Two recent trades in the Options Alerts model portfolio in Nike ( NKE - Get Report) and Palm ( PALM) have spotlighted strategies that sell options. Investors often are 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 are owned, and establishing a position for a net credit. In both Nike and Palm, the positions consisted of a credit put spread.

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 believe it's a huge mistake to overlook the fact that credit spreads are also directional bets that not only limit risk but offer a distinct advantage: Credit spreads have a higher probability of achieving profitability.

Being Worthless Pays

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.

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 0.30 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 cent out of the money. By contrast, a debit spread needs to be fully in the money to realize the maximum profit.

For example, if one had bought a $90/$95 call spread in Nike for a cost or debit of $2, the stock would need to rise to $92.01 to realize a profit and would need to close above $95 to realize the maximum $3 profit. On the other hand, a sale of the $90/$85 put spread for $2 only needs the stock to rise to $90.01 to realize its $2 maximum profit.

Limited Risk

So while the risk/reward of a credit spread may be slightly less attractive than a debit 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.

The real risk to credit spreads is always simply the difference between strike prices, minus the credit received. So, if you sell a $90/$85 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 with 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.

Assignments and Closure

You can always close out a position prior to expiration. But be aware of one of the main drawbacks of a credit spread: The maximum profit usually cannot be realized until expiration unless the position moves very deeply in or out of the money.

Always open and close spread positions as a spread, a single transaction, rather than making an attempt to leg into them. This means you will be closing both sides at once. Most online brokers now offer the ability to enter multistrike 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.

Given that brokers still do get paid a little something for executing trades, spread orders, which used to lie 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 risk 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.

Another important factor to consider 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.

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. Then you can come in Monday with a clean slate and look for new moneymaking opportunities.

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Steven Smith writes regularly for 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.

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