I'm an avid reader of your excellent and commonsense columns. Would you consider a column commenting on: 1. Credit spreads; 2. the risks involved; 3. and the appropriateness of engaging in them for novice option investors such as myself. I'm really concerned about risk: What if I get assigned? Or, is the assumption being made that I will (can?) close out the credit spread before being assigned? What happens if I cannot close out both sides of the trade? Thanks in advance. -- R.C.
The first takeaway from this reader's email should be that flattery always helps. I was about to refer this reader to
a recent column on credit spreads when I received a quick follow-up email saying he had already read the recent article but still had some questions regarding the mechanics and risk involved.
The real risk to credit spreads is always simply the difference between strike prices, minus the credit received. So, if you sell a $35/$40 call spread for a net credit of $2, the position's maximum profit is limited to $2, while the maximum loss is $3 per spread. One of the problems with credit spreads, compared to debit spreads or simply buying premium, is that even though they have a higher probability of being profitable (by profitable I mean earning even a single penny), the absolute risk/reward of the position is usually less than the even money.
You can always close out a position prior to expiration. But be aware that the maximum profit of a vertical credit spread usually cannot be realized until expiration. In fact, one of the drawbacks of most spreads, debit or credit, is that the maximum profit cannot be realized until expiration or until the position moves very deep in or out of the money.
You should always open and close spread positions as a spread, a single transaction, not making an attempt to leg into them. This means you will be closing both sides. Most online brokers now offer the ability to enter multi-strike transactions as a single order. With electronic trading and exchange linkage, the bid/ask on spread orders usually will be much tighter than entering the legs as separate pieces.
And given that brokers still do get paid a little something for executing trades, spread orders, which used to lay in mothballs on the "spread book," now are very likely to get filled not only in a timely fashion but at a price that represents fair value between the bid and the ask.
The possibility of an early assignment is certainly a risk when writing credit spreads. But this is mostly at expiration if the short option is likely to expire in the money. By the Thursday or Friday of expiration week, you should have a pretty good handle on whether the short option on the spread will be assigned. Remember, for credit put spreads, this means the higher-priced strike, and for credit-call spreads, it's the lower-priced strike. Most brokerage firms follow the auto-exercise rule, which automatically exercises all options that are 25 cents in the money.
If it appears that the short, in-the-money options will be assigned, you always can take appropriate action in the underlying shares. For calls, this would mean buying enough shares to offset the assignment of those calls sold short. This will help you avoid carrying risk over the weekend. But I would wait until the last hour of the day before taking any preemptive action regarding assignment.
If the position was fully in the money, I would, as suggested above, look to close it out by entering a spread order with prices that represent fair value or the midpoint of the bid/ask. If the position goes unfilled, remember to exercise the options you own, which will offset the expected assignment of the short options.
Another important factor to consider when selling credit spreads, especially calls, is dividend dates. When a stock goes ex-dividend, it greatly increases the likelihood of an in-the-money call receiving an early assignment. Make sure you are aware of all ex-dividend dates on stocks in which you hold positions.
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