Milk the Spread for More Profits
by John White
For those familiar with credit spreads, the advantages of trading these types of positions become evident
rather quickly. A knowledgeable trader can get paid the credit (the potential profit) right up front,
as soon as the position is entered. Secondly, one can obtain an accurate assessment of the likelihood that
the trade will become profitable even before a decision is made to actually enter the trade.
Thirdly, and my personal favorite reason for trading credit spreads, is that they provide some room for
error. The trader can be wrong about the direction the stock (or index or exchange traded fund) is going and
still have a more than fair chance at profit.
Although all these are obvious benefits of this type of trading, there is one advantage that is often overlooked.
I’m talking about milking the spreads.
Suppose that we wanted to establish a bull put spread on the underlying XYZ, which is currently trading at a value
of 500. We do this because we believe that XYZ will either go up from here or at least stay above the 420 level.
To enter a trade, we might decide to sell the 420 put option and then buy the 410 put option as an insurance policy.
Here's what the trade would look like.
Underlying XYZ at 500
Sell To Open XYZ 420 put (4.00 x 4.60)
Buy To Open XYZ 410 put (3.00 x 3.60)
We could sell the 420 put for $4 (which is in bold print in the example) since that is the bid price of that option.
Likewise, we would buy the 410 put for $3.60, (also in bold print) since that is the ask price of that particular option.
Selling at $4 and buying an insurance option (the 410 put) at $3.60 would result in a credit of 40 cents for the trade.
That 40 cents (or $400 for 10 contracts) would be added to our account the moment the order is filled.
Although this represents a nice return, let’s take a second look at this position. If you notice, both bid-by-ask spreads
of the 420 and 410 put have a difference of 60 cents. So, we can actually negotiate or “milk” these spreads, just as we
would negotiate the price when buying a new car or perhaps purchasing a new home.
The 420 put spread is $4.00 by $4.60, a 60-cents difference, of which we can skim off about a third, or 20 cents.
The 410 put spread is $3.00 by $3.60, also a 60-cents difference, which we can also take a third, which is of course
another 20 cents.
Now, let's go back to the beginning. We started with a trade that gave us a profit of 40 cents, which is approximately
a 4.2% return on our investment. But by simply “milking” the trade a little we were able to squeeze out an additional 20
cents on each of the put options. This brings our total credit from the original 40 cents up to 80 cents or an 8.7% on
the same exact trade.
Not only did we more than double our profit by “milking” the spreads, but we did so with very minimal effort. Most good
option brokers out there have an order screen in which to place these types of trades. You would simply place the order
by selling the 420 put and buying the 410 put for a credit of 80 cents, rather than the lesser 40 cents, which is what
most traders out there will be asking for. Too bad for them, huh?
The good news is that we don’t really care at what price the 420 put is sold nor do we care at what price the 410 put is
purchased. The only factor we are concerned with is that the transactions are executed and we get 80 cents credit out
of the deal. After all, those of us who know how to “milk” the trade know that’s exactly what we can get. All we have
to do is ask!
For more on “milking” spreads, join me at one of my upcoming live events. You'll learn more about this technique, as well
as other methods to use that will enable you to trade in a non-directional manner and make money whether the stock market
is going up, going down, or trending sideways.
John
