Before We Discuss Credit Spreads – Daily Update

What a crazy week this has been with a monstrous rally.Last week in our podcast, we talked about overnight and 3 day weekend risks — and how we bounced from 1800 all the way to 1930 in the S&P500.This week, we dipped below 1900 towards 1890 – before rocketing even higher above 1940 – towards 1950+.This week we had a very profitable week with a total of 4 trade – primarily credit spreads.Our trade from last Friday reached close to max profit this past monday. We had ether MOnday or Tuesday to exit that trade and on Tuesday, we posted on our blog the potential for downside before upside — and that’s exactly what happened.We were able to re-enter our bullish plays Wednesday morning and we ended up putting on 3 different bullish plays on Wednesday and Thursday at various times. The rally rocketed up even faster than it did from the 1800 lows — our trades reached max profit. We also have some trades expiring next week – so we are holding those over the weekend to take advantage of time decay.We finished the futures ending at 1944.In yesterday’s post Thursday, 2/25/16 S&P Hits 1950ES, As Predicted All Week!, we said ES hit 1950 – it actually kept going higher overnight all the way to 1968. However, during the day, it turned back down below 1950 all the way to 1942.

Yesterday’s S&P500 Hourly Chart

Today’s S&P500 Hourly Chart

This is a funky looking b-wave down. It doesn’t look like how it should if that were the top. I have to be open to the possibility that I could be wrong, but given the size of the big wave A and the big wave B – it would be a bit awkward if the size of this big C is just less than 2 days. So I’m leaning towards a little bit more. Let’s see how Sunday night trades.

3 Best Answers to What Is A Credit Spread

For a beginner starting to learn about credit spreads as they relate to options trading, it can be difficult to  really understand credit spreads and how they are useful — why traders even bother with something that’s more complicated than a simple buy or sell.A credit spread is simply a paired option trade that results in your account receiving (rather than paying out) a net credit.But that doesn’t really help you understand what it actually is and how it is useful for options traders.What you’re missing is this: Credit spreads allow you to bet where the market won’t go.Betting where the market won’t go is my favorite definition of a credit spread.But just so you get the big picture of it, we’ll start with why the credit spread was even “invented” which stems from the problems of traditional short sale of options (short calls and short puts). We’ll then show how “credit spreads” helps solve that problem. Then we’ll dive deeper into the mechanics of a credit spread from 3 perspectives on what a credit spread is – starting with a theoretical take, then a practical trader’s take, then a broker’s take. Once you know these, you can use credit spreads strategically to help you make money.

Problems with Traditional Short Sale of Options

Unlimited Theoretical Risk!

Selling short options is a a great way to collect premium upfront — the way insurance companies do. You collect a small amount upfront — so long as there is no big accident (ie stock goes above the strike price of that option you sold), you get to collect that premium and the option is worth $0 to your counter-party.

But the problem here is the “what if” scenario. What if that accident (stock goes above the strike price of that option you sold) happens — you will lose a TON of money. Can we mitigate that risk?

That’s where credit spreads come in. It’s not for free though. You’ll have to take a counter-position — buy an option, but ideally farther out strike-price and at a lower price than the option you sold. Should the BIG accident occur and  you lose a lot of money on that first option you sold, no worries. Your second, cheaper option you purchased cancels out the losses — essentially capping your losses.

And should no big accident occur, you collect your option premium like normal.

End result? Rather than collecting a full premium (as from a simple option short), you collect “net credit”. Net Credit = Full Premium – Cost of Insurance Option.
What did you get in return for this slightly lower amount you get to collect upfront? Protection against infinite loss, or having a defined max loss when “accidents” occur. These credit spreads are essentially safer versions of simply selling an option (which lets you collect money upfront – yours to keep so long as that option value doesn’t spike up).

Let’s dive deeper and look at 3 different definitions for a credit spread.

