Put Option Credit Spreads: Three Ways to Win – And an 80% Chance of Success

by Lee Lowell, Stock and Commodity Option Specialist
Monday, August 16, 2010: Issue #1324

When the stock market behaves erratically and volatility is the order of the day (as it is now), what can you do to combat the upheaval?

Many investors surge en masse towards gold. No surprise there.

But gold isn’t the only shelter from a market storm. Its sister commodity – silver – enjoys just as much “safe haven” status as the headline-grabbing yellow metal. Not only that, it boasts great intra-day trading ranges and solid liquidity, too, which makes it excellent for trading.

Question is: What’s the best way of investing in the silver market? By using put option credit spreads, here’s more on this strategy…

The Spread Trade… A Better Way to Buy Silver

Let’s face it… the uncertainty in the equity markets will likely remain for a while. That should ensure that silver is a good bet on the long side.

However, instead of just buying shares in a silver company or ETF, here’s a trade that allows much more room for directional error and still has the potential for a good payout.

It’s called a spread trade.

As you can see on the chart below, the December 2010 silver futures contract is currently trading around $18.50 per ounce, with good support near the 200-day moving average at the $17.80 level.

To see the image in it’s original size, click here.

The Put Option Credit Spread Explained

Since silver prices will likely continue to move higher in the near future (or at least not move much lower), you could play the market using a put option credit spread.

(Please note that the following trade is just an example of how this strategy works, not a specific recommendation. We won’t be tracking this trade.)

With a put option credit spread, you sell one put option, while simultaneously buying another put option in the same transaction.

• For example, using that December 2010 futures contract, you could sell the December 2010 $16.250 put option and buy the $16.100 put option for a limit spread sell price of $.03 (cents)
• In silver options, 1 cent = $50, so you’d receive $150 for each spread you sell. (If you sell 10 spreads, you’d receive $1,500.)

In a trade like this, you’re considered the seller of the spread because you collect money from the option spread buyer.

• Risk/Reward: Whatever you receive from the option spread becomes your maximum potential gain. In this case, it would be 3 cents per spread, or $150.
• Maximum Potential Loss: This would be 12 cents – or $600 per spread (this is because the spread is 15 cents wide, so if you sell for 3 cents, the loss would be 12 cents). Now, it may seem counter-intuitive to enter a trade where your maximum potential gain is less than your maximum potential loss. But in the world of options, it all comes down to probabilities…

You see, we wouldn’t necessarily need silver prices to move higher in order to win on this trade. All you want is for it to remain above the $16.25 per ounce level by option expiration day.

And with the December 2010 futures currently at $18.50 per ounce, it gives a $2.25 cushion. Only if silver moves below $16.25 per ounce would you need to put risk management plans into action.

Give Yourself a 3:1 Winning Advantage With Credit Spreads

In other words, you have three chances to win on this trade – and keep the full $150 per spread:

1. If silver moves higher.
2. If silver moves sideways.
3. Even if silver moves lower than its current price (but not below $16.25).

On the other hand, the buyer of this spread can only win in one scenario: Silver must move below $16.25 per ounce.

This gives the seller a 3:1 advantage as far as the directional probability goes. But what about the true probability of winning? Well, you know that before entering the trade, too…

Want to Know Your Chance of Winning on This Trade? Here It Is…

Based on the previous movement of silver futures, there’s an 80% chance that silver will remain above $16.25 per ounce at the time of option expiration. You can see that on the probability calculator below…

To see the image in it’s original size, click here.

So the spread seller has an 80% of winning, while the buyer’s odds are only 20%.

This is why the potential payoff for the seller is smaller than the risk, but I like the seller’s odds much better. An option credit spread like this can be a safe way to receive cash right off the bat with a high probability of winning.

Good investing,

Lee Lowell