Options Strategies: Art of the Credit Spread 🎨

Photo by Erik Mclean on Unsplash

2021 is almost halfway over and the finance space is growing rapidly as interest in personal finance and investing are fueled by 100x returns in a matter of days (Cryptocurrency & Equities).

From these main asset classes, a couple of “ticker symbols” have gone to the moon and propelled investing into the brains of boomers and 10-year-olds alike.

I think we all know what these tickers are; *ehem GME & DOGE

That being said, this is an introduction to derivative spreads and how to trade them let’s goooooo 📈

*Guide requires background knowledge on options & and their mechanics. If you’re unfamiliar with the subject, check out THIS article for more info !!

Photo by Tech Daily on Unsplash

Part 1 — The Basics

Credit spreads are complex options strategies that employ the use of 2 options in a single trade.

4 Types of Spreads👇

• Put Credit Spread
• Call Credit Spread
• Put Debit Spread
• Call Debit Spread

This guide will mainly be covering CREDIT spreads, but if demanded I will put out a guide for debit spreads even though I don’t prefer them.

Similar to betting if a stock is either going up or down with puts and calls, credit spreads are directional plays that give traders an “edge” through a high POP and an optimal risk:reward ratio.

Because credit spreads allow traders to put forth collateral and receive a premium for taking on that risk, that means that we’re holding this position betting that the stock will either go in our direction or trade flat.

Example: FB Put CS (One of my existing positions at the time of writing)

• Thesis: Facebook is currently lying on a strong 5 year support line and is currently retracing back to that line. Assuming the trend holds, we can assume that FB will test the 5 year support and bounce off of it fluidly. Assuming no binary events in the short-term, we have a bullish outlook.
• Trade: FB support level is — $300, we’ll execute a 1 month long put credit spread where we bet that the stock will stay above 295 at the time of expiration. (Position: FB PCS 6/1 — 290p/-295p @$1.70 credit)
• Expiration Day: FB perfectly bounced off the 300 support line and has been slowly pushing back up to ATHs never coming down to test our short & long puts. Our spread is now worthless and we collect 100% of our net credit.

Mechanics of the Trade

When placing the short -295p we collect a credit on the trade because we define our risk profile by buying a protective leg that mitigates our loss. That’s why we can see that our loss line goes straight instead of just down.

• Ex. If we decided to just start a -295p position with a bullish outlook (@2.00c), things can go horribly wrong as we have a capped max profit and unlimited downside. If for some reason FB announced a spontaneous hack had been done on their security systems, FB stock would tank and put our position at a significant loss

Instead of having a spread where our max loss is capped, to close the position we’ll have to pay an exponential debit to close out the trade. And if this happened near expiration, and we somehow got assigned on the position, we would have to fork out $29,300 to buy the shares. In essence, we would be chasing $200 dollars by putting up 30k in potential risk collateral.

We can also see that because FB traded above our -295 short put, both legs expired out of the money, thus netting us the entire credit that we sold for.

However, in most cases we would optimally close out the position as early as possible if the spread hits 50% return on credit.

• You can check out the reason we do this HERE

Now it’s also important to determine the risks of the positions when entering a trade and understanding what you’re doing instead of just chasing high premiums.

In the risk diagram above we can see a breakeven price, max win, and max loss. We already know our max win is the net credit collected when opening the trade, what’s our breakeven and max loss?

Well, max loss is calculated by taking the width of the spread and subtracting the credit received.

— Ex. FB 295–290 = $5.00 intrinsic value - $1.70= $3.30 Max loss

This position illustrates a 2:1 risk reward ratio and is the most optimal when trying to maximize our long term POP.

Similarly breakeven is calculated by taking our short strike and subtracting it by the amount of credit received

— Ex. FB 295p - $1.70 = $293 BE

Knowing these numbers we can either adjust our positions or use them to determine if we want to take on the risk and start this trade.

Part 2 — Trade Mangement and Best Practices

The best advice when trading spreads is to never chase loses and always close out positions when they hit your profit target.

