Today, I’m going to talk about another options strategy… the CREDIT SPREAD. This is actually a directional strategy, which means you have to be either bullish or bearish about a stock.

Let’s start with an example… Suppose you are a big iPhone fan and are extremely bullish about Apple (AAPL). You looked at the chart and identified strong support at $148.28. You believe that there is no way AAPL is going to fall below $148.28. In that case, you can choose to sell the nearest OTM Put, which is the $145 Put. In order to protect yourself from any unexpected plunge in the stock, you buy an even lower OTM Put, which is the $140 Put.

Example of a AAPL Bull Put Spread

Let’s just suppose you sold the $145 Put for $2.70 and bought the $140 Put for $1.20. What you’ve done is you’ve just sold a Bull Put Spread. Since the $145 Put that you sold is more expensive than the $140 Put, this spread is actually a credit spread; you earn premium upfront (($2.70 – $1.20)*100 = $150 per lot in this case).

If you are right and AAPL never trades below $145 for the entire period till expiry day, both the $145 and $140 Put options will expire worthless and you are a few hundred bucks richer.

However, if you are wrong (say Steve Jobs is suddenly ousted from AAPL again) and the stock price plunges to $100 on expiry date, your lose is limited. This is because although you will be forced to buy AAPL stock at $145 now, you can turn around and sell that same stock at $140, since you bought a $140 Put to protect yourself. Thus, your loss is only limited to $500 for every Put you sold.

But wait! Remember you earned a premium of $150 on that fateful day when you decided to sell the spread? This means your loss is actually $500 – $150 = $350 per lot (excluding commissions). That’s not half as bad as if you had not bought the $140 Put. In which case you would have lost ($145 – $100)*100 per lot… Even after deducting the premium that you earned, you would still have lost $4500 – $270 = $4230 per lot…

That’s the merit of doing a credit spread, as opposed to selling a naked option (i.e. selling an option without buying another to protect yourself)… Better safe than sorry.