Credit Spreads Explained - Passive Income from Trading Options

what's up guys jake here in this video we're going to continue talking about trading options and cover an advanced trading strategy and when you finally learn more about trading options then you might want to consider a credit spread there are two kinds that we're going to cover in this video there is the bear call spread and the bull put spread we're going to explain them and then do some examples and before you can do this of course with your broker you have to get approved for vertical spreads this is charles schwab my broker so i need to be approved for level two so make sure that you're capable of trading vertical spreads and definitely this is not an intro video guys if you don't have a firm grasp and confidence in selling covered calls and selling cash secured puts this video is not for you go go watch those videos first i have a playlist on trading options with 27 videos so far so there's lots of examples for you to better familiarize yourself with selling covered calls and selling cash secured puts before you try vertical spreads but why would you want to sell credit spreads and it's the same reason you would want to sell covered calls or sell cash secured puts it's to collect that premium you're the seller net seller in this exchange and you're taking advantage of theta decay of options contracts so the best time period to sell credit spreads is in you know that one week to two month time period where the theta decay of an options contract really starts accelerating and credit spreads have two legs first you're going to sell an option either a call or a put because you want to collect that premium however you don't want to tie up collateral a huge amount like you do with a cash secured put or covered call so you're going to buy another option for premium but it's going to be a lesser uh lesser cost to you and it's going to have a further strike price with the same expiration so your profit on this credit spread is the difference between these two contracts and the collateral tied up on this trade is much lower than 100 shares of whatever stock or etf you're trading on so specifically the two kinds of credit spreads are the call credit spread sometimes called a bear call spread and this is where you sell a call option and then buy a call option with a higher strike price same expiration date the other one is the put credit spread aka the bull put spread where you sell a put option and then buy a lower strike put option with the same expiration date let's get into examples so first let's talk about the call credit spread and this is when you're bearish on a stock you think it's gonna go down over the next one week to two months so you're going to sell a call now normally if you're selling a a covered call you have to own 100 shares of the stock but we don't want to do that and if you just sell a call then this is a naked call this is very high risk your broker doesn't allow this because your losses are uncapped theoretically if the share price moves on you and you're negative and it just keeps going up once again your losses are unlimited so what you do to protect yourself is to limit your losses by buying a call so you sell a call for a strike price you then buy a call for a higher strike price this in effect covers you and caps your losses on your call so once again let's assume that you're wrong you're wrong on this entire trade and the share price of the stock blasts through the call you sold but then hits the call that you bought the call that you bought is now gaining value at the exact same rate by expiration that your the call that you sold is losing you so in effect these two cancel out so what is your max loss on a call credit spread if you're wrong and if you're wrong it's just the difference between these two strike prices this sweet spot here when all extrinsic value is converted to 100 intrinsic value this is the most collateral that you can lose and the only amount of collateral that your broker requires you to be tied up but as long as the share price of the stock stays below what you sold a call at if it just goes sideways or down then you're going to be able to collect the premium yes the call that you bought will expire worthless but so will the call that you sell allowing you to keep the premium minus what you paid for the call that you bought let's do an example with my broker charles schwab on the stock apple apple has had a huge run up lately it hit 149 and let's pretend that you're saying apple was overbought uh it's run up too much in the short term i think over the next month it won't get back to 149. it will stay below 149. now in my brokerage account uh how you do this is on the right there's a drop down menu this will take me to the option chain and if we go to apple's option chain first thing you have to do is choose an expiration date i'm gonna go roughly one month in the future and we have to choose a strike price and just looking at the graph i said well 149 looked like it was overbought i don't think it's going to get back to 149 in the next month now to sell a covered call on apple with a strike price of 149 i have to buy 100 shares i need 14 200 worth of collateral locked up in addition if i think apple's share price is going down why would i want to be holding 100 shares of it so a a a credit spread protects you from having to tie up that much collateral and hold a stock that you think is going down anyways so let's figure out what range we want to do our spread with so if you go to custom range let's do strike prices between 142 and 160. additionally i just want to reference the greeks to quickly check delta so on schwab you can go to this drop down menu and then hit greeks and this is actually great because the strike price of 149 has a delta value of about 30 percent 30 is what i usually do anyways and i wanted that 149 strike because there's a resistance line that's where sellers stepped in it wasn't able to get above that now we have to determine how wide we want our credit spread to be so i'm gonna choose uh the call that i'm buying with a strike price of 152. so let's recap here i'm selling a call with a strike price of 149 and i'm buying a call with a strike price of 1.5250 so when you select these two your your broker should build you the the chain and you have to under action uh correctly select sell to open for the call with a lower strike and then buy to open the call with the higher strike your broker that will then just calculate for you uh based on the bid and ask what credit you will be receiving and i will be i will be receiving a credit of 78 dollars 78 dollars is that a good credit for a one-month call spread well let's do the math here and the collateral you're tying up for this trade your broker is going to set aside this