Trader s Guide to Credit Spreads

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1 Trader s Guide to Credit Spreads Options Money Maker, LLC Mark Dannenberg mark@optionsmoneymaker.com

2 About the Author Mark Dannenberg is an options industry veteran with over 25 years of experience trading the markets. Trading is a passion for Mark and in 2006 he began helping other traders learn how to profitably apply the disciplines he has created as a pattern for successful trading. His one-on-one coaching, seminars and webinars have helped hundreds of traders become successful and consistently profitable. Mark s knowledge and years of experience as well as his passion for teaching make him a sought after speaker and presenter. Mark coaches traders using his personally designed intensive curriculum that, in real-time market conditions, teaches each client how to be an intelligent trader. His seminars have attracted as many as 500 people for a single day. Mark continues to develop new strategies that satisfy his objectives of simplicity and consistent profits. His attention to the success of his students, knowledge of management techniques and ability to turn most any trade into a profitable one has made him an investment education leader. This multi-faceted approach custom fits the learning needs and investment objectives of anyone looking to prosper in the volatile and unpredictable economic marketplace. Mark has a BA in Communications from Michigan State University. His mix of executive persona, outstanding teaching skills, and real-world investment experience offers a formula for success to those who engage his services. This document is the property of Options Money Maker, LLC and is furnished with the understanding that the information herein will not be reprinted, copied, photographed or otherwise duplicated either in whole or in part without written permission from Mark Dannenberg, Founder of Options Money Maker, LLC. This work has been created and provided as part of a paid service and is intended to be used by the person who is the registered client of Options Money Maker, LLC.. This work is protected by copyright. Page 2

3 Introduction Congratulations! You have made a decision to invest in yourself by learning the art of profitable trading. The team at Options Money Maker is committed to your success! The strategies and ideas presented in this and each companion guide have been designed to provide you with a comprehensive program of learning. Our goal is to guide you through the learning experience so you may be an independent, educated, confident and successful trader. Trading can be exciting and extremely rewarding when done well. You will benefit from our years of experience and understanding of what works and what does not work. Financial media, the latest trends and most expert opinion will generally lose you money. We will show you the proper steps to achieve a level of profitable success that only 1% of traders ever achieve. There are numerous variations of traditional options strategies and each has a desired outcome. Some are very risky strategies and others require a considerable amount of time to find, execute and manage positions. The Options Money Maker team will show you how to devote a small amount of time each day to trading while realizing exceptional returns. Peace of mind is important to us so the training is designed to give you knowledge and confidence, both of which will give you the core skill set to be a successful trader. All of the strategies we teach are spread strategies and the ones covered in this guide are; Credit Spreads. You will see how this strategy can be successfully traded in any market condition. If you don t have time to do something right, when will you have time to do it over? - Albert Einstein Page 3

4 Spreads Spreads are simply an option trade that combines two options into one position. The two legs of one spread position could have different expiration dates and/or different strikes. Spreads can be established as bearish or bullish positions. How the spread is constructed will define whether it is bullish (rising bias) or bearish (declining bias). Different types of spreads can be used for the same directional bias of the stock. For example, if the stock has a declining bias, a call credit spread or a put debit spread could be opened to take advantage of the anticipated move down. When traded properly, spreads are a limited risk strategy. Learning how to manage the risk is as important as learning the details of the strategy. Position management will be covered in the Trader s Guide to Position Management. Spreads 101 Credit Spreads are option trades that involve more than one option. Stock movement and determine profit or loss. Directional bias down Call Credit Spread Directional bias up Put Credit Spread Credit Spreads A credit spread is created when an investor simultaneously sells-toopen (STO) one option and buys-to-open (BTO) another option. The premium received for the STO is always greater than the premium paid for the BTO thus, creating a net credit to the account. Credit Spreads STO OTM BTO 5-10 points further OTM Same Expirations Example: STO a call using the 120 strike for a credit of $5.20 BTO a call using the 130 strike for a debit of $3.80 Net credit for the spread is $1.40 The proper construction of a credit spread is to STO an out-of--the-money (OTM) strike and BTO the strike that is 5 10 points further out-of-the-money (OTM) but using the same expiration. When opening a call credit spread, further OTM means a higher strike. When opening a put credit spread, further OTM means a lower strike. Both legs are opened on the same underlying equity and use the same expiration month. Page 4

5 Credit Spreads Continued Call credit spreads are opened when there is a declining bias and will be profitable if the stock moves down. This is because a call credit spread is opened for a credit and since the value of a call option decreases as the stock goes down, at some point the spread will be bought to close for less than it was sold to open. Here is an example: Stock trading at 500 and has a declining bias. STO 510 call This spread creates a credit of $4.80 BTO 520 call Stock declines to 490 causing the values of the calls to also decline. The position can now be closed for a profit. BTC 510 call The cost to buy back the spread is only $3.80. Since the stock declined in STC 520 call value the call options are cheaper. The spread was STO for a credit of $4.80 and BTC for a debit of $3.80 resulting in a $1.00 profit. Put credit spreads are opened when there is a rising bias and will be profitable if the stock moves higher. This is because a put credit spread is opened for a credit and since the value of a put option decreases as the stock goes up, at some point the spread will be bought to close for less than it was sold to open. Here is an example: Stock trading at 520 and has a rising bias. STO 510 put This spread creates a credit of $4.80 BTO 500 put Stock rises to 530 causing the values of the puts to decline. The position can now be closed for a profit. BTC 510 put The cost to buy back the spread is only $3.80 because since the stock STC 500 put went up in value the put options are cheaper. The spread was STO for a credit of $4.80 and BTC for a debit of $3.80 resulting in a $1.00 profit. Time decay is a positive factor in trading credit spreads. Since the position is opened for a credit, money comes into the traders account immediately. As time value decays, combined with a favorable movement of the stock, the value of the position will decrease allowing the trader to buy-to-close (BTC) the position for less than it was originally sold-to-open (STO). Page 5

