Ken Trester

How to Initiate a Credit Spread

by Ken Trester   02/28/09

In my Maximum Options trading service, we employ a strategy where we not only expect options prices to drop to zero, but we strive for it and position ourselves to take advantage of it with option credit spreads. Why? Because someone else's loss becomes our gain!

Simply put, credit spreads work by simultaneously writing (or selling) a call or put option and buying the same type of option with a lower strike price on the same stock and expiration date. When you employ a credit spread, you are simply buying one option to "cover" the risk you take when you write the other option.

We've had a lot of success with credit spreads over the years, but we hit some home runs recently, while everyone else was flailing. One of our latest wins used a credit spread on a pair of Dow Jones Index calls.

Specifically, we recommended readers sell the Dow Jones Calls at the $142 strike price and buy the Dow Jones Calls at the $138 strike at the same time for a spread credit income of 40 cents or higher. Both of these calls were in the same expiration month, which was August.

Let's walk through the trade as though you were executing it. For illustrative purposes, we'll say the August 142 Calls were priced at $1 and the August 138 Calls were priced at 60 cents.

The reason we're choosing prices for example purposes is because when you enter a spread trade, the price you pay for the individual parts of the trade doesn't really matter, just as long as your broker gets you into the trade for a set price. In this case, as long as you collected at least 40 cents when you initiated the spread, you were starting off on the right foot!

If we wrote (or sold) the August 142 Calls, our account would be credited with $100 (the $1-per-share price multiplied by 100 shares in a contract). Then we would buy the August 138 Calls, which would be a debit to our account of $60 (60 cents x 100).

Our goal, then, was for both the $142 Calls and $138 Calls to expire worthless, so that we could keep our $40 credit. (Or, a $100 credit from the sold calls minus the $60 debit to buy one call contract.)