buying power is 350 so the difference between 150 250 and 149 is three three dollars and fifty cents multiplied by a hundred so your broker is going to tie up 350 dollars with the buying power now what is your max loss on this trade and if the share price of apple blow pass blows past 149 goes above 152 350 is your max loss from the trade but you got to remember you're getting paid today a credit uh for doing this spread of 78 dollars so your max loss is 350 minus 78 only 272 dollars that's not that bad so if the max you can make 78 if all these contracts expire worthless by the uh by august 20th or something your max profit is 78 your max loss is 272. now you might be saying jake 78 bucks for a month that's not doing all this effort and work for just 78 well what people do with credit spreads is they sell multiples of them so let's say that you find a trade that you really like and you have a high confidence level in you can change these quantities to whatever number you want you can up these to 10 and if you up it to 10 then your collateral that you're locking up is just 350 times 10. so 3 500 and then what is your max profit well it's 78 times 10 you can make 780 dollars in a month so what kind of return on investment are you getting here and your return on investment is 78 your your max profit if you do successfully do this trade and the collateral you tied up 350. so the most you can make on your money in a one month period is 22 percent 22 percent is pretty good the equivalent apy on this vertical spread is 267 percent now at this point you might be wondering why is this so much better than covered calls and the reason why is because you're not locking up the full collateral to sell a covered call the little bit more premium you're getting uh so for example 227 for a true covered call you have to lock up the full premium of 100 shares 14 000 to only make 227 but this way you're only locking up 350 to make uh the credit of 78 a much better return on your capital so that was a bear call spread now let's look at a bull put spread which is the opposite so instead of selling a cash secured put you want to sell a bull put spread so in this scenario you think that the stock price is going to continue going up and you're going to sell a put probably just below where the current share price is and if you're wrong you're going to be in trouble this would be a naked put that you just sold so your losses are not unlimited but it's basically the entire value of the stock price if the company were to go bank bankrupt and the share price were to go to zero so to protect yourself you have to buy a put with a lower strike price same expiration date so just like the other example your losses are now capped if you're completely wrong on this trade and the share price goes down below the put that you sold and also down below the put that you bought the money that you're making in intrinsic value from the put you bought is cancelling out what you're losing from the put that you sold so this caps your loss at this line so as long as the share price of the stock trades sideways or goes up then you will make money on this exchange the put that you bought will expire worthless out of the money and the put that you sold will expire worthless out of the money allowing you to keep the premium so once again let's do an example with apple and we'll say no way apple's an amazing company this pullback to 142 is temporary it's going to shoot back up next week or for sure within the next month so once again you can look at a chart and see it two different ways so let's choose a strike price of 135 and you'll say there's no way that apple's share price is going to get below 135 so let's go with an expiration date of august 20th and a strike price of 1 35 and when you go to uh the expiration date august 20th custom range i chose between 130 and 141 we're going to choose the uh the strike of 135 for the put that we're selling and then 130 for the put that we're buying and when you plug these in buy to open for the 130 sell to open for the 135 it's going to calculate our credits so let's run the numbers again and see how much we're tying up and how much we're making on our money and the collateral that we're locking up once again is the difference between the two strike prices so five dollars per share five hundred dollars total the credit we're receiving it's quoting us at one dollar times a hundred one hundred dollars so our max loss is four hundred dollars on this trade our max profit if we're correct and apple's share price uh only goes down a little bit goes sideways or goes up is one hundred dollars so our return on our investment over this one month period is 20 that's the equivalent apy of 240 percent and once again if you're just not impressed with a credit of one dollar you could change these quantities to ten that would lock up five thousand dollars in collateral and you could potentially make one thousand dollars over the next month with just a bear put spread on apple okay guys i hope that summarized credit spreads the last thing i want to tell you is to sell everything always with your contracts buy to close them sell to close them on the expiration date before the expiration date the reason why is when you hear these stories of people blowing up their accounts and their robinhood account shows an account balance of negative seven hundred thousand dollars that's because they were getting in trouble selling credit spreads you know quantity something like 50 on amazon and then one leg of their uh of their spread was exercised and something weird happened after hours on friday where the other leg the share price moved and the other leg doesn't get exercised so to just avoid any any murkiness or confusion when these contracts are moving between the brokerage firms buy to close sell the clothes don't hold these until expiration unless it's really obvious that all the contracts are way out of the money there's no way after closing bell on friday that they could potentially end up in the money okay guys if you enjoyed this video give me a thumbs up so the algorithm knows it's good in addition if you have any comments or questions leave them down below i'll help you if i can until the next video take care

Channel: Jake Broe

Views: 41,699

Keywords: credit spreads, credit spread strategy, credit spreads explained, credit spreads for income, credit spread weekly options, credit spread investing, trading options, earn passive income, trading stock options, understanding the credit spread, credit spread, credit spread options, put credit spread, call credit spread, vertical spread, short vertical spread, options trading tutorial, credit spread options strategies explained, covered calls, cash secured puts

Id: HtO6h683Fr8

Length: 15min 3sec (903 seconds)

Published: Tue Jul 27 2021