1) Credit Spread Textbook  Definition –

A credit spread is (most commonly) a 2-legged option trade of the same underlying stock/index with the same option expiration date — but the difference is that each option leg has a different strike price, resulting in a spread difference in value between these two strikes.

You short (sell) the strike that is closer to where the stock is currently trading at (hence you collect more money for this leg) — and you long (buy) the strike that is further away (hence you pay out less for this leg).The net result is a net credit — hence the name “credit spread” because you are shorting (collecting) the more expensive option while simultaneously buying (paying for) the less expensive option. Note this is opposite of a “debit spread” – in which the net result is that you pay out money to execute the trade.With credit spreads, the net result is that you receive money by executing the trade. So money money goes into your account with credit spreads, which is inherently opposite of what usually happens when you buy a stock, which involves money leaving your account. As rosy as this sound, this doesn’t mean you get to keep that money — because you are still under contract of those options you just entered — but it does make your cost basis positive and it does give you a little bit of cushion or room for error when trading.

2) Trader’s Practical Definition of Credit Spread –

A trade strategy that lets me bet the underlying stock/index will stay above or below a certain strike at the date of the option expiration.This type of bet is fundamentally different from a simple buy or sell stock scenario in which how much you make or less depends on how much the underlying stock/index moves away from where you executed your trade.With credit spreads, you can achieve your maximum profit even if the stock goes no where.When executed properly, this is a high-probability trade that lets you make money under 3 scenarios:a) Market moves in the direction you tradedb) Market moves nowhere (neutral)c) Market moves against you by a little bit (up to a certain break even point)So you can see, this is a very appealing trade set up — because you can potentially make money in 3 market scenarios — and so this can offer a trader some cushion in the event he/she is wrong by a little bit. As long as you are not wrong by a lot, you can make money.

3) Brokerage / Risk Analyst’s Definition – Credit Spread

A credit spread is a risk-defined trading strategy that does not require as much margin as the riskier alternatives of naked short puts and naked short calls. Credit spreads, because they are risk-defined trades, are allowable in many retirement IRA trading accounts. Their riskier alternatives — which consist only of the short leg and not the long leg of the paired option trade — are usually not allowed in retirement trading accounts because they involve unlimited theoretical risk. A credit spread without the long leg is either a naked short call or a naked short put. These naked short options carry unlimited risk and are generally not recommended for novice traders.The long leg of a credit spread removes the unlimited risk scenario that is inherent in the other short leg of the credit spread. Hence, when combined, it produces a risk-defined, limited loss strategy.

There are 2 types of Credit Spreads

1) Bull Credit Spreads (Puts)2) Bear Credit SPreads (Calls)These are the two most common (and profitable) types of credit spreads.

The Bull Credit Spread (Puts)

Credit =  Collect money now (but doesn’t mean you’ll necessarily keep it)

Bull = Your market view. You bet the underlying will stay positive (or at least neutral) relative to strike price of the option you shorted.

Put = Someone else thinks the underlying will go down but you don’t think so since your market view is bullish, so you’re happy to sell him this “put”. You make money so long as things stay positive (or at least neutral).

Spread = Adding in the second cheaper counter-option (put), but buying it rather than selling, you cap your losses, enabling a pre-defined risk on the bet. The net of the two options (higher priced put that you sold MINUS lower priced put that you bought) gets you the “credit spread” that you collect today.

These are paired option trades that involve taking two “put” positions — both with strikes lower than where the stock is trading at. One put will have a higher-strike price that you SELL, the other will have a lower strike price that you BUY. You can think of the higher-strike price put as your main bet, while the second “lower-strike price” put as your insurance — limiting your losses.

You sell the higher-strike put (worth more since it’s closer to where the underlying is trading at) while simultaneously buying the lower-strike put (cheaper since it’s farther from where the underlying is trading at) in one single transaction. This results in a net “credit” – positive gain that you can collect now. With these two positions, here are your 3 outcomes. The underlying stock…

    1: … falls and trades below the “lower-strike price”:  The lower strike price put makes money while the higher-strike price put loses money — essentially canceling each other out resulting in a neutral outcome once the underlying stock falls below that lower strike price. You essentially outline a “limit” for your losses should the stock price fall below this strike price — enabling a “pre-defined risk” or “pre-defined loss” outcome here.

