Why Use Credit Spreads?

Option selling can be a very profitable thing especially when you sell options using credit spreads. But many investors go about it the wrong way.

There are a number of people who try to sell naked options on a stock. And if you do not know what that is it is simply selling an option on a stock.

Say you expect the market will go down, or at least not go higher in the short term. You can still profit from it by selling calls. The problem is many people will just sell a single call option and wait for it to expire.

Way to risky, I never sell naked calls. Let's say we sell the $ 80 call on a stock for $ 2. We may have made $ 2 entering the trade, but if the stock shoots up all of a sudden the amount we could possibly lose in unlimited because there is no limit to how much a stock can go up.

Now if we turn this into a credit spread we can still profit but we would limit our risk, just in case the worst case scenario happens. Instead of only selling the $ 80 call for $ 2 we can also buy the $ 85 call for say $ 1.

We have limited our profit to $ 1 because we spend some of the profit buying another call, but in return we have just limited out risk. Now if the stock shoots up to infinity the most we would ever have to buy it at is $ 85.

Now that is not saying that we would not get out before we hit our max loss. If the trade starts turning against you it is a good idea to exit it early. But if the worst case scenario does happen it is nice to know that your account will not go under.

Source by Shaun Rosenberg

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