Generate Cash Flow with Less Capital – Consider Credit Spreads

Many investors seek to enhance cash flow in their portfolios. For the option educated, this can involve the implementation of the Covered Call strategy or selling Naked Calls or Naked Puts. The objective is to collect a credit through the sale of an option contract with the expectation that it will expire worthless. This can occur if the underlying stays the same or moves in a direction that places the written contract Out-Of-The-Money.

A Quick Review

Call Writer – Paid a premium/collects a credit and is obligated to deliver shares at the written strike
Put Writer – Paid a premium/collects a credit and is obligated to buy shares at the written strike

For the Covered Call writer, the obligation to deliver the shares at the written strike is “covered” by the ownership of the underlying shares. The investor incurs a loss as the shares drop in value below the purchase price, less the credit.

For the Naked option writer, the risk is also unidentifiable. As a result, the broker will require the Investor to have sufficient enough capital in their account to cover the obligation. For the record, I am by no means suggesting that these approaches don’t have a place in an options oriented portfolio. In fact, I believe that the Covered Call strategy is a powerful approach to enhancing yield in a portfolio. I also believe that writing puts on shares that you want to own, at levels that you want to own them has its place as well.

The common consideration for the Covered Call, Naked Call and Naked Put is that in all three scenarios, the investor is required to have sufficient enough capital or margin available to maintain the position. Further to that, the credit received for the sale of the option is limited, while the risk on the position is undefined.

To limit the amount of capital required to implement an option writing strategy we can create a Credit Spread. Credit Spreads involve the sale of an option at a strike that is close to the current share price of the underlying and the simultaneous purchase of an option at a strike further out.

To Simplify

Sell the expensive option = collect a credit
Buy the further out “cheaper” option = incur a debit

Net result = Credit

Maximum risk = Difference between the strike prices minus the net credit
Maximum profit = Net credit

The typical approach to this strategy is to sell options that are Out-Of The-Money. The expectation is that as long as the option is written at a level where the stock is not likely to trade with in the time frame, the contracts will expire worthless and the net credit will be realized at expiration.

This strategy can be implemented using calls and puts, however for the sake of this post, we will take a look at a Bull Put Credit Spread.

Out-of the-Money Put Credit Spread – Agrium (TSX:AGU)

Since option prices are based on probabilities, the further Out-Of The-Money the written strike is, the higher the probability that it will expire worthless. The challenge is that the credit received for the spread is significantly less than the risk. This means that you can be right several times over, but the one time that you are wrong and the stock moves greater than expected, the profits from many successful spreads can be compromised.

Take for example the following Put Credit Spread on Agrium (TSX:AGU) with shares at $96.70

SELL April, 92 strike put = $1.60 ($160.00)
BUY April, 90 strike put = $1.35 ($135.00)

Net Credit = $0.25 ($25.00)

Maximum Risk
(92-90) -$0.25 = 1.75 ($175.00)

Break even on expiration
92-$0.25 = $91.75

To summarize, this trade has a profit potential of $25.00/contract and a risk of $175.00/contract. This represents a 14% return on risk.

Confident in the Direction?

If you were confident that Agrium (TSX:AGU) is going to trend higher over the next month and a half, you could implement an At-The-Money Bull Put Credit Spread for a more attractive risk/reward opportunity.

SELL April, 96 strike put = $3.15 ($315.00)
BUY April, 94 strike put = $2.55 ($255.00)

Net Credit = $0.60 ($60.00)

Maximum Risk
(96-94) -$0.60 =1.40 ($140.00)

Break even on expiration
96-$0.60 = $95.40

In this example, the trade has a profit potential of $60.00/contract and a risk of $140.00/contract. This represents a potential 42% return on risk.

On Expiration

In the event that the stock stays the same or goes higher, both Bull Put Credit Spreads would expire profitably as the options expire Out-Of-The-Money and the full credit is realized. The further Out-Of-The-Money spread has a higher probability of expiring worthless, however a greater risk is undertaken for that benefit. If the investor is confident enough to take a more decisive stance on the direction of the stock, a greater credit may be obtained with a reduced risk while still taking advantage of the passage of time.

By considering a Credit Spread the the investor is able to generate cash flow by taking advantage of the passage of time. This strategy also reduces the amount of capital required to participate as the margin requirement is typically calculated as the spread minus the credit. By choosing a spread closer to the current value of the underlying stock, a greater credit is received which reduces the the risk. This subsequently reduces the margin requirement further.

It is important to note that the Credit Spread strategy is not permissible in registered accounts.