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Excerpt for Options Trading: This Book Includes Two Manuals: Credit Spreads and Trading Momentum by , available in its entirety at Smashwords

CREDIT SPREADS

Beginners Guide to Low Risk, Secure, Easy to Manage, Consistent Profits for Long-Term Wealth Creation

Casey Boon



Table of Contents











Introduction

If you are considering an investment strategy that has a high potential for returns while limiting the risk of losses, options trading is an ideal place to start. While options trading can appear complicated to beginners, there are many tools and strategies available to you to help the novice trader start making profits from their trades sooner, generating consistent returns month after month. One of the best tools available to you is credit spreads.


Credit spreads allow you to make returns in any market whether bearish or bullish and while you make predictable returns, you also have a limit to your potential losses. Credit spreads are quite simple to learn and present opportunities greater than those offered by simple buy and hold investment strategies.


In this book, we will explore credit spreads and their relationship to options trading as well as explain how you can get started using credit spreads by opening your first options brokerage account. We will then walk through each of the credit spread strategies, from beginner to advanced and how these work with detailed examples. These strategies can be applied in every market whether stocks are falling, rising, volatile or stable.


This book will also explain the advantages and disadvantages of each strategy as well as options trading in general. We will also teach you how to determine the probability of success for each trade allowing you to create a trading plan that when followed, will generate returns every month allowing you to compound your wealth a rate far greater than standard assets.


Options trading is not without risk though, therefore we will explore risk and money management in our last chapter including how to create and use a trading plan and helpful advice on getting started in trading without losing your entire portfolio.


If your goal in life is to amass wealth at a rate faster than real estate investors or stockholders, trading options can be highly lucrative yet also predictable, and allow you to generate consistent profits and over the long term, create wealth which will enable you to get closer to retiring in comfort. Whichever you decide, credit spreads are one of the safest and most reliable strategies available for traders and are an excellent place to start learning.






Chapter One: What is a Credit Spread



Options Trading

Before learning what a credit spread is, you will need to understand what options trading is and how they work. Options are contracts which allow the buyer the right to buy or sell an underlying asset such as a stock at a specific strike price on a specific date. The holder of the option is not required to exercise the option.



The seller, on the other hand, has an obligation to fulfill the buyer's request, whether to buy or sell. When the owner of the option is seeking to buy at a price, this is known as a call. If the owner holds the right to sell at a specific price, we identify this as a put.



Credit Spreads

Before we can dive into the exciting strategies of options trading, we first must learn what a credit spread is and how we can use it to our advantage. A credit spread is also known as a net credit spread. This is a financial term that involves the purchasing of one option and simultaneous sale of another option in the same asset class but with different strike prices.



The strike price is the fixed price of an option which the owner of the option can buy or sell. In trading, we use the term call when purchasing an option and the term put when selling the option.



When an investor performs a trade, they will receive a net credit when entering the position and as the spread narrows, the greater the profit. This isn’t entirely risk-free of course as a wider spread can lead to an investor having to pay a debit spread. This occurs when the investor purchases the option at a high premium and sells at a lower premium to minimize their risk.



Options spreads are one of the most powerful tools you have available to you when trading options. They are essential when combining more than one position on options contracts which are the same security to create an overall trading position.



You can find options spread amongst complex trades. This is an industry term to define trades which are just a small share of the total volume of trades. This contrasts with a majority the options which are traded on U.S. exchanges which are termed outright. These are the purchase and sale of an option on its own.

An example of using options spreads would be if you were to buy in the money calls on a specific stock option only to then write cheaper out of the money calls on the same stock, creating a spread which is known as a bull call spread. You can reap the benefits of a buying calls by gaining if the underlying stock increases in its value. Of course, the stock can go in another direction and decrease in value in which case you would experience a loss. You can maintain control of some of the initial costs when making calls on the same stock which allows you to minimize the amount of money you could potentially lose on a given position.



