Selling option premium is something that has great appeal to those who understand it. Many of you may have heard that the vast majority of option contracts expire worthless each month. This is true. The question that arises from all those contracts expiring is…where does all the premium go? Those who sell the options pocket the premium when they expire worthless.

So, as we can see, selling option premium offers a lot of incentive. The chances that our options will expire worthless are high, and that is a good thing. A credit spread strategy provides us with the opportunity to sell premium, coupled with the protection of a spread to reduce the exposure selling naked would carry. Selling naked options carries an enormous amount of risk, and is therefore a challenging strategy. Credit spreads give us a chance to tap into the high probabilities without the high exposure.

A credit spread consists of selling one option and buying another that is further out of the money. We sell closer to the stock price to bring in a larger premium than the cost on the bought leg. Generally credit spreads are done with options expiring within about 30 days. This provides us with the most rapid time decay, which is essentially how the spread profits. If we have a stock trading at $50, and we sell a 45 strike put, buy a 40 strike put for our spread, and the stock stays anywhere above $45, we will get to keep our credit.

Another appealing thing about credit spreads is that they are a high probability trade. High probability not only because most options expire worthless, but also because we don’t need the stock to move directionally to profit. In fact, the stock can go against us some and we will still profit. A stock will either go up, go down or stay sideways. Most trading strategies will only profit from one of those potentials. Credit spreads make money in two and a half out of the three scenarios.

The risk in a credit spread is generally higher than the potential reward, which is backwards from what we normally look for. A common ratio would be reward of 1 to risk of 4. We will manage the trade so that if things go bad, we don’t let the maximum loss happen.

One approach to managing the loss would be setting our exit if the trade goes against us, such that we have a loss of $1 per contract. This would mean that regardless of where the stock is, we exit if the cost to buy back the spread was one dollar above the credit amount we brought in.

Other loss exit strategies could be based on where the stock is trading rather than the value of the options. If the stock stays out of the money, our trade will be profitable at expiration. In fact, we would have the maximum profit in our trade at expiration if the stock ended out of the money. So, we might set an exit based on the stock crossing a threshold that would indicate it was more likely to be in the money. This threshold might be a support level on the stock just above the strike price we sold in our trade.

Let’s look at an example of a bullish credit spread on Research In Motion (NASDAQ:RIMM) from May 15, 2009. This is just an illustration and should not be construed as a recommendation of any kind.

The stock closed on 5/15 at $72.34. We entered this trade with out-of-the-money puts selling the 65 strike price. As long as the stock stays above 65 until expiration day in June, we get to keep all $1240. This means that we have some wiggle room if the stock goes down against us, as well as safety if the stock stays stagnant or goes up like we plan.

At expiration day in June, the stock closed at $72.78. The price at the beginning of the trade and end of the trade are very close…this stock did, in fact, move quite a bit during the life of the trade, rising significantly and then retracing…but it never got below $65. The close of the trade was simple, we let the options expire. Both legs were out of the money, and therefore expired worthless. No trade was needed to close the position. No commission costs, nada, nothing…they just evaporated. We got to keep the $1240 credit we received originally. So we made 100% of our potential profit.

Credit spreads require a margin requirement to be held by your broker in escrow until the position is closed. This margin requirement is equal to the difference between strike prices, minus any credit brought in, multiplied by the number of contracts traded. So in the above example, the requirement would be $3760 held aside ($5000 – $1240 = $3760). If we calculate the return as a percentage of the risk in the trade we find that we made 33% on our risk ($1240 credit/$3760 risk = 32.9%). The trade lasted 35 days, so we essentially made 1% per day that we were in the trade. Not a bad investment. We can’t even get 5% per year at a bank right now.

Hopefully you can see the benefits of selling option premium, and also recognize that protecting yourself by doing a spread is a wise move. Credit spreads are a great income strategy that can provide a solid base for our options trading. Good luck!

You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

And be sure to check out our new Zacks Options Trader.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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