The versatile credit spread is designed to collect credit premiums when a stock moves up, down or sideways.
Credit spreads are one of the most powerful tools a trader has in his arsenal. Why? Because it is rare for a stock to move only in one direction, either up or down. It might move up a couple days then down a couple days, but overall if a stock moves up or down more than 20% in a year, it is a big event. Credit Spreads allow you to take advantage of these market moves.
With a credit spread you can hedge your downside risk by collecting credit premiums on your trade regardless of market directional movement. Let’s see how.
What Is A Credit Spread?
A credit spread in a simple option trade in which the trader sells one option and buys another option farther away from the money. This results in a credit to the trader. This credit is the max amount that can be made on the trade and is deposited into the traders account as soon as the trade is made.
Example: XYZ stock is currently trading at 100. A trader feels XYZ is a good candidate for a Put Credit Spread. This trader think XYZ is a great company and the stock is going to continue its uptrend. So he sells one 90 strike Put, and buys one 85 strike Put. The credit he receives is 60 cents.
In this trade the highest premium the trader can keep is 60 cents or $60 because each option is made up of 100 shares. The most the trader can lose is $440. This max loss is also the margin requirement the broker will require to be in the account to make the trade.
We can calculate the margin/ max loss by subtracting the credit from the difference between the strikes. In this case 90-85 = 5. So $5 is the max loss per share. But the trader already got paid .60 per share for the trade so the max loss really is $4.40 per share or $440 per option spread.
We calculate the return on our credit spread options trade by dividing the potential profit by the amount used for the trade. 60/440 = 13.6% potential return on this trade.
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How the Credit Spread Option Trade Makes Money
Ok so now we have the trade. But how does it work?
Since we are short the 90 Put, we want XYZ to stay above 90. If it is above 90 at expiration (30 days in our example) then we get the keep the whole credit. XYZ could go up or it could stay around 100 or even down 10% and the trade still makes money.
Even if XYZ goes below 90, as long as it stays above our breakeven point of 89.40 we still make money.
In our example the trader thought XYZ was not going to go down. But if he thought instead that it was going to drop, he could have done a Call Credit Spread using Call options instead. The idea is the same except that he would not want XYZ to rise above the strike of the call option that he sold.
Finding Credit Spread Trades
Since the credit spread is so easy to trade, it can be done on any optionable stock, ETF or index. The more volatile a stock the more expensive the option and thus the more credit you get. Also, the more expensive the stock, the more expensive its options.
Many traders use technical analysis to find trades. Find a stock in an uptrend and sell Bull Put Credit Spreads month after month. Or do the opposite. Find a stock in a downtrend and sell Bear Call Credit Spreads
Other traders only trade their favorites. So if you like trading a stock like Apple, you can sell call spreads or put spreads depending on what direction you think Apple is going to move. And if you think Apple will just sit there and do nothing, you can sell both a call spread and a put spread at the same time. That is called an Iron Condor and something I do on a monthly basis – but not in Apple.
What’s the Risk?
Does it sound too good to be true? It’s not, but there are risks involved. If you look again at the example above we could make $60 but also lose $440. If XYZ has bad news the stock can drop. It has happened to every stock. For this reason, credit spread trading is usually reserved for the educated and trained trader.
So you have to protect yourself. Notice that a credit spread is made up of two options, one you sell and one you buy. If you did not buy an option your position would be considered naked and your risk could be unlimited. By buying an option we start off by limiting the credit spread risk.
Second, you must have proper money management. If you have a $10,000 account, putting it all in Put credit spreads on IBM would not be a good idea. You need to spread your money around so it is not at risk in the same trade, in the same direction, or in the same month.
If you sign up for my FREE Option Selling Course I will show you some examples of Credit Spread trades I did and how I adjusted them. To sign up just fill out your name and email in the sign up form at the Top, Right of this page.
Third, you should know how to adjust your position when it gets into trouble. This is probably the most crucial part of the formula. Anyone can put on a credit spread. But it takes a real trader to know how to fix his trade when it gets into trouble. By proper adjustments, you can limit your loss, breakeven, or still make money on a trade even if it goes against you.
Once you get a good handle on the credit spread you can get into more complicated option positions like the Iron Condor, the Butterfly, and the Iron Butterfly. These positions are all made up of credit spreads.
A great way to understand any trade is to get experience trading it. That is why I recommend paper trading to all my members. Paper trading is always a good idea. When you get started, don’t just paper trade one spread, pick 20 stocks and put on a trade in all of them. Keep records about why you went with calls or puts and why you chose the strikes you did. Eventually you will see what works for you and you can develop your own trading style.
Or you can join a service like mine and see what spreads I am trading. You can see how I choose my trades and how I manage them. Trading along with a professional trader is the best way I can think of to get started on the right foot.
Your Own Credit Spread Business
With enough practice, experience, and a proper trading plan you can actually turn trading credit spreads into a business. Since there are options for every month in the year, you can just trade credit spreads month after month.