« »

Tuesday, December 31, 2013

Options trading: Limiting the risk

By Brad Reinhard

If you are managing your own investment portfolio and are interested in developing it further, options trading, though often perceived as risky, actually provides the trader more control. It can limit risk with predetermined levels of reward.

Most starting investors are often taught to stay away from options and margin accounts because of the potential high risk. However, there are specific options trading systems that are optimized to provide consistent income while minimizing downside risk. One such option trade is called a Bear Call Credit Spread. This article will provide an introduction to what this option trade is and how you can benefit from it.

Understanding the terminology

Without having to learn myriad option buying and selling strategies you can often be proficient at just one or two popular strategies, one being the bear call credit spread. To become proficient in a targeted strategy you first need to understand the industry jargon and terminology associated with the strategy. Here are a number of definitions that will help you better understand the bear call credit spread option trade:
  • Decay of time value - options are considered wasting assets whereby their value declines over time as long as they are not in the money. If an option is approaching its expiration the chances that it will be in the money are reduced, thereby reducing its time value.
  • At/Out of/In the money - these three terms refer to whether options are gaining, losing or neutral in terms of money positions. At the money (ATM) means the underlying asset price (stocks, commodities or futures) is identical to the strike price of the option (either puts or calls); this position is in neutral position. In the money refers (ITM) to the fact that the option currently has some intrinsic value because the put or call price has been met; a positive cash position. Out of the money (OTM) refers to an option that has no intrinsic value; generally a money losing position.
  • Strike price: Refers to the price at which a call option can be exercised in which the underlying asset is purchased or refers to a put option where the underlying asset can be sold. Strike prices are determinant of an options premium which represents the market value of the contract.
  • Spread: The strategy of buying and selling options with different strike prices establishing a price range difference providing the possibility of a net credit.
  • Vertical spread: Refers to a spread position that has the same expiration dates but differing strike prices. Profits on this type of spread are determined by the difference between the premiums on the two positions.
  • Legs: Represents a single call or put; for example, a bear call spread comprises 2 legs – one short call option at one strike price, and one long call option at a higher strike price.

Bear call credit spread explained

Stock options control risk and increase potential financial returns
Bear call spreads reduce investment risk
This strategy is best used when you think the underlying asset (stock, commodity or future) is going to hold steady or decline in price. This strategy is implemented when you buy out-of-the-money (OTM) call options at a certain strike price and at the same time sell the same number of OTM call options at a lower strike price within the same month.

This trade is called a credit spread because upon entering the trade a credit is received. The credit minus any commissions paid will be the total profit available for this type of trade. The maximum profit is achieved when the price of the underlying asset is at or below the strike price of the short call when the options expire.

Benefits of the bear call spread

There are number of benefits to this type of strategy such as:
  • Losses are limited to the difference in strike prices which is usually about a maximum of five points less the net credit.
  • Risk in the strategy can be controlled by how far out of the money the sold option is positioned. Longer OTM spreads will yield less profit but are safer and have higher break even points.
  • If the underlying asset price climbs, the investor can buy back the short call and have unlimited profit from the long call.
  • This strategy also provides a highly leveraged position because of the low margin requirement of the spread.
The bear call credit spread strategy provides limited risk along with predetermined, but limited reward, and it’s a strategy to consider for those investors seeking alternative methods to generate consistent returns for their portfolio.

About the author: Brad Reinhard is interested in stock trading and informing others on how to invest properly.

Image license: US-PD