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Last week we started a new mock trade using Activision (ATVI) so that we could see how a credit spread works. Before we go into the specifics of this trade, let’s review a credit spread.

A credit spread is a spread that uses different strike prices, but the same month, to bring in a credit. This credit is received by selling the costlier strike and buying the farther out option. The idea is to bring in a credit on a stock that we feel will not move through a certain area. For example, if we feel that the $30 area is resistance for a stock, we may choose to enter a credit spread using the 30 and 35 calls. This is called a bear call spread because we are bearish on the shares, but are using calls. If we see support holding for a stock, we could enter a bull put spread. The advantage of a credit spread is that a trader makes a profit if the stock stays the same or moves in the appropriate direction. This gives us a 67 percent chance of success. However, we also have risk, and this is why we buy an option as well as sell one.

In the 1980s, traders had what they thought was a money tree by selling naked puts. This process brought in a credit that was kept as long as the stock market kept rising. However, in 1987, a crash occurred that taught these traders an important lesson. As the market fell that ominous October day, traders across the world were hit with huge margin calls as their short puts moved into the money. In order to curtail most of this risk, we buy an option to hedge our sold option. This lowers our risk to the distance in strikes, minus the credit received.

Now, let’s review our mock trade and discuss what we need to do from here. First, below is the data for last week and this week, along with a chart showing the stock’s movement.

11/12/02
ATVI Bear Call Spread
ATVI @ 19.97
Buy 10 Dec 22.50 Calls @ 1.00
Sell 10 Dec 20 Calls @ 2.00
Net Credit = 1.00 or $1,000
Max Risk = $1,500
Breakeven = $21

11/19/02
ATVI Bear Call Spread
ATVI @ 18.77
10 Dec 22.50 Calls @ 0.35 (bid)
10 Dec 20 Calls @ 1.20 (ask)
Net Credit = 1.00 or $1,000
Profit/loss = 0.15 or $150
Max Risk = $1,500
Breakeven = $21

We often talk about having an exit before we enter a trade. For ATVI, we talked about getting out if the stock moved above its descending trendline. We also said that once this trendline moved below $21, we would use this breakeven point as our exit. ATVI continued to fall this past week, leaving our trade in positive territory. However, our max profit won’t be achieved until expiration, but so far so good.

After the market closed on Tuesday, ATVI announced plans to offer a $500 million mixed shelf offering. This news is not viewed positively by traders and ATVI is falling sharply in after-hours trading. This will likely move our profit up, but we are best to hold on unless we feel the $20 area will be broken before December expiration. If you don’t want to take the chance of waiting for December expiration, you could take profits at a predetermined point. Maybe this is 80 percent of the max profit, or some other figure, but there is nothing wrong with taking a profit.

Let’s say that the stock falls far enough that we can get out of the spread making $800, or 80 percent. If we take the margin that was required, which was $1,500, and divide it into our profit, we get our profit margin. In this example, our profit would be greater than 50 percent. This wouldn’t be bad for just over a week of trading. Exit strategies are personal decisions, but the last thing we want to do is let a profit turn into a loss. Overall, the market seems to be stuck in a consolidation phase. This is a good thing for our trade, so we’ll hold on seeing what happens over the next week.


Jody Osborne
Senior Staff Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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