There's a really dangerous investment craze burning up the Internet right now. Some unscrupulous individuals are pushing it as a surefire "short-term" strategy, while talking up the admittedly high profit potential… and completely glossing over the near-unlimited risk it imposes on unwary traders.
It's called naked options selling, and I wouldn't even discuss it if it weren't costing lots of traders everything. People are putting on these trades in the hope of huge, quick profits… but they don't own the stock they're trading on. There's nothing "covering" their trade.
And when the markets go wrong and these traders have to honor the contracts and produce the stock… Well, it's not pretty. The losses can be catastrophic, and the "smiles and sunshine" trading guru who recommended the trade won't be around to help cover those debts.
This strategy is so dicey, in fact, that I've never recommended it to my students. What's more, I've never put on a naked trade myself. Personally, I think the real beauty of options is how they give you complete and total control over your risk – not foist limitless piles of it on you.
But, that said, I love trading and profiting, too. So I want to show you a much better, far safer way to make a bid for outrageous profits, while keeping your risk firmly in check…
Why the Spread Is a Much Safer, Better Trade
A credit spread is a sell strategy, but thanks to its construction, it eliminates the naked part of selling. It involves selling an option while simultaneously buying another option on the same order ticket – it's all one trade.
A credit spread reduces your risk by capping your profit potential. Remember, less risk means less reward.
But here's the thing. This trade is so easy to put on that you can still boost your weekly, monthly, and yearly profits even though your profit potential per trade is capped. And putting a max on your profitability for a higher probability of successful trades is just fine by me.
Check out the benefits of the put credit spread, or bull put spread, as it's called…
You'd use a put credit spread when you expect a stock to move higher in price, or at the very least to stay right around the price at which it's currently trading.
As I mentioned, you'd need to buy a put option at one strike price and expiration while simultaneously selling another at a different, higher stike price to create a put credit spread. However, you'd need to make sure both options have the same expiration date and, of course, the same underlying stock.
When using puts, the higher of the two strikes is going to be the more expensive option. When you buy the put with the lower strike price and sell the put with the higher strike price, you end up with a credit to your account. That credit (or a portion of it) is yours to keep once you either close the trade or the trade expires. As you can see, you're still selling a put option in this scenario… BUT it's not considered a naked put sale because you've hedged it by purchasing another put option.
The goal here is for the stock to stay above the strike price of the option you sold so that no one will exercise the right to that stock at that lower price, which means you wouldn't have to (or want to) exercise your right on the put you bought. If this happens, then both options expire worthless, and you keep the premium.
Here's an example of how this works using Valeant Pharmaceuticals International Inc. (NYSE: VRX):
Say you believe Valeant is going to increase a bit in price, so you create a $1-wide put credit spread on it. As you can see above, you're selling-to-open the $26 put while simultaneously buying-to-open the $25 put. This means that the markets have the right to "put" the stock to you at $26, and you have the right to "put" the same stock to the markets at $25 any time before expiration.
The credit you bring in from creating the spread at the prices shown above would be $0.50 (or $50) per contract. This also the maximum profit you can make per contract, which is a potential 100% rate of return, as you see below:
To realize your maximum profit, the stock needs to move above the strike price of the option you sold ($26) and be there at expiration so that way both options expire, leaving you with the credit you took in when you opened the trade.
Now your maximum risk is also $0.50 (or $50). Here's why…
Say the stock moves to $23. The markets could exercise the $26 put, meaning you'd be forced to buy the stock at $26. And although the stock is at $23, you're most definitely not stuck with a $3 loss because you bough the right to put the stock to the markets at $25.
That's only a $1 (or $100) difference per contract, which is offset by the $0.50 (or $50) credit you took in per contract ($1.00 minus $0.50 is only a $0.50 loss, or $50 loss).
With a call credit spread (AKA the bear call spread), it's just the opposite.
Here, you'd buy a call option at a higher strike and sell another call option at a lower strike to generate a credit to your account. In the case of a call credit spread, you need the stock to move below the strike price of the call option you sold and stay there at expiration so that both options expire. That way, both options will expire, and you'll get to keep the credit.
Trade Options Naked, by All Means, but Never Trade Naked Options
Whether you opt for trading a put credit spread or a call credit spread, you can set it up to where you simply need the stock to remain at the price at which it's currently trading and be there at expiration so that both options expire worthless – giving you the full premium.
In both cases, you're creating a credit spread based on what you think the stock will not do. So if you create a put credit spread, you believe that the stock will not be under the strike price for the option you sold. If you create a call credit spread, you believe that the stock will not be above the strike price for the option you sold. And in either instance, you're further increasing your probability that the trade will work – without the risks of selling naked options.
He's no longer with us, but my late best friend and trading partner, George Fontanills, always said, "you can trade options naked, but I would never trade naked options." He was a smart guy, to put it mildly.
And if anyone comes to you with a "can't-lose" naked options selling proposition, I hope you'll remember what he said and what you've read here, and run – do not walk – in the opposite direction.
The credit spread is bar none the best alternative trade: You can create a hedged position, with closely managed risk, that can yield high profits again and again.
Tom has taught more than 300,000 people the basics of trading in a fun, easy-to-understand way. Click here to start his Power Profit Trades service. You'll get a world-class trading education, plus profit recommendations and strategies so you can start making money with your new skills. Plus, you get to play one of Tom's biggest trades ever: A way to double your money with one of the world's biggest, most valuable companies… in less than a month. Tom's service is free of charge.
About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.