Credit Spread

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Of all of the different option strategies out there, the credit spread technique is probably one of the most well-liked, the most talked about, one of the most used (or abused depending on how you look at it) – and perhaps the most harmful option approach of them all.

The thing is, when rookie option traders very first hear of this strategy – very few of them seem to be able to fight off the temptation to bounce right into trading them – with way too much actual hard earned dollars on the line – and way too little preparation, knowledge, and know-how.

And it appears that a great amount of them – if not nearly all of them – immediately wind up finding their groins bashed in, their heads chopped off, their eyes poked out, and getting really, very, badly hurt.

Now before you start to get the wrong impression here, please, let me clear up some thing.

I actually LOVE credit spreads.

I think they are an absolutely wonderful and excellent way to trade.

And all those reports and claims about generating five to ten percent a month even though barely taking any time looking at the marketplace – and how the possibilities are so unfairly on the side of the credit spread trader – and how trading credit spreads are just like being the ‘house’ as opposed to the gambler – yes – I believe and agree with all those claims and tales as well. Actually, not just do I agree and believe those claims – I KNOW they are accurate – mainly because I watch it happen first hand in my very own trading account on a standard basis.

The trouble is – there is something very large that’s getting left out of all those claims and testimonies – and this one large thing is causing way to many fresh faced ‘hypnotized’ option traders to misunderstand this technique correctly from the start – and in a way it’s actually encouraging them to leap thoughtlessly into trading them with quite inaccurate expectations.

See, even though it might be accurate that the credit spreads (and the iron condor strategy) can generate yields of over ten percent monthly, and that they favour the trader by offering higher probabilities of winning (in some situations as much as 80 and 90 percent) – what is just not getting talked about is the risk to reward ratio of these trades – which can regularly be as high as ten to 1.

10 to 1! Which means that in order to obtain those 80 to 90 % probability trades you might very well need to risk 10 dollars to create just a single dollar – or to be more accurate – you have to be willing to lose $10,000.00 for the chance to make just $1,000.00.

And as my dear mother used to say – ‘that’s an honest to goodness awful smelling spoiled rotten deal’.

Because as soon as you start to do the math you uncover the fact that even with those glorious monthly returns with 80 to 90 percent probability of winning – all it takes is just one problem month to arrive and induce a loss that may entirely obliterate the eight to nine wins you’ve accumulated – or worse – in addition it could also wind up cleaning out the rest of your account.

However – all isn’t lost…

As I mentioned earlier, I love the credit spread. And the iron condor trade as well.

And – I regularly make really good income from both of them.

So certainly there’s a way around those problematic losing months and that nasty risk to reward.

Of course there is.

It’s all in how you go about managing the trade.

See, so long as you learn the proper way to first put these trades on, then blend that with a very easy, uncomplicated management procedure (see below) and several simple adjustment tricks (see below) – this risk to reward ‘problem’ is absolutely eliminated and no longer any trouble.

You just need to take some time BEFORE you go slap on a credit spread or an iron condor – and arm your self with a little bit of our ’spread trading insight’. Learn a couple of our ‘tricks of the trade’ – so when those tricky months DO arrive (and they definitely will believe me) – you will know EXACTLY what you must do to immediately crush out that danger, adjust yourself and your credit spread and/or iron condor out of the difficulty, and truly enjoy these trades for all they are ‘really’ cracked up to be.

To learn more about how to properly place, manage, and adjust these trades for consistent income, sign up for our free option trading newsletter by clicking here.

When the market tanked on Thurs – May 6, 2010 – the VIX spiked over 40 and the vols soared. Then the market bounced back up pretty quickly, and around 20 minutes before the close, talk started coming out on the networks that the huge drop was due to some ‘fat finger’ error by some overweight guy at some trading firm. As soon as this rumor started circulating on the networks it felt like immediately the volatility levels began shrinking back down – giving us the opportunity to quickly throw on a split strike iron butterfly trade to see if we could take advantage of those sinking vols. This was with about 20 minutes left before the market close. (The split strike iron butterfly could also be considered an iron condor – or two separate credit spread)

Within about 15 minutes of putting this trade on – this trade had a profit of 2.5%. We closed it at this point – with 5 minutes left before market closing. Even though we closed it – we continued to monitor it as if we had left it on – and as the bell rang to close the market the trade was up another 2.5% for a total possible profit (had we held on until market close) of about 5% gain in around 20 minutes.

The screen shot above was taken as market closed on Thurs. This iron butterfly was placed at even money about 20 minutes earlier. Due to the vols falling back down after the huge drop, this trade shows a 5% profit made in about 20 minutes.

Today when the market went nuts (dow dropping 1000 points) our TOS platform started acting haywire. Risk graphs were creating crazy formations for awhile there, then our net liquidating value suddenly said we had over 20 million dollars available.

Tried as I might, I was never able to  liquidate any of that before it corrected itself and went back to showing the actual correct sum. Unfortunate really…

However, through out that huge drop, our Iron Butterfly trade did amazingly well.

About 2 hours prior to the craziness starting our position was down around $100.00.

