One of the most basic option trading strategies is to sell a credit spread. This is usually done whenever the trader has an opinion on a stock or other underlying issue that it is going to go up or down in price, in a certain period. For instance, let’s suppose APPL was trading at $106 per share and you thought that APPL would stay above 100 for the next few months, you might sell the December APPL 100 Put and then buy the December 90 Put; thereby creating a credit spread, because the 100 Put you sold would be more valuable than the one that you bought at 90. As long as APPL stays above 100, the duration of the trade, that is until December expiration, you will be profitable . You have time decay on your side in this trade, that is, it’s positive theta. Each day that passes by, the short you sold is worth a little bit less in time value. This is how you make your profit over time.
Often the difficult part of this type of strategy is the management plan. What do I do if APPL does drop in price towards our below $100? One strategy that you can utilize is using your P&L percentage of profit, or percentage of loss, as your guide to either make adjustments to the trade or to close the trade. For instance, you could use a guideline: If the trade is up 10% on profit, I will close the trade or close half the trade and maybe let the rest go for higher profit. And conversely, if the trade is down 10%, I will close half the trade or even all the trade. This type of risk management will prevent you from just staring at the screen while APPL goes down further and further and your loss deepens. Of course, the percentages you use are up to you and what works with your portfolio level and your level of conviction of APPL’s movements. Always have a plan such as this, though, that prevents catastrophic losses or at least losses that outpace your gains from previous trades.
Mark Fenton- Senior Mentor at Sheridan Options Mentoring