What is a Credit Spread?

A credit spread is an option trading strategy which is so named because it puts a credit into your broking account rather than taking a debit from it when you enter the position. In order to understand why this is so, you need to know a little about how option prices work.

Options have two main features – the ’strike price’ and the ‘expiry date’. The ’strike price’ is the price of the underlying financial instrument such as a share, that you agree to either buy or sell it at, by a given date. The general rule is that the closer the strike price is to the current market price, the more expensive the option contract. The further away the strike price is, to the current share price, in line with the type of option you are trading (ie. call or put), the cheaper it is. This is called ‘out of the money’.

So the idea is that you SELL (write) an option at a strike price which is closer to the current stock price, preferably ‘at the money’ and simultaneously BUY the same number of options at a strike price further away, or ‘out of the money’. The SOLD option will be more valuable than the BOUGHT one, thus resulting in a credit to your account.

So you have a ’spread’ in that your trade consist of both bought and sold positions at different strike prices – and you have a credit as explained above.

What Advantages Do Credit Spreads Provide?

Credit spreads provide a number of significant advantages, particularly in the area of risk. As such, they are not a ‘day trading’ type strategy, but more of a longer term approach. They ususally take about 4-6 weeks to mature, but can be closed out before then. They can also be taken based on a view of either a future rise or fall in the share price.

During the term of the spread, the underlying share price can only move in one of 5 ways:

1.  A small move upwards2.  A small move downwards3.  A side ways move – “goes practically nowhere” or returns to its original price by expiry date.4.  A large move upwards5.  A large move downwards

An option credit spread will make you a profit from 4 out of the above 5 possible price directions. That’s 80 percent odds in your favour! How is this so? Because credit spreads take advantage of the time decay associated with options. If the share price is ‘out of the money’ by expiry date, you get to keep the full credit you received when the trade was taken out. Even if it is close to the money, even in the wrong direction, you will still make a profit due to time decay.

But what if the worst case scenario occurs and the share price makes a strong move against your anticipated direction? Here is where one of the main advantages of credit spreads comes into play. Because the main feature of your spread is a ’sold’ position, you can do what is called ‘rolling out’ to a future month. Alternatively, you can also ‘roll out and down (or up)’. You simply close out your original position and re-open it with next month’s expiry date. If the share price has moved against you, you will receive a much larger credit this time, which will compensate for the loss on the previous one and then some.

What are the Best Setups for Credit Spreads?

Before you take out a credit spread, you should check a stock chart for price patterns. You want to enter at a time when a stock has moved significantly in one direction and is due for a reversal. One of the most common patterns that help you are are called channels. Draw a line along the highs and lows of a daily price chart and you may see a channel appear. If so, and there are no signs of weakness in the channel, you’re onto a pretty good thing for a credit spread trade.

Is there Anything Else I Should Be Aware Of?

Yes. One final matter is an ingredient in option prices called the ‘implied volatility’ (IV). If you are able to enter a position where the sold option has a higher IV than your bought position, it will increase your credit and at the same time, diminish your risk even further.

Conclusion

Credit spreads are a low risk, sleep at night, style of option trading strategy. It is not for those who want to be in one day and out the next. It works it magic ideally over about a month. But the return on investment is still excellent and the lower risk makes it very appealing.

Just like the seasons in which flowers blossom in the spring, torrential downpours come in the summer, the leaves change in the fall, and snowflakes fall in the winter, there are patterns that exist within the stock market that recur year after year.

For example the Santa Claus rally usually takes place during the last 5 trading days of the year and the first 2 trading days in January. This time period has averaged a 1.4% gain since 1969. If Santa fails to appear this usually portends a bear market.

One of the most famous and consistent patterns is the so called “January Effect,” in which small cap stocks have outperformed large cap stocks 41 out of 43 years. The run up generally begins in mid-December and most of it ends by mid-January.

Then there is the January barometer in which the first 5 trading days of the year act as a gage for how the rest of the year will turn out. This has been a very effective tool in which the last 36 times the first 5 days have been up has led to gains for the year 31 times. The average gain in each of the 36 years has been 13.1%.