With the market moving down we added a bear side adjustment. Then when everything hit the fan, even though we were well outside our profit tent area, the vols took this trade from what started as a $100.00 loss to over $1000.00 profit. See risk graph below…

Hedged Iron Butterfly During Dows 1000 Point Drop – May 6, 2010

New article from the people at ‘O’ on the ‘Appreciating Collar‘. If you haven’t read the book from R-Walk on this trade, could be worth a look. There is also a good video on a similar ‘married put’ strategy found in our option course as well as some unique and new ‘rules’ for when to cash in puts and re hedge underneath. Learn more by watching our free option income trading video.

There are numerous option spread strategies non directional option traders can use to profit from the market without having to ‘know’ or be necessarily ‘correct’ about market and/or stock direction.

These include the iron condor, the butterfly spread, the diagonal and the double diagonal, the calendar spread – the double calendar spread – and, the credit spread (also know as a vertical spread).

The credit spread can actually be found hidden within many of the above mentioned option spread strategies. For example, the iron condor is created from two individual and separate credit spreads – a put credit spread positioned down under where the stock being used is trading at – and a call credit spread put on up above where the underlying is ticking at.

The credit spread can also be found in the butterfly spread. It is the upper half of the ‘regular call’ or ‘traditional’ call butterfly – is the lower half of the put butterfly – and the iron butterfly is comprised from 2 credit spreads – both a put spread and a call spread.

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photo credit: hiwarz

The credit spread option strategy can be played with either call options or put options. A credit spread / vertical spread placed with calls is called a bear call spread – while those that are placed with puts are called bull put credit spreads.

An example of a bull put credit spread would resemble the following…

Sell 1 XYZ Stock 50 Put Option
Buy 1 XYZ Stock 45 Put Option

This is a bullish play – as the option seller placing this trade is of the opinion that XYZ stock will be either remaining nuetral over the next however many days there are to expiration – or that XYZ will be bullish.

As long as the investor is correct and XYZ remains above the 50 dollar strike price by expiration day, the trade will be a winner and the trader will be able to keep the credit that brought into their account upon the initiation of the trade.

This traded is called a bull put spread because even though it is a trade using put options – it is done so in a way that benefits if the stock or underlying proceeds in a bullish manner.

photo credit: Furryscaly

The credit spread option strategy can be used with either call options or put options.

For the most part this option spread is used when the trader placing it feels that the stock being used will not breach the short strike chosen for the spread which does make this trade somewhat of a directional play.

For example, if option trader Jane felt as though AAPL would not move above the 220 price range before the May expiration, she might decide to sell a credit spread – a bear call spread – where she sells the 220 strike call and then purchases the 230 call above it in order to ‘cover’ herself. Let’s say for this vertical spread trade she generates a 5.00 credit.

If in fact AAPL DOES stay below the 220 level all the way until expriation, Jane gets to keep the credit which could bring in a very nice return in a relatively short amount of time.

What is nice about these trades is that they give the option trader quite a lot of ‘wiggle room’ to be wrong. For example, if AAPL was at the 210 level when the above trade was initiated, Jane would make money on the trade if the the stock went down, or – went sideways, or – even if it went a little bit up (as long as it doesn’t breach the 220 strike level). This means, that out of four possible scenarios, Jane wins on this trade if the stock winds up doing three of them – and loses only if the stock does ONE of the possible scenarios.

These types of probabilities are one of the main reasons why option traders love the credit spread trade so much.

Discuss this and other stock market related topics at : www.internationalstockforums.com Credit Spreads, that is Bull Put Spreads and Bear Call Spreads are some of the most mythologised strategies in all of Option Land. This is part one of a video, exploding some of those myths and looking at the real truth of this strategy, warts and all.

Another name for the credit spread is the option vertical spread.

Actually, the term vertical spread is used for both option credit spreads and option debit spread.

A credit spread is an option spread that brings a ‘credit’ into the traders account. The trader sells either a call or a put that resides closer to the money – then purchases a corresponding option further away from the money in order to cover the short option sold.

An example of a credit spread  would be…

Sell 1 IBM 105 PUT option (at the 105 strike)
Buy 1 IBM 100 PUT option (at the 100 strike)

A debit spread, on the other hand, pulls a ‘debit’ from the traders account. The trader purchases either a put or a call option that is positioned closer to the money – then sells a corresponding option further away from the money.

A debit spread example is…

Buy 1 IBM 110 CALL option (at the 110 strike)
Sell 1 IBM 115 CALL option (at the 115 strike)

When discussing option spread strategies, the opposite of the option credit spread is the option debit spread.

While credit spread option techniques bring premiums in the form of credits INTO a traders account, debit spreads do just the opposite as the title of this method suggests – it pulls a debit out of the account. Also – generally when credit spread are used, the investor believes – or at least ‘hopes’ that the vehicle being used will move in the opposite direction of the options being used.

For example – if a non directional trading person had the opinion a particular stock would move downwards, they might put on a call credit spread – in hopes that the underlying moves down and away from that sold call spread,

In the case of debit spreads, the trader who is utilizing this spread option either believes or hopes that the stock or ETF being used will move towards the direction of the options being used in the vertical spreads.

For example, in the trader has the opinion that a specific stock will be heading higher, instead of SELLING a call credit spread – that trader would instead BUY a call debit spread – or a bull call spread – which would then profit if a move higher did in fact happen.

Let’s look at an illustration of a call debit spread:

Buy 4 GLD 110 Calls
Sell 4 GLD 115 Calls

The debit – or the ‘cost’ of this trade is the difference between the two strikes of the trade. This trade profits when the underlying being used moves bullishly.

photo credit: petesimon