what are credit spreads Archives - How to Trade Options

Option Credit Spreads – Low Risk Option Trading

The Stock Market is one of the largest markets in the world, so it is going to be around for a long time. This means that if we can master a few strategies that bring consistent profits, it is not inconceivable that we could set ourselves up with a reliable income stream. The fact is, one of the most profitable skills we can ever master, is the skill of option trading.

There are many option trading strategies “out there” such as strangles, straddles, bullish call debit spreads, bearish put debit spreads, ratio backspreads, calendar spreads and credit spreads. In this article, I would like to focus on the superior advantages of option Credit Spreads. With the flexibility and power of Credit Spreads, you can safely trade options for the rest of your life.

First, let us define option credit spreads. They are called such because when they are created, they put a “credit” into your trading account, as opposed to a “debit” which normally occures when you are paying for a stock or its derivative. If, by the time the options in the credit spread expire, the share price hasn’t breached a certain level, you get to keep the “credited” funds.

The reason it creates a credit and not a debit, is because you’re SELLING an option at a strike price which is closer to the current share price, but so as not to leave yourself exposed, you limit your risk by BUYING the same number of option contracts at a strike price further away, both having the same expiry date. The “sold” option, being closer to “the money” (share price), is more valuable than the “bought” option and so you receive a credit.

The trick here, is to sell option credit spreads with a short time to expiry, thus taking advantage of the “time decay” factor in options. Options have a time decay which falls away exponentially the closer the expiry date approaches, so creating a credit spread with a maximum 4-6 weeks to expiry is where we want to be. Sometimes you can even enter with under 2 weeks to expiry and keep your credit much quicker, but you need to be more certain about the short term direction the share will move to do this, because your time frame is shorter.

So why are Option Credit Spreads so advantageous?

Essentially, in a given time frame, the market can only move one of five ways:

A small move upwards
A small move downwards
A side ways move – i.e. in a given time frame, the market price “goes practically nowhere” or before that timeframe expires, returns to its original point.
A large move upwards
A large move downwards

If you’ve taken out an option credit spread, the market can move any four of the above five ways and you make a profit. Even if the unfortunate happens and that unlucky “fifth” way occurs, you can act to either delay your profit, by “rolling out” or “rolling out-and-down” your positions to a later expiry date and/or lower strike prices, waiting for the market to return to a profitable position – or sometimes if the new market direction is evident (lower highs confirmed) and you are onto it early enough, you can buy back your sold option and still make enough on the bought option to either break even or make a small profit. You could even sell a call option credit spread in the meantime.

Wonderful flexibility!

This is why Option Credit Spreads are so advantageous. Firstly, 80{3a39a80e0257ac0455bc3b3978d4f68a2ed2cda6344ecf0a5f3dbf28ade020eb} (4 out of 5) of market movement is in your favour; Secondly, even if that unlucky 20{3a39a80e0257ac0455bc3b3978d4f68a2ed2cda6344ecf0a5f3dbf28ade020eb} hits you, you can still come out unscathed or even profitable.

In my view, put option credit spreads are preferable to call option credit spreads, especially in a bull market. But either way, there are some factors you need to take into consideration.

Money Management – don’t put all your eggs in one option spread basket. Divide your capital up into at least 5 portions (preferably 7) and only risk that portion on any one trade.

Risk Management – with credit spreads, your total risk will be the difference between the strike prices, less the credit you receive. So if your strike price difference is $1.00 (e.g. you sell a $20 put option and buy a $19 put option) and the share price drops to say $18, the most you can lose is $1 x No. shares x No. contracts – less your original credit. This being the case, you will want to pay attention to the amount of credit you are receiving vs the risk. You should look for at least 20{3a39a80e0257ac0455bc3b3978d4f68a2ed2cda6344ecf0a5f3dbf28ade020eb} which in our case just mentioned, would be 20 cents (the risk being $1).

Share Direction – this is not as hard as it appears. You simply look at charts for shares which have options. Most shares over a longer time frame, will “channel” i.e. they will bounce back and forth between two parallel lines. Find these lines, determine where your shares are within that pattern and when they reach the extremities, take out your credit spread. Alternatively, you can look for price consolidation around “support” and “resistance” levels. Where resistance has become support beforehand, the likelihood of a bounce northward is particularly strong. If you’ve paid attention to Money and Risk Management above, you’re sure to profit.

