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I had done a nifty credit spread a few days back so I will be discussing a live example with you. BTW credit spreads is my favorite strategy. I mostly do them every month and occasionally naked selling only if the markets gives me a great opportunity. If you do not know what a credit spread is here is an explanation.
An option credit spared is a position when the nearer strike option is sold and the further out of the money (OTM) option is bought for protection. Ideally they both should be of the same stock or index and of the same lot size and of the same months (some people create credit spreads with different months but that is entirely different subject. This article deals with same month credit spreads). Since the nearer option is sold – the difference of the amount between the sold and the bought option is “credited” to your account. Therefore the name – Credit Spreads.
Confusing? Ok let me give an example to help you understand.
Lets suppose nifty is at 5800. It has already fallen 200 points recently and you think a re-bounce may happen anytime soon. Even if it falls a bit further you do not think that it will go below 5600 this month. What do you do? You sell (short) one lot (or more) of the PUT at 5600. Now as you know shorting options can be very risky, to protect yourself from a great downfall you buy the same number of lots you sold at the strike price of 5500 or 5400 as per your risk. Now if nifty goes for a free fall you will realize some profit from the options you bought limiting your losses to a certain extend in the short options.
But then, how do you profit?
If both the options expire worthless you keep the premium. That is your maximum profit. Do not worry about losing the premium you paid for buying the options – you will profit anyway because the sold options will also expire worthless. Remember they were costlier than the ones you bought so the premium you received should be more than what you paid to buy the options.
Lets take a real example – a trade I did. As on June 12, 2013 Nifty closed at 5760. In the last 30 days Nifty made a high of almost 6200 and since May 30, 2013 Nifty is continuously falling from a high of 6133.75. This is a fall of almost 6% in 12 days. Yes Nifty can fall a bit further – but certainly from some point it will rebound. I don't know from where, but eventually it should. (Even if it doesn’t I don't have much to lose – I will explain why).
The VIX (volatility index) was also on the higher end. Note that option prices are directly proportional to volatility. If VIX is high option prices will also be priced higher. Tomorrow if volatility drops the same options will lose their value. (In that case I can actually profit tomorrow itself and close my positions. However I am not in a hurry.) For those who want some more info on volatility here is a para taken from http://www.moneycontrol.com/indian-indices/india-vix-36.html:
Volatility Index is a measure of market’s expectation of volatility over the near term. Volatility is often described as the “rate and magnitude of changes in prices” and in finance often referred to as risk. Volatility Index is a measure, of the amount by which an underlying Index is expected to fluctuate, in the near term, (calculated as annualized volatility, denoted in percentage e.g. 20%) based on the order book of the underlying index options.
India VIX is a volatility index based on the NIFTY Index Option prices. From the best bid-ask prices of NIFTY Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days.
Since the volatility was high I was getting a good price on July 5500 PE (put option). I got it at 45. Now you tell me what are the chances that after falling 6% in 12 days Nifty will fall another 5% and more? Slim. But one can’t predict markets, so protection is important – very very important. Here is what I did:
1. Short (sold) to open Nifty July 5500 PE at 45*400 (8 lots) = Rs. 18000.00 (credit in my account)
2. Long (bought) to open Nifty July 5300 PE at 20*400 (8 lots) = Rs. 8000.00 (debit from my account)
Total credit = 18000 – 8000 = Rs. 10,000.00.
ROI: 45 days are left for expiry. Total money invested is 1,30,000.00. Absolute return is 7.69%. it comes to almost 5% return in a month. Of course, I need to get out in a profit.
Here is the profit and loss graph of Credit Spreads:
By seeing the image I hope you can understand that profit and loss in a credit spread is always limited.
Now coming to my trade. As you can see I got a credit, the trade is called “Credit Spread”. This can be done either in calls or in puts. You just have to sell the option with the higher value and buy the option with the lower value to get a credit in your account.
Credit spread usually have a success rate of 80%. But here is a cliche – one losing trade can eat profits of many months. Therefore its important to adjust your credit spreads if your short leg is in trouble – and it does happens believe me – more often than you can think of.
Why I did a trade in July month and not June month. Only 15 days are left for expiry of this month so I would have not got a good credit at 5500 puts. (June 5500 PE is at 13.05) plus if Nifty starts moving down fast I will have no time to adjust my credit spread. It made sense to play the next month options.
Profits are limited, what about the losses?
Good question. You see losses are limited too since I have bought 5300 puts for protection. The difference between the prices of the options will be my maximum loss. Lets take an example. What happens if Nifty closed at 5200 in July expiry:
1. 5500 PE = 300 (5500-5200 = 300) I had received 45 so ((45-300)*400) = -102000.00
2. 5300 PE = 100 (5300-5200 = 100) I had paid 20 so ((100-20)*400) = 32000
32,000 -1,02,000.00 = -70,000.00 this is my maximum loss. However my profits are only 10,000.00. As you can see even if I make profit for 7 months – just one month loss will offset my profits. Therefore I should adjust my spread if Nifty gets closer to my shorted puts i.e… 5500. and I have to do it much before I enter a huge loss.
Lets see how we adjust our credit spread if it really comes to that. Luckily I did not have to adjust my spreads as Nifty never came close to my short puts. 🙂 (BTW if I had to, I would have taken a small loss in my credit spread and rolled it down 200 points if Nifty had fallen sharply near 5500 very fast as soon as I opened my spreads. If nifty closed above my new position I will have no profit or no loss or some profit / loss depending on the trade. But I would have certainly avoided a huge loss as explained earlier. And further I keep a record of my trades so if anytime I adjust my spreads I will update this post with a real adjustment of credit spreads.)
Here is a update: On July 04, 2013 I closed my credit spread.
I bought July 5500 PE (remember I had sold it earlier) at 16.00, and
I sold July 5500 PE (remember I had bought it earlier for protection) at 4.50.
Lets calculate my profit or loss:
Sold July 5500 PE (8 lots): (45 -16) * 400 = 11,600.00 (profit)
Bought July 5300 PE (8 lots): (4.50 – 20) * 400 = -6200.00 (loss)
Total Profit: 11,600.00 – 6200.00 = 5,400.00
Some people might be thinking why I bought the protection. My profit would have been great. Yes you are right, but falls are steeper, even before you know you can incur huge losses. With this small price for insurance at least I can sleep better in night. You don’t want to make money without sleeping, do you?
Lets calculate return on investment.
Total cost of opening the spread: 1,30,000.00
Absolute returns: (5400/130000.00) * 100 = 4.15% in 20 days.
Note that I could have close my spread a few days back when Nifty went near 5900 and got even better profits in less days – but these things keep happening in trading. You never get the best price. Ultimately its the profits that matters. 🙂
Also I did not wait for the expiry. Why? Because I am already getting a good profit and a full month is left for expiry. A winning trade can become a losing trade some day, who knows. So its better to close the spread when you have realised a good profit from it and release your locked for margin cash for opening another spread or doing any other trade.
Hope this article has helped you to understand credit spreads. If you want to know anything please ask in the comments section below.
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