Investors who like a steady cash flow should look into the credit spread strategy using options. In a choppy, directionless market, creadit spreads can be a great strategy.

Most of the time, when we think about establishing a bullish position using options, we think about buying a call.  But another bullish strategy that is more conservative is to sell a put.  By selling a put, we are now incurring the obligation to buy shares from someone else at a specific price (the strike price), up until the expiration date.  We can close the position early by buying back the put if we wish. But this put selling strategy is known as a naked put, in which a big overnight plunge in a stock could obligate you to buy the stock at a much higher price.

A credit spread makes the naked put strategy more conservative, by purchasing a cheaper option than the one you sold, for insurance to lock in a much lower risk should the worst-case scenario occur.  While I mentioned Wednesday that I don't like to use index options like the S&P 100 Index (OEX) for straddle buying, I love to use the index options for credit spread trading.  You have better liquidity and better risk management compared to using most individual stocks.  For example, if the OEX were at 497.09, a mock trade for bulls might be to sell the 1-month 480 put at 5.60 and simultaneously buy the 1-month 475 put at 4.60.   This allows you to collect the 1 point credit, or $100 gross before commissions.  You want to make sure you are getting reasonably low commissions from your options broker when you do credit spreads, since there are two sides to the transaction on the way in, and also two sides on the way out in the minority of cases where both options don't expire worthless.

Did I mention you want both options to expire worthless? Ideally if you're neutral to bullish, the credit spread strategy will work out unless the OEX starts dropping much under your 480 strike price you sold. Actually you can be wrong on the market by 18 OEX points, about 3.5%, and still make money with this strategy.  Contrast that to buying calls where the index must rise for you to profit, and you see you have many more scenarios where you can win with credit spreads.  Your breakeven point is 479.00 here (the 480 strike price you sold minus the 1 point credit you collected).  Your maximum loss is the 5 point difference between the strike price, minus the 1 point credit you collected, or 4 points.  So your fixed maximum return on a winning trade here would be 25%.  Some traders don't like the idea of risking 4 to make 1, but if you try to get more aggressive with this strategy by doing a closer credit spread like the 490/485 instead, your risk of losing will go up. 

If you're bearish, you can do the same thing with call credit spreads above the market price.  I always look at out-of-the-money credit spreads because you want to take advantage of the time decay in options. The time decay is greatest in the front-month options that are about to expire.  Ideally I'd like to do a credit spread with 2-4 weeks until expiration, and then see those options expire worthless and look to do it again in the following expiration month. Credit spreads can give you market exposure with a high chance of winning.  They're not foolproof, but they offer a better consistency "get on base" mentality for the conservative trader versus the home run mentality for the aggressive options buyer.

Price Headley is the founder and chief analyst of BigTrends.com.