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July 31, 2014

A Credit Spread can be Similar to Insurance

Selling a credit spread involves selling an option while purchasing a higher or lower strike option (depending on bullish or bearish) with the same expiration and with the short option being more expensive than the long option. For example, selling a put credit spread involves selling a put and buying a lower strike put with the same expiration. Maximum profit would occur if the underlying is trading at or above the sold put strike at expiration; the spread would expire worthless. Selling a call spread involves selling a call and buying a higher strike call with the same expiration. Maximum profit would be realized if the stock is trading at or below the sold call strike at expiration; the spread would expire worthless.

The long options are there to protect the position from the potential losses associated with selling options. With a spread, the most the position can lose is the difference between the strikes minus the initial credit received. This would occur if the stock is trading above at or above the long call or at or below the long put. Using a call credit spread as an example, if a trader sold a 50 call and bought a 55 call, creating a credit of $1, the most the trader can lose is $4 (5 – 1) if the underlying closed at or above $55.

The Objective

The objective of a credit spread is to profit from the short options’ time decay while protecting gains with further out-of-the-money (OTM) long options. The goal is to buy back the spread for less than what it was sold for or not at all (meaning it expires worthless). Just like selling short stock, a trader wants to sell something that is expensive and buy it back for cheaper. The same holds true for credit spreads.

An Example

Here is a credit spread trade idea we recently looked at in . When Amazon Inc. (AMZN) was trading around $348 towards the middle of July, a July 335/340 put spread could have been sold for 0.55. This means the July 340 put strike was sold and the July 335 put strike was purchased for a credit of 0.55. The maximum profit in the spread was the credit received (0.55) and would be realized if AMZN was trading at or above $340 at July expiration. Remember that a profit would be realized if the spread could be bought back (closed out) for less than the credit of 0.55. The most that can be lost on the spread is 4.45 (5 – 0.55) and that would be realized if the stock was to close at or below $335 at July expiration.

What’s the Point?

The risk/reward ratio of this credit spread begs the question why would anyone want to risk maybe eight times or more on what they stand to make in the example above? The simple answer is probability. Given the ability to repeat the trade over and over again with different outcomes, the trader will make $55 many, many more times than he or she will take the $445 loss. This was a hypothetical situation, but let’s say that the strategies winning percentage was close to 85% like in the example above. The trader needs to look at prior historical price action of the stock to determine probability of success.


How does this seem similar to insurance you ask? The credit spread strategy is similar to the insurance business because insurance companies get to keep premiums if people don’t get sick or if people don’t have accidents, etc. Traders turn themselves into something like an insurance company when they implement credit spreads and keep premium as long as something doesn’t go drastically wrong.

Just like an insurance company has to decide if the risk is worth the potential reward, option traders that trade vertical credit spreads have to analyze how much can they collect, how much can they lose and the probability of having a profitable trade. In a future blog, we’ll discuss how a trader can use options implied volatility to help put probability on his or her side.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring


July 10, 2014

Option Delta and Option Gamma

The option “greeks” help explain how and why option prices move. Option delta and option gamma are especially important because they can determine how movements in the stock can affect an option’s price. Let’s take a brief look at how they can affect each other.

Delta and Gamma

Option delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. For example, if a call option is priced at 3.50 and has an option delta of 0.60 and the stock moves higher by $1, the call option should increase in price to 4.10 (3.50 + 0.60). Long calls have positive deltas meaning that if the stock gains value so does the option value all constants being equal. Long puts have negative deltas meaning that if the stock gains value the options value will decrease all constants being equal.

Option gamma is the rate of change of an option’s delta relative to a change in the stock. In other words, option gamma can determine the degree of delta move. For example, if a call option has an option delta of 0.40 and an option gamma of 0.10 and the stock moves higher by $1, the new delta would be 0.50 (0.40 + 0.10).

Think of it this way. If your option position has a large option gamma, its delta can approach 1.00 quicker than with a smaller gamma. This means it will take a shorter amount of time for the position to move in line with the stock. Stock has a delta of 1.00. Of course there are drawbacks to this as well. Large option gammas can cause the position to lose value quickly as expiration nears because the option delta can approach zero rapidly which in turn can lower the option premium. Generally options with greater deltas are more expensive compared to options with lower deltas.


Option gamma is usually highest for near-term and at-the-money (ATM) strike prices and it usually declines if the strike price moves more in-the-money (ITM) or out-of-the-money (OTM). As the stock moves up or down, option gamma drops in value because option delta may be either approaching 1.00 or zero. Because option gamma is based on how option delta moves, it decreases as option delta approaches its limits of either 1.00 or zero.

An Example

Here is a theoretical example. Assume an option trader owns a 30 strike call when the stock is at $30 and the option has one day left until expiration. In this case the option delta should be close to if not at 0.50. If the stock rises the option will be ITM and if it falls it will be OTM. It really has a 50/50 chance of being ITM or OTM with one day left until expiration.

If the stock moves up to $31 with one day left until expiration and is now ITM, then the option delta might be closer to 0.95 because the option has a very good chance of expiring ITM with only one day left until expiration. This would have made the option gamma for the 30 strike call 0.45.

Option delta not only moves as the stock moves but also for different expirations. Instead of only one day left until expiration let’s pretend there are now 30 days until expiration. This will change the option gamma because there is more uncertainty with more time until expiration on whether the option will expire ITM versus the expiration with only one day left. If the stock rose to $31 with 30 days left until expiration, the option delta might rise to 0.60 meaning the option gamma was 0.10. As discussed before in this blog, sometimes market makers will look at the option delta as the odds of the option expiring in the money. In this case, the option with 30 days left until expiration has a little less of a chance of expiring ITM versus the option with only one day left until expiration because of more time and uncertainty; thus a lower option delta.

Closing Thoughts

Option delta and option gamma are critical for option traders to understand particularly how they can affect each other and the position. A couple of the key components to analyze are if the strike prices are ATM, ITM or OTM and how much time there is left until expiration. An option trader can think of option delta as the rate of speed for the position and option gamma as how quickly it gets there.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring