Credit spread trading strategy

Option Credit Spread Strategy: An Opportunity For Success.

Founder and CEO, OptionsANIMAL.

Every trade has a personality. Every trade represents an opportunity for success and an opportunity for failure. The choices you make about what, when, and how much define your success. You make those choices based on the personality of the particular trade. Options are perhaps the most personality driven of all trading instruments.

Understanding the different strategies available for use in options trading is like a golfer understanding the different clubs in his/her bag. A driver in a very useful club, but should not be used in every situation on the golf course. It is awfully hard to putt with your driver. It is equally as hard to chip out of the sand with a putter. Let us look at a pretty common personality for options—a bullish credit spread—and how that personality should be played in the market: just like the right club should be played on the golf course.

A bullish credit spread should not be used in every scenario in the market. It is important for you, as a trader, to know the different trading tools available for any market scenario. Meet a bullish credit spread here, and understand its personality.

Profit/Loss Diagram of Bull Put Spread.

One of the key trading tools I employ regularly is the bullish put vertical, or Bull Put. This trade is applied in a stagnant or stagnant-to-bullish trend. The bullish trend can be slight, moderate, or accelerated. You will be selling a Put and buying a Put simultaneously. The Put that you short (sell) will be at a higher strike price than the Put that you long (buy), and therefore you will generate a credit to your account. This credit is your maximum profit. The strategy with this trade is to capture the effects of time decay on the option sold, as well as take advantage of a bullish move in the stock. The put option that you long (buy) is your hedge, in case the stock moves quickly in the other direction.

Primary and Secondary Exit Strategies.

As with all trades it is important to have both a primaryandsecondaryexitstrategy. If you miss the green on the golf course, what will you do to save par? The primary exit strategy for the Bull Put trade is to let both the long put and the short put options that you hold expire worthless. The added benefit to this exit strategy is that you will eliminate the commissions on the back end of the trade by simply allowing the options to expire worthless. The secondary exit strategy can involve either closing out the position for a small pre-determined loss or convert the trade into a collar trade. Let’s take a look at an example.

1. You “sell to open” a July 50 Put for XYZ Corp. $1.50 per share;

2. You “buy to open” a July 45 Put for XYZ Corp. $0.50 per share;

3. Your net credit for the trade: ($1.50 - $0.50) = $1.00;

4. With one contract per leg (a total of 2) you would generate a profit (credit) of $100.

Rules of the Game: Basic Rules to Follow When Applying Credit Spread Trades.

1. Use Out of the Money (OTM) options. Credit spreads can be written At The Money, but have a higher risk of assignment. By structuring this trade in a way where you are writing an option far from the current stock price, it increases your probability of success with the trade.

2. Look for options high in implied volatility. Overpriced options are generally a good thing to sell. Oftentimes there is a reason why implied volatility is high, so make sure there is not significant fundamental risk in the stock before placing.

3. Use strike prices that are side by side. Try to stay to 5-point spreads when using short-term credit spread trades. You can go smaller if they are available. The closer together your spread, the lower your risk.

4. Trade with the market trend. Do your due diligence. This is a trade that truly does follow the old saying, “The trend is your friend”.

5. Where is the risk in this trade?

a. We have an OBLIGATION to buy the equity at the strike price of the short put;

b. We have the RIGHT to sell the same equity at the strike price of the long put;

c. Our risk is the difference between those two actions;

d. (However, we do get to keep the net credit.)

6. Short Put is best placed at or below support.

7. Do not place this trade during an option series where a scheduled news event (like earnings) could cause the equity to change its direction rapidly.

8. Set a minimum and a maximum credit needed based on the time until expiration and your tolerance for risk.

9. Time decay is an ally (this is a credit trade).

10. Long Put is used to minimize and control risk.

a. You can use spreads as small as $1.00, when available, if you wish.

There is an old saying, “You’ll never go broke taking a profit.” This is the strategy behind credit spread trades . Put money in your pocket . It may not be a significant amount of money but, when structured correctly, these trades have a very high ratio of success. Winning more consistently is the single most important thing a trader can do. Understanding the personality of the trade will allow you to make the right decisions on how to play it, and increase your profitability. Trading, like golf, is a game of practice, discipline, and skill.

For more information on how to structure other trades like the Bull Put and how to adjust losing trades into winning trades, visit optionsanimal.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.

Credit Spreads.

A credit spread is an option spread strategy in which the premiums received from the short leg(s) of the spread is greater than the premiums paid for the long leg(s), resulting in funds being credited into the option trader's account when the position is entered.