6 Risk and Reward on Credit Spreads Reward Trader s Guide to Spreads The maximum profit that can be earned from a credit spread is equal to the net credit received when the spread was opened. For a credit spread to realize the maximum profit, both legs of the spread would need to expire worthless which means the position would need to be held until expiration. Options Money Maker traders do not hold positions until expiration. Short term movements in the stock plus time value decay provide opportunities to close out positions for a profit of, generally, about 10%. If a position is profitable and the trader decides to hold the position hoping for a bigger profit or in an attempt to carry the position to expiration, there is a good chance that the profit will disappear and the position could turn into a losing position. A good way to lose money is to wait for a bigger profit Years of Experience Risk The maximum risk or potential loss from a credit spread is the difference between the strikes minus the net credit. Example: STO 120 call for a credit of $5.20 BTO 130 call for a debit of $3.80 Net credit for the spread is $1.40 The difference between the strikes is 10 points. $10 is the max risk less $1.40 credit = risk of $8.60 Losses occur when the short strike (the STO leg) is in-the-money at expiration. This is because the trader has sold to someone else the right to buy the stock at the short leg strike. Since the trader does not actually own the stock they will need to buy it and sell it at a loss. A maximum loss will occur when both strikes are in-the-money at expiration. Learning how to properly adjust positions will avoid this. Credit spreads have multiple potential adjustments which are discussed on our Daily Position Analysis reviews. A trader establishes a bearish (call) credit spread when the chart indicates a declining bias. The breakeven point is the lower strike price plus the net credit. Referring to the example above, if the stock was at at expiration, there would be no loss and no profit. Page 6

7 Risk Continued Example of breakeven point on a credit spread: Stock trading at Buyer exercises right to buy stock from you at 120. Since you do not own the stock, you buy it at the market price of and sell it at 120. This results in a $1.40 loss You get to keep the original credit of $1.40. This netted against the $1.40 loss results in breaking even on the position. A trader establishes a bullish (put) credit spread when the chart indicates a rising bias. The breakeven point is the higher strike price minus the net credit. Call Spread Breakeven point is: Short strike + spread credit Put Spread Breakeven point is: Short strike spread credit Maximum loss occurs when both strikes are ITM at expiration Calculating the Return There are two ways to view the percentage return of profits from a credit spread. One is to divide the profit by the difference between the strikes. If the difference between strikes is 10 points and the trade resulted in a $1.00 profit, that would be a 10% return ($1.00 / 10). The second approach is to calculate the return based on the amount of capital that was at risk. After all, if the trade lost 100% of the risk that is the amount the trader would no longer have. So, the profit percent is calculated by dividing the profit by the risk. In the example above, the net risk is $8.60. If the credit spread trade resulted in a $1.00 of profit, the percentage return would be 11.63% ($1.00 / $8.60). This approach shows the importance of managing risk. Lower risk drives higher returns relative to capital at risk. Opening a new Call Credit Spread The following steps should be referred to when opening a new call credit spread position: 1. Review the technical indicators on your chart and confirm there is a consensus between multiple indicators pointing to a declining bias. 2. Select an expiration that is two to four weeks out. Two weeks is generally the minimum time to expiration you want to use. We build time into all positions in case it needs to be managed. If a position is opened with two weeks to expiration, we have one week for it to be closed for a profit. If it is not closed for a profit when there is one week remaining to expiration, the position will need to be managed. The sweet spot for opening new positions is three weeks to expiration. Page 7

8 3. STO an ou-of-the-money (OTM) call strike. 4. BTO the strike that is 5-10 points further out-of-the-money (OTM). With a call spread, further OTM means a higher strike. Generally, when properly constructed, the credit on a 5 point spread will be in the range of $ $1.80. A 10 point spread will generally be When placing the order, always use a Limit order. A limit order specifies to the market the amount of the credit you will accept. A limit order will be filled at the specified limit or higher. Market orders should not be used. 6. With some stocks and indexes, the difference between the bid and ask is quite large. The broker will usually give you a quote called the Mark. This is the midpoint between the bid and ask. It is the price you should start with when submitting your limit credit order. 7. Calculate the risk of the position. Difference between the strikes credit = risk. So a position with a credit of $4.50 and 10 points between the short (sold) and long (buy) strikes would have a risk of $ Use the risk number to determine the number of contracts to open. Risk x 100 = the investment required for each contract. With $5.50 of risk and 4 contracts, the total investment would be $2,200 ($5.50 x (4 contracts x 100 shares per contract)). 9. Once you know the total investment required per contract, you can decide how many contracts to trade based on the size of your portfolio. 10. After the trade has been opened, place a Good-til-Canceled (GTC) order to close the position. A GTC order will stay active until market conditions are such that the position can be closed for a profit. GTC orders execute automatically and do not require you to be in front of your computer to take advantage of the profit opportunity. Place the GTC for a limit debit price 50% of the credit you received when you opened the position. Page 8

9 Notes Page 9

10 Notes Page 10

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12 Bullish Positions Bearish Positions Put Credit Spread Call Debit Spread Call Credit Spread Put Debit Spread Mark Dannenberg (773) Page 12

13 Trader s Guide to Spreads Page 13

Credits And Debits. Learning How to Use Credit Spread Strategies

Credits And Debits. Learning How to Use Credit Spread Strategies Credits And Debits Learning How to Use Credit Spread Strategies Neither Better Trades or any of its personnel are registered broker-dealers or investment advisers. I will mention that I consider certain