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Some of my trades are starting to work out to my favor, even during this slight pullback… and I’ll just have to wait and see if it holds up.

Now, I want to use it as an opportunity to teach you about one of my favorite strategies.

Of course, in order for me to do that, I’ll have to explain the basics of credit spreads and how you can use these strategies to your advantage

And who knows, maybe something will click for you and you discover how to develop strategies on your own based on my teaching

I genuinely believe that there are great learning opportunities no matter what the market gives you. And since every day is different, trading is a never-ending process of learning, practicing, executing, and learning again.

That said, let me show you my two reasons why I like to sell options instead of buying them, and why I believe it’s possible to improve your trading with understanding the basics of credit spreads.

 

Learn How Credit Spreads Can Help Your Trading

 

The Classic Put

 

Typically if a trader is interested in going short and using the options markets, the first thing that comes to mind is to purchase a Put.

A purchase of a put option does two main things for a trader. It allows a trader to benefit from the decrease in the price of the asset and it limits or decreases the amount of loss they may incur.

This is much less risky than shorting the underlying asset and the trader can use the leverage of options to increase their gains, potentially, as well.

Here is a payout diagram for both a short stock and put option.

 

 

The diagram on the left shows a traditional short sale of a stock. With this, there is an unlimited loss as the share price increases!

The diagram on the right shows the purchase of a put option. With this, there are limited losses as the share price increases!

Quick Lesson: If a trader wants to short a stock and they are aggressive with the direction, buying at the money puts gives them the most bang for their buck.

So what’s the benefit of using this strategy?

  1. There is limited risk if they get the trade wrong
  2. There can be high upside gains if they get the trade right.

Unfortunately, there is something I must remind you of. If a trader is wrong on the timing, your options may expire and they will lose on the trade.

That’s the pain I feel all the time, and I don’t want to teach you my techniques to avoid it.

It really sucks to be right, just to be wrong.

But I have a solution that I think you might like.

It’s called a Call Spread.

I know that you may be confused, and it’s ok if you are.

Let me break it down for you a little more.

 

The Short Call

 

An alternative to buying a put is to sell a call.

This is usually described as a “naked call” and is one of the most terrifying trades anyone could place. Just ask one of the many hedge funds that blew up from this trade.

It works… until it doesn’t, that’s an old saying on the street.

 

 

As you can see in the risk diagram, you are subject to unlimited loss the further price increases.

I mean, who wants to sleep with one eye open?

Trading is stressful enough without having to worry about some pot stock going from $5 to $500 overnight causing you to lose your home and all your assets. There are some traders who think naked selling options is tried-and-true, and I can’t understand why for the life of me.

What if there is a way to still gain exposure to the short call and stay protected?

Let’s take a look at one of my favorite trades… the Credit Call Spread.

 

The Credit Call Spread

 

The Credit Call Spread (or Bear Call Spread) is a bearish to neutral options trading strategy.

It aims to capitalize on both downward price movement of the asset and theta decay.

Credit call spreads work extremely well in both directional and sideways markets as the options will expire worthless at the end of the trade, leaving the premium for the trader to collect on.

What does that mean exactly?

It means that I receive the cash upfront …

That’s right, I get paid to take that trade!

Another huge benefit of this trade is that it has a lower max loss compared to selling calls and even purchasing put options.

 

 

 

As a seller of options, I can still make money even in a sideways market!

This is such a great strategy since it allows me to trade a short call and have a max loss on the trade. This is a must to capitalize on premium decay and also market direction on the trade.

 

The Odds Can Be Stacked In My Favor At Times

 

Option sellers take maximum advantage of the option time decay theory, commonly known as Theta Decay.

OTM options lose value quickly and become worthless at expiration. This allows traders to not have to worry about correctly predicting the market direction or timing the market perfectly to generate income.

I can take advantage and I think I can be “the house” with odds in my favor

Now, keep in mind the markets move fast and prices will change, and if you’re a second or two late… it means the odds may not be in your favor. Again, not everyone will have the same odds utilizing this strategy, so make sure you do your due diligence to learn more about the ins and outs of it.

Don’t forget that an option buyer needs to be right about direction and time!

Remember traders, there are many ways to make money in this market and selling options is one of my absolute favorite go-to strategies.

Key Points:

  • Credit Call Spreads can gain if the stock goes down, stays the same, or goes up
  • Limited risk vs naked calls
  • Can improve the odds in some cases, in my opinion
  • Allows one to get paid to take risk
Author:
Dave Lukas

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