The net credit received is also the maximum profit attainable when implementing the credit spread option strategy.

Vertical Credit Spreads.

Bull Credit Spread.

The bull put spread is the option strategy to employ when the option trader is bullish on the underlying security and wish to establish a vertical spread on a net credit.

Bull Put Spread.

Bear Credit Spread.

If instead, the option trader is bearish on the underlying security, a vertical spread can also be established on a net credit by implementing the bear call spread option strategy.

Bear Call Spread.

Non-directional Credit Spread Combinations.

Spreads can be combined to create multi-legged, credit spread combinations that are employed by the option trader who does not know or does not care which way the price of the underlying security is headed but instead, is more interested in betting on the volatility (or lack thereof) of the underlying asset.

Bullish on Volatility.

If the option trader expects the price of the underlying security to swing wildly in the near future, he can choose to implement one of the following spread combination strategies on a net credit.

Bearish on Volatility.

If instead, the option trader expects the price of the underlying security to remain steady in the near term, he can choose to implement one of the following credit spread combination strategies.

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Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

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As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls.

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls.

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Day Trading using Options.

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It.

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity.

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks.

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks". [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis.

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

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Risk Warning: Stocks, futures and binary options trading discussed on this website can be considered High-Risk Trading Operations and their execution can be very risky and may result in significant losses or even in a total loss of all funds on your account. You should not risk more than you afford to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Information on this website is provided strictly for informational and educational purposes only and is not intended as a trading recommendation service. TheOptionsGuide shall not be liable for any errors, omissions, or delays in the content, or for any actions taken in reliance thereon.

The financial products offered by the company carry a high level of risk and can result in the loss of all your funds. You should never invest money that you cannot afford to lose.

The Risks of Weekly Credit Spreads.

There are hundreds of options trading "gurus" promising you all kinds of ridiculous returns like "5% per week". What most traders don't realize are the risks that come with those returns. I would like to share with you an I got from one of those options "gurus".

Short term weekly options trading remains a tough road in 2016 as the weekly market volatility is whipping around weekly option traders. Case in point, our newsletter experienced a losing trade last week as bulls hammered markets higher. The loss was unfortunate but what really stood out to us were the reactions and sheer surprise of some traders.

Below is a copy of what we sent to our members over the weekend to remind them of just how aggressive (and volatile) weekly options trading can be:

Last week's loss stings, of course. The market ground higher all day Friday eating further into the expiring call spread. What was worse was that prudent adjustments for the trade were nonexistent.

Our weekly credit spreads are highly exposed to Gamma (the option greek) and the latest trade was a textbook example of it. As SPY ground higher debits to adjust exceeded $0.10 to simply the move the trade out a week and up $0.50. Doing so would have resulted in the new adjusted trade still being well in the money. We have been bitten before by that bug (paying to adjust higher while not actually reducing the risk to the new adjusted trade) before in March 2016 and did not want to repeat that experience.

The issue with weekly credit spreads is that everybody likes the fast pace weekly profits of weekly credit spreads until they take a loss . The weekly credit spread game is that there are many, many small profits and the losses are ALWAYS larger than the gains. That is how it works. That is risk curve of weekly credit spreads.

Although, when a loss occurs, retail traders become flabbergasted. The biggest misstep most retail traders make is underestimating the aggressiveness of our newsletter (and weekly credit spreads in general) due to its years of fairly smooth profits.

Retail traders are lulled into a false sense of security with weekly credit spreads forgetting that along with extreme profits (>4% per week and >100% per year) comes a healthy dose of risk. Look at it from another view: If large profits like that were easily available at low risk wouldn't everybody be producing them ? Mutual funds and the like?

Weekly credit spreads are very volatile and aggressive; despite how their ease and consistency can lull you into a sense of safety. Think about, you don’t make >4% PER WEEK by not taking risk.

The real success and consistency over the long term in selling options is using expirations further out.

I appreciate the . Those are very wise words. Too bad this came after two devastating losses the newsletter experienced in 2016 (150% and 69% losses before commissions).

From the FAQs of this newsletter:

Q: How much money can I lose?

A: You can lose $100 per spread traded, less whatever we received as a credit when we entered the trade. We do everything we can to prevent large losses and have yet to have greater than a -15% loss on any trade. Statistically and as experienced in our Track Record, losses should not occur very often.