When trading options, you will make all profits from the use of spreads. Using spreads will help you manage risk as well as increase the value of your portfolio. You can reduce the costs of going into a position as well as dictate how much you are willing to lose in a given position. While this could also mean you are potentially reducing the profits you could make on a position, your exposure to risk is much lower, meaning it is a far safer strategy when trading options.



When entering a short position, you can use spreads to allow you to minimize the risks by writing money puts on a stock and then receiving an upfront payment for writing those options. This would also mean you are exposed to potential losses should the stock decline in value. If you were to purchase a cheaper out of money puts, you would be required to spend some of the upfront payment. However, this also means you can cap any losses which would be incurred with the stock losing value. This is known as a bull put spread.



The advantage of spreads is that while you can gain from the price movements when entering positions, you are also able to reduce the exposure to the risk of losses which could occur if the price moves in the opposite direction to what you anticipated. As you can see from these examples, options are incredibly useful for career traders when building their portfolios as they can manage their risks and consistently turn profits with minimal losses.



We will explore further into options trading strategies and the options spreads available to you and how they can help you in building your portfolio wealth when trading.



To understand a little more clearly, let’s look at an example of how we would use a credit spread. With credit spreads being quite a conservative strategy, you will be able to make a modest income as a trader, but the true advantage is that your losses will be minimal and limited. As mentioned before the concept of options, spreads will involve simultaneous buying and selling, also known as writing, options for the same security within a given month. These options will be at different strike prices which we will call a vertical spread.



In a bearish market where the trader would expect the prices to fall, you will be using a bearish call spread which we will take a look at in more detail in the next chapter. We use the term bearish call because this is the position we are taking when buying and selling a call.



In this example, you would be expecting a certain security, let’s say XYZ to fall from a current price of $35 a share. Let’s take a look at how you would be able to make a profit on this analysis.



Write 10 January 36 calls at 1.10 $1,100

Buy 10 January 37 calls at .75 ($750)



In this case, your next credit would be $350.



The stock falls or remains below $36 by expiration. If this were the case, all the options would expire worthless allowing the trader to make a net credit of $350. There would be brokerage commissions which would take around 5-7% of the net credit enabling you to make a net profit of around $320 - $330.



If the stock were to rise above $37 by expiration, you would need to unwind the position by repurchasing the $36 calls as well as sell the $37 calls you purchased. The difference would be the difference in the strike prices which in this case is $1. When making ten calls, you would have a cost of $1,000, and if you subtract the $350 credit, you would have a maximum possible loss of $650.



In the case that the final price was between $36 and $37, you would have a loss or gain in between the maximum and minimum. You would calculate your break-even stock price to be $36.35 which is where the lower strike price plus the credit for the money you received up front.



There are many programs you can use to chart and analyze stock prices to assess whether a stock is overpriced due to an over demand from traders, in which case there would be a period of stagnation or a sell-off, where the prices return to their actual value. These are the ideal stocks to employ a bearish call spread.



Chapter Two: How to Get Started Trading Credit Spreads



Before we move into the different types of credit spreads, we will first look at how you can get started in trading. To do this, you will need to have a greater understanding of options. Options trading is mainly based on speculation but can also be used to hedge against losses on your stocks in a bearish market. While you can make a significant amount of money trading options, you will need to understand how to correctly predict the magnitude, timing, and direction of the underlying security's price movement.



This can mean that while you are open to massive profits, you are also potentially exposed to losses and high trading commissions, particularly with the more complicated credit spread strategies.



Terminology

We already spoke about some of the terminologies in the first chapter, so we will just have a quick recap and then move into introducing you to newer terms. The best way to understand all these terms is to have them written out on a spreadsheet as it can be quite a lot of information to take in when you are first learning.



As you remember, a call is the option or right, but not the obligation to buy a particular asset at a certain price at a given moment. When you enter a call, you are expecting the price of the stock to rise at the time of the expiry date.



