by Don Fishback

A trader can buy a call or a put to limit risk while allowing for potentially unlimited profits. The bad news is that the odds are automatically against you. One could also sell a call or a put to instantly put the odds in your favor. But that would leave the investor exposed to potentially unlimited risk. The good news is that there are some simple solutions.

One method for limiting risk, while putting the odds in your favor is using a contingency order. For example, let’s say that if XYZ shares currently at 100, dropped to 90, we would exit the option position in an offsetting transaction. In that instance, our loss would be limited. The problem is, what if XYZ shares gapped lower, let’s say from 91 to 70. Although this is extremely unlikely, it is certainly possible. Such an occurrence would be devastating, and unpreventable.

A better solution would be to use a spread. By combining option purchases and short sales, you can create an option spread that both limits risk and puts the probability of profit in your favor. This is exactly the strategy I used to identify 306 trades during a 3-year period, with only 5 losers. That’s right, using a simple spread, I discovered 306 limited risk option trades, of which only 5 lost. I didn’t have to worry about any “gap” moves in the underlying asset. My system simply looked for limited-risk option strategies to win at least 90% of the time, and that was it.

The strategy is called a credit spread, because when you implement a credit spread, you are paid at the inception of the trade. A credit spread is a strategy where you sell an option and then simultaneously buy an option that is further out-of-the-money. For example, let’s say you are a stock index trader. The index you are following is trading at 400. If you were bullish, you would sell a 380 put and buy a 375 put. As long as the index stayed above 380, you’d win. In other words, if the index went up, you’d make money. If the index stood still, you’d make money. If the index dropped by 5% you’d make money. Only if the index dropped by more than 5% would you lose. That’s why the odds are so fantastic – there is only one situation that’s a loser, and even then, the loss is limited.

You can also implement a credit spread that has a bearish bias. In this instance, you might sell the 420 call and simultaneously buy the 425 call. If the index dropped, you’d make money. If the market stood still, you’d make money. If the index rallied 5%, you’d still make money. Only if the index rallied by more than 5% would you lose. As it is with selling a put credit spread, the odds are fantastic because there is only one situation in which you lose, and even then, the loss potential is completely limited.

There seems to be an exception to nearly everything in trading. In the two instances above, cash-settled, American-style index options can behave unusually if they go “deep-in-the-money” as expiration approaches. Please be sure to read Characteristics and Risks of Standardized Options before trading.

What’s really special is combining a call credit spread and a put credit spread. The stock market rarely trades up or down more than 5% in a month. You can put that phenomenon to work for you by using options. By simply selling a call credit spread and a put credit spread at the same time, you can earn income while the market trades up and down in a very wide range. History shows us that this type of strategy should make money at least 90% of the time.

Historical analysis shows that in the right market, even better results can be achieved.

Results like this come from using just one type of spread. There are virtually an unlimited number of strategies and option combinations you can utilize to make money and control risk.