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Credit Spreads

All About Credit Spreads - Definition, An Example, and How to Use

A credit spread comes about when you purchase one option and simultaneously sell an option (for the same underlying security, of course), and you end up with cash in your account.  In a credit spread, the amount that you collect by selling an option is greater than the amount you have to pay for the option that you buy.   

In a typical credit spread, you are hoping that both sides of your credit spread (i.e., the long option you bought and the short option you sold) will expire worthless, and you will be able to pocket all the cash you collected when you first sold the credit spread.

Just in case you are so lucky, and both options in your credit spread do not expire worthless, the broker will charge you a maintenance requirement which is equal to the maximum possible loss you could experience with your credit spread.  Usually, that works out to be the difference between the strike prices of the long and short option.  The maintenance requirement (i.e., the maximum loss possible) is reduced by the amount of cash you collect from the credit spread when you first placed it.

In similar fashion to all spreads, credit spreads are purchased to reduce risk.  The other side of the coin is that your maximum gain is limited. 

There are two greats feature of credit spreads.  First, if either or both of the options expire worthless, there is no commission to pay when the options expire.  Second, if you are trading in an account in which you have a margin loan on stock, the money you collect from the credit spread will offset some or all of the margin loan, and you will not pay interest.

An interesting side-note: If you sell stock short in a margin account, the cash is not generally applied to a margin loan.  Only cash received from the sale of an option credit spread will offset a margin loan.

 

Terry's Tips Stock Options Trading Blog

August 12, 2019

Ulta Beauty (ULTA) Looks Poised to Break to Fresh Record Highs

Several analysts are optimistic regarding Ulta Beauty’s stock price following their recent earnings surprise, here are two of them - Why the Earnings Surprise Streak Could Continue for Ulta (ULTA) and How one retailer is beating the odds.

August 5, 2019

Consider Essent Group (ESNT) Following Their Earnings Report

This week we are looking at another of the Investor’s Business Daily (IBD) Top 50 List companies.  We use this list in one of our options portfolios to spot outperforming stocks and place option spreads that take advantage of the momentum.

Terry

Consider Essent Group (ESNT) Following Their Earnings Report


ESNT reported earnings in the past week and despite an early day dip, the stock managed to close higher on the day. The following article provides a view on why the stock could continue higher – 2 Stocks Poised to Thrive in Volatile Times: Essent Group Ltd., Cognex Corporation. Also take a look at this article which discusses the earnings report and the declaration of a new dividend – Essent Group Ltd. Reports Second Quarter 2019 Results & Declares Inaugural Dividend.

There are two significant things going for ESNT from a technical perspective. First, the stock dipped below major support at $45.38 on Friday but managed to close above it. This has resulted in a hammer candle which is a popular candlestick that signals the potential for a reversal. This pattern is not just seen on a daily chart, it is also present on a weekly chart and even on a 4-hour chart. The horizontal level is considered significant as it triggered a major turn last year and as it has acted as support in recent months. The fact that the candlestick pattern printed above such a significant level strengthens it. The other thing going for the stock is that it managed to close higher despite an overall heavy tone in the markets on Friday. This divergence is quite important as the markets look a bit heavy following the price action in the past week.

[caption id="attachment_2451" align="alignnone" width="916"]ESNT Chart August 2019 verticle options spread ESNT Chart August 2019[/caption]

If you agree there's further upside ahead for ESNT, consider this trade which is a bet that the stock will continue to advance over the next seven weeks, or at least not decline very much.

Buy To Open ESNT 20SEP19 40 Puts (ESNT190920P40)
Sell To Open ESNT 20SEP19 45 Puts (ESNT190920P45) for a credit of $1.68 (selling a vertical)

This price was $0.02 less than the mid-point of the option spread when ESNT was trading near $46.  Unless the stock rallies quickly from here, you should be able to get close to this amount.

Your commission on this trade will only be $2.50 per spread (the rate charged by thinkorswim for Terry’s Tips’ subscribers).  Each contract would then yield $165.50 and your broker would charge a $500 maintenance fee, making your investment $334.50 ($500 – $165.50).  If ESNT closes at any price above $45 on September 20, both options would expire worthless, and your return on the spread would be 49% (389% annualized).

[caption id="attachment_2452" align="alignnone" width="304"]IBD Underlying Updates August 1, 2019 via Terry's Tips IBD Underlying Updates August 1, 2019[/caption]

Changes to Investor’s Business Daily (IBD) Top 50 This Week:


We have found that the Investor’s Business Daily Top 50 List has been a reliable source of stocks that are likely to move higher in the short run.  Recent additions to the list might be particularly good choices for this strategy, and deletions might be good indicators for exiting a position that you might already have on that stock.

As with all investments, you should only make option trades with money that you can truly afford to lose.

Happy trading,

Terry

July 29, 2019

PayPal (PYPL) Dips Following Earnings, What’s Next?

PayPal slipped lower after reporting earnings in the past week. Take a look at what these analysts are saying about the stock post-earnings – PayPal Q2 Earnings Beat Estimates, Revenues Up Y/Y and PayPal’s Earnings May Have Disappointed but Its Chart is “BTF”.

Making 36%

Making 36% – A Duffer's Guide to Breaking Par in the Market Every Year in Good Years and Bad

This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).

Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.

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TD Ameritrade

This Chicago brokerage firm with the unlikely name thinkorswim, Inc. by TD Ameritrade is considered by many to be the best option-friendly broker. For openers, they have extremely good analytic software and their option trading platform is exceptional. Thinkorswim Mobile has been called the best mobile app in the industry. In 2017, TD Ameritrade received 4 stars out of 5 in the annual Barron`s* Best Online Brokers Survey. TD Ameritrade was tops as an online broker for long-term investors and for novices. The company is the only broker that receives the highest 5.0 score for research amenities among all firms participated in the ranking last year.

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