Option Investor

Spread Trading - Q&A

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A number of new readers have asked about the "target credit" that we list for each position. Here is some additional inforation on that topic...

Many of our subscribers are less experienced traders that need simple, easy to understand strategies and one of the first skills participants must learn is to execute a favorable opening trade. A good technique for initiating a combination position such as a credit spread is to place the order as a "net" credit (or, with certain strategies, a net debit) for both positions in the spread. When a new spread position is listed, we include a suggested "net credit" target to help traders open the position. This is simply a recommended entry point; just an opinion of what a trader might use as an initial "limit" for the spread order. It should be a reasonable price to initiate the play even with small changes in the stock and option quotes. The target price is always less than the straight BID/ASK numbers (Do not pay "market" price for spread orders!) and generally, you can expect to shave $0.05-$0.20 off the composite BID/ASK price when opening or closing even the smallest spread order. The margin can be more or less, depending on the price of the options, whether they are ITM or OTM, the time value remaining, the volatility of the stock, etc. The published "target" is intended to give beginning traders an idea of the value of the spread because the option prices are always different the next day. Of course, you may need to adjust this target based on the activity of the underlying issue, the trading volume of its options or the implied volatility of the series being traded.

Other common questions:

Does this mean that you should not enter a spread spread position until such a time as the "net credit" is available?

No, our "net-credit" target is simply an initial goal. A smaller amount may be acceptable -- based on your personal risk/reward outlook -- if the order can not be filled at the suggested price within a reasonable period.

Is there a certain length of time when you should cancel the order if it hasn't been filled (eg a week, etc) ?

A reasonable period might be one day to one week, or longer, depending on the volatility of the underlying issue, time remaining until expiration, etc. You will have to evaluate each position individually and determine a suitable balance between the potential for achieving a higher credit and the possibility of not entering the spread.

In the summary, we will generally record the target credit only if it was obvious that the spread could have been filled at that price, on a simultaneous order basis, within the first session (or two) after the play was listed. We will also report when a spread simply does not offer a viable credit after it is published as a candidate. The recent bullish position in Goldman Sachs (NYSE:GS), which gapped higher on the day after it was offered as a candidate, was a good example of that situation.

MCM Staff

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