Did You Know That You Can Make a Good Living Using Option Credit Spreads?

Want to Know the “Nuts and Bolts” of How to Do It?

To Find Out How Easy it Is, Click Here

credit spreads options

Option sellers believe that if it is not, it is pretty darn close. Probably the closest an investor will ever get to the long sought “Holy Grail of Investments” or what is considered to be the ideal investment.

Let’s take a look and see what exactly is regarded as the ideal investment. When asked to define what this is investors have various versions of what they consider to be the ideal investment or the Holy Grail of Investments.

In the ultimate analysis, with few exceptions, most investors feel that an ideal investment should provide the following qualities: safety of capital, consistent high returns, immunity from economic and market fluctuations and finally, liquidity, or availability of funds should the investor find an immediate need to tap his resources.

Safety of capital and high returns seem to be the most desirable of all yet these two are totally opposing qualities in any investment. As the saying goes, the higher the risk, the greater the reward or inversely, the lower the risk the smaller the reward.

That said let’s explore our choices. Until the advent of options there appeared to be nothing that came even close to being called an ideal investment let alone be called the Holy Grail of Investments. We had to face the fact that investments were either low risk low reward or high risk high reward. Some investments were somewhere in the middle ground but few or none were in the Holy Grail category.

Investors may be classified into two groups, passive and active investors. Passive investors prefer entrusting their capital to third parties and doing nothing more than expect returns from their investments either on a regular basis or value appreciation over time. They put their money into a fixed return instrument such as passbook savings accounts, money market funds, treasury bills, certificates of deposits, bonds and included in this lot are dividend paying stocks and mutual funds.

Then there are the other passive investors that prefer to place funds into long term appreciation assets with capital growth as their main goal. Examples of these types of investments would be real estate, precious metals, arts and antiques. All these investment instruments while delivering small returns on a year-on-year basis do offer much safety of capital.

The active investor on the other hand is a more adventurous individual. He seeks high returns for his money, hopefully at reduced risk, by actively being involved in trading the markets, be it real estate, stocks, bonds, commodities, futures, foreign exchange, options or whatever else can be traded and made money on. Although more of a risk taker he nevertheless tries to moderate his risk exposure by restraining his profit objectives or rates of return on his capital.

While passive investors are happy with annual returns of 6 to 10 percent, active investors seek higher rates of over 12 percent and more like in the region of 14 to 18 percent per annum. Is this doable? Yes, it is and many are happy actively trading the markets and achieving these returns using their own trading techniques that somewhat controls risk to an acceptable degree. Now here’s the shocker. Option traders are able to generate annual profits in excess of 20 percent without exposing themselves to any more risk that those achieving 14 percent. Now here is an even greater shocker. Among those that trade options the ones specializing on the selling side generate annual returns in excess of 30 percent with many averaging annual returns in the region of 40 to 50 percent without increasing the risk factor any more than the passive investor!

Foreign currency traders as well as commodities and futures traders sneeze at this claim saying that they can outshine the option seller in annual returns. True. But can they claim to do so at the same risk level as the passive investors? Most probably not.

Selling options (stocks, commodities, futures, etc) has become for many the Holy Grail of Investments. To the experienced option seller this trading strategy offers high, consistent returns, a fair degree of immunity against economic and market fluctuations, liquidity, and finally safety of capital.

This last claim may be open to debate from non-believers in this trading strategy. To be fair let’s qualify the safety claim by saying that the inexperienced option seller is open to potentially heavy losses if he does not know what he is doing. But to the seasoned trader selling options is a safe investment strategy delivering all the qualities of an ideal investment to the point where successful option sellers claim to have found what to them is the closest one can ever get to the Holy Grail of Investments.

Selling options on stocks can be particularly rewarding using a carefully planned trading system combined with disciplined money management and with proper safeguards in place. There are many trading strategies in selling options. Some are simple enough, like the covered call technique, delivering fairly decent returns while others are more complex but more rewarding.

Did You Know That You Can Make a Good Living Using Option Credit Spreads?

Want to Know the “Nuts and Bolts” of How to Do It?

To Find Out How Easy it Is, Click Here