In Search of Credit Spreads - TheStreet

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) - Get Report

or

Martha Stewart Living Omnimedia

(MSO)

, 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.

On Wednesday, with Martha Stewart trading at $26.45, one can sell the April $25/$30 call spread for a net credit of $2.15. This represents the maximum profit that would be achieved if MSO is below $25 on the April 15 expiration day. The break-even point is $27.15 and the maximum loss is $2.85. But based on the delta of the position, it has a 65% probability of turning a profit.

Compare this to buying the April $30/$25 put spread for a net debit of $2.90. It has the same risk/reward, which is a maximum loss of $2.90, and a slightly greater maximum profit that is equal to the credit call spread, and a maximum profit of $2.85 but has only a 59% probability of achieving a profit. If one bought the March $25/$20 put spread for a net debit of 90 cents, the maximum profit is $4.10 but the probability of achieving any profit drops down to just 28% based on the current delta.

Think Inside the Box

In looking at these prices, you should notice they present a basic mirror image in terms of pricing and risk reward. Probably the most fundamental way to understand the relationship between various strike prices is to look at something called the box spread. While the box spread's implications come intuitively to some people, it's not a simple concept to grasp. Not being mathematically oriented myself, I still struggle with divining its implicit message of highlighting the mispricing, or "out of line" valuation, of specific options.

A box spread is a four-sided option play that involves a long call and a short put at one strike price, as well as a short call and a long put at another strike price. Essentially, this creates both a synthetic long position and a synthetic short position using different strike prices.

If all option prices are "in line," a box spread represents a riskless position. For example, let's assume ABC Corp. is trading at $52.50 and you buy the 50/55 box, meaning you sell the $50 call and the $55 put and buy the $50 put and $55 call. If all strikes are trading at parity, or in line, this should net you $5, because you're creating a synthetic short at $55 simultaneously with a synthetic long at $50. At expiration the position must be worth $5. This relationship holds true among all strikes, so the 45/55 box is worth $10, just as the 50/60 box should be worth $10.

Once you understand this dynamic, if you're given the prices of three strikes, you can determine the fair value of the fourth piece of the box regardless of the price of the underlying stock. This helps you recognize when any one option price gets out of line; it can be bought or sold, then hedged using the other three strikes to create a risk-free arbitrage situation.

For professionals and market makers, boxes -- and their relatives, the conversion and reversal -- are basically risk-management tools or interest rate plays. But for the rest of us, they provide a great way to see how multiple-strike positions can be broken down into the component parts, making it easier to scan for equivalent replacement positions.

We've all been frustrated at some point when we were unable to get a trade off at what we believe is a "fair price" in our chosen strike. Being able to look at other strikes and identify better prices when confronted with wide bid/ask spreads or thinly traded issues (or any other obstacle that prevents establishing the first choice of position) is invaluable. The flexibility to move to a second, third or even fourth alternative will allow you to execute more trades and, hopefully, be more profitable.

Looking at credit spreads, that is using calls to establish bearish positions and put options to create bullish positions, adds additional tools to your trading arsenal and often offers superior probability of achieving profitability.

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 invites you to send your feedback to

steve.smith@thestreet.com.