Ken Trester

How to Initiate a Credit Spread

by Ken Trester   02/28/09

The savvy investor might ask, "Why even bother with buying the calls for a debit at all?" The answer involves reducing risk.

If we did not buy the $138 Calls, we would have otherwise been writing a "naked" call. This means that if someone who was a buyer of the calls we sold for upfront profit decided to exercise them, then we would be obliged to come up with 100 shares of Dow Jones Index stock -- and there's no telling how much we'd have to pay for each share. We could easily lose our initial investment 100 times over.

With the calls we purchased, they served as an inexpensive insurance policy. In this trade, we were betting that the stock would stay below $138, the level of the lower strike price (and the call option that we bought). If the stock traded up through the higher strike price ($142), the call buyer would have likely chosen to exercise his or her right to buy stock at that price.

Our long calls at the $138 strike, then, would give us the right to buy stock and turn around to sell it (for a loss) at $142 a share. However, those long $138 calls would have helped us to cap our losses at $5 per share (or $500 per contract).

If we didn't have them and the stock traded up to $150, then we would have had to buy shares at $150 but be forced to sell them at $142. And that's assuming we had enough money in our trading accounts to cover that kind of expenditure. Ouch!

This trade worked wonderfully in our favor, as the Dow dipped, as we expected it would. Thus, the call options did in fact expire worthless.

In order for the trade to have moved away from us, the Dow would've had to have risen 2.5% before expiration Friday. But as you may remember, the Dow didn't start rising again until that day, and it didn't move enough to make a difference insofar as our trade.

Bottom line: If you'd bought 10 contracts, you would have made a cool $400 in less than two weeks. Any way you slice it, it's a nice 100% return as you got to keep the money you collected at the outset of the trade.

This trade is a great illustration of why options investing really is an all-seasons strategy, and credit spreads in particular can pave a path to profits no matter how challenging the overall trading conditions may be.