As we mentioned here: Often times you'll find this in a credit spread newsletter where the big loss just hasn't happened yet (it will).

Here is the problem with weekly credit spreads: most of the time, they will do fine, but if the market really does go south the position will be in trouble well before the short options go in-the-money. If the market drop is fast and severe (e. g., flash crash) there will be nothing you can do - the trades will be blown out with no way to recover, your entire investment will be gone.

We warned about those "easy gains" several times. This is what we wrote in Can You Really Make 10% Per Month With Iron Condors? article:

Here are some mistakes that people do when trading Iron Condors and/or credit spreads:

Opening the trade too close to expiration. There is nothing wrong with trading weekly Iron Condors - as long as you understand the risks and handle those trades as semi-speculative trades with very small allocation. Holding the trade till expiration. The gamma risk is just too high. Allocating too much capital to Iron Condors. Trying to leg in to the trade by timing the market. It might work for some time, but if the market goes against you, the loss can be brutal and there is no another side of the condor to offset the loss.

Unfortunately, many options gurus present those strategies as safe and conservative. Nothing can be further from the truth. As mentioned (correctly) in the above , weekly credit spreads are very volatile and aggressive. You should allocate only small portion of your options account to those trades.

Want to learn how we reduce our risk?

Edited November 15 by Kim.

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Baseline Strategy for Trading SPY Put Credit Spreads.

When I got interested in trading credit spreads, like most I harbored some skepticism. A credit spread trade seemed to be the type that works—until rather dramatically it does not. More than once I put on a series of successful trades and then Dr. Jeckyll transformed into his evil alter ego Mr. Hyde and suddenly I was blowing up my account. Clearly, I did not know what I was doing. On the verge of giving up, I convinced myself that I was just missing something. And so a quest was born, my friends.

c I knew that I needed to build a reliable trading strategy using past data. But even backtesting offered little hope of success until I discovered my baseline strategy.

What’s a Baseline Strategy?

What I call a baseline strategy is a set of simple restraints (or signals) that I apply to a backtest to verify that a trading strategy is profitable (and beats the S&P 500). When I first devised my baseline strategy I did not think about credit spreads or options. Rather, I identified a trend to inform the thesis of my strategy. I focused on the SPY (an ETF tracking the S&P 500 index), a safe place to start because the price movement is pretty stable compared to individual stocks (in contrast, take a look at Netflix after an earnings announcement). Because credit spread trades expire I examined 30- and 45-day windows, which revealed that the movement of the SPY is pretty predictable (at least downward movement; see How Often the SPY Falls More Than 5% in a 30-Day Period and Why You Should Care). With this information about how the SPY moves I was able to form my thesis and start backtesting.

My Baseline Strategy.

My put credit spread baseline strategy is pretty simple. I look for 2 dollars-wide SPY spreads that are at least 4% from the current stock price. I do not consider any spreads that expire more than 45 days out, and I make sure the credit received is at least $0.18. Typically you can choose from about 10 credit spreads with different expirations, strikes, and credits received. For my baseline strategy I always choose the spread with the least risk—that is, the credit spread whose short strike is furthest below the current stock price.

In terms of trade frequency I have two other restraints: I only make one trade per day, and I never have two spreads that share the same short strike price (though two spreads might have different expiration dates). All of these restraints were born out of trial and error and guided by a mission to keep the baseline strategy as simple as possible.

When I backtested my baseline strategy from 2005 through 2014 I got the following results:

Simply purchasing the SPY and holding it during the same period would have returned 72.45%. In contrast, my baseline strategy returned 82.78%. If you are thinking, “Why bother?” I urge you to remember that the strategy is only a baseline. The next step is bringing in all the fancy signals (e. g., RSI, MACD, volatility rank, delta) to optimize the strategy. The beauty of the baseline is always having something to compare against as you optimize the trading strategy.

(It’s worth noting that the weekly SPY options did not become popular until early 2011, and if I backtest my baseline strategy starting in 2011 I beat the SPY by roughly 17%; this figure is approximate because I ignored dividends when comparing the SPY to the baseline strategy.)

A simple baseline strategy serves two very important functions: it confirms whether your strategy is effective and serves as a benchmark you can use later when optimizing your strategy with additional, more sophisticated signals. Most of the battle with a trading strategy lies in the preliminary development and subsequent optimization. A baseline is a great way to organize yourself in that critical phase to ensure that you end up deploying a SPY put credit spread trading strategy that’s more Dr. Jeckyll and less Mr. Hyde.

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