In nine out of the last fourteen post election years the S&P has shown a loss during the first five days of January, six of which resulted in a full year’s loss of 11.1%. This leaves five post election years where there were gains during this period. One of these years ended up being a loser, but four of these years the average gain was 22.6%. So investors should watch the first few days of January closely.

There are other things one can take a look at when examining yearly patterns. For example the days before and after certain holidays generally show a tendency towards bullishness. Under the democrats markets usually show bigger gains than when republicans are in power. The last two years of a presidency have been substantially more bullish than the first two years, with the third year showing an average of a 10.6% gain and the fourth year a 6.7% gain.

When considering seasonal patterns one should never rely on these alone for taking trades, because unusual events like war, acts of terrorism, and acts of God can disrupt these patterns. However when combined with with technical and fundamentals these patterns can act as a road map for decision making in the markets.

I like trading the Indexes because they are not subject to the same wild price swings as individual stock. It is also easier to make risk management adjustments on Index trades than say GOOG which can change in value quickly on some bad news.

An option credit spread is a limited risk option trade involving the simultaneous purchase and sale of two differing option contracts on the same Index, i.e. the SPX. This produces an immediate cash credit in your trading account. A profit is realized in a credit spread position if the index moves in the direction anticipated, remains the same and even if under appropriate circumstances the index moves adversely to your position.

Benefits of Index Credit Spread Trading

• Index credit spread trades have a 90% probability of expiring worthless when filled.

• These credit spread trades can profit in any type of market. Markets today are more likely to trend sideways, or move slightly higher or lower month to month.

• The majority of time you just make a trade, collect your credit and wait for the next month. This is not a day trading system. There is no need to monitor the market and your active trades all day long in front of the computer screen. In fact it’s really a very boring trading system.

• Paper trading is the best way to learn this option strategy. It’s all free with CBOE’s new Virtual Trading system.

• The SPX, NDX and RUT Indexes are not subject to the same wild swings as individual stocks.

• With Iron Condor trades you get double the credit but only have one margin side at risk.

• You want your credit spread trades to expire worthless but you can always buy them back for way less than you sold them for.

• Your trading capital is only used to support margin requirements. Most option brokers allow you to invest your trading capital and use it as collateral for spread trading. This way you can earn 2 returns with the same capital.

You can see my actual performance results of all trades for the last 12 months and the current YTD return which is amazing. My website is over 25 pages and full of content that covers all aspects of this trading strategy.

Now, let’s compare the above spreads with these other types of spreads.

Clearly, there are more spreads that require the Implied Volatility to be differentiated between Calls versus Puts, compared to the use of a combined IV. So, in choosing a data provider of Implied Volatility, make sure you get the IV data of Calls that is set apart from the IV of Puts; as well as, data that combines the IV of Calls and Puts together. That means 3 sets of IV data in one service.We have just established the structural logic for decoupling the IV of Calls from the IV of Puts. How do you apply this to a trade? Here’s how.

Is there a working example of a consistently profitable portfolio that treats Implied Volatility of Calls separate from the IV of Puts? Yes. Follow the link below, entitled “Consistent Results” to see a model retail option trader’s portfolio that applies this logic.To conclude, I’ll use an analogy. Though an egg comes in one shell, the yolk is separated from the white, for a different purpose that distinguishes the individual parts of that same egg. Treat Implied Volatility of an option’s anatomy in the same way.

Selling Option Credit Spreads on the broad based stock indexes was my new strategy. My goal was to collect premiums each month using OTM (Out of The Money) options spreads, specifically Bull Put Spread and Bear Call Spreads on the SPX index. I was choosing spreads that were very far OTM so that I had a greater cushion which reduced my risk.

Selling spreads is more akin to waiting for the big move to occur and it rarely does. Time decay is very relevant because despite being a spread, the spread does have a significant rate of decay in the last week or two. The beauty of this strategy is that you do not necessarily need to sit on top of it all the time. If your strikes are 40-60 points OTM and the SPX is up 1.20 today, you gain nothing by checking the quotes every minute. You can just check in the morning and at the close at your leisure as long as you are sufficiently OTM. When the market starts moving closer to your short strike, some due diligence is required. With credit spreads you want the position to expire worthless or buy back for way less that you sold it for.