Next, we have the put which is the option or right, but not the obligation to sell a specified asset at a specific price within a particular time. When you purchase a put, you are expecting the underlying security to fall during the term of the option.



A holder is a person who has bought the option whereas the writer is a person who has sold an option.



As was mentioned in the first chapter, the strike price is the price at which the asset which will be bought or sold, depending on your purchase of a put or call. This is the price you would want the stock to reach above in the case that you had purchased a call or fall below if you were to buy a put.



The expiration date is the date which was agreed upon where the owner must decide to either buy or sell the security, once the date has passed, the owner losses this right.



When an option is in the money, this means that the price of the asset is higher than the strike price in the case of a call or lower than the strike price in the event of a put. If an option is out of the money, this would indicate the opposite with the price of the asset being lower than the strike price for a call and higher than the strike price for a put.



Opening a Brokerage Account

Before you can start trading options, you will need to open a brokerage account to make your transactions on the market. You can do this by searching for brokerage accounts online, and there will be many to choose from. It is up to you to do the research and find a reputable site which you feel comfortable with to get an account started. There are also traditional accounts offline if you prefer to work away from the computer.



There are many ways in which you can compare different brokerage accounts with certain elements to be aware of. For example, the commissions charged will vary across the various brokerages, and some will even offer no commissions. Choose one that you feel has the most benefits for the most competitive price and don’t hesitate in reaching out to a representative of the website or firm to help you with the decision-making process.



You will also find many reviews online, and past experiences from users. You will obviously want to avoid any that have been suspected of fraudulent activity or poor performance.



Learn How to do Technical Analysis

If you are unsure of how to assess a stock to determine whether it will go up or down, it is time to learn and understand technical analysis. This is a little more complicated when considering options trading, as opposed to just purchasing and holding a stock. You can anticipate price movements once you have learned the basics of technical analysis. There are many ways you can do this such as through courses, books, forums, and videos. For this book, we will do a quick breakdown of what is involved.



First, determine how to use chart patterns, these will become handy tools when trading options. You will notice that many stocks move in a pattern and if you can identify this pattern, you will be able to determine where the price will be moving next.



Next, you will need to gain an understanding of support and resistance levels. These are the points where the stock will rarely fall below for the support and rarely rise above for the resistance. Once you have identified these, you will be able to see where a stock is nearing its peak allowing you to make a move. The resistance is the price level where significant sales of the security have occurred in the past, meaning once it had reached this point, investors made a sell-off. The support is the opposite, the point where investors have started purchasing the asset historically.



Another important consideration is volume. Stocks move in certain directions when there is a large a volume behind it. When you have identified significant movement, this is an indication that there is a trend towards the movement and an indication that the stock might be presenting an opportunity that you could take advantage of, by setting up a credit spread.



The final consideration we will mention as part of technical analysis is moving averages. This is when a stock price will cross above or below the average that it has been moving around over a period. This is indicating a higher probability that the stock will ultimately respond to the average allowing you to capitalize on the opportunity.



Start Paper Trading

Paper trading is essential for beginners. This allows you to make practice trades without having to spend any actual money. You can do this either by your own set up on a spreadsheet or practice software. Or, if you have a brokerage account in mind, many of these provide for a paper trading account to get you started. This will allow you to put in place many of the credit spreads that will explore in the next chapter and have a full understanding of how it is done and how you can profit without risking any of your funds.



It is important to consider the fact that paper trading is much different to real trading. You have not exposed the same psychological elements or the commissions that will be tied to your brokerage accounts. While it is great for learning how to make the trades, it should not be relied upon as an actual indication of how much profit you will be able to make.

Types of Credit Spreads

There are some different types of credit spreads which you will be faced with when options trading. The credit spreads you use will depend largely on your personal strategy and how you expect the market to move in the future. There are four commonly used credit spreads, each with their own advantages and disadvantages as well as the ideal time to use each one. These are:



Bull Put Spread

Bear Call Spread

Short Butterfly Spread

Iron Butterfly Spread



There are many other strategies which you can employ when options trading outside of credit spreads, however for this book we will be strictly focusing on just the credit spread strategies.









