2. The stock goes up a little
3. The stock stays the same
4. The stock goes down a little
5. The stock goes down a lot
Generally speaking, only the first outcome will make the call buyer a profit, and only the fifth outcome will make the put buyer a profit. But four of the five outcomes benefit the option seller.
For example, as a put seller, we will profit as long as the stock goes up (a little or a lot), trades sideways, or falls, as long as it does not drop below our cost basis (strike price minus premium). However, the stock could go as low as zero. That can open up put sellers to potential losses since they will be obligated to buy the stock at the strike price regardless of how far below it shares trade.
Limit Your Risk With A Credit Spread
Setting up a credit spread is one way to sell an option but also limit our risk.
A credit spread is created by simultaneously buying and selling two different options on the same underlying stock or ETF. This is done so that the value of the short option (the one sold) is greater than the value of the long option (the one bought), generating a net credit. These options have different strike prices but the same expiration date.
Let’s look at a hypothetical example of a credit put spread, also known as a bull put spread or a vertical spread.
To initiate a bull put spread you would sell a put option and simultaneously purchase another put option on the same underlying asset with the same expiration date but a lower strike price. (For a credit call spread, or bear call spread, you would sell a call and simultaneously buy a call with a higher strike price.)
With XYZ stock trading at $50 per share, you could sell one XYZ Sept 40 Put at $1 and buy one XYZ Sept 35 Put at $0.25 for a net credit of $0.75 (or $75 per contract). This is the maximum profit on the trade.
The difference between the two strike prices, known as the width of the spread, is $5. Our maximum loss per share is the width of the spread minus the net credit, so $4.25 in this case. Remember that option contracts represent 100 shares of the underlying stock, so our maximum loss is $425 per contract.
If we just sold the XYZ Sept 40 Put and the stock went down to zero, we would still be obligated to buy shares at the $40 strike price, leaving us with a $39 loss per share ($40 minus $1 received in premium), or $3,900 per contract.
With the credit spread, however, no matter what happens to the stock, the maximum loss per contract is $425, which is only 11% of the potential loss without the spread.
Here is how this bull put spread could work out:
If XYZ stays above the $40 short put strike price on expiry, both options will expire worthless, leaving us with the $75 in premium, which represents a 17.6% return on our capital at risk of $425.
The breakeven point is the higher strike price ($40) minus the net credit ($0.75), so $39.25 per share. A profit is realized when the stock price is above this number, and we would not experience a loss unless it falls below it, giving us a cushion of more than 20%.
We can close this spread by buying the short option and selling the long option to either take a smaller gain or a smaller loss depending on the value of the spread at any time.
If XYZ is between the two strikes at expiration, let’s say at $38 per share, then the short option will be assigned, forcing us to buy 100 shares at a net cost of $39.25 per share. The long option will expire worthless, leaving us with a “loss” of $1.25 per share ($39.25 net cost minus $38), but we still own the shares, which may go up in value.
If the stock is below $35 at expiration, even if it is at zero, then the short option will be assigned and the long option will be exercised, forcing us to buy the shares at a net cost of $39.25.
Due to the defined loss potential, the margin required is the width of the spread. And it will never go up due to adverse stock movement. With a naked put, the initial margin required can be larger and could become even larger with adverse movement in the price of the stock.
In summary, with a bull put spread we can be net option sellers and benefit from four out of five possible outcomes. The potential gains will be smaller with a bull put spread than with a naked put, but risk is also decreased. Additionally, with the lower margin requirement, we can better diversify.
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