For people seeking to be financially free, stock markets represent the ultimate frontier. One can open a trading account in a matter of minutes and start trading with very little capital. The thought of hundreds of thousands of dollars of profit rolling in as you laze around a sun kissed tropical beach is indeed, very alluring!
Many people set off on this journey. I am sure you know a few who have, in their lifetime. If you are reading this, you also may be contemplating or may already have started on your stock market journey.
But most do not make it. The trading world is littered with corpses of decimated dreams and pulverized portfolios.
Why is it that most people are unable to make profits in the stock markets consistently?
One big reason is that almost everyone knows how to make money in a rising stock market – you buy low and sell high. But, a much smaller percentage of people know that money can be made in a rising stock market and a falling stock market by short selling – sell high first and buy lower, later.
And even fewer people know that money can be made (lots of it) when the markets are rising, falling or direction less. And even fewer actually do it!
In fact, directionless or range bound markets can be the best friend of a trader, giving her the opportunity to make steady returns. Most stock markets spend long periods of time being range bound or directionless.
It is in these range bound times that savvy traders continue to make a healthy return on their money invested in stocks.
The world of traders is somewhat divided like this.
In the perfect trader’s world, the best way to get phenomenal and regular returns from the stock market means correctly predicting the direction the market will move and then placing trades accordingly. But for the most seasoned of traders with years of experience, with the latest technology and tools and an army of analysts for all sorts of data crunching, correctly predicting the direction of market movement on a regular basis remains an impossible to attain chimera.
On the other hand, Options Trading provides many strategies where you can generate regular income, even when the direction of your prediction of market movement goes wrong by a significant margin. This is the closest that one can possibly come to be able to profit in the stock market without predicting its future direction of movement.
These strategies are designed to give you a significant room for error if the market moves against your expectation. One such strategy that I employ very often is selling out of money credit spreads.
What are Out of Money Credit spreads?
Out of money (OTM) credit spreads involve selling out of money call or put options and buying further out of money call or put options. Since the sold options is closer to money than the bought option, there is a net credit in your account, hence they are credit (and not debit) spreads.
Let us understand this with an example. We will use Microsoft Options Chain (expiring in 3 weeks), as shown below for our example.
The underlying, Microsoft (MSFT) is at $45.
If you are bullish on Microsoft, your analysis tells you that there is a good likelihood of the price of Microsoft going down. You can construct a “Bull Put Credit Spread”. You can do that by selling, say 500, $43 put options for Microsoft at $0.62 per option. You will buy 500 $42 put options for $0.55 per option. Your net credit is $0.07 per option or $35 for 500 options.
Using the Ultimate Options Visualizer, we see that the payoff profile of our position will be as follows:
You can see, you will earn $35 even if the market moves 4.5% in the wrong side of your expectation.
This is powerful. You can check out my options position excel that I use to visualize simple to complex options positions with calls puts and underlying stocks.
Also notice that along with selling out of money options, we buy equal number of further out of money options. While this reduces our profit levels, this is our insurance. Stock markets have a habit of surprising the best of traders. Our objective is to earn steady returns from stock markets with minimum risk. We are gunning for longevity. If we stay in the market long enough, the power of compounding will give our investments and income a massive booster dose.
You can build a converse, Bear Call Credit Spread if you are bearish on the underlying.
In my various avatars, I am an Options Trader, an Author and a Coach. I use Options Trading to create a source of passive income for my family and myself. I am also using the cash flow from Options Trading to create a long term portfolio of stocks. You can easily learn and replicate my methods, just go ahead and explore my blog.