Chapter Three: The Bull Put Spread Strategy



This is a particularly popular strategy used in options trading especially when speculating that security you are analyzing is going to go down in price. The approach requires just two transactions to employ, and it is one of the more beginner friendly approaches to wrapping your head around before learning the more advanced strategies.



If you identify that the price of a security is going to decrease by a fair to moderate amount, you can use this strategy to reduce the costs of buying puts. This strategy will affect your potential profits by limiting them. However, it does ensure that your losses are kept to a minimum.



The idea behind this strategy is that you can make a profit when you have determined the price of a security to go down. It is best used when you have analyzed a security which is set to go down by a marginal amount rather than a significant amount. The purpose of the strategy is that you can reduce the capital requirements when buying puts as well as limiting the negative effect of the drop-in value when compared with other options that in which you currently have positions open.



The bull put strategy is one of the simpler strategies to use which is why it is suitable for beginners who are just starting their education on options trading as well as credit spreads. Chances are if you are reading this book, this strategy is an ideal place to start. To apply the bull put strategy, you will need to make two transactions. You should make these two transactions simultaneously with your broker, although if you are feeling confident about the timing of the price decrease, you may also consider legging into the position.



The two transactions that will need to be made are buying at the money puts as well as writing an equal number out of the money puts. An example of this, are contracts with a lower strike. You should base these contracts on the same security as well as have the same expiring date. What this will do is create a debit spread which will require an upfront cost since you are writing options at a lower price while you are also buying the option at a more expensive price.



The idea behind writing the contracts is that you can reduce the cost of buying the contracts that you are aiming to make a profit from. From there you can decide which strike to use when writing the contracts but you will also need to keep in mind that it is best to use a strike that is similar to what you are anticipating the price of the security to be, once it reaches the time of expiration.



If you use a lower strike, you can increase your potential for profits, but you will receive less credit as you are offsetting the initial cost of the investment. Not only are you able to make profits with the underlying security decreasing in price, but you are also able to profit from the effects of time decay since the options you have written will drop in value over the course of time.



The ideal scenario when using the bull put strategy is that the underlying security will fall into the exact strike used in the contracts you have written. This will allow you to profit from the puts that you own as they increase in value as well as eliminating liabilities that you have on the contracts that you have written as they will reach expiration and become worthless, providing you with maximum profit. You start to lose money, however, if the security you own is falling further than this and you begin to lose money on the contracts that you have written. The advantage of this strategy is that the puts you own will then start to increase in value, meaning there is no net effect.



The worst-case scenario would be if the underlying security increase increases in price, does not move at all or doesn’t go down the price you had anticipated meaning you won’t be able to make a profit on the puts that you own. Fortunately, the maximum you can lose is your initial investment which will only occur if the puts you own, as well as those you have written ultimately, expire worthlessly.



The strategy is quite simple with obvious benefits and very few downsides. If you are currently in a bear market, confident that the particular securities you are assessing will likely fall, then you have an opportunity to make profits and only stand to lose your initial investment. On the other hand, your profits are also limited to doubling your initial investments.



Advantages and Disadvantages of the Bull Put Strategy

This strategy is quite advantageous for beginners, as you can reduce the cost of putting on a long-put position by also putting on a short put position. What this means is that, while you also limit the potential profits you could make, you are also able to influence how much you can make from the spread by selecting the strike of your written contracts.



Due to the fact the spread reduces the upfront costs, you can make a massive return on your investment considering you are also able to decrease the amount that you could potentially stand to lose. With this strategy, you can have the exact figure that you could lose when going into the spread which allows you to follow your trading plan with more simplicity. This strategy also has advantages in that it is quite simple, easy to grasp and a great strategy for beginners wrapping their heads around credit spreads.




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