Option Trading School: Our Profitable SPY Credit Spread, Part 2

Posted by jbrumley on August 27, 2018 4:26 PM

In part one of this two-parter look at the Index Option Timer’s recent winner on a put-credit spread on the S&P 500 ETF (SPY) – a neutral-to-bullish trade – we dissected what it was about the chart that prompted us to make what seemed like an unlikely trade. That is, we actually went semi-bullish on the market (using the SPY as our proxy) at a time when it looked like the S&P 500 was in real trouble. If you missed that piece of the commentary, be sure to check it out here. The second part of this lesson will look specifically at how and why a credit spread was the best way to play this particular setup.

This dissection isn’t going to look like other examples of how credit spreads work though. If you’re new to option trading or are just curious about other ways to use options as strategic tools, this is going to be something of a philosophical primer. If you want the more mechanical aspects of using credit spreads, we also recommend you look at this more technical explanation we posted about a year ago.

Both will help you get a grip on these not-so-complex trades.

Let’s just start with a couple of assumptions, one of which is that you’re at least somewhat aware of what an option is, and how they work. You know that owning a call gives you the right to buy 100 shares of a particular stock at a specified price at some point in the future. Conversely, a put option gives you the right to sell 100 shares of a particular stock at a certain date at some point in the foreseeable future.

Did you ever stop and think about who you’re buying those rights from? For every buyer, there’s a seller giving up their rights to buy or sell that stock. Or, more specifically, they’re selling YOU the right to make THEM do that buying or selling at the market price at a point in time of your choosing… should you choose to do so.

Sounds risky, right? And truth be told, it is. There are certain disadvantages to ownership of options though, which become advantages to the sellers…. sellers, by the way, that pocket the money you pay to buy a put or call option.

Chief among that advantages/disadvantages is the fact that time decay, or theta, chips away at the value of the option as time moves along. Even if SPY was going nowhere at the time, the SPY August week 4 (08/24) 279 puts (SPY 180824P279) – the ones we shorted – were losing about $6 of their value per day (a ‘theta’ of 0.06) for each contract that was selling for $53 apiece ($0.06 x 100 contracts = $6.00). That’s a HUGE hurdle to get over. The SPYders would have had to gain six cents per day during our holding period just for owners to breakeven.

And actually, it would have had to do more than that! For every $1.00 that SPY moved lower, the option was only gaining about 25 cents in value (a ‘delta’ of 0.25). So, for anyone who owned the put in question, SPY would have had to lose 25 cents to move the option’s price enough just to negate the impact of time decay. There would have been no actual profitable change in price for even more tepid movement.

A 25-cent move may not seem like much, but for an index, it’s a lot… especially when you only have a few days to make the trade pay off.

Confused? Don’t be. Here’s the easy-understand version of the buyer’s point of view. Owners would have had to pay $53 a piece for each SPY August week 4 (08/24) 279 put (SPY 180824P279). Each contract would have lost about $6 worth of value per day just because time was passing. And, even if SPY had been able to move from the then-price of around $281 to $280 – again, a pretty big move for an index ETF – then the contract would have only gained about $25. Never even mind slippage, commissions and the spread between the buying and selling price! Also never even mind the fact that the SPYders were deep into the red at the time, making it unclear what the future held.

With that as the backdrop, owning the puts just seemed like a very risky proposition at the time. What would have been the point?

The smarter trade in this case would have been ‘shorting’ the August week-4 279 puts, putting that $53 in your pocket up front and then seek to close that trade out later by buying the contract back at (hopefully) a lower price. The price of the contract was losing $6 per day just because, and the puts weren’t all that responsive to the market’s action, only losing about 25% of their value for every dollar the SPYders gained. Selling high and buying low, rather than buying a call low and aiming to sell the call at a higher price was actually the riskier trade, as the calls were losing about $6.00 worth of their value per day as well.

So, we shorted the 279 puts, collecting $53 per contract for selling someone the right to make us buy their SPY at a price of $279.

That’s still not a risk-free trade though. In fact, in the grand scheme of things, owning a ‘naked’ put is still incredibly risky. If something horrible happened and the SPYders fell to… say $276, we’d be forced to honor our commitment. That means we’d have to pay $279 per share of SPY even though we could only sell them at $276 each. That would translate into a $3.00/contract loss, subtracting the $53/contract we collected at the onset of the trade.

There’s a way of abating that risk though. We can buy another, cheaper put option with a strike price below the strike of the option we shorted. Think of this as an insurance policy for our 279 puts. We’ll explore how this leg of the credit spread works in part-three of this lesson.