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.
Target (TGT) reported earnings before the bell on Wednesday that beat estimates on both revenue and profits. The company also expects its fiscal Q4 comparable sales growth to be higher than previous forecasts. Moreover, TGT claimed the supply chain mess has not been an issue - store shelves are full and ready for the holiday buying onslaught.
Analysts were mostly bullish on the report, giving TGT several target price increases (there was one lower price). One went as high as $350, a 38% premium to Friday’s closing price. The stock price was not rewarded, however. The shares dropped 4.7% on Wednesday and slid further the rest of the week. However, this was a common theme among several retailers, including Walmart (WMT). In fact, the overall retail sector was lower for the week.
The pullback dropped the shares to just above their 50-day moving average (blue line in chart). This trade is thus a bet that TGT will regain its footing and stay above the 50-day as holiday sales numbers – that are predicted to be robust – start rolling in. The short 245 strike (red line) of our put credit spread is below the 50-day, relying on trendline support to hold through expiration.
If you agree that TGT will stay atop its 50-day moving average line in chart), consider the following trade that relies on the stock remaining above 245 (through expiration in six weeks.
Buy to Open TGT 31Dec 240 put (TGT211231P240)
Sell to Open TGT 31Dec 245 put (TGT211231P245) for a credit of $1.60 (selling a vertical)
This credit is $0.02 less than the mid-point of the option spread when TGT was trading around $251. Unless the stock rises quickly from here, you should be able to get close to this amount.
Your commission on this trade will be only $1.30 per spread. Each spread would then yield $158.70. This trade reduces your buying power by $500 and makes your net investment $341.30 ($500 – $158.70) for one spread. If TGT closes above $245 on December 31, both options will expire worthless and your return on the spread would be 46% ($158.70/$341.30).
Affirm Holdings (AFRM) provides a platform for point-of-sale payments for consumers and merchants. In August, AFRM announced a partnership with Amazon.com (AMZN) to offer flexible payment solutions to customers with AMZN purchases above $50. AFRM reported earnings on Wednesday after the bell that missed on profits but beat on revenue. The company also raised sales guidance.
Wall Street apparently forgave the earnings miss, largely because it was not clear if the discrepancy used comparable numbers. Moreover, AFRM said its AMZN relationship as a buy-now-pay-later service was exclusive. Clearly, analysts were looking at AFRM’s growth prospects, as the company was greeted with several target price upgrades that reached as high as $185 (the stock closed at $149 on Friday).
After a nasty, four-day 21% plunge heading into earnings that pulled the stock to its 50-day moving average, the stock rebounded 13.7% the day after the earnings news. Given the earnings rebound, analyst target upgrades and deal with AMZN, we are going with a bullish trade on AFRM that keys on the stock maintaining its three-month rally and staying atop its 50-day moving average (blue line in chart). The short put strike of our credit spread sits at $133 (red line in chart), just below the 50-day.
If you agree that AFRM will continue its uptrend and stay atop its 50-day moving average line in chart), consider the following trade that relies on the stock remaining above $133 (through expiration in seven weeks.
Buy to Open AFRM 31Dec 128 put (AFRM211231P128)
Sell to Open AFRM 31Dec 133 put (AFRM211231P133) for a credit of $1.85 (selling a vertical)
This credit is $0.05 less than the mid-point of the option spread when AFRM was trading at $149. Unless the stock rises quickly from here, you should be able to get close to this amount.
Your commission on this trade will be only $1.30 per spread. Each spread would then yield $183.70. This trade reduces your buying power by $500 and makes your net investment $316.30 ($500 – $183.70) for one spread. If AFRM closes above $133 on December 31, both options will expire worthless and your return on the spread would be 58% ($183.70/$316.30).
MetLife (MET) won’t get anyone’s juices flowing. It’s frankly a rather boring insurance and financial services company that’s been around for 158 years. But who cares … if we can make money on a trade, right?
MET reported earnings last week that beat estimates on the top and bottom lines. Hardly anyone noticed. Analysts were silent. There were no stories other than a dry listing of its key performance numbers. And the stock fell 2% the next day. Ho hum.
But MET is up 36% for the year, which is well ahead of the S&P 500’s 25%. After a swoon in June and July, the stock has been grinding steadily higher along the dual support of its 50-day and 200-day moving averages. The key is the 50-day (blue line in chart), which has allowed just three daily closes below it during the past three months. This trendline, which is rising slightly, sits at $61.10, which is above the short strike of our put spread trade. Thus, MET would have to pierce this support to hurt this trade. And the 200-day (red line in chart) sits at $61 to provide another layer of support. The last time MET closed below the 200-day was more than a year ago.
If you agree that MET will continue its slow ascent and stay atop its 50-day moving average line in chart), consider the following trade that relies on the stock remaining above $62.50 (through expiration in six weeks.
Buy to Open MET 17Dec 60 put (MET211217P60)
Sell to Open MET 17Dec 62.5 put (MET211217P62.5) for a credit of $0.75 (selling a vertical)
This credit is $0.04 less than the mid-point of the option spread when MET was trading at $64. Unless the stock rises quickly from here, you should be able to get close to this amount.
Your commission on this trade will be only $1.30 per spread. Each spread would then yield $73.70. This trade reduces your buying power by $250 and makes your net investment $176.30 ($250 – $73.70) for one spread. If MET closes above $62.50 on December 17, both options will expire worthless and your return on the spread would be 42% ($73.70/$176.30).
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