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Trader's Guide to Credit Spreads

SPCFD:SPX   S&P 500 Index
The strategies and ideas presented in this guide have been designed to provide you with a comprehensive program of learning. The goal is to guide you through the learning experience so you may be an independent, educated, confident and successful trader. There are numerous variations of traditional options strategies and each has a desired outcome. Some are very risky strategies and others require a considerable amount of time to find, execute and manage positions. Spreads are a limited risk strategy.

Spreads

Spreads are simply an option trade that combines two options into one position. The two legs of one spread position could have different expiration dates and/or different strikes.

Spreads can be established as bearish or bullish positions. How the spread is constructed will define whether it is bullish (rising bias) or bearish (declining bias).

Different types of spreads can be used for the same directional bias of the stock. For example, if the stock has a declining bias, a call credit spread or a put debit spread could be opened to take advantage of the same anticipated move down.

In this guide we will be talking about Credit Spreads, which are a limited risk strategy. Learning how to manage risk is as important as learning the details of a strategy.

Credit Spreads

A credit spread is created when an investor simultaneously sells-to-open (STO) one option and buys-to-open (BTO) another option. The premium received for the STO is always greater than the premium paid for the BTO thus creating a net credit to the account.

Example:
  • STO a call using the 120 strike for a credit of $5.20
  • BTO a call using the 130 strike for a debit of $3.80
  • Net credit for the spread is $1.40 = 5.20 credit - 3.80 debit

The ideal construction of a credit spread is to sell-to-open (STO) an out-of-the-money (OTM) strike and buy-to-open (BTO) the strike that is 5 – 10 points further out-of-the-money (OTM) using the same expiration. When opening a call credit spread, further OTM means a higher strike. When opening a put credit spread, further OTM means a lower strike.

Both legs are opened on the same underlying equity and use the same expiration month.

Call credit spreads are opened when there is a declining bias and will be profitable if the stock moves down. This is because a call credit spread is opened for a credit and since the value of a call option decreases as the stock goes down, at some point the spread will be bought-to-close ( BTC ) for less than it was sold-to-open (STO).

Here is an example:
Stock trading at 500 and has a declining bias.
  • STO 510 call
  • BTO 520 call
This spread creates a credit of $4.80

Stock declines to 490 causing the values of the calls to also decline. The position can now be closed for a profit.
The cost to buy back the spread is only $3.80. Since the stock declined in value, the call options are cheaper.

The spread was STO for a credit of $4.80 and BTC for a debit of $3.80 resulting in a $1.00 profit.

Put credit spreads are opened when there is a rising bias and will be profitable if the stock moves higher. This is because a put credit spread is opened for a credit and since the value of a put option decreases as the stock goes up, at some point the spread will be bought-to-close ( BTC ) for less than it was sold-to-open (STO).

Here is an example:
Stock trading at 520 and has a rising bias.
  • STO 510 put
  • BTO 500 put
This spread creates a credit of $3.60

Stock rises to 530 causing the values of the puts to decline. The position can now be closed for a profit.
The cost to buy back the spread is only $1.80. Since the stock went up in value, the put options are cheaper.

The spread was STO for a credit of $3.60 and BTC for a debit of $1.80 resulting in a $1.80 profit.

Time decay is a positive factor in trading credit spreads. Since the position is opened for a credit, money comes into the traders account immediately. As time value decays, combined with a favorable movement of the stock, the value of the position will decrease allowing the trader to buy-to-close ( BTC ) the position for less than it was originally sold-to-open (STO).

Risk and Reward on Credit Spreads

Reward

The maximum profit that can be earned from a credit spread is equal to the net credit received when the spread was opened. For a credit spread to realize the maximum profit, both legs of the spread would need to expire worthless which means the position would need to be held until expiration and be out-of-the-money at expiration.

It is not advised to hold positions until expiration. Short term movements in the stock plus time value decay provide opportunities to close out positions for a profit of, generally, about 10%. If a position is profitable and the trader decides to hold the position hoping for a bigger profit or in an attempt to carry the position to expiration, there is a good chance that the profit can disappear, and the position could turn into a losing position.

A good way to lose money is to wait for a bigger profit.

Risk

The maximum risk, or potential loss, from a credit spread is the difference between the two strikes minus the net credit.

Example:
  • STO 120 call for a credit of $5.20
  • BTO 130 call for a debit of $3.80
  • Net credit for the spread is $1.40

    The difference between the strikes is 10 points. $10 is the max risk less $1.40 credit = risk of $8.60. The maximum profit is equal to the net credit, $1.40.

    Losses occur when the short strike (the STO leg) is in-the-money at expiration. This is because the trader has sold to someone else the right to buy the stock at the short leg strike. Since the trader does not actually own the stock, they will need to buy it and sell it at a loss.

    A maximum loss will occur when both strikes are in-the-money at expiration.

    The breakeven point on a bearish (call) credit spread is the lower strike price plus the net credit. Referring to the example above, if the stock settled at 121.40 at expiration, there would be no loss and no profit.

