Daniel is a retired business executive who now devotes most of his free time to trading stocks and stock options in the stock market.
Stretching the Dollar
Selling covered calls against stock you own or covered puts against cash in your brokerage account are among the favorite strategies of traders and investors for generating income and/or increasing yields on stock investments and options. The use of options spreads allows the trader to stretch his dollar for more purchasing power.
A spread is defined as the difference between the bid and the ask prices as listed in an option chain or stock table. In an option chain where the bid price is listed at 2.00 and the asked at 2.25, the spread is $0.25. The reason that spread trading is gaining much following is that it requires much less cash outlay in entering a call or put position and allows the trader/investor to control more shares.
Apart from the two main types of spreads, the debit and credit spreads, there are numerous other types of spreads. There is the variable spread, calendar spread, vertical spread, butterfly spread and many more combinations of one or the other. For this article, I will confine myself to describing and illustrating the two main types, debit and credit spreads.
The debit spread is applied primarily as a buying strategy where you can enter into a long position at a discounted option price.
The credit spread is the more preferred strategy by option sellers as it is mostly applied to reduce the margin requirement in selling calls or puts. More importantly, the credit spread serves to protect the option seller from the perceived risk of unlimited losses in option selling.
Let me first touch on the debit spread system since this is the simpler one.
Assuming you wish to buy Microsoft stock because you believe it will rise in value in a fairly short period of time. Assuming further that you only have a cash balance of $3,000 with your broker and you wish to enter a position in Microsoft (MSFT) which is currently trading at $24.30. Buying the stock outright would give you around 123 shares.
Because you feel strongly that MSFT is about to make a major move upward you wish to control more than just 123 shares. Therefore you decide to buy call options instead. Looking at MSFT’s option chain you see that you can buy the call strike 25 at the ask price of $0.58. At this price, your $3,000 will give you control of approximately 5,172 shares, but since options are sold in lots of 100 shares per contract, you can buy 50 contracts which equate to your controlling 5,000 shares.
If your assumption pans out and MSFT goes on a rising trend then stays at say, $25.80, your call option 25 could easily be priced at around $1.95 at this level, depending on how much time is left in the option contract. Your 50 contracts (5,000 shares) is now valued at $9,750. If you had bought the stock outright your 123 shares would have a current value of only $3,173 at the new higher price of 25.80.
By trading options, your $3,000 capital was able to control 5,000 shares of MSFT whereas if you bought the stock you would own only 123 shares. Now let me show you how using a spread trade would allow even more firing power with your $3,000 capital.
By doing a spread trade of buying the Call 25 strike at $0.58 and simultaneously selling the Call 26 strike at $0.21 you are in effect reducing the price of the 25 strike by 37 cents (0.58 less 0.21). You have just discounted the price of the Call 25 strike and now your actual cost is only $0.37. A spread trade is actually a two-legged transaction where you buy one leg and sell the other leg leading to a net debit or credit as the case may be.
At a net price of $0.37, your $3,000 capital will now allow you to control 8,000 shares ($3,000 divided by 0.37 rounded to nearest 100) of MSFT stock instead of 5,000 if you just purchased the Call 25s. Your total cost of the 80 contracts would be $2,960 (0.37 x 80 contracts x 100 shares per contract).
If we assume that MSFT’s price goes up shortly after the spread trade to say, the $25.80 price mentioned earlier, with the call 25 option climbing up to the 1.95 price, then the 26 option should be at around $0.65 thus giving the trader a profit of 1.35 if he chose to close the spread at this point. His gross revenue would be something like $10,800 (1.35 x 80 contracts x 100) less his cost of $2,960 netting him $7,840. The same $3,000 capital now has yielded a profit of $7,840 using the spread system against a profit of $6,790 using the straight buy call method. This is because the trader was able to acquire more contracts by using the spread versus the lesser contracts if he just bought calls.
Downside to Debit Spread
But there is a negative to doing a debit spread.
The downside to doing debit spreads is that the potential for profit is limited to the difference between the buy and sell option strikes; in this case, it is $1 (the difference between strike 25 and 26). Per the example above where you acquired 80 contracts (8,000 shares), your maximum profit is, therefore, $8,000 if the underlying stock went up to a price of $26 or higher. Deducting your original cost of the spread ($2,960) leaves you with a profit of $5,040 no matter how high the underlying stock price goes.
In the example in the previous paragraph where the spread resulted in a difference of 1.35, it was because the stock rose rapidly thereby causing high volatility which resulted in option prices to rise abnormally.
Why you would ask, would anyone want to do a debit spread when the profit potential is limited? There could be many reasons according to each individual’s investment goals and how one views market conditions.
The most obvious of course is that with a spread position you could control more shares for the same capital outlay. Another reason could be that the investor in MSFT believes the stock will not rise more than just a few dollars above his/her entry point of $24.30. In this instance doing a spread allows him/her the ability to acquire control of more shares than just buying the calls thus making for greater profit if in fact the stock only rises a few points.
In short, the big benefit of doing debit spreads is the lower capital required to control a greater number of shares of stock. And this is why it is said that spreads give you more bang for your buck.
Now let’s move on to credit spreads. Credit spread trading is mostly done by option sellers or option writers. This is because of two very important reasons: it reduces the potential for unlimited risk in naked option selling; it substantially reduces the margin requirement in option selling.
As you may have already learned selling call and put options when secured by stocks or cash carries no more risk than the sale of the stock (if the call option is exercised) or being assigned (buying) the underlying stock (if the put option is exercised).