    2: … stays above the “higher-strike price”. This is your “bull-ish” bet that the underlying stock will stay above the higher-strike-price. You already collected your premium when selling the higher-strike price put. The lower-strike price put is out-of-the-money and not worth anything (just cost you a small amount). So you get to collect your “net credit” — full amount or “max profit”. Essentially, this “bull-ish” credit spread (with two “puts”), makes you a defined profit when the underlying stock stays “bull-ish” or at least neutral.

    3: …falls somewhere between the “higher-strike price” and “lower-strike price”. Here, your “net credit” which is positive will gradually fall toward negative as you get closer to the lower-strike price. There will be a break-even point somewhere in between depending on how much the put options were sold vs bought at the two strike prices. Recall, losses will reach a limit once the stock reaches the “lower-strike price” and below — your loss there is capped.

Let me give you an example.

If the underlying stock or index is trading at 100, then you might short/sell the 95 strike put (collect $2 immediately on this bet that it won’t go below 95) while simultaneously buying the 90 strike put (pay out $0.25 immediately on this bet that it WILL go below 90), resulting in a net credit (+$2 – $0.25 = $1.75)

The 95 strike, because it is closer to where the stock is trading, will typically have more value than the 90 strike, which is further away from where the stock is trading. This difference in value creates a spread and results in a net credit when this single paired transaction is executed ($1.75 in the above example). As long as the stock/index continues trading above 95 (ie stays at 100), then you can lock in your net credit of $1.75. Even if the stock goes way higher to 110, the amount you gained is still the same — at the max of $1.75.

If the stock/index falls between 90 and 95, that net credit will start turning into a net debit, with the breakeven somewhere in between. Once the stock/index falls below 90, the net loss will be capped, thanks to the “small leg” of the trade (buying the 90 strike put directly offsets selling the 95 put at this point). The losses below 90 are capped and the gains above 95 are capped.

This strategy lets you bet that the stock won’t go below 95 (ie “bull-ish”) and the result is largely binary and capped on both the winning side (above 95) and the losing side (below 90). The “capped” nature of this bet makes it a safe risk-defined strategy, worthy of repeated use. In contrary, without that opposing option, you’d have a naked short put which has unlimited losses – a much more dangerous trading strategy.

One shortcut to remember, if you’re bullish (betting stock will remain above a certain price), you want to achieve that goal via selling a put (collecting money now), and buying cheaper (farther out) puts as insurance to limit losses.

Now, you might think, why don’t I do the opposite if I were bearish? Why don’t I “Buy the Expensive Put and Sell the Cheaper Put”?

Well, this creates a “Debit” spread since the result of this trade is that you are negative today. You still get the benefit of a pre-defined loss limit but for you to make money, the underlying stock needs to move in your favor (downward), rather than neutral. Debit spreads require a correct directional view to make money, but credit spreads can make money if your direction is correct OR when the direction is neutral. And you get to collect that money today.

The Bear Credit Spread (Calls)

Bear Credit Spreads work the other way around — but the predominant option sold is a “call” instead. If you’re bearish (betting stock will remain below a certain price), you want to achieve that goal via selling calls (collecting premium money now), and buying cheaper (farther out) calls as insurance (in case underlying actually does go up, you limit your losses). The “net credit” between selling the call (more expensive) and buying the insurance call (cheaper) gets you money now. \ As long as the underlying stock does not move upward, that call premium that you collected when selling is your money. That means if it goes down or stays neutral, you’re in good hands. However, if the underlying stock does indeed move upward, your cheaper “call” that you bought will serve as your insurance loss limit.With bear call spreads, you want both strikes ideally above where the market is trading. So if the market is trading at 100, you want to sell the 105 strike and buy the 110 strike, for example.Since the 105 strike has more $ value than the 110 strike, by selling the 105 and buying the 110, you’ll receive more than you pay out — so the net difference is a net credit to your account. So you actually receive cash by doing this trade. Of course, you can’t actually keep that cash, because it just sits there in your margin account and isn’t actually part of your net liquidation value — but having the cash there does help to improve your break even point just a little bit past your short strike. So if you are short the 105 strike and long the 110 strike — and say the cost of that transaction is a credit of 50 cents — then your break even point is actually 105.5 — not 105.