    Example of breakeven point on above credit spread:
  • Stock trading at 121.40
  • Buyer exercises the right to buy stock from you at 120.
  • Since you do not own the stock, you buy it at the market price of 121.40 and sell it at 120. This results in a $1.40 loss
  • You get to keep the original credit of $1.40. This netted against the $1.40 loss results in breaking even on the position.

    The breakeven point on a bullish (put) credit spread is the higher strike price minus the net credit.

    Calculating the Return

    There are two ways to view the percentage return of profits from a credit spread. One is to divide the profit by the difference between the strikes. If the difference between strikes is 10 points and the trade resulted in a $1.00 profit, that would be a 10% return ($1.00 / 10).

    The second approach is to calculate the return based on the amount of capital that was at risk. After all, if the trade lost 100% of the risk, that is the amount the trader would no longer have. So, the profit percent is calculated by dividing the profit by the risk. In the example above, the net risk is $8.60. If the credit spread trade resulted in a $1.00 of profit, the percentage return would be 11.63% ($1.00 / $8.60). This approach shows the importance of managing risk. Lower risk drives higher returns relative to capital at risk.

    Opening a new Call Credit Spread
    The following steps should be referred to when opening a new call credit spread position:
    1. Review the technical indicators on your chart and confirm there is a consensus between multiple indicators pointing to a declining bias.
    2. Select an expiration that is two to four weeks out. Two weeks is generally the minimum time to expiration you want to use. Building time into options positions is advised in case it needs to be managed. The sweet spot for opening new positions is three weeks to expiration.
    3. STO an out-of-the-money (OTM) call strike.
    4. BTO the strike that is 5-10 points further out-of-the-money (OTM). With a call spread, further OTM means a higher strike. Generally, when properly constructed, the credit on a 5 point spread will be in the range of $1.20 - $1.80. A 10 point spread will generally be 2.50 – 3.50. The closer the strikes are to the current price, the higher the credit, while this reduces the overall risk of the position, it also increases the chances of the position moving in-the-money ( ITM ) which can result in an overall loss.
    5. When placing the order, always use a Limit Order. A limit credit order specifies to the market the amount of the credit you will accept. A limit credit order will be filled at the specified limit or higher. Market orders should not be used.
    6. With some stocks and indexes, the difference between the bid and ask is quite large. The broker will usually give you a quote called the “Mark”. This is the midpoint between the bid and ask. It is the price you should start with when submitting your limit credit order.
    7. Calculate the risk of the position. Difference between the strikes – credit = risk. A position with a credit of $4.50 and 10 points between the short (sold) and long (buy) strikes would have a risk of $5.50.
    8. Use the risk number to determine the number of contracts to open. Risk x 100 = the investment required for each contract. With $5.50 of risk and 1 contract, the total investment would be $550. ($5.50 x (1 contract x 100 shares per contract)). The total investment on 4 contracts would be $2,200. ($5.50 x(4 contracts x 100 shares per contract)).
    9. Once you know the total investment required per contract, you can decide how many contracts to trade based on the size of your portfolio and personal risk tolerance.
    10. After the trade has been opened, place a Good-til-Canceled ( GTC ) order to close the position. A GTC order will stay active until market conditions are such that the position can be closed for a profit. GTC orders execute automatically and do not require you to be in front of your trading platform to take advantage of the profit opportunity. Place the GTC for a limit debit price based on your desired profit target. One example is to set a GTC for 50% of the credit you received when you opened the position. With a credit of $4.50, a GTC would be placed to buy to close the position at $2.25 allowing a $2.25 profit.





Comment: It should be noted that Credit Spreads on American Style expirations should generally not be held overnight if they are in-the-money, as they can run the risk of exercise/assignment. Ideally the out-of-the-money credit spread should be closed or managed before the week of expiration. This will limit the risk of any exercise/assignment.

One way to completely eliminate the risk of exercise/assignment on credit spreads is to trade European Style expirations on the cash indexes (SPX, RUT, NDX) and never hold until expiration. As mentioned in our Trader's Guide to Options, European Style options may only be exercised or assigned at expiration.
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Comments

One of the riskiest and least understood plays IMO. The short leg entails great risk in melt-ups like we saw on 6/30; in a ten-dollar spread the long call will not appreciate nearly as much as the short call, which could easily double or even triple. When shorting weeklies, the ten-penny long contracts will remain nearly worthless, other than to limit margin use on the spread. If you bought them for a dime, they won't get over a quarter, unless they go ITM, but the short legs can wipe you out. I have lost tens of thousands on these vicious animals. Have also made enormous bank when there is a selloff, but mostly these just kill you.

There is considerable hidden risk in possibility of early exercise, or exercise on expiration day. If the short contracts close within a dime of the strike price, MMs will exercise them for arbitrage to get the nickel difference on stock price or ETF spread. So you can expect a huge margin call when you broker buys shares at the market and delivers them to satisfy the contract. It is possible to sell far more contracts than you could possibly hope to deliver; just week before last a guy offed himself from doing this, after he got a $750K margin call.

