In Search of Credit Spreads

Investors are often warned against shorting options because it offers only limited profit potential. But I want to make the distinction between selling options "naked," meaning having a position consisting of more options sold short than owned, and establishing a position for a net credit.

A credit position simply means you are selling more premium than you are buying. There's a multitude of ways to establish a credit position but I want to focus on one of the most basic: the vertical spread. A credit spread calls for investors to sell higher-priced or closer-to-the-money options while simultaneously buying an equal number of lower-priced or further-out-of-the-money options.

Most investors want to use options to make a directional bet and opt for buying options or purchasing a spread for a net debit because of the limited risk associated with owning options. But I think it's a huge mistake to overlook the fact that credit spreads are also directional bets that not only limit risk but also offer a distinct advantage. Credit spreads have a higher probability of achieving profitability.

The main advantage to selling a spread for credit is that time decay, as represented by theta, works in your favor, while a long or debit spread is an eroding asset. A credit will be profitable on a smaller percentage price move and the break-even point requires a larger percentage price move than a debit spread.

Being Worthless Pays

A good way to understand the probability associated with the profitability is to look at the delta of each of the positions. Remember, a rule of thumb regarding delta is that it equates to the likelihood of an option expiring in the money. So an option with a .30 delta has a 30% chance of expiring in the money and a 70% chance of expiring out of the money or worthless. The key advantage of credit spreads is that they achieve maximum profitability even if they expire just one penny out of the money. A credit spread that is one penny in the money realizes a profit of just that one penny.

So while the risk/reward of a credit spread may be slightly less attractive than a credit spread, it produces profits at a greater frequency. For active investors, the prospect of realizing a slightly lower return more often, say 40% profit 70% of the time, is much more attractive than shooting for a double, which pays off only 10% of the time.

Trading on Credit

Selling call spreads looks like an attractive strategy in some high-profile names such as Apple(AAPL Quote) or Martha Stewart Living Omnimedia(MSO Quote), two stocks in which many skeptical investors are itching to establish bearish positions.

Shorting these stocks outright has been hazardous to your financial health for the past few months, and due to the high implied volatilities, buying put options or a put credit spread have been equally ineffective and have only become profitable as each stock has sold off sharply in recent days. With the bloom temporarily off these roses, I expect the gains, sharp short-covering rallies notwithstanding, to be limited. But given the recent selloffs, I don't think the share price will drop significantly in the short term. This makes them good candidates for selling a call credit spread.