To explain how credit spreads work, we need to understand a little about options.
Options, in their most basic form are the right but not the obligation to do buy or sell something at a specific price for a specific period of time. Options are basically, a paper contract on a real position, and paper is bought and sold in the open market place. Usually the CBOE (Chicago Board of Options Exchange).
Options give us choices in the trading world. Options serve as a contract between two parties: he Buyer and the Seller. The buyer of the options has rights where as the seller has obligations. When an option is purchased, a person is purchasing the right to buy a stock at specific price (Call Option) or sell a stock at a specific price (Put Option).
Let’s break this down a little further. There are two types of options. The first is known as a “call option.” When purchased, it gives the buyer the right to call the stock away from someone else at a specific price and at a specific time in the future.
Let’s demonstrate this using real estate as the example. If you are in the housing market and identify a nice home in a nice area that you think will increase in value in the next year, you can do a couple of things to profit from this movement of perception. Let’s say that you find a home in a rural neighborhood for $250,000 and your analysis predicts that the home is going to go up to $300,000 in the next year. Your first choice open to you would be to just purchase the house outright for the $250,000 and a year later if the house appreciated to $300,000 in value you could sell the house and realize a profit. If you were right on your assessment you would yield a $50,000 profit off of your $250,000 investment, a 20% return.
However, there is also another choice open to in this case. You could approach the homeowner and offer to give him or her 5% of the value of the home or $12,500 to have the right to buy the home for $250,000 sometime in the future. No matter what the market does the homeowner gets to keep the $12,500 and can spend it immediately. Let’s say the home owner gives you one year in which to buy the home for the $250,000. So just like the previous example you have locked in the right to buy the home for $250,000 but in this scenario you only had to put up $12,500 for that right. Should the home appreciate to $300,000 the contract that you have with the homeowner would be worth $50,000. As you can see, by leveraging yourself a little better you allowed yourself to invest $12,500 in order to make $50,000 and gave yourself a 400% return on investment. You bought the right to buy something for an extended period of time and you were willing to give up some money up front to have that right.
However, now let’s imagine a scenario in which that same house depreciated by $50,000 instead of appreciating by $50,000. If you had purchasing the home for the full $250,000 you would have lost $50,000 in the value of the home, definitely not a good day at the office. However if you had only purchased an option, you would have put up only $12,500 to have the right to buy the home for $250,000 within the year. Once you had realized a year later the home was now only worth $200,000 you could simply allow our option to purchase the home to simply expire in which you would lose the entire $12,500. While it is still not a great day at the office you did manage to lose a lot less money through the use of an option than you would have by simply purchasing the home.
This same type of analysis can often be used in the stock market as well. We feel that a stock may appreciate in value and instead of purchasing the stock outright we can often times purchase an option to purchase the stock at fair market value for a later date, for a fraction of the cost.
Let me give you an example: XYZ stock is trading at $140.00 per share. If I thought that XYZ was going to appreciate to $160.00 in the next 2 months I could buy 100 shares for $ 14,000.00 and if it went to $160 I could then sell my shares for $16,000.00 and profit $2,000.00 on the trade for a return of 14% on my initial investment.
My second choice is that I could purchase an option for $600.00 which allows me to purchase 100 shares of XYZ for $140.00 in three months. If XYZ’s stock goes up to $160.00 a share in the next three months then my option will increase to $2,000.00. I could simply sell my option for $2,000.00 leaving me a credit of $1400.00 in the trade or a return on investment of 233%.
By purchasing an option-or to be more specific, a “call option” which gives me the right to call the stock away from the market at $140 per share between now and the next three months-I am allowing myself to profit if the stock appreciates and I have avoided putting up the large sum of money that would have been required for me to purchase the stock initially..
The opposite of a call option is a “put option.” If you purchase a put option you are purchasing the right, not the obligation, to “put” the stock to someone else at a specific price and at a specific time in the future. So, when we think something is going to increase in price we want to look at buying call options, and when we think something is going to decrease in price we want to look at put options.
Think of the homeowners insurance you purchase every single month. You buy this insurance to protect you in the case that your house decreases in value due to some catastrophic event. If your home was to burn down then you could simply exercise your insurance policy and “put” your house to your insurance company and they will be obliged to give you the amount that you are insured for. When you purchase homeowners insurance you are buying the right to capture your losses should your home depreciate or go down in value because of some unforeseen catastrophe.
Remember that in the stock market, for every person that thinks something is going up there is someone else with the opposite opinion. It is easy to understand that if you think a stock is going to go up in value you want to buy the stock low and sell it higher. However, let’s talk about what people can do who think that a stock may go down in price and want to profit off of this bearish biased stock. A trader who believes a stock is going to depreciate in value “shorts” the stock at a specific price. This means that they go to their broker and borrow the stock with the promise of repaying it back in the future. They want to sell high and then buy the stock back at a lower price and then give the stock back to the broker allowing them to keep the difference between selling high and buying back at a lower point.
If you were looking at XYZ which is currently trading at $140 a share and your analysis said that it was going to decrease to $120 a share in the next couple of months, then there are a couple of things that you can do.
Firstly, you could go into your brokerage site and short 100 shares of XYZ for $14,000.00. You are borrowing stock that you do not own with the promise to purchase stock in the future and return it to your brokerage firm at a future date. If XYZ goes down to $120.00 a share, you could purchase 100 shares of XYZ a few months later for $12,000.00 and give the shares back to your brokerage firm, thereby closing the trade. Since you sold something for $14,000.00 and purchased it back for $ 12,000.00 you are left with a profit of $2,000.00, a return on investment of 14%.
The second possible scenario is that if you thought XYZ’s stock, currently trading at $160, was going to decrease in value you could purchase a put option for $600.00 which allows you the right to put the stock (or sell the stock) to someone else for $160 a share. If after a few months XYZ goes down to $140.00 your put option would be worth $2000.00 (since you could purchase 100 shares of XYZ at its lower price of $120 a share or 12,000.00 for 100 shares and have the right to sell it for $140 a share or $14,000 for 100 shares). At this time you could sell your put option for the $2,000.00 giving you a profit of $1,400.00, a return on investment of 233%.
As you can see, options lower your cost to get in the trade, thereby lowering your risk. And when the analysis is correct, using options gives you the opportunity to realize a larger return on investment.