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Up, Down - Which Way Do I Go?
by Freddie Rick
www.TheGumpInvestor.com
The stock market is in continuous conflict between investors that hold long positions and the traders with short ones. For years, during the extended bull market, the long investors were the dominant force. Lately, the shorts have been showing up in mass and have benefited while the market has fallen from its highs. Typically individual investors have had to choose between these two camps and decide if they are long and expect the market to go up, or elect to go short and sell borrowed stock, expecting the price to fall. There is a new player in the market who holds a more neutral position and is quickly gaining popularity. This player is the credit spread investor. The spread investor has the option to take either bullish or bearish positions and can profit equally when the market climbs or falls.
The short investor picks a stock and says, "This one is going to fall." His or her position will not be profitable unless the stock does indeed decline. Unlike the short traders, a spread investor who opens a bearish position does not need for the stock to fall to profit. Instead, the thinking behind a bearish spread position is, "This stock is not going to climb above a certain price during the next couple of weeks." (Both the time and price is flexible in a spread position.) As you can see, the spread investor is much more neutral to the market. Over the next couple of weeks whether the stock price falls, stays unchanged, or even gains a little in price, the position profits. Likewise, a bullish spread position does not need the stock or broader market to rally for the position to make money.
Credit spreads are a limited risk options investing strategy that disproves many of the common myths about options trading. The first myth is that options are extremely risky. While it is true that the most aggressive option strategies carry significant risk, there are other options strategies that are considered safer than buying individual stocks. With credit spreads, the maximum amount of capital at risk is limited. A typical position that represents 100 shares of stock has a maximum loss of $500. The second myth is that options are extremely complicated and best left to the institutional investor. This myth has originated from investors who have tried to learn everything there is to know about options before they start investing. There are over 20 different options strategies and learning each of these can be quite a task. We have found that it is best for investors to first focus on a single strategy, preferably one with limited risk, and expand their knowledge from that point.
But what about the bottom line? What type of returns is achievable with spreads? These are some of the most common questions we receive about credit spreads. I'm sorry, but you won't pull in returns of 200%, 100% or even 50% with spread positions. The reward is capped along with the risk. With this said, it is possible to achieve consistent returns of 10% to 25% with credit spreads. Those of you who are familiar with options may point out that spreads are typically a monthly position, and this is true. The 10% return is on a monthly basis, but don't immediately extrapolate this to a return of 120% per year. First of all, you never want to put all of your trading capital into spread positions. While it is not uncommon to have 10 to 20 profitable spread trades in a row, eventually you will have a losing position. If you have overextended yourself, an otherwise small, manageable loss could wipe out all of your profits and more. With proper money management this can be avoided. However, it requires taking some of the profits off of the table, which will reduce your annualized return. Credit spreads are best utilized to generate a consistent stream of revenue, not to make you rich overnight.
If you have typically been a long investor and are looking for alternatives in today's market, take a closer look at credit spreads. There are many ways to get started. One of the best and safest methods of learning the strategy is to review example trades and case studies. For this reason, we post all of our closed positions, both winning and losing trades, on our site. If you are interested in more information, visit the options education section of The Gump Investor at www.thegumpinvestor.com/options/home.asp. For more information on our recommendation services follow this link www.thegumpinvestor.com/products/services/home.asp.
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