Credit Spreads

May 25th, 2012, 10:21 PM

I am a newbie options trader and have a few questions that I would like to get some info on from the members. When considering Vertical Credit Spreads, although I understand the basic structure of the trade, I am reading differing executions of the play. Although some of them make sense to me, some appear to contradict each other (or so it seems) so I would like to get some clarifications.

My question :

(1) For credit spreads, one book advised me to always place the BUY side ITM and always SELL the OTM price as that would be priced higher and bring in the credit. Another book though asks the reader to place the SELL leg closer to the money always and the BUY leg at a higher/lower price. Some confusion here for me, I thought the SELL side should always be higher priced.

(2) In some books I've seen examples where both legs are ITM. Is that okay for a credit spread ? Should I not be bound by the rule in (1) above with one of the legs (SELL) always being OTM ?

(3) Suppose I have placed a bull put spread thinking the stock XYZ will move higher. Suppose XYX is currently at $ 50 and my spread looks like this : BUY 49 (ITM) / SELL 53 (OTM). Suppose also that I pick up a credit for $150. Now suppose the stock moves higher to $ 52.50 and stays there at options expiration. My question then is : (a) Is my Credit Spread invalidated as my target on the SELL leg was not reached ? (b) Will I need to close the position manually because the stock did not close above my spread target of $ 53 ? (c) Because the stock didn't close above $ 53, will the stock get "assigned" to me if I do not close manually (d) Does the fact that the stock did not close above $ 53 mean that the option will not "expire" normally and will trigger an assignment ? (e) What does that mean to me financially as I know that the SELL leg has an obligation under options ?

Advise needed. Thanks.

traderwerks · May 26th, 2012, 04:32 AM

It can be confusing when you are starting out

The easiest way for you to understand what is going on is try a trade on paper and see what happens. Just plot out what the price would be at expiration and that exercise will help you understand, especially when it comes to time value & intrinsic value.

The best place to start learning ( IMHO ) is CBOE, and it is free.

May 26th, 2012, 09:06 AM

You really do need to get some education about options and, as suggested, the CBOE website is a great place to start. If you are short the 53 put and the stock closes below there on expiration day then you will indeed be assigned a long position in the stock at $53. The 49 put will expire worthless. The safest thing to do is to close out the position before expiration by buying back the spread you sold. Once you understand gamma, you will know why. Good luck.

Credit Spreads

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Credit Spreads