Example – “Bull Put” Credit Spread

The “Bull Put” credit spread utilizes “put” options and assumes a neutral to slightly bullish outlook, for a particular market index, over a specified period of time.  For example purposes, let’s assume that we have a fairly positive (bullish) outlook for the S&P 500 over the short-term (next 30 days).

For simplicity, let’s assume that today is March 23^rd and the S&P 500 is currently at 850.  Based on our market research and analysis, let’s assume that we recommend a “bull put” credit spread position, on the S&P 500 index, which is due to expire at the next option expiration (April 17^th).

Let’s assume that an investor could execute an “SPX” APR 670/680 PUT credit spread order and realize a “net credit” of $.40 per option.  Let’s also assume that an investor has $20,000 in their investment account and they wish to use the entire account buying power (cash, not margin) for credit spread option trading:

Credit Spread Order

Sell – [SPX] ARP 680 PUT (APRIL)

Buy – [SPX] APR 670 PUT (APRIL)

Cash Requirements

When executing a credit spread position, the brokerage firm will require the investor to maintain a certain level of cash in their account, per option contract, as a means to secure potential obligations if the options were exercised.  Cash requirements may vary between brokerage firms and investors should always verify trading requirements with the brokerage firm prior to placing any trades. If this trade executes successfully, lets say the cash requirement for this trade (per option contract) would be as follows:

(Option Strike Difference – Net Credit) x 100 = Cash Requirement (per option contract)

In this example, the cash requirements are….

($10.00 – $.40) X 100 = $960.00 (per option contract)

Since this investor wants to use their entire $20,000 account for credit spread positions, this investor could place an order for 20 contracts without exceeding their buying power:

$20,000 / $960 = 20.833 Contracts (Round down to 20 Contracts)

In this example, the total cash requirements for 20 contracts would be….

20 Contracts x $960.00 = $19,200.00

Maximum Profit (upon order execution)

If the trade is executed, the $.40 per option “net profit” will immediately be credited to this investor’s brokerage account.

In this example, the “Net Credit” (profit) would be:

Net Credit = $.40 per option  x 100 (options per contract) x 20  =

Net Credit = $800.00 (profit, however, commission expenses not included)

Maximum Potential Loss

In the event the underlying market index does move dramatically in the “wrong” direction of the “credit spread” position, we always recommend placing a “contingent trade” to close out the positions if the underlying index reaches the first option strike price.  A contingent close order should always be entered after every successfully executed open order.  These orders are designed to close credit spread positions, in the worst case scenario, and limit a potential maximum loss scenario.

Maximum Potential Loss = (Option Strike Difference – Net Credit) x 100

In this example, the Maximum Potential Loss would be:

($10.00 – $.40) X 100 = $960.00 (per option contract)

* Same as the cash requirement

If the contingent close order is executed at the “exit limit” (in our example, the S&P 500 reaches 680), actual losses would inevitably be much less than the maximum potential loss.  Actual losses would depend upon a number of factors, such as: time remaining to expiration, market volatility, option open interest, etc.

“Return on Invested Capital” (for this option cycle)

(Net Credit Premium/Cash Requirements) = Return on Invested Capital

In this example, the Return on Invested Capital is….

($800/$19,200) = 4.17%

Final Analysis

At this point, the S&P 500 must remain above 680 at all times prior to the next option expiration (April 17^th) for this investor to realize the $800 maximum profit. Let’s examine various scenarios to evaluate how the S&P 500 performance and direction would affect the “net profit” for this “bull put” credit spread position:

a)   If the S&P 500 Index moves UP (over 850), 100% of your $800 “net premium” is PROFIT!

b)  If the S&P 500 Index moves SIDEWAYS (no change),  100% of your $800 “net premium” is PROFIT!

c)  If the S&P 500 Index moves LOWER, but stays above the “sold” option strike price (above 680), 100% of your $800 “net premium” is PROFIT!

In other words, the beauty of a conservatively placed “credit spread”, whether a Bull Put or a Bear Call, is that you don’t even have to necessary be correct in regards to market direction in order to profit!

