This concept is especially important when using options to hedge a position. Consider an existing position of 100 shares of SPY. The inexperienced investor seeking to fully hedge his position would purchase one ATM put and rest easy, until the anticipated downward move occurs and he is left pondering the source of his newly minted losses. It is only through hedging the portfolio on a delta basis (delta-hedging) that it will be fully protected.
These positions are examples of debit strategies, or strategies that leave investors’ accounts with debits as they are paying for access to these positions. Credit strategies are those trades that produce a net credit in investors’ accounts as they involve the writing, or selling, of option contracts.
Writing or selling options has been a strategy that is becoming increasingly popular with investors as a way to enhance returns on their existing positions. However, writing options obligates the writer to deliver or take receipt of underlying shares if the contract is exercised or assigned. If options are written against existing positions (covered either by shares or cash), then the investor may be forced to either deliver his position against the open written call or receive (purchase from the holder of the put contract) shares to close out the written put. If options are written without any collateral, they are said to be "naked." Writing naked options can quickly lead to great financial success, as the writer could end up keeping the entire collected premium as the contracts written expire worthless, or to financial ruin as the writer could be on the hook for the difference between the underlying share price less the contract strike less collected premium. Theoretically, this obligation could be infinite.
Consider the ATM September 140 SPY call. If an investor were convinced that SPY was destined to trade off sharply, he might consider selling this call. If he is correct, he realizes a gain of $293 at expiration for each contract sold. If he is incorrect, he must deliver 100 shares of SPY at $140 per share regardless of the prevailing price. For example, if SPY is trading at $160 at any point prior to expiration, he would have to purchase shares in the open market at $160 and deliver (sell) them to the buyer of his contract for only $140. Multiply this scenario by 10 and you can see why the possibility of earning $2,930 is quickly outweighed by the possibility of having to source $160,000 and immediately lose $17,070 ($20,000-$2,930) on the transaction. This is why most brokerage houses permission their clients’ options activity in tiers, with naked option writing being one of the highest-level activities allowed.
An easy way to mitigate the risk of this lopsided trade is through a spread trade. Spread trades can take any number of forms, such as vertical spreads, horizontal (calendar) spreads, back spreads or ratio spreads, to name a few. We are going to consider the vertical spread trade; specifically, the vertical bear call spread and the vertical bull put spread.
The vertical bear call spread is a neutral-to-bearish multileg options strategy (Figure 3). Premium is collected through the sale of a call (obligation to deliver the underlying stock). Part of the premium received is used to buy a call (right to buy the underlying stock) at a higher strike price. Selling a call theoretically represents unlimited risk. Buying a call limits the risk to the difference between the sold and bought strike prices (strike spread) less any premium collected. For example: