Stocks & Commodities V. 31:2 (40-41): Explore Your Options by Price Headley

Stocks & Commodities V. 31:2 (40-41): Explore Your Options by Price Headley
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Explore Your Options by Price Headley


How does a credit spread work?

There are several types of spreads, but they all work similarly. Option spreads can be used to take a bearish, bullish, or neutral position. For example, letís look at a credit spread, which is what a spread is called when it generates a net inflow of cash into your account.

In this instance, we are bearish; according to our calculations, we think the price of XYZ stock will go down. We decide to sell a September 30 call for a price of $3. Since we think that XYZ will go down in price, we assume that nobody will want to exercise our short call against us ó that is, make us sell them XYZ shares at $30 ó since they can be bought in the open market for less than $30.

However, to protect ourselves in case we are wrong (in case XYZ shares increase in value), we buy a September 35 call at a price of $1. That way, if XYZ shares go to $40, we can get someone else to sell their shares to us at $35, and we can cap our risk at the $5 difference. Our real maximum risk is the $5 difference minus the credit collected. Take a look at our position in Figure 1.

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