How to Do Credit Spreads - Risk and Probability of Success
This matter of how to do credit spreads is really interesting. There are huge benefits with this nice option trading strategy where you BUY the same number of option contracts, call or put, at one strike price and simultaneously SELL the same number of option contracts at a strike price CLOSER to the current market price of the underlying, but both with the same expiry month.
The premium received from the sold option must be higher than the bought option, thus creating a credit to your brokerage account at the time of the trade. Over time, the 'sold' option premium will experience time decay, and as long as the share price does not pass the sold strike price at expiration, you keep the full credit.
There are two ways how to do credit spreads - either a low risk trade or a high probability trade.
How to do Credit Spreads - Low Risk Way
The low risk trade is to compose a deal in the money (ITM) options or at the money (ATM) options for credit spreads. Let's assume the example of a stock currently trading at $55. You have a bearish outlook for the stock and believe it could fall under $50 until option expiry date. So you create a credit spread with call options, called a Bear Call Spread. You would create (sell) a $50 ITM call for $ 5.75 and buy an ATM $55 call for $2.00 for an overall credit of $3.75. The maximum loss for the spread, is the difference between strikes, $ 5 (55-50), which makes your max risk $1.25 (5 - 3.75). This why it is a low risk strategy. You receive $3.75 for a maximum loss of only $1.25, which is a 300% return on risk. When you understand how to do credit spreads, you prefer a high yield for low risk.
So what could go wrong with this trade? The probability of success. The stock fall to under $50 and remain so at option expiry date for a successful trade. You need to be correct in your assessment of the direction of trade. So knowing how to do credit spreads this way involves prediction of future market direction.
How to do Credit Spreads - High Probability Trade
A high probability strategy is to construct your position using out of the money (OTM) options. Using the above example of a stock at $55, and you believe its upward move has exhausted itself and so have a bearish outlook, feeling it will fall and remain below $50. We are creating a credit spread using different strike prices. You might sell an OTM $65 Call for $1.10 and buy an OTM $70 Call for $0.50 resulting in an overall credit of $0.60. The maximum loss is still $5 which means your risk in this scenario will be $4.40 - much higher than in the previous example. This creates a higher risk trade - only $0.60 maximum return for $4.40 risk, which is only a 13% return on risk.
The difference however, is the probability of success for the trade. The stock must close below $60 at expiration and since it is now only $55 and you feel the stock is weak and will go lower, the likelihood of keeping all your premium credit is high.
We have seen the difference between a low risk setup with a low probability of success for someone unfamiliar with stock analysis - or a higher risk trade but with a high probability of success. These are the two alternatives for the credit spread trader. What you choose to do depends entirely on your trader personality. You may prefer to receive more for a trade but also be prepared to make adjustments in the form of rolling out your trade to a later expiry month if future stock direction doesn't go as anticipated.
The above two examples assume a $5 difference between option strike prices for the underlying stock. You can of course, find many optionable stocks with only $2.50 or less between available strike prices. This will provide greater flexibility for how you set up your credit spread. But remember, the one important thing you need to know before you press the submit button, is your risk to reward ratio.