Trading Credit Spreads

by Chris Johnson and Jon Lewis | May 18, 2010 12:17 pm

Most option strategies require the underlying stock to move sharply in the right direction. Speed of movement, magnitude of the move, and a move in the right direction all must happen to be successful.

But what about a strategy that benefits if a stock doesn’t move? In fact, the strategy can yield a maximum profit even if the stock moves somewhat against your directional view. How is that possible?

New Coming Soon![1]

The strategy is a credit spread, which involves the simultaneous purchase and sale of either puts or calls with the same expiration. If you believe a stock will stay flat or move higher, the credit spread involves buying and selling puts. If you are neutral to bearish, you do the same with calls.

We prefer using out-of-the-money options, buying the option that is further out of the money and selling the option with a strike price closer to the stock price. Because the near-the-money option has more premium, you collect a net credit when opening this trade.

The goal of a credit spread is for both options to remain out of the money through expiration. If that happens, both options expire worthless and you retain the premium, without incurring any extra commission costs[2].

Let’s look at an example using the SPDR S&P (NYSE: SPY[3]), which is sitting around $113.40 late Monday afternoon. Let’s say we think SPY will stay flat or drop over the next week. We can open a bearish credit spread in which we sell the SPY May 116 Calls for 29 cents and buy the SPY May 117 Calls for 16 cents. The net credit is therefore 13 cents, or $13 per pair of contracts.

This spread is about 2.3% out-of-the-money. That is, SPY will have to move 2.3% higher before the sold call (at the $116 strike) is in the money.

Profit Potential

There is a margin requirement for credit spreads equal to the width of the spread (one point in this case) minus the amount of credit collected.

So the margin for our example is 87 cents or $87 per pair of contracts. The return on margin is simply the credit received ($13) divided by the margin ($87), or 15%.

That may not sound very attractive for an option strategy, but considering that the trade will be in effect for less than a week (May options expire on Friday), 15% for one week is not a bad deal.

Our goal with this trade is for SPY to remain below the sold call strike ($116) through option expiration (the end of this week). If that happens, both options will expire out of the money (worthless) and we keep the 100% of the credit for a 15% percent return on margin.

Advantages of Credit Spreads

This trade points out two important advantages of credit spreads.

First, the trade will achieve its maximum return over a wide range of outcomes. Note in our example how SPY can move higher — against our expectations — by more than three points and we still have a maximum outcome because the sold $117 call remains out of the money.

So we can be wrong about direction (to a certain degree, of course) and still be very successful. There aren’t too many strategies that can make that claim!

The second advantage is that a winning trade involves no extra commission costs. Both options expire worthless, and no additional actions are required. You just pocket your winnings! This increases the net profit, although you also must recognize that two commissions are required to enter the trade.

However, you can usually enter this as a spread to incur just one commission cost along with the typical per contract cost.

Let’s say you want to trade five spreads and your broker charges $10 per option trade plus 75 cents per contract. You would pay $17.50 to enter the trade — $10 plus 10 contracts at 75 cents apiece. Of course, you pay nothing to exit a winning trade.

Tips for Trading Credit Spreads

Before playing a spread, keep these pointers in mind:

We prefer to trade credit spreads using front-month, out-of-the-money options. Typically, we’ll trade these spreads with a week or less remaining until expiration (such as this week). Why? Because we’re using out-of-the-money options, their premium is comprised totally of time value. Remember that options undergo time decay such that there is no time value remaining at expiration.

Furthermore, this time decay increases as an option approaches expiration. Therefore, we are trading these spreads when time value is undergoing its greatest decay, which is an advantage to us. We want the options to be worthless, so trading them close to expiration gives us the greatest decay and gives the underlying stock or index less time to move such that our sold option could move into the money.

Second, the key is not for the stock to move in your direction, but for it to not move against you to the point where your sold option is in the money. Unlike buying an option, direction and speed of movement are not important. You gain no extra benefit if the stock moves in your favor, as the value of your trade will not increase beyond the credit received. But you can be hurt if the stock moves against you.

Third, understand the variables in play with credit spreads. You can adjust the width of your spread (the difference between the options’ strike prices) to alter the credit received. A bigger spread results in greater credit. But the wider the spread, the less protection you have until the “protection” of your purchased option kicks in. You’ll also have to put up more margin as the spread widens.

The art of playing a spread is to juggle the credit, spread width, and the amount the sold option is out of the money. You’ll receive more premium if the option is closer to the money. But the risk of that option moving into the money, and thus of being assigned (having the option exercised), also increases.

Win Small, Over and Over

Playing credit spreads is a great way to make small profits with a high win rate. They can be used in any type of market, especially with trading ranges, where directional moves are contained.

We’ve traded credit spreads very successfully in the Winning Edge[4] service. In fact, since last August, we’ve logged 12 maximum winners in 13 trades. That’s a 92% win rate, something you won’t find in straight option buying. We like to trade at least one per month, usually during the week of expiration (we have a couple in mind for next week).

If you’re not in the service, try paper trading[5] these spreads for a few months (just before expiration) to get a feel for how they work. Once you’re comfortable with their behavior, they’ll be a great addition to your trading arsenal.

Tell us what you think here.[6]

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