Option Based Credit Spreads

  • October 7, 2020

Have you tried trading option based credit spreads? Trading credit spreads with a mythical twist.

Credit spreads are a relatively low risk way to trade volatility with any account size. Your risk is limited but so is your reward. The objective is to risk as little as possible.

How to Trade Option Based Credit Spreads

  • Let's learn more about option based credit spreads. I like to trade $0.50 spreads over a really short time frame on contracts that are about a month out. My goal is to sell spreads with no more than $10 risk per spread. Oftentimes my risk is just $5 per spread. Everyone will have their own set of Standards when trading credit spreads this is just my preference.

Sometimes I will trade $1, $2.50 and even $5 credit spreads on equities that do not have $0.50 spreads but only when they are quite volatile.

Yes I have traded spreads on GOOG and even AMZN. If the volatility is there and the premium is right I will use my chart analysis skills to take advantage of premium.

I haven't traded credit spreads on SPY because it almost never qualifies for my risk to reward ratio tolerance. Penny stocks rarely offer profitable credit spreads but sometimes have great potential for covered strangles.

Option Based Credit Spreads

1. Do Your Due Diligence

Like any other trading strategy it's going to take a little bit of due diligence to trade option based credit spreads profitably. My strategy is to trade in and out of the spreads within just a few days.

That much premium in a spread usually means that it is very likely to expire in the money. Most of the time I will buy to close the spread for a small profit.

But there are plenty of other ways to trade them and sometimes you can just let them expire out of the money. When that happens you get to keep all of the premium.

However, tight spreads close to the money with low risk will rarely expire out of the money. There is more to this strategy but I'll get to that towards the end of the article. For now let's go over the basics.

2. The Basics

Let's start on the basics of option based credit spreads. The prevalent idea is to get the most premium possible without assignment risk.

As such the most important factor is your risk-to-reward ratio. This is as simple as weighing the distance between the strikes versus the premium received.

First you have to consider a simple fact. When you are trying to get the most premium from a credit spread. You are relying on implied volatility, skewed Delta between the strikes and thus skewed  extrinsic value. This usually only happens with volatile equities.

Looking for volatility events will be key when choosing an equity to sell spreads on. Assessing your risk to reward ratio will be a deciding factor along with open interest and expiration.

Ideally I find this strategy to be very successful when trading equities that are channel bound between support and resistance. One reason spreads are so popular, is their ability to limit risk.

3. Another Strategy

Another strategy for option based credit spreads is to sell a spread that's so far out of the money there's very little chance of the short leg expiring in the money.

Usually the risk reward ratio wouldn't be that great when the spread is just a few strikes out-of-the-money when trading contracts that are 1 month out.

If you were considering a $0.50 spread far out of the money you would likely have a 1:1 ratio or $25 risk for a $25 reward or somewhere close to that.

More often than not wider spreads will have the same effect. Your risk will be greater and your reward will be smaller. I like trading ridiculously tight spreads but there is a reason for that.

You can have the spread be any width you want. But the further the strikes are from each other the lower your reward ratio will be; especially if you are trading contracts that are one month out. It can still be profitable but the risk-to-reward ratio isn't as appealing.

Spreads that are further out of the money have a much lower assignment risk and if you are patient you can usually just let them expire worthless and keep the premium. That's all fine and great but I have another idea.

Some of the experts would probably wonder why the hell I would consider a $0.50 spread one month out when I have to be really close to the money to get that kind of premium for it. The chances of making a profit on it are actually pretty slim.

How Do You Do a Credit Spread?

  • Option based credit spreads are opened when you buy one option and sell another option with a different strike but same expiration as the first. If this sounds a little complicated, read our post on options trading for dummies part 1to get the basics on options.

There are two ways the strategy can go but I have an even greater goal in mind. At my core I am a swing Trader. I like to buy at support and sell at resistance.

Worst case scenario I take a small loss. In some cases I will have to close my spread for a small profit or at break even if necessary.

That's why we can simply buy to close a spread when the trade moves against you. The important thing to remember is that if you need to close a spread you should never close it for more than the distance between the two strikes.

1. Options Based Credit Spreads Expiration

If you can't close it for the maximum loss you can simply let it expire but you should make sure you read the fine print in your brokers options policy. 

Make sure that they will automatically exorcise your long option if you are assigned on your short option. Most brokers do this but it is up to you to know for sure.

Likewise, you should be aware of option assignment and exorcise fees. Also you may be in for a freaky weekend with a temporary short position.

For instance, I once had been assigned on a GOOG put. With about $1k in my account. My balance was -$145,000 from Friday night until Monday morning.

Needless to say I had fun freaking my wife out but I knew what was going on. Sadly there've been instances of people panicking over situations like this.

You have to know that you can only ever lose your maximum loss in a credit spread which is the difference between the two contracts less the premium received.

If this situation should arise please prank your spouse responsibly. Make sure your spouse is sitting down and not being prescribed any heart medication.

2. Here's Where We Get Schwifty

If I sell a put credit spread that is either in the money, at the money or straddling the share price while the share price is at support, I can take advantage of the put credit spread; losing value as the price moves away from it.

If the share price breaks out and has very little chance of threatening my short put. I can simply let it expire worthless. If things start to turn against me I can capture more premium if I sell a call credit spread when price is at resistance.

If I sell that $0.50 call credit spread with the same expiration for anything above my risk on the put credit spread I have created the mythical Positive Delta Iron Condor. 

Of course I would prefer to sell that spread for $40 to $45 but anything above my risk on the put credit spread will eliminate all risk.

That's to say that I can let the whole thing expire. Even if one of my short options is in the money I will still make a profit. Ultimately I'd rather let a simple credit spread expire worthless.

Knowing that I have positive Delta in an iron condor takes away all of the stress involved and leaves me free to take on other positions.

The profit from a Positive Delta Iron Condor will be the average of the premium received from the two spreads less the average of the risk of the two spreads.

Since only one spread could possibly close in the money your maximum loss will be $0. Your minimum gain will be anywhere from $1 to the maximum of the width of the spreads.

3. Option Based Credit Spreads Example

Example, if your average risk is $10 and your average reward is $40 your minimum profit will be $40-$10=$30 if one spread expires in the money.

If neither spread expires in the money you get to keep all of the premium from both spreads i.e. $40+$40=$80!

This strategy can also be opened in reverse. You can sell a call credit spread at resistance and either close at support, let it expire worthless or sell a Put credit spread to create your Positive Delta Iron Condor.

This strategy has served me well on many volatile stocks that I have found to be channel bound or swinging between support and resistance repeatedly. I have even used this strategy on bull flags and bear flags.

So far my most fruitful use of this strategy has been with UUP. For example, however I had to increase time on the trade by selling spreads that were 6 weeks to two months out.

This strategy can also be used on some slower moving equities and ETF's although you will likely have to move into expiration that is 2 to 6 months out to be profitable. Sometimes I'll even sell leap credit spreads.

Bottom Line

Trading option based credit spreads can be quite versatile and you can tweak the strategy any way you want. Just remember the primary focus should always be your risk to reward ratio.

You can trade them on trends, reversals, channel swings, volatility events and even on IPO's that have been trading long enough for options to become available.

Whether you're trading options with Robinhood or a different broker, you can take profit you can simply buy to close and move on to your next trade.

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