There have been many times when I tell myself that I can squeeze the lemon a tiny bit more for some extra credit as I don’t think the underlying can move. Next thing that happens is the stock moves 1 standard deviation which then puts me at max loss. When I could have closed out for 50% ROC, I decided to be immature and not take my gains when I had it.

When a spread moves against you: AKA spread moves closer and closer to your short position/breakeven/long position, then you’ll probably want to manage the trade and avoid those big loses if possible.

3 Ways To Manage a Broken Spread

• Close out the position and take a loss, move on to the next trade
• Roll the strikes/exp higher
• Leg into a corresponding Call/Put CS to create an Iron Condor

#1 Closing Out the Position

Even though as traders we hate taking on losses, sometimes it’s necessary to prevent even bigger losses and accept that math can also work against us.

This is usually the best option when doing weekly spreads that give us less time/flexibility to manage.

— Ex. FB Max Loss=$3.70, instead closed for $2.90: avoided paying +$.80

#2 Rolling out the Position

This option is what I primarily do as I setup most of my positions so that they’re flexible and as easy to manage as possible.

However, if the trade doesn’t go my way it’s an efficient way to give me more wiggle room if I think the position has a chance at profit. But at the same time rolling a position contains the risk of increasing max loss.

So personally I try to roll out as less as possible as I don’t want to be chasing losers.

You can check out what rolling positions are HERE and some examples

#3 Legging into an Iron Condor

When opening a credit spread trade, we’re taking a direction and betting on the stock molding to that thesis. We can make our trade more bullish, bearish, but we can also make our trade neutral.

That’s the idea of an Iron Condor — a combination of a PCS and CCS

So when we actually open up a PCS by itself and the trade goes the opposite way, we can leg into a delta-nuetral trading strategy by employing a CCS hedge.

This lowers our breakeven points/max loss on the trade as we collect an additional credit.

But in many cases, legging into an iron condor may not be the best idea and it’s up to the trader to determine market sentiment and take into account many market conditions such as call skew, low IV rank, etc.

Part 3 — External Risks

In addition to the max loss and taking losses when trading credit spreads, there are also many external risks that can occur solely because of market mechanics.

#1 Early Assignment

I have never had a problem with early assignment as I tend to close out most profitable trades pretty early on.

Though very rare, I have heard stories of people getting assigned early on short call/put positions which completely threw off their trading roadmap.

Early assignment isn’t ideal as you sacrifice the extrinsic value associated with the option and also helps realize max loss in spreads.

It’s also important to realize the difference between American style and European style options. In Laymans terms, European options can only be exercised at the time of expiration while Ameriacn style options can be exercised anytime before expiration.

#2 Pin Risk

We already know that spreads can expire in the money or out of the money, giving us either a gain or loss.

However at the time of expiration, since we have 2 options; one leg can expire in the money and one leg can expire out of the money.

This is called pin-risk and can be very dangerous depending on the size of your account.

• Ex. FB stock price at expiration is $290.00
• We have a -300p/280p PCS that we collected $7.00 in premium
• We are now long 100 shares at $300 average cost and over the weekend the FB announces something that shoots the price down to 275
• Our max loss on the spread was $1300, but since we didn’t close out the position we have now incurred a loss of $2500–700=$1800

I can not express enough how important it is to close out positions when profitable and also when at a loss.

Takeaways

Credit Spreads are a directional options strategy that employs the use of short and long call to define risk.

Trading spreads are a good way to grow smaller accounts with higher probabilities and gaining an edge in the market.

It’s important to understand the basics mechanics of your trade and also analyze how the market influences these positions.

Built upon your own thesis and place trades that fit within your own requirements. As your trading career expands, you can employ many different strategies that will help expand percentage gain year over year.

Also never forget to take breaks from trading as it can be very stressful at times, time in the market always beats timing the market!!

THANKS FOR READING⚡️

I will be writing more about my Instagram experience, financial freedom, and whatever I find interesting. Please let me know in the comments on how I can improve my writing, and if you enjoyed please consider smashing that follow button!!

— Tristian Xu