The goal is to collect premium month to month. Using OTM spreads is a way to do this without predicting the market for the month. In any given month, the market can still move sideways, lower or higher and your positions will still be profitable. You are trading without concern over market direction for a major crash lower.

Today I employ a very safe and conservative Iron Condor credit spread trading strategy. My strategy with iron condor trading is to leg into the trade by selling the Bull Put Spread first for .20 – .25 cents. This is only a 2% – 2.5% return but the trade is very safe and the short strike is usually 60 points or more away from the current index price. I will then complete the condor by selling the Bull Call Spread later on for another .20-.25 cents, but only if the trade is safe. Safety is the key to my strategy with a goal of earning on average a 3% return each month.

Guy Cohen has extensive experience of both the US and UK derivatives and stock markets.  He specializes in trading and analytics applications ranging from real estate to derivatives and has developed comprehensive business, trading and training models, all expressly designed for maximum user-friendliness. There are adequate reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those who have just started or are about to read the book, I’ve summarized the core concepts in the larger and essential chapters to help you get through them quicker.The number on the right of the title of the chapter is the number of pages contained within that chapter. It is not the page number.  The percentages represent how much each chapter makes up of the 302 pages in total, excluding appendices.1  The Four Basic Options Strategies.  20, 6.62%.2  Income strategies.  68, 22.52%.3  Vertical Spreads.  30, 9.93%.4  Volatility Strategies.  56, 18.54%.5  Sideways Strategies.  44, 14.57%.6  Leveraged Strategies.  20, 6.62%.7  Synthetic Strategies.  54, 17.88%.8  Taxation for Stock and Options Traders.  10, 3.31%.Focus on chapters 2, 4, 5 and 7, which makes up about 74% of the book. These chapters are relevant for practical trading purposes.  Here are the key points for these focus chapters, which I’m summarizing from a retail option trader’s perspective. Chapter 2: Income Strategies. These strategies construct spreads where part of the spread sells Theta as premium within a shorter term (typically 30-45 days), to collect income.  In its entirety the strategy may result in a Net Debit or Net Credit spread.  There are 13 types of spreads in this category: Covered Call, Short (Naked) Put, Bull Put Spread, Bear Call Spread, Long Iron Butterfly, Long Iron Condor, Covered Short Straddle, Covered Short Strangle, Calendar Call, Diagonal Call, Calendar Put, Diagonal Put and a Covered Put (a.k.a. Married Put).Chapter 4: Volatility Strategies. These strategies use spreads that are indifferent to price direction, so long as price explodes out of range.  For a given explosion in price, the volatility of the spread needs to rise for a Net Debit spread and fall for a Net Credit spread,.  There are 11 spread types are defined in this category: Straddle, Strangle, Strip, Strap, Guts, Short Call Butterfly, Short Put Butterfly, Short Call Condor, Short Put Condor, Short Iron Butterfly and Short Iron Condor.Chapter 5: Sideways Strategies. These strategies involve non-directional spreads, requiring price to drift within a confined range. As price remains range bound, the volatility of the spread needs to rise for a Net Debit spread and fall for a Net Credit spread.  There are 11 types of spreads in this category: Short Straddle, Short Strangle, Short Guts, Long Call Butterfly, Long Put Butterfly, Long Call Condor, Long Put Condor, Modified Call Butterfly, Modified Put Butterfly, Long Iron Butterfly and Long Iron Condor. Chapter 7: Synthetic Strategies. Synthetic strategies mimic the risk profile of a stock, futures or other option position by combining calls, puts with or without stock.  Though typically, most synthetic positions are either long or short stock.  If you have a 401K plan or employee stock purchase plan that is long stock, then it may make sense to consider synthetic strategies, as you are already long Delta.  There is unlimited risk for some synthetic spreads, regardless if the strategy involves stock or not.  There are disadvantages to using synthetics.  