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Trading Vertical Credit Spreads

by | Dec 22, 2021 | Strategy

The prior post I wrote discussed the basics around Vertical Debit Spreads and how to use them. Now let’s look at essentially the opposite of a debit spread, which is a credit spread. The beauty of options is that you can construct all sorts of trade strategies based on what your market assumptions are. Vertical credit spreads are an excellent way to create a defined risk directional trade that also benefits from time decay. A credit spread is the flip side or opposite of a debit spread because instead of buying the closer to the money strike option, you are selling it when trading a credit spread. A vertical credit spread is easily created by selling an option that is either at-the-money (ATM) or out-of-the-money (OTM) and then buying a further OTM option to define the risk. You will always sell these as a credit to open since the near money strike you are selling is worth more than the long option. When selling a credit spread you want the stock to move away from the strike you sold before expiration as the best case scenario is that both options lose value and expire OTM and are worthless. 

Credit Spread Benefits

The main benefit of a credit spread is the combination of being defined risk and still taking advantage of positive time decay in a directional manner. That means you can have an opinion about where a stock might go by expiration and still benefit if the stock only grinds towards that direction or stays sideways. If a trader buys a long call and expects the stock to rise, there’s only one way to profit, if the stock rises. And it must rise in a quick way generally to offset the time decay or theta. With a credit spread you instead have time on your side. This is partly why credit spreads are one of my favorite strategies when trading options. Not needing to be precise with your entry and being able to sit through the inevitable fluctuations of the market allows you to use duration and allow enough time to be profitable on your idea. Because you are selling a spread for a credit and benefiting from both directional moves in the stock and time decay in the options, this makes credit spreads a higher probability trade than debit spreads or simple long calls/puts.

Short Put Vertical Credit Spread (Bull Put Spread)

Directional bias: Bullish

Max profit: Credit collected

Max loss: Difference between width of spread and credit collected

In the example below using Nvidia stock, you can see that a NVDA January 290/280 put vertical credit spread is about $4.00 per spread. With the stock currently at 294, you can sell this OTM put spread and if NVDA rallies or even just stays above 290 by expiration in January you make money. Infact, NVDA can close below 290 on expiration day and you still make money because you sold the credit spread for 4.00 making your breakeven 286 (290 minus $4 credit received). A breakeven which is a full 8 points lower from where the stock is today. That’s the benefit of trading credit spreads in a nutshell. The stock can stay at the current price for the next month and this trade still wins from time passing. Of course a rally makes money much sooner and so this is still a positive delta trade.

Max Profit and Managing Risk

As the risk graph shows, the max profit you stand to make is that $4.00 credit collected at order entry or $400, and the max loss is $6.00 or $600. This $600 is also the buying power requirement to make the trade. So for the potential to make $400 you only have to put up $600 in capital. Newer traders might look at the risk/reward and not like it but in exchange for a smaller max profit you get a higher probability of that profit happening. You can see in the graph that if NVDA stock rises about 20 points to the 314 zone, the put credit spread falls in value and the spread you sold is likely profiting around $200 per spread. Since this is a directional trade it makes sense to enter a bull put spread at support after the stock has pulled back. If part of your strategy is buying dips in strong uptrends, it’s a great idea to have levels in mind where you would sell a put credit spread on the pullback.

In general when selling a 10 point wide spread for $4.00 you are getting about a 60% probability of profit based on the option pricing models probabilities. If you would sell that same spread for $3.00 then your probability of success rises to 70%. 

In my experience the sweet spot to target on a credit spread is somewhere between 30-40% of the width of the spread. That means on a 10 dollar wide spread, selling between 3.00 and 4.00 credit is a reasonable risk/reward. On a 5 dollar wide spread that is around 1.50 to 2.00. This provides enough credit for the risk you are taking while still having a decent probability of making something. Every stock is different and often these strategies are best employed with higher implied volatility stocks that have juicy credits. When looking to take profits on a credit spread, the simple target can often be buying back for 50% of the credit received, especially when you get that directional move quickly in the stock and there is still plenty of time until expiration. Also it’s often best to not hold these into the final week of expiration as gamma risk becomes higher and you are essentially just relying on the stock to move your way. If still bullish on the stock, it can be smart to just close and roll to the next month’s expiration, maintaining the similar position and collecting more credit.

If the trade goes against a trader, it can be closed by buying back the credit spread for a higher price than was entered. The risk management plan will differ for each trader, whether you look to close when the stock changes trend or something technical triggers an exit. The risk is defined at entry based on the spread but you can also manage a loss but closing at 1x of the credit received if preferred. For example if I sold this spread for 3.00 and it goes to 6.00, something clearly is not going my way so it may benefit me to close the trade and still have that 1 to 1 risk reward ratio in play while moving onto the next trade idea.

Short Call Vertical Credit Spread (Bear Call Spread)

Directional bias: Bearish

Max profit: Credit collected

Max loss: Difference between width of spread and credit collected

The opposite of the put credit spread is the call credit spread. Instead of selling a put spread if I am bullish, I can sell a call spread if I am bearish. The characteristics of a call credit spread are the same as a put credit spread in that risk is defined and max profit is the credit collected. Selling an ATM or OTM call and buying a further OTM call strike creates the short call vertical spread. This is fairly black and white as credit spreads are similar no matter if you trade put verticals or call verticals, the main difference being your directional opinion on the stock. Just as with a put vertical spread, if you sell a call spread in a higher implied volatility market environment you can collect more credit for the trade and position your short strike further away from the current stock price. 

In the example below you can see the QQQ Nasdaq January 400/405 call credit spread can be sold for $2.00 or $200 per spread. With the stock currently just above 394 that means even if QQQ stays under here or goes up small towards 400 you still potentially can be profitable by January expiration in one month. The breakeven on this bear call spread is 402 (400 short strike plus the 2.00 credit received). You can see from the pink line in the graph that if QQQ drops roughly 10 points to the 384 zone, the credit spread you sold for 2.00 is now worth closer to 1.00, which means the trade is up $100 per spread. Since this is a directional trade it makes sense to enter these call credit spreads at resistance or after a rise in the stock.

You can see the clear advantage of credit spreads. By giving up the unlimited profits potential that so many traders are lured into with options, you can increase your odds on every credit spread trade you enter. This is an incredibly useful strategy I like to use in volatile markets or into binary events like earnings reports. The most important thing in trading is to define your risk when putting on a directional idea. The vertical credit spread achieves that and plenty more. If you only want to risk 2-3% of the account on each trade, then structure a credit spread to make that your max risk. Enter the trade and then let time play out and the stock do what it’s going to do without worrying about each fluctuation. Since a credit spread is a premium selling strategy it inherently has a greater than 50% probability of making money. The further away you sell a credit spread from the current stock price, the greater the chance it expires worthless and you keep the full credit. However, it’s best to collect enough credit to make the risk worthwhile.

Takeaways:

  • With vertical credit spreads you are always selling the strike price closer to the current stock price and buying a further out of money strike. 
  • Vertical Credit spreads are defined risk.
  • Max profit on credit spreads is the credit you collected when entering.
  • Max loss is defined and is the difference between the spreads width, minus the credit collected.
  • Credit spreads are still a directional trade but offer positive time decay.
  • Selling credit spreads in higher IV helps collect more credit and increases odds of profit.