One of the best ways to create consistent income (for a trader, anyway!) is to trade credit spreads. There is a lot of confusion around what spread trading is, so let’s demystify some of that.
Credit spreads are generally low-risk
As an options trader, I would like to know two things before I place a trade:
- My profit potential
- How much capital I am risking
I find that low risk credit spreads are a useful risk management tool. They automatically limit risk – and profit potential, but that’s the tradeoff. I give up potential gains in return for taking on less risk.
Of course all trades in the market are financial transactions and thus subject to some risk. Unlike uncovered options (which can have substantial or unlimited risk), you can usually calculate the exact amount of risk when you enter the position.
Spread trading can provide consistent income
Different types of credit spreads can be used depending on your stance on the stock or the overall market conditions. In my experience, credit spreads are a great way to produce income in a consolidating market environment. We typically use SPX credit spreads and sell vertical bull put spreads that are substantially out of the money. On each market dip, we ladder different expiry’s using weekly and monthly strikes to maintain an income stream.
There are three different types of credit spreads to consider:
- Credit spread or “vertical spread”: Simultaneously purchase and sell options (puts or calls) at different strike prices.
- Credit put spread or “bull put spread”: A bullish position in which you obtain more premium on the short put.
- Credit call spread or “bear call spread”: A bearish position in which you obtain more premium on the short call.
Bull put spreads are best used for a consolidating market or when you think the market/stock will rise. Put on these trades when the market sells off and appears to be bottoming. Bear call spreads are best on when you think the market/stock is topping.
The goal of the credit spread is to produce a net credit. That’s your income. You cannot make any more money than the credit you bring in. The credit is produced because the premium you pay when you purchase the option is lower than the premium you receive when the option is sold.
The difference in the strike prices is called the spread; your risk is the spread less the credit received. For example, if the strike prices are 5 points apart, and I sell the spread for $1.00, my risk is $400 and my reward is $1.00. When the spread value reaches .05 – .10, I will buy it back and put on a new spread. If it is very obvious that my strike prices are not going to be met, I can let it expire worthless and keep the full credit.
In an ideal world, we want the spread we are selling to expire worthless so we can keep our entire credit. In fact, that is our goal each time we enter the trade. However, things happen. The further away the stock moves from the current price, the more likely this is to occur, yet we know the market doesn’t exist in a perfect vacuum. Therefore, we want to maintain maximum flexibility and have the option to close out the spread earlier in order to avoid a potential tail risk event.
Credit spreads are typically considered bullish or bearish. We find that selling them way out of the money, underneath major support, and with a very low odds of being in the money during expiry is a more neutral approach to generating income.
Pros and cons of spread trading
To summarize, all options involve risk, but you can employ credit spreads to reduce risk.
- Spreads can lower your risk substantially if the stock moves dramatically against you.
- The margin requirement for credit spreads is substantially lower than for uncovered options.
- It is not possible to lose more money than the margin requirement held in your account at the time the position is established. With uncovered options, you can lose substantially more than the initial margin requirement.
- Debit and credit spreads may require less monitoring than some other types of strategies. Once established, they’re usually held until expiration. However, spreads should be reviewed occasionally to determine if holding them until expiration is still warranted. For example, if the underlying instrument moves enough, you may be able to close out the spread position at a net profit prior to expiration.
- Spreads are versatile. Due to the wide range of strike prices and expirations that are typically available, most traders are able to find a combination of contracts that will allow them to take a bullish or bearish position on a stock. This is true of both debit spreads and credit spreads.
- Your profit potential will be reduced by the amount spent on the long option leg of the spread.
- Because a spread requires two options, the commission costs to establish and/or close out a credit spread will be higher than the commissions for a single uncovered position.
Credit spreads can be an integral part of your portfolio management. If you’d like to get started but need some guidance, check out our spread trading service here.
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