12 spread types are defined in this category: Collar, Synthetic Call, Synthetic Put, Long Call Synthetic Straddle, Long Put Synthetic Straddle, Short Call Synthetic Straddle, Short Put Synthetic Straddle, Long Synthetic Future, Short Synthetic Future, Long Combo, Short Combo and Long Box.From a retail option trader’s viewpoint, I prefer to establish positions without the use of stock.  Using stock synthetically in a position makes each trade more capital intensive than it needs to be.  Especially, if your trading account is below USD $50,000.  The use of stock in configuring these positions does not add material merit in controlling risk and there is no added monetary benefit in tying up available trading capital in a stock-dependent synthetic position that could otherwise be achieved without the use of stock.  As an options trader in the first place, you want as little to do with the stock itself as possible, other than to configure the required option position around the underlying product, which can be substituted with a cash-settled Index instead of a stock-settled Index.Out of a total of 56 strategies covered in the book, I have reduced the list down to 35 Limited Risk Spread types that do not need to include stock as part of its original construction.  Limited Risk means there is a cap to the maximum loss – “Capped Risk” is the term used in the book. This should always be the starting point of any strategy you choose to construct. Do not just look at the unlimited profit (Uncapped Reward) side of the strategy without realizing that there is an unlimited loss (Uncapped Risk) side to same strategy.Limited Risk Spreads with “Unlimited” Reward and their Directional outlook.1. Long Call.    Bullish.2. Long Put.    Bearish.    3. Put Ratio Backspread.    Bearish; reverse Bullish.4. Call Ratio Backspread.    Bullish; reverse Bearish.        5. Straddle.    Indifferent/~Neutral.6. Strangle.    Indifferent/~Neutral.7. Strip.    Bearish.8. Strap.    Bullish.    9. Guts.    Indifferent/~Neutral.    1-9 are Debit spreads: IV needs to rise.10. Bull Put Ladder.    Bearish.    10-11 are Credit spreads: IV needs to fall.11. Bear Call Ladder.    Bullish.    Limited Risk Spreads with Limited Reward and their Directional outlook.12. Bear Put Spread.    Bearish.13. Bull Call Spread.    Bullish.14. Long Call Calendar.    Bullish; Indifferent/~Neutral.15. Long Put Calendar.    Bullish; Indifferent/~Neutral.16. Long Call Butterfly.    Indifferent/~Neutral.17. Long Put Butterfly.    Indifferent/~Neutral.18. Long Box.    Indifferent/~Neutral.19. Long Call Condor.    Indifferent/~Neutral.20. Long Put Condor.    Indifferent/~Neutral.21. Long Iron Butterfly.    Indifferent/~Neutral.22. Long Iron Condor.    Indifferent/~Neutral.    12-22 are Debit spreads: IV needs to rise.23. Bear Call Spread.    Bearish.    23-35 are Credit spreads: IV needs to fall.24. Bull Put Spread.    Bullish.25. Short Iron Butterfly.    Indifferent/~Neutral.26. Short Iron Condor.    Indifferent/~Neutral.27. Diagonal Call.    Bearish.28. Diagonal Put.    Bullish.29. Modified Call Butterfly.    Bearish to ~Neutral.30. Modified Put Butterfly.    Bullish to ~Neutral.31. Short (Naked) Put.    Bullish.32. Short Call Butterfly.    Indifferent/~Neutral.33. Short Call Condor.    Indifferent/~Neutral.34. Short Put Butterfly.    Indifferent/~Neutral.35. Short Put Condor.    Indifferent/~Neutral.Other than the 35 Defined Risk Spreads that do not require stock as part of their original construction for entry, there are 6 Defined Risk spreads that need stock to configure their positions. The 6 positions that I have deliberately excluded from the list above are the Long Call Synthetic Straddle, Long Put Synthetic Straddle, Synthetic Call, Synthetic Put, Collar and Covered Call.In conclusion, for new to intermediate traders do not be overwhelmed by the 56 strategies in the book.  It’s entitled the “Bible of Options Strategies” for a reason. What is critical is to get a deep understanding of the Long Call, Long Put, Short Call, Short Put, Long Vertical Call/Put, Short Vertical Call/Put and the Long Calendar Call/Put. That is the 4 Basic Options Strategies, plus the Vertical and the Calendar – the only 2 strategies that floor traders define as true spreads. The other combinations are a mixture of the basics with or without stock.