But when you sell options without owning the stock or not having the cash to meet a put assignment you are said to be in a naked position. In this event your potential for loss is unlimited. A very risky situation to be in unless you are a seasoned options trader and very knowledgeable in selling naked options.
What Is Meant By 'Potential Risk of Unlimited Losses?'
Here is how selling naked options can expose one to the risk of unlimited loses. Using Microsoft (MSFT) once again as your selected stock let’s assume you strongly believe that the stock is poised to go on a rise. You want to take advantage of the price surge by selling put options against the stock and thereby generating cash income.
Assuming you wish to trade 1000 shares of MSFT, this would require that you maintain a total cash balance of $24,800 in your account with MSFT’s current price at $24.80. That is the cash you would need if you were to do a covered put position. But let’s say you only have $6,000 in your broker account.
If your broker has already pre-qualified you to sell naked options (called a margin account) you could do the 1,000 share deal even with this little cash. The margin privilege allows you to only need approximately 25 percent of the total value of the transaction to proceed with the trade. The actual percentage may not be 25 percent after a complex mathematical computation of the margin requirement. But for this exercise let’s just use 25 percent to simplify matters.
You look at the option chains for MSFT and decide to sell the OTM (out-of-the-money) put strike 23 expiring in 60 days with a bid price of $0.17. If you were to do a covered put trade you would need a cash balance of $23,000 in your broker account to sell the strike 23 puts (23 x 10 contracts).
With a naked trade, the margin privilege allows you to only have $5,750 (25% of the strike 23) in your account to enable you to sell 10 contracts (1000 shares).
You proceed with the trade and generate a cash inflow of $170 (option bid 0.17 x 10 contracts). If the stock goes on a rise as you suspected or does not move at all during the 60-day validity of your put option then the put will expire and you end up with a nice $170 return on the $5,750 you invested for a 2.9% ROI in 60 days.
But what if the stock price goes in the opposite direction, down. As you already know in this situation you could be assigned the stock if it goes ITM (in-the-money) on or before expiration.
Assuming you are assigned the stock when MSFT’s price had dropped to $21.50. You would then have to buy the 1,000 shares (10 contracts) at the strike price of 23 which is the contract price when you sold the put options. You would need $23,000 to meet the obligation of purchasing the shares at $23.
You are now buying a stock at 23 when the market price is 21.50. Since you don’t have the money to buy the stocks – your cash account balance is only $5,750 – your broker would force you to sell the stock that has been assigned to you at the current market price of 21.50 thereby picking up a loss of $1,500 on the deal ($23.00 – 21.50 x 1000).
What if the stock had suddenly dropped to $18 or $15 or $10 or even lower? Your losses could continue without let up as the stock price drops. This is what is referred to as the “potential risk of unlimited losses" in naked option selling.
If you really come to analyze the situation closely there is no such thing as a potential for unlimited losses because there are many antidotes to the disease. So this belief that selling naked options carries the risk of unlimited losses is a farce! A myth! The risk does not exist for experienced option traders!
..the belief that selling naked options carries the risk of unlimited losses is a farce! A myth! The risk does not exist for experienced option traders!
Example: Using Microsoft again, you can sell the put strike 23 (this is near the ATM strike of 25) at $0.16 (bid price) and buy the strike 22 (farther away from strike 25) at $0.09 (ask price) for a net credit of $0.07 ($0.16 - $0.09). Or you can do the put strikes 22/21 spread or the 21/20 put spread. You can also do spread calls by selling the strike 26 call at $0.21 and buy the strike 27 call at $0.08 for a net credit of $0.13.
In the put example above your potential for loss is well defined should the underlying stock go on a downward slide. It would be limited to a maximum loss of $0.93 (strike 23 – strike 22 – net credit of $0.07) while on the call side your potential maximum net loss is $0.87.
After showing the value of the spread in limiting potential loses in option selling let me now illustrate the value of spread trading in reducing the margin requirement in option selling.
If you were to do a naked option trade of selling say, 10 contracts of Microsoft put strike 24 at $0.35, you would need to have on deposit with your broker at least $5,650 in cash to satisfy the margin requirement using again the 25% assumed margin rate. This is computed as follows: Strike 24 x 1000 (10 contracts) x 25% less $350 (option premium x 1000) = $5,650 margin required.
Doing the 24/23 spread whereby you sell the strike 24 at $0.35 and buy the strike 23 at $0.18 for a net credit of $0.17, the margin requirement would only be $830. This is computed as follows: Strike 24 less Strike 23 less credit of 0.17 x 10 contracts = $830
By doing a spread trade you are accomplishing two objectives; reducing your risk exposure since the trade is now no longer naked and, reducing your margin requirement dollars. As you can see the spread trade required a capital of only $830 while the straight naked position required $5,650.
To sum up, using a different comparison, if you only had $5,650 cash balance in your broker account it would only give you 10 contracts using the naked option strategy while the same amount will afford you a total of 68 contracts using the spread strategy.
Again, as in the previous examples, you can see how spreading gives you more bang for your buck.
Any and all information pertaining to trading stocks and options including examples using actual securities and price data are strictly for illustrative and educational purposes only and should not be construed as complete, precise or current. The writer is not a stockbroker or financial advisor and as such does not endorse, recommend or solicit to buy or sell securities. Consult the appropriate professional advisor for more complete and current information.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2018 Daniel Mollat