How to Master the Stock Market at WARP Speed

The Credit Spread Strategy

This is a more advanced strategy and is really only for sophisticated investors. The bullish version involves selling a Put Option, as in the Selling Insurance example, but also buying insurance as protection.

The sold leg of this trade is typically the first or second out of the money option and the bought leg typically a few percent further out of the money.

The spread is the difference between the Strike prices of the short leg and the long leg. (Short means Sold and Long means Bought). The advantage of this strategy is that you can insure shares with the need of having the full price of the shares in your trading account as collateral.

The bullish version of this strategy, that uses Put Options, is used when the stock price is expected to rise, go sideways or even fall slightly. However if the stock price falls below your breakeven point, then other protection strategies need to be employed to guard against losses.

This strategy is pre-programmed in Paper-Trader

This is quite a powerful strategy if used correctly. In this strategy we are again selling a promise to the market. However, where in the covered call strategy we’re selling a promise to sell OUR shares, in this Insuring Shares strategy we are promising to BUY someone else’s shares if we’re asked to, on or before the pre-agreed date.

This strategy can be used for a few different purposes but one very popular use is to buy shares below market value. Let’s look at an example.

Suppose we decided we wanted to buy some shares either to hold to maybe to rent out. We’ve done our analysis, spoken to our Broker or Advisor and have selected a stock to purchase. Let’s say this stock is trading around $41.50. Now we could simply go and buy the shares at this price OR we could sell insurance on these shares.

If we sell insurance we are selling a promise that we will buy the shares for a pre-agreed price by a pre-agreed date, if we’re asked to. Let’s say we sell a promise to buy these shares for $40.00 on or before the end of next month. And for this we receive a premium of $1.75 per share. We receive this premium straight away and it goes into our trading bank.

Now if the stock price ends up at or above $40.00 by the end of next month, do you think the other party is going to want to sell their shares to us for $40.00? No they won’t because they can sell their shares on the open market for more than $40.00. Only if they shares fall below $40.00 will we be asked to buy the shares.

So if the stock prices ends up above $40.00 we do nothing and we get to keep $1.75 per share ($3,500 if we sold 2000 of them). We’ve made $3,500 for not much work.

If the stock price ends up below $40.00, we’ll have to buy the shares for $40.00. Let’s say they dropped from $41.50 down to $39.50. We’ll be asked to buy the share for $40.00 even though they are only worth $39.50. But we’ve already received $1.75 in premium, so our real buy price for the stock is $40.00 – $1.75 = $38.25.

In other words we’ve bought this stock that’s trading around $39.50 for $38.25. We’ve bought this stock at a discount. And if we aren’t asked to buy the shares, then we can do the same again the next month. Our effective buy price continually drops until we’re actually asked to buy the stock.  And once we own them we can then rent them out.

Now when people hear about this strategy the immediate response is “what if the stock crashes”. Well if this happens you will still have to buy the stock at $40.00; that’s the promise we made and the reason we received the premium.

But remember, we were going to buy the shares anyway for $41.50. If we’d bought the shares and the stock crashed we would have lost the full $41.50 per share. However because we received the premium our effective buy price was $38.25 so our losses, if the stock crashed, would be less.

Sidebar: For more advanced traders there are ways to insure yourself against this. This then becomes a Credit Spread strategy, see below.

The other thing is that if the stock rises sharply after you’ve sold this insurance then, whilst we keep the premium, we won’t own the stock to enjoy the gains in stock price. So again you need to choose the stock to use this strategy with.

The option type used here is called a Put Option and because we are selling this without any protection it’s called Naked. So this strategy is called Selling Naked Puts.

This strategy is pre-programmed in Paper-Trader

This is a very common strategy these days and it’s probably the easiest and safest of the option strategies. It’s even considered reasonably safe by the fund managers and legislators because it’s one of a few options strategy you can do in your 401k or Superannuation fund.

It works in a similar way that you rent out your house. You give control of your shares to another party for a certain period of time. And for this you receive a rental income called premium.

And just like the rental agent takes care of finding a tenant for you, the stock exchange takes care of finding someone to rent your shares.

Here’s how it works… Firstly you need to own some shares to rent out.  You can buy the shares and then rent them out, or you can buy the shares and rent them out in the one transaction. Let’s assume that we have bought some shares in company x for $38.00 per share and we bought 2000 of them, that’s $76,000. Now that we own the shares we can rent them out.

We do this by calling our Broker and saying that we want to “write a covered call”. What this means is that we will be selling the right for someone to buy our shares at a pre-agreed price by a pre-agreed date. The pre-agreed price is called the Strike Price and the pre-agreed date is called the Expiry Date.

So we might decide to rent out shares (or in technical words… write a covered call) with a Strike Price of $40.00 and an Expiry Date of the end of next month. And when we do this we receive a rental income called premium. Let’s assume the premium is $1.50 per share.

Now what does this agreement mean. It means that we have sold a promise agreeing to sell our shares for $40.00, if we are asked to, on or before the end of next month. And for this we receive $1.50 per share, in our example of 2000 shares that’s $3,000. And we receive this $3,000 immediately and we get to keep it no matter what.

Now if by the end of next month the stock price of our company x is at or below $40.00, do you think the other party would ask to buy our shares at $40.00. No they wouldn’t because they can buy them cheaper on the open market. Only if the stock price rises to above $40.00 would the other party ask us to sell our share for $40.00. And if they do, we are obliged to sell. That why we got paid the $1.50.

So the other party believes that the stock price is going to rise above $40.00 be the end of next month. If they are right they profit but if they are wrong they lose. We get to keep the premium paid regardless.

So we are effectively trading potential capital gain on our stock for guaranteed income i.e. the premium. To get the most from this strategy you need to select the right stock. You may not for example, want to do this strategy on “growth” stocks that are experiencing big gains because you’ll miss out on this gain.

However if you have stock that are going nowhere, why not rent them out and receive some free income from them.

You might like do some more reading and study of this. Just search the web for Covered Calls and you’ll find a stack of material.

This strategy is pre-programmed in Paper-Trader