Credit Spreads
A credit spread involves the simultaneous purchase and sale of puts (or
calls) that expire at the same time but have different strike prices. Puts
are used if you are bullish on the underlying stock or index, while calls
are used for a bearish outlook. For out-of-the-money credit spreads, the
strike price of the sold (or written) option is closer to the underlying's
market price than the purchased option and therefore has a higher premium.
This results in a net credit. The goal of a credit spread position is to
retain this net credit by having both options in the spread expire
worthless.
This strategy allows investors to achieve both steady rewards and
controlled risks. This is accomplished by collecting premium up front and
waiting until expiration, when hopefully the positions expire worthless.
With credit spreads, the effect of time decay is working for you, not
against you.
Credit spreads offer two primary advantages over straight put or call
purchases. First, by using out-of-the-money options, you can profit from a
wide range of outcomes, including the market moving somewhat against your
expectations. If you initiate a bearish credit spread with the sold call
option two percent out of the money, you will keep the entire premium if
the underlying stock or index moves down, stays flat, or goes up two
percent. Only when the sold option slips into the money is your position
at risk of losing value. In addition, losses are usually capped at the
difference between the strike prices of the options minus the premium
collected. This will become clearer in the example below.
The second advantage is that no commission costs are incurred to exit
your most successful trades. This occurs when both options expire
worthless, allowing you to retain the full credit. Worthless options
require no closeout and hence do not incur commission costs. This feature
thus increases your net return on a winning credit spread trade.
Normally, a credit spread investor trades front-month options only, as
the time decay evaporates most rapidly in the final month ahead of
expiration. The quick time erosion benefits credit spreads, assuming no
change in the other variables that affect option pricing - underlying
security price, volatility, dividends, or interest rates. Plus, with their
limited life spans, front-month options allow less time for the underlying
to move substantially against you. Such a move has a far more
negative impact on a credit-spread position than the benefits of having
the underlying move for you.
We have found that it is normally considered more beneficial for the
credit spread investor to use index options rather than equity options. A
gap in one component of an index will not unduly affect that index, while
an equity that gaps sharply in the wrong direction (i.e., on an earnings
report or a restructuring plan) gives you much less ability to manage risk
in equity option credit spreads. Note that it is not always appropriate to
initiate a credit spread trade in every expiration month. Successful
credit spread investors will identify periods of excess short-term
volatility and avoid these periods, as there is a risk of getting whipped
out of a trade in a volatile environment.
Here are a few points to keep in mind.
First, as with all options, your assessment of the underlying stock or
index is the most important factor. For credit spreads, the only objective
is for the sold option to stay out of the money. This means that you can
be less precise in your assessment of the underlying, a luxury not
afforded to a straight option purchase. This also means that credit
spreads can be profitable in a range-bound market environment, as
out-of-the-money spreads can profit from the lack of a directional move.
Nevertheless, for bullish spreads, make sure that there is solid downside
support above the strike of the sold put (e.g., a moving average, heavy
put open interest, the bottom of a trading range, etc.) to increase the
probability that the options finish out of the money. The opposite would
be the case for a bearish spread using calls - look for overhead
resistance below the strike of the sold call.
Second, make sure that the spread is initiated at strikes that are
sufficiently out of the money. In other words, give yourself a cushion so
that the position can withstand a move against your expectations. The
trade above, for example, incorporated a cushion of over three percent.
Note that volatility becomes an issue. If market volatility is high, you
may have to build in more cushion to avoid getting whipped out of your
position. Credit spreads are thus better suited for a low-volatility
environment.
Third, adjust your spread width to allow enough premium to match the
risk of the trade. For the SPX, if five points doesn't provide enough
credit, look at a 10-point spread. Remember that the wider spread will
also have a greater loss potential and a larger margin requirement. QQQ
offers the added flexibility of allowing spreads in one-point increments
over a range of strike prices.
Finally, as with all option trades, it is important to consider
transaction costs. This is especially true with spreads where two
commissions are incurred to open the trade. Thus, you may want to consider
several contracts as a minimum play to make a spread trade worthwhile.