Credit Spreads As Insurance

Buying or selling Credit Spreads is kind of like selling insurance.With insurance – there’s some event risk – insurance companies bet that you won’t get into an accident. As long as you don’t get into an accident, you have to pay the insurance company  monthly premiums.If you do get into an accident, then the insurance companies pay for your high medical costs.But of course, before they are willing to do that, they’re going to want a lot of information about you — your age, how likely you are to get into an accident etc..–and based on that information, they price you a monthly premium — which is what you pay every month.Likewise, when it comes to selling options — and for most traders — selling credit spreads — we want information about the market. Based on volatility and other measures, the market prices weekly and monthly premiums for different levels of the stock market.If we want, we can sell insurance at any level — any strike price – in the stock market betting that that event risk – that accident — won’t happen. We are betting that the market won’t go there.So credit spreads are essentially a way traders, as well as investors, can sell insurance in the global stock market.That’s exactly what we do here at LifeStyleTrading101.

Using Credit Spreads to Bet A Stock Won’t Go Below A Certain Level

If a stock is trading at 100 and the trader wants to bet that it won’t go below 95 by expiration date, then he/she can initiate a bull put spread by shorting the 95 strike price.This would be considered a naked short put.  However, a naked put has significant risk. While technically not infinite risk, since the most a stock price can drop is all the way to 0 — it’s still a significant amount of theoretical risk. Additionally, the naked short put, like the naked short call, eats up an enormous amount of margin on your account and could prevent you from initiating any other trade in your account. So in order to reduce the margin required for naked puts, a trader will a put with a slightly lower strike — say the 90 strike.So at this point, the trader is short the 95 strike and long the 90 strike when the stock is trading at 100. This trader is effectively betting the the market won’t go below 95. The long 90 strike is simply there to satisfy margin requirements and provide a defined limit on the losses (should the underlying fall below 90). But the actual dominant view of this trade is from the first step taken — the short put (selling of that put) — which is a bullish (or at least neutral) view.

Using Credit Spreads to Bet a Stock Won’t Go Above A Certain Level

If a stock is trading at 100 and the trader wants to bet that it won’t go above 105 by expiration date, then he/she can initiate a bear call spread by shorting the 105 strike price.This is a naked short call position. However, this trade has potential unlimited risk to the upside in the event that the stock goes up towards infinite. Additionally, a short naked called option will eat up an enormous part of your account margin and you won’t be allowed to do other trades. So in order to reduce the account margin required to put on this trade while simultaneously removing the possibility of unlimited risk to the upside, a trader typically buys a call with a slightly higher strike — say the 110 strike.So at this point, the trader is short the 105 strike and long the 110 strike when the stock is trading at 100. What this means is the trader bets the stock won’t  move above the 105 level by the expiration date of those options.

Benefits of Credit Spreads

So both the bull put spread and the bear call spread are excellent ways to bet that the market won’t go below or above a certain point, respectively.These are excellent credit spread trading strategies that traders use that have many benefits.

1. Defined Risk

Credit spreads have the second component which acts as an insurance play, capping losses which tremendously improves the risk profile of a trade. Credit Spreads might not have as big a premium to collect (due to the cost of that insurance call) as a naked short, but the defined risk profile gain is well worth it. With risk more manageable, margin requirements at your broker are much much lower.

How much capped loss a credit spread takes in depends on how far out the “farther-out” strike price is of the 2nd option. The farther out it is (cheaper), the bigger the risk. The closer it is (more expensive), the smaller the risk.