How this can go bad real fast:
SPY traded around $310 today; from listed closing prices: sell 100 calls on SPY strike 315 for $2; buy 100 calls strike 325 for 0.25c: expiration next week (10 July 2020); collect net credit of $1.75 (@2 - 0.25c) on 10000 shares (100 contracts) that's a net credit of $17,500, sounds great! But, ooo I have to risk maximum loss of $100,000k on a $10 spread!

Your maximum risk is 325 - 315 = $10 on 10000 shares SPY. Margin required for this trade is rather small, depending on your broker, 5-10%, so you could short 100 contracts on as little as 10K for $10 spread, of if that makes you nervous (and it should), you can write a $5 spread, get a bit less, as of COB on 1 July 2020, the $320 calls are 0.75c, so you collect $12,500 and risk only $50K. Yes you can lose $50K on a $5k margin vertical spread!

Any trade that could lose ten times what you wager should give you pause IMO. What you will discover, as the spread approaches expiry, is your long legs will dwindle to pennies and become worthless, while the short leg holds value and may even increase. These work real well in downtrends but bear rallies can still kill you. In March we saw days that gapped up over 100 pips at open. Your short legs would be ITM overnight and NOTHING you can do for it! Instant kill...

The real joy in these positions comes if your short legs go In The Money (ITM) on expiration with a melt-up; you will then have to deliver 100 shares of ETF or stock for every contract if exercise is assigned; on 100 contracts, can you afford to buy 10K shares for $315 and deliver these to the callholder? It's $3.15m to buy the stock... for which you got $12500 credit. Early exercise DO happen. If you write a vertical credit spread, it cannot be left unattended! You must watch it!
Reply
NewCycleTrading DaddySawbucks
@DaddySawbucks, Thank you for your comments! I posted an update on how to avoid exercise/assignment when trading credit spreads. I have personally traded credit spreads for many years and stick to the cash indexes such as SPX since you can only be exercised/assigned at expiration and behaves much differently with that exercise and assignment since it is a cash settled index.

In your SPY example it looks like the expiration you are using is quite close. As we recommend above, 3 weeks until expiration is generally the sweet spot. This allows time for position management, if necessary. So, that would put the expiration at 7-22 for both strikes. Currently the 7-22 expiration for a 315/325 credit spread gives a credit of about 3.06. Potential profit on one contract is $306, potential loss on one contract is $694. It is always important to be aware of your personal risk tolerance and never risk more than you can afford to lose, regardless of how much margin is required by the broker.

You are correct, American style expirations do require some attention, and can easily be done via price alerts when the stock/ETF moves close to the short leg and taking action on the position prior to the week of expiration.

Again, thank you for adding to this discussion!
Reply
DaddySawbucks NewCycleTrading
@NewCycleTrading, YVW, I read your comment about exercise, ty for posting, this is a trap that most novice traders never realize until they get served with an exercise notice! Yes selling a 3-4 week contract is the best trade-off for credit received vs risk exposed. However, given the wild price swings we've seen of late, 3 weeks is an eternity! The time to sell a vertical call (Bear) spread is after a melt-up rally; the time to sell a vertical put (Bull) spread is right after a massive selloff. There is absolutely no guarantee that the trend might not just continue in the next sessions, squeezing your position painfully. Best advice to a new trader trying this position on for the first time; "Start small and sell far OTM!"

If using Etrade, the broker will automatically exercise your long options on your behalf when they expire in the money; they will exercise your contracts and simultaneously buy or sell the shares, netting you any profit less commission fees. BUT if you are SHORT an option and exercise is assigned (it will be assigned, 100% if it expires ITM!), the broker will deliver the shares if put to you, or buy shares at market and deliver them if called from you, in either case billing you for fees, commissions and margin interest. If you do not have sufficient funds to meet the margin call, they will restrict and then lock your account and eventually get lawyers and collection agents to squeeze it out of you.

If this happens, do not despair, and FGS please do not auto-mort, as some have; lawyers will argue about who owes what and eventually insurance agencies will pay for the broker's losses. Chapter 11 beats lining a coffin and you will live to trade again one day (carefully!).

Timing is crucial when writing these spreads, you have to be judicious and look for trend change signals to time entry. These spreads are also part of a complex vicious trade called the Iron Condor, which is essentially a bull vertical put spread combined with a bear vertical call spread. Given market volatility, it is quite possible to lose money both ways on these 'dread spreads' when a meltup or meltdown occurs and you get scared out of one side, then violent whipsaw reverses the prices and you lose the other side too. If you write a Condor, and get forced out of one side, for God's sake close both sides together! Good advice in this post, tyvm for marvelous detail, well worth a careful read;

"A good way to lose money is to wait for a bigger profit."
Reply
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