When I was a kid, one of my favorite things to do was go to the arcade.
There was something so satisfying about handing that wad of tickets in for a new bouncy ball, or a pack of Razzles, or one of those Chinese finger trappers – even if it took me 100 quarters to get there.
When it comes to arcade games, you lose more often than you win.
It’s just like that old-time casino saying: “The house always wins.”
All this means is that casinos – and in this case, arcades – always maintain a probability edge over their customers.
And in the end, probability wins and the house rakes in the cash.
When it comes to trading, there’s actually a way for you to maintain that same probability edge… and start collecting cash just like casinos and arcades do.
And that probability edge will have you doubling your chance of profits – if you play it right.
There’s only one way to double your profit probability every single time…
Why the Credit Spread Is Your Key to High Probability Profits
You probably know by now that one of my favorite option trading strategies is spreads – I introduced you to the world of spreads back in March. Specifically, we talked about the long call spread strategy.
This type of spread has numerous benefits – one of the biggest being that it’s a lot cheaper than long calls.
Here’s a refresher of how it works…
We build a long call spread by buying one option with a lower-strike call and selling another with higher-strike call.
Apart from the price, though, long call spreads are pretty similar to long calls. They’re both bullish and make money when the underlying stock rises.
Now, there are two sides to any trade: A long side and a short side, which consist of the buyer (long) and the seller (short). For long calls, there has to be a short side of the trade.
Let’s take a long XYZ $50 call as an example. This call must have a short XYZ $50 call on the other side.
The long call makes money when the stock rises. The other side of the trade, the short call, makes money when the stock doesn’t rise. In other words, the short call makes money if the stock drops or goes sideways.
So let’s assume that a stock has an equal probability of going up, down, or sideways. That’s a 33.3% chance of each. That means, if the long call needs the stock to go up to profit, then it has a 33.3% chance of making money.
But the short call makes money if the stock goes down or sideways – meaning it has a 66.6% chance of profit.
That simple act of selling an option doubles your probability of profit.
And with the chance to double your profit probability, you may be wondering…
Why would anyone do anything else?
Well, with every strategy comes a few “tradeoffs,” and shorting calls is no exception.
Here are a couple of them:
- Limited (Lower) Profit
The most you can make on a short call is the amount you take in for selling it. If you sell an XYZ $50 Call for $1.00, the most you can make is $1.00. Ideally, the short call will expire worthless. You may even choose to buy it back for $0.20, netting $0.80.
- Unlimited Risk
Remember, long calls give you the right to buy a stock. The other side, short calls, give you the OBLIGATION to sell a stock. If you buy an XYZ $50 call, you have the RIGHT to buy XYZ at $50. If you short (sell) an XYZ $50 call, you have the OBLIGATION to sell XYZ at $50.
That’s fine if XYZ is at $50 or less. However, if XYZ makes a bullish run and is trading at $70, you’ll be obligated to sell a $70 stock for $50 – losing $20 in the process. There is no limit to how high a stock can go, so short calls have unlimited risk. They are called “naked calls” for this reason.
Now, the lower-profit tradeoff isn’t too much of a problem. Most would settle for less money in exchange for a 67% chance of profit.
The unlimited risk part, however, is a problem. For this reason, you must protect yourself.
And you can do that easily by acquiring a right to cover your obligation.
Here’s what I’m talking about…
Selling an XYZ $50 call gives you the obligation to sell XYZ at $50.
To cover the risk of the stock rising, you could buy an XYZ $55 call. This gives you the right to buy XYZ at $55, capping your risk.
The spread now has limited risk. In the example above, if the stock went to $70, you’d be covered by the long $55 call. If you were forced to sell XYZ at $50, you could exercise your rights to buy it back at $55. This caps your risk to just $5!
Welcome to the world of credit spreads – the world of higher-probability and limited-risk trading.
And it’s pretty nice!
Here are some basic rules to get you started with credit spreads – also called short call spreads or bear call spreads:
- Sell at-the-money/out-the-money call
- Buy higher strike call
- 5-10 points between strikes
- Use 30-day options
Remember, short call spreads are a bearish strategy. Be sure to sell them at or above a price point you feel the stock will be beneath in 30 days.
In the example below on Altria Group Inc. (NYSE: MO), the $50/$55 bear call spread will make money as long as the stock is at or below $50 once expiration hits.
This will get you going in the world of high-probability credit spreads. As you can see, it’s pretty amazing.
To your success,
Source: Power Profit Trades