Credit Spreads Demystified
Today’s lesson is entitled “Credit Spreads Demystified”. Credit spreads are one of the best option trading strategies that I use. What I will do is to explain the difference between a bear call and a bull put, how you set them up, and how you can profit from them.
Advantages of Credit Spreads
1. Credit spreads have great returns when coupled with a probabilistic approach to price action.
2. This option trading vehicle will yield monthly income on a consistent basis if you use proper rules, trade management, and deploy the advantage over a large population of trades.
Will you have some losing trades? Sure, but over the long run you will build an equity curve that has very little draw-down.
Credit Spread Delta
Most of the credit spreads we’re going to put on have a delta of about (.10). This delta means that there’s a 90-percent chance that that option will expire worthless, and those are the options that we are selling (green in your account). When we sell premium, time is in our favor. With credit spreads, you don’t have to constantly watch the market. You don’t have to chart-hawk. You don’t have to constantly be watching your computer. It’s a low-anxiety trade. With a credit spread we’re selling, but we never sell naked. We always are going to buy an option further out of the money, and that is for protection against catastrophic losses. The other protection we have is you set up rules whereby if it gets to a certain point, you exit the trade.
Best Time to Enter a Credit Spread Trade
Options don't decay at a linear rate, as gets closer to expiration the price of the contract decays exponentially. Therefore, we want to take advantage of that period of ever increasing premium decay (money in our account) by deploying our spreads on that last third of their life.
Think of a credit spread as simply selling one and buying one. You’re going to make money on the one you sell, called the short strike. When you sell an option potential loss can be unlimited so we’re going to buy one, called a long strike, further out of the money. This is the one that protects you from the unlimited losses.
Managing the Trade using the Risk Profile
This screenshot show a risk profile, and this is how you manage the credit spread. The green line is what it would be at expiration. You can see that this is the max profit you can make, and then your loss is truncated by the wing down here, and that’s the option that you bought. This risk profile is for a bull put. The combination of the one that you sold and the one that you bought gives you this amount of credit.
Every day, just take a look at this risk profile, and the purple line shows you what the spreads value is today. You’ll notice that it’s a curved line, versus the straight lines for the bull put at expiration. As long as you stay to the right of the break-even point just let the spread work. When it goes to the left, and you begin losing, and you’re out of the profit zone, that’s when you want to watch closely and make sure you don’t allow the loss to get out of hand. This is when I use my easy to follow exit rules.
3 things to know before you enter a credit spread:
- How far out you’re going to set up your credit spread.
- The trade's delta. (delta of .10 - .20 depending on your risk tolerance)
- Understand the risk profile and follow previously defined profit/loss exit rules.
I always put the profit zone on my chart, so that I’ve got a visual look on the chart and follow the risk profile.
The Best Equity|ETF to Trade Credit Spreads
You can set up credit spreads on any stock, but the less-expensive/liquid ones produce a smaller credit. Therefore, I trade the big liquid names like Amazon, Google, Priceline, the Russell 2000, and the S&P 500 indices.
These are the credit spreads that I got for the big boys — over $1, in most cases. Compare that to common stocks that are trading right around the $50-$100 region, where you’re only getting about a quarter of the credit. On Verizon, you’re only getting about 19 cents. These credits were all based on a bull put spread just 43 days from expiration with a delta of 0.1, and with a 10-point spread.
The problem with the less expensive stocks, where you get less credit, you might have slippage. I always put the price in at the mid-point — halfway between the bid and the ask which the floor traders may not be able to fill (slippage), tack on commission and your trade prospects dwindle quickly. That does not occur with the big boys. Let’s say this slips from $100 to $98. You pay commission on that, and it drops down to $95. You only have a 5-percent possible drop.
I hope I have demystified credit spreads for you. The thing to remember is to make sure you setup the trade at a delta that suits your risk tolerance, optimize your strike price differences, and now when to take profits and when to kill a bad trade. Happy trading, everyone.
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