Example – “Bear Call” Credit Spread

The “Bear Call” spread utilizes “call” options and assumes a neutral to slightly bearish outlook, for a particular market index, over a specified period of time.  For example purposes, let’s assume that we have a fairly negative (bearish) outlook for the S&P 500 over the short-term (next 30 days).

For simplicity, let’s assume that today is March 23^rd and the S&P 500 is currently at 850.  Based on our market research and analysis, let’s assume that we recommend a “bear call” credit spread position, on the S&P 500 index, which is due to expire at the next option expiration (April 17^th).

Let’s assume that an investor could execute an “SPX” APR 1000/1010 CALL credit spread order and realize a “net credit” of $.40 per option.  Let’s also assume that an investor has $20,000 in their investment account and they wish to use the entire account buying power (cash, not margin) for credit spread option trading:

Credit Spread Order

Sell – [SPX] ARP 1000 CALL (APRIL)

Buy – [SPX] APR 1010 CALL (APRIL)

Cash Requirements

When executing a credit spread position, the brokerage firm will require the investor to maintain a certain level of cash in their account, per option contract, as a means to secure potential obligations if the options were exercised.  Cash requirements may vary between brokerage firms and investors should always verify trading requirements with the brokerage firm prior to placing any trades. If this trade executes successfully, lets say the cash requirement for this trade (per option contract) would be as follows:

(Option Strike Difference – Net Credit) x 100 = Cash Requirement (per option contract)

In this example, the cash requirements are….

($10.00 – $.40) X 100 = $960.00 (per option contract)

Since this investor wants to use their entire $20,000 account for credit spread positions, this investor could place an order for 20 contracts without exceeding their buying power:

$20,000 / $960 = 20.833 Contracts (Round down to 20 Contracts)

In this example, the total cash requirements for 20 contracts would be….

20 Contracts x $960.00 = $19,200.00

Maximum Profit (upon order execution)

If the trade is executed, the $.40 per option “net profit” will immediately be credited to this investor’s brokerage account.

In this example, the “Net Credit” (profit) would be:

Net Credit = $.40 per option  x 100 (options per contract) x 20

Net Credit = $800.00 (profit, however, commission expenses not included)

Maximum Potential Loss

In the event the underlying market index does move dramatically in the “wrong” direction of the “credit spread” position, we always recommend placing a “contingent trade” to close out the positions if the underlying index reaches the first option strike price.  A contingent close order should always be entered after every successfully executed open order.  These orders are designed to close credit spread positions, in the worst case scenario, and limit a potential maximum loss scenario.

Maximum Potential Loss = (Option Strike Difference – Net Credit) x 100

In this example, the Maximum Potential Loss would be:

($10.00 – $.40) X 100 = $960.00 (per option contract)

* Same as the cash requirement

If the contingent close order is executed at the “exit limit” (in our example, the S&P 500 reaches 1000), actual losses would inevitably be much less than the maximum potential loss.  Actual losses would depend upon a number of factors, such as: time remaining to expiration, market volatility, option open interest, etc.

“Return on Invested Capital” (for this option cycle)

(Net Credit Premium/Cash Requirements) = Return on Invested Capital

In this example, the Return on Invested Capital is….

($800/$19,200) = 4.17%

Final Analysis

At this point, the S&P 500 must remain below 1000 at all times prior to the next option expiration (April 17^th) for this investor to realize the $800 maximum profit. Let’s examine various scenarios to evaluate how the S&P 500 performance and direction would affect the “net profit” for this “bull put” credit spread position:

a)   If the S&P 500 Index moves DOWN (below 850), 100% of your $800 “net premium” is PROFIT!

b)  If the S&P 500 Index moves SIDEWAYS (no change), 100% of your $800 “net premium” is PROFIT!

d)      If the S&P 500 Index moves HIGHER, but stays above the “sold” option strike price (above 1000), 100% of your $800 “net premium” is PROFIT!

In other words, the beauty of a conservatively placed “credit spread”, whether a Bull Put or a Bear Call, is that you don’t even have to necessary be correct in regards to market direction in order to profit!