I had a few requests about credit spreads v. investing in the stocks (underlying). Here are a few thoughts that come to mind.
There are many advantages to selling spreads instead of buying the underlying. I will try to keep it simple and in plain English. I would rather sell a spread in $NFLX for example than buy the stock itself. Here are a few reasons why:
*** TRADE MORE AND BIGGER POSITIONS: with the same pile of cash I can do a lot more with credit spreads than just buying the underlying. Consider $AAPL for ex: if I have $20k with TDameritrade I can buy 31 AAPL shares and hope it goes up. Meanwhile, I am done since I have no more money to trade anything else without borrowing money. This brings me to my second point.
*** MARGIN REQUIREMENT: this is NOT the same as Margin that you use to borrow money in order to buy stocks. Margin requirement in option spreads is money the broker locks up when I sell a spread. For example: I sell 10x april aapl call spread 645/650 (sell the 645 call and buy the 650 call for protection). As a result, my available cash at TDameritrade will become $20k (starting investment) - $5k (max$ at risk) = $15k. So I now have a position on aapl yet I still have 15k to use for other trades AND this trade expires in 2weeks at which point the $5k gets out of jail. Sure someone might say that if you bought aapl and held from when it was $14 blablabla. Valid point but the flip side is that I also could have sold spreads the whole time and pocketed just as much and more. In credit spreads' case I am building actual cash all along the way which allows me to trade even more and more positions as opposed to having my cash locked up in one stock for 15 years. Also should the market crash tomorrow, I know exactly what I have at risk! this brings me to my 3rd point.
*** DEFINED RISK: when I sell a credit spread I know exactly my dollars at risk in a worst case scenario. This is true for selling Credit PUT spreads or CALL spreads. Here is an example:
$AAPL price is 626
I Sell weekly 615 put for $2
At the same time I buy weekly 610 put for $1.3
for this I collect the difference in premiums: 2 - 1.3 = .7
If I do this 10 times I collect $700. This is the MOST I can make!
Say apple goes to zero tomorrow, I can only lose $5 per share and since I did this 10 times, $5000 is my total dollars at risk! This allows me to have several positions and still sleep at night. Sure as with all good things there is a price to pay with this defined risk: Limited gain (700 in this example) but if I pick the right strikes, the reward to risk ratios can be very attractive. I usually want .2 or better (risking $5 to make $1).
*** DEFINED ENTRY AND EXIT: when I sell a credit spread I know exactly when the trade ends. I usually stay close to present maybe go a month out. More importantly, I can AVOID catalysts. Yes, you head right, avoid things like earnings. I feel that in most cases, the earning move is a coin flip. I could be a genius and guess the company's beat or miss and still get the move direction wrong. How the market reacts is a coin toss. So I prefer to wait out the earnings periods and put the position the next day or two when I can actually count on research not to be blown out by market interpretations. Having control over entry and exit times allows me to set a game plan for the whole year with regards to returns expectations.
*** HEDGED RISK (I just added this section 12/26/12): I can hedge every credit spread that I sell. Most often I sell the credit spreads in opposite pairs which are known as iron condors: sell credit put spread (bullish) AND sell credit call spread (bearish) with the same expiration date. I usually set both spreads far enough apart so that my ideal situation is for both to expire worthless (maximum profit). Another way I can hedge my credit spreads is by buying protection puts that are shorter term than the credit spread. Here are 2 examples that I did last month for $CF:
1) 11/30/2012: Sold Iron condor in CF
bullish leg of IC: sold the Dec 195 put and bought the 190 put behind it for protection
bearish leg of IC: sold the Dec 230 call and bought the 235 call behind it for protection
for this, I collected .63 per contract. I did this 10times so collected 630ish.
2) The trade went according to plan until about 2weeks before it expires; CF started to drop. So, to protect myself and not have to close a good trade or ruin it, I bought naked weekly puts above my strikes. So, if CF had continued to drop then the puts would protect my lower leg of the IC. Indeed that was what happened. The weekly CF puts are cheap if you buy them early enough;I didn't wait until my spread was in trouble. Instead I bought the protect when it was just pennies. To make things even better, CF dropped enough to make my weeklies pay off and then stabilized so I was able to sell them off for a nice additional profit. I did this 2weeks in a row until the Dec spreads became worth pennies and I closed them for almost full profit. BUT if you count the money I made on my protective puts then I made more than full profit. No, I am not a genius (thank you for thinking that ;-), I merely stuck to my rules and it played out well.
*** MOMO STOCKS: perfect example of this when NFLX was THE momo stock of the year. After a huge run I would never buy it after a monster run for fear of a monster crash. I would however sell a credit put spread (bullish) but with only $5k on the line. Indeed, real example. I had a credit put spread in NFLX 10x at 205/200 on sep 12th all was well. On Sep 15 stock opened like $35 down then tumbled to land around 120. I closed my spread for a $3792.49 loss (5221.47 premium paid to close - 1428.98 premium collected) the trade was for 10x so 1000shares. Had i owned the stock outright I would have lost 35k IF i had the guts to sell the 1st day it tumbled. if not then double that because it continued to fall.
More current example is $CMG $PCLN etc. They've been on a tear; I want to get involved but can't buy them up here so instead I sell put spreads and participate that way.
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THE ABOVE IS NOT TRUE IF I SOLD NAKED PUTS OR CALLS WHICH NO ONE SHOULD EVER DO!
As with any trade there are risks but in this case the I am very comfortable with the dollars at risk. I always try to know and manage my risk; I ask 'what will I lose if the crap hit the fan in the worst possible way.' If I know the answer to this and am ok with it then I should be ok.
THIS IS NOT A RECOMMENDATION OF ANY KIND. I ONLY INVEST MONEY I CAN AFFORD TO LOSE.
$AAPL $AMZN $bidu $SPX $NDX $RUT $C $GS $wynn $SPY $GOOG