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The strategy behind this technique is simple.  Please note this description is not meant to be a thorough analysis or detailed instruction of the factors used to determine this spread, but to depict the general strategy in a graphical format.  I am not a professional trader and have been learning as much as I can about option trading in these last few months.

The option seller establishes a break even strike price on the upper end of his spread.  This option is purchased by a buyer who is bullish and may exercise his option if the underlying security will surpass his option’s strike price.  Currently the security’s price is not at a point where the option would be exercised because the buyer could simply go into the market and obtain the security at a better value than using his option.

Graph A:  In this example the break even points are at $32 and $38.5.  The position starts at $0 profit.

The option seller also establishes a break even strike price on the lower end of his spread.  Similar to the above situation, the security’s price is not at a point where the option would be exercised because the buyer could simply go into the market and obtain the security at a better value than using his option.

As long as the underlying security’s strike price only fluctuates between the upper and lower strike prices but does not equal them or pass them, the seller of this option spread will be profitable at expiration of the options.  He is profitable because by keeping his credit spread position on until expiration,  he retains 100% of the money or credit he received from buyer’s buying the options.

Before putting on this trade, some of the points a seller may look at are, and this is not limited to what is listed here:

- analyzing the price history of the underlying security to determine its general price ranges

- whether it is uptrending or downtrending or travelling in a channel

- what resistance or support lines, if any, there are

To be in a neutral position, the seller will start the spread with the underlying security’s price as centered in the spread as possible.  The position starts slightly in the negative, because of the commission to put on the position, but will become profitable as time passes.

To receive the full maximum amount buyers would pay the seller for the options he sold, the seller would have to keep these positions on right up until they expire.  He would then retain the full amount the buyer paid for the option.  If the seller closes out the position anytime before it expires, he would only keep money for the amount of time he had kept the position on but would give up

Graph B: In this example, the current security’s price is around $35.5.  An example of a neutral range would be to put on a credit spread with an equal range on either side of $35.5 (ie. $32-$38.5)

Otherwise, if he is more bullish, he would start his spread with the price sitting slightly more on the lower end of his range, to give room for price movement up without touching his upper range.  Or if he is more bearish, he would start his credit spread with the price sitting slightly on the higher end of his range, with the expectation that the price would move down more than up.

As this credit spread option trade nears expiration, the profit arc begins to rise above the $0 profit line.  If the seller closes out the position before the options expire, he doesn’t get to keep the full credit he initially received for putting on the position.  He does however get to keep a portion of the credit, depending on how long he had kept the position on and how much time is remaining before the options expire.

Graph C: As time passes and the option comes closer to the date it would expire, the profitability of the credit spread increases until it reaches its maximum profit potential, which is the full amount of the credit he received for putting on the position.  Even though the price has moved and is now just past $36, it is in this spread’s profitable price range of $33-38.

The more the arc is above the $0 profit line, the wider the range prices can fluctuate between and still be profitable for the seller.  The more the security’s price falls more in the middle of the arc, the maximum amount a seller of a credit spread option can extract from it, should he choose to close it out before expiration.

Graph D:

Eventually the original spread range the credit spread option seller put on will be completely profitable as the profit arc rises to cover the entire price range of the credit spread.  This usually happens near the expiration of the options.

To learn more about an effective way to use this strategy, which will pull in at least 15% return on your investment monthly, review David Vallieres Tradingology Options Course.

After starting The Trading Pro System home study course in mid March and going through all the video tutorials (there was quite a lot!) I started up an options paper trading account with Think or Swim early this month (April 2009).

It is now about 2 weeks since I put on my first paper trade in some index options.  I also put some positions on last week.  These particular options expire May 16th and every day I hold my options their profitability value increases.

I have gotten into the habit these last 2 weeks of checking my positions soon after I wake up.  Since I am in Pacific time, the markets have already been open for a few hours.  Although the type of trading I am engaging in is short-term (ie. holding positions and closing them out in less than a month), the time of day I enter my entrance or exit in a position doesn’t matter because I am trading via the Trading Pro System strategy, which bases decisions of trading on overall price fluctuations of the underlying stock or index you are trading over time.

I’ve already practiced adjusting one of my positions (EEM) because it had moved very close to my upper break even point.  I lost about $30 on that trade, but my new position via the adjustment if closed near the expiration date of that option will bring in a profit potential of up to ~ $250.

So the choice is:

1) potentially have a maximum loss of ~ $840 in the original position which would have brought in a potential profit around ~ $360 (43% gain) or

2) close the position out, lose only $30, readjust the position and potentially gain $250, which is a ~63% gain on a $380 investment?

I chose the latter and just recently reviewed where my previous position would have been had I kept it; it is currently at a loss of -$60.  My adjusted position is at a profit of $60…but since I lost $30 closing out the other position, I am really only up $30 in that position.

The longer I hold the option closer to expiration, the profit potential of this position will increase. If I hold this EEM position for another 2 weeks and the price of it generally stays where it currently is at around $27, give or take $1.50 up or down, my profit potential will be anywhere from $95 to $115 if I were to close it out in 2 weeks.  If I hold my position for 3 weeks  the profit potential increase to anywhere from $143-$175 within the same underlying $27 price range I mentioned above.

In total, I am holding 4 positions in my paper trading account and have invested about $1800 for a potential profit of around $1000(56% potential ROI) if my positions are held until the option’ expiration date.  I will most likely close them out just before they expire and hope to capture at least 75% of the potential maximum profit amount.

I’ll let you know my progress later.