Strategy session: credit spreads

Call Credit Spread

A call credit spread is a bearish position, meaning it is employed when you do not have a positive outlook a stock.

For example, one stock I've been growing increasingly bearish on is Netflix, Inc. (NASDAQ: NFLX). The company is in a brutal price war with Blockbuster (NYSE: BBI) as Blockbuster shifts to a more competing model. Despite its solid balance sheet, I still think the company's margins are set to fall and Wall Street hasn't fully modeled continued price warring into their estimates. For example, Netflix announced further price slashes just today to match Blockbusters new low prices.

As a result of these factors, I tend to believe the stock isn't going to rally back unless a dramatic news event, such as a merger with Blockbuster, is announced. Therefore, a call credit spread could be an interesting position for the situation. Such a position could be established like this:

• Sell January 08 $25 calls for $1
• Buy January 08 $30 calls for .45

In this position, the options salesman would stand to quickly make $65 per contract assuming the stock didn't go above $26 per share. Considering the stock would need to move 32% to reach this price, I'd consider this contract losing money to be highly unlikely. However, even if the trade does in fact go against you, the $30 call protects you from losing more than $435 per contract ($500 - $65).

Although this risk/reward certainly seems unfavorable, two truths exist. First and foremost, I'd consider it highly unlikely to see a company stuck in a price war to rally 33% in six months. Also, if the circumstances changed dramatically (which would be necessary to move the stock 33%, in my opinion), you could close the position before it expires and prevent losing the entire $465 per contract.

Put Credit Spread

A put credit spread is a bullish position because you are betting that the stock won't hit the option you sold short. I like to employ this strategy when I believe basically all bad news scenarios are priced into the stock.

For example, let's consider the trading thesis I recently discussed in this post about homebuilding stocks. In this post, I talked about my belief that any further bad news is already priced into housing stocks, whereas I believe pretty much no potential upside is even being considered. As a result, investors might want to consider selling a put credit spread on the Streettracks Homebuilder ETF (AMEX: XHB) which is currently trading for $29.90 per share.

• Sell: August $28 puts for .45
• Buy: August $26 puts for .15

In this situation, the maximum reward is $.30 (Premium - cost of hedge) and maximum is $2. While this risk-reward seems very flawed, the position is only used when you believe a given trade is very high probability. For this trade, the homebuilding ETF would have to fall to $27.55 per share to be executed, or roughly 8%. I consider this to be highly unlikely. As long as the ETF remains above this price, the $30 per contract premium can be collected. The reason I'm using such short-dated puts on this position is because it is event-driven (based on this week's housing numbers) and I don't like the sector over the medium term.

While the risk/reward on these trades certainly isn't as opportunistic as something like a deep-value play, I think they have their place in certain trader's strategies.