2. Opportunity to achieve “max profit” with ample wiggle room

Unlike traditional stocks where you make less when the stock moves only a little bit and you make a lot when the stock moves a lot, this credit option spread bet doesn’t behave like that. Rather, your maximum profit is largely binary — if underlying stock is above a certain level, you get 100% of the profit. If underlying stock is below that level, your maximum loss is reached. Even if the stock expires really close to the short strike, AND it doesn’t cross it at expiration close, then we still reach maximum profit — that’s the beauty with credit spreads. Risk is defined AND you don’t have to be all that accurate to collect 100% of the profit.

You are simply betting that the stock won’t be above or below a certain level — how much it is above or below does not matter. All we care about is that short strike level — and if it doesn’t get breached and it expires that way, then we collect maximum profit from that trade.

3. Favorable Time Decay

Options are sensitive to time. The more time available, the greater the chance that the underlying stock could jump up to make a previously “out of the money” call option become an “in-the-money” call option.  As more time passes, the time value of this option falls more and more. It accelerates. On the last day before expiration,  you will see the biggest decline in the time value of the option. This gradual but then accelerated loss in the value of the option due to time passing, is known as time decay.

With a credit spread, each day the market does or does not move in your favor, your account value will increase slightly until max profit is reached on the day of expiration. Technically, you are long one option and short one option – so it may not be apparent how you are a “net-seller of options” and therefore benefiting from time decay.

The reason is because the option you are short is closer to where the market is at (the basic credit spread mechanics). The time decay here is larger than the time decay of your other option, which is long, but further away from the market price. Because this long option is further away, the time decay for that option is less pronounced than your short option, which is closer to where the market is. Being closer to market price, for an option, means the time value was originally high as there was a “good” probability that the option could go “in-the-money”. But each day that passes and this has NOT happened, the option’s value falls. Compared to the long option farther away — its time value was small to begin with (probability that that long option could become “in-the-money” the next day is small) and so each day that passes will result in a smaller time decay than for the short option that was closer to market price.

As such, even though you are long one option and short the other, you are effectively a “net-seller” of options and are benefiting from time decay. Of course, you would benefit MORE from time decay if you are simply short the option without having that other long option, but in that case, you would also be exposed to unlimited theoretical risk. With credit spreads, you cap your theoretical losses and at the same time are still a net-seller of options, benefiting slightly from time decay.

So because of this time decay benefit, your credit spread position will increase in value more and more as each day passes and the underlying stock does not cross the option’s strike price. While the counter-party’s options time-value decays at an accelerated rate toward $0, your option positions move in the positive direction, at an accelerated rate, toward max profit. Thanks to time decay, your position gradually goes up if nothing else changes — and that’s value you can realize by exiting the position.

Summary: What is A Credit Spread

A credit spread is a paired option trade where the sale of one option is used to take your dominant view on the market while a counter option is used as insurance protection to limit losses should things go the other way. The resulting credit spread has benefits of

1. defined risk loss (compared to a naked option short),
2. opportunity to achieve full max profit of the trade with ample wiggle room (the stock can go nowhere and you can make the same amount of max profit as if the stock moved a lot in your favor)
3. favorable time decay (the short option has stronger time decay being closer to the market price, rewarding you slightly more when the underlying stock is unchanged)

Most importantly, a credit spread allows traders to bet where the market won’t go. By shorting a call strike on the upside or shorting a put strike on the downside, a trader bets that the stock won’t go above that short call strike or won’t go below that short put strike.The trader is essentially selling insurance at this strike price. In the event the stock price does cross that line, then losses begin to go up exponentially. So it is important to pay extra attention with strike selection so you don’t get in trouble when the option becomes “in-the-money” — which means if the stock goes higher than your call strike price or below your short put strike.To learn how to trade credit spreads including bull put spreads and call spreads, subscribe to our trade of the week and follow along.