Spreading the Wealth - TheStreet

One of the great challenges in trading options is evaluating whether the options you are buying are cheap or expensive. Recent columns that suggested either selling

puts or

calls prompted many readers to ask how I could possibly suggest selling options with volatility so low and took me to task for recommending selling options naked because it can expose you to unlimited risk.

Let's look at one position, the basic vertical spread, which limits risk and reduces volatility's role in the decision-making process to a minimum. A vertical spread consists of buying and selling options of the same class with the same expiration on a one-to-one basis, typically separated by only one or two strike prices, so the current implied volatilities will be similar.

More important, both strikes will respond to changes in the price of the underlying stock with relatively parallel changes in implied volatility. Unlike outright long or short premium positions, such as straddles, where success depends highly on getting volatility right, the profit-and-loss profile of vertical spread is barely affected by a change in volatility, making these more pure, directional positions.

Buyer or Seller, but Not a Borrower or Lender

The long vertical (debit) spread is one of the first strategies taught to options traders, and for good reason: It offers a defined risk/reward scenario and relative ease of execution. But let's look at the inverse, the rarely utilized, underscrutinized selling of vertical spreads, otherwise known as a credit spread.

A credit spread is created by selling the closer-to-the money strike (which has a greater dollar value) while simultaneously buying the further out-of-the-money strike (lower value), resulting in a net credit. Two important distinctions of a credit spread are that a bullish position is established by selling a put spread and a bearish position uses the sale of a call spread. The maximum profit is realized when the spread expires out of the money or worthless -- essentially the opposite definitions of a debit spread.

One of the reasons that credit spreads are far less popular than debit spreads is that the risk/reward ratio is less attractive. But the trade-off is that there is an increased probability of the position resulting in a profit. So while credit spreads' profit/loss profile is typically less than the 1-to-1 ratio that I like to see when establishing a position, it's largely offset by the fact that it should produce a profit with a much higher frequency than a net long premium position.

Decay Pays

This advantage of the credit spread, of course, is due to the fact that a good portion of an option's value is time premium and because options are a decaying asset. Statistics on the percentage of options that expire out of the money are frequently bandied about and range anywhere from 70% to 90%; suffice it to say, the majority of all options expire worthless.

One of the main attractions of credit spreads is they allow you to let time decay work in your favor. This is done by using strikes that are out of the money (making the entirety of the spread's credit composed of time value) and employing front-month options (or those with the shortest life span) because theta accelerates as expiration approaches. Also, out-of-the-money options reduce the possibility of an early assignment, meaning you won't be forced into selling (in the case of short calls) or buying (short puts) shares you don't own or want.

RIMM Shot

While I have no fundamental opinion of

Research In Motion

(RIMM)

, it will provide a good illustration of how a debit spread works. One of the reasons I chose this stock is because its volatility, both real and implied, has traded from a low of 41% to a high of 97% over the past six months; its current level of 57% makes these options neither cheap nor expensive and we're not provided with a predictive edge as to whether volatilities are likely to move up or down.

Currently trading at $43.75, one can sell the October 42.50 put for $1.30 and buy the October $37.50 put for a net credit of $1 for the spread. The maximum profit is only $1 if the stock settles above $42.50 on the Oct. 17 expiration, while if it drops below $37.50 the maximum loss of $4 would be realized. At first blush, this looks like a terrible risk/reward profile. But compare it to its symmetrically bullish cousin, the October 45/50 call spread, which can be purchased for a net debit of about $1.20, allowing for a maximum profit of $3.80 a spread if the stock closes above $50 on expiration.

The table below compares the profit/loss profile of vertical spreads: the October 42.50/37.50 put credit spread vs. the October 45/50 call debit spread.

The credit spread "pays," or the premium is collected, over a much larger price range than the debit spread. For example, even if the shares decline by 2.7% over the next two weeks, the credit spread will realize its maximum profit. The break-even on the debit spread is $41.50, or a 5% decline in the underlying stock price.

On the other hand, the call debit spread shows that it would take a 5% increase in the share price just to reach the break-even point of $46.20; anything less will result in a loss. And you'll need an impressive 14% gain to $50 to achieve maximum profit.

In simple terms, the credit position realizes a profit if the stock moves in two of the three possible directions, making it a great strategy for generating moderate returns -- especially in a range-bound market or when not expecting a large move in an individual issue.

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.