In the Options Alerts newsletter, we frequently look at credit spreads (selling a higher priced option/buying the lower-priced option on a one-to-one basis) rather that establishing the spread for a debit. These are both limited-risk positions which mirror each other, being basically the inverse of the other. In a credit spread, you trade a lower maximum profit for a higher probability of profit.
For example, right now in Tidewater (TDW - commentary - Cramer's Take), a stock trading around $55, the $55/$60 call spread is trading around $1.60, as is the $55/$50 put spread. Buying the call spread for a debit offers a profit/loss potential of $3.40/$1.60, but the breakeven point is $56.60; the stock would have to trade above $60, a 9% move, to achieve maximum profit. Selling the put spread for a credit has the inverse profit/loss, but the breakeven is down at $53.40 and the maximum profit is achieved at any price above $55, a negligible move to achieve the maximum profit.
Because both are vertical spreads, the impact of changes in implied volatility, or vega risk, is greatly reduced, so the decision on which to use should be based more on market expectations.
On a related issue, many readers and subscribers have written saying that their brokers will not allow them to "sell" options as part of a credit spread. This makes no sense to me, because again, it is a limited-risk position. Granted, the margin requirements tend to be a bit higher for the credit spread, but I don't understand why investors need to be approved for a "higher level" of option trades. optionsXpress lists its basic margin requirements on its Margin Guidelines page. thinkorswim, which doesn't have trading levels -- meeting margin requirements approves users for any trading strategy -- also lists its Margin Schedule.
That said, a number of firms I've put this question to say, without promising, that all a customer needs to do is call and show that he understands the risk involved in a credit spread (remember to say it's limited!) in order to be cleared to enter this type of order.
P.S. Will you be there when Cramer makes his next move?
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Steven Smith Blog Poll Numbers Tighten Up 1/25/2006 9:48 AM EST II's bulls and bears have tightened up lately. Watch earnings reports as they'll drive option trading.
Steven Smith Blog Comparing Option Brokers 1/24/2006 4:56 PM EST thinkorswim, optionsXpress and Trade King offer different merits for different types of traders.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.To read more of Steve Smith's options ideas take a free trial to TheStreet.com Options Alerts.
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