Credit Spreads For More Income

Credit spreads are a great way to make a consistent profit.

I thought I'd share it with you because I found employing credit spreads result in a high probability of making repeated small profits, especially when the stock market is range bound. It is a strategy I use repeatedly to make additional income.

A spread is a strategy that sells option contracts while simultaneously buying a certain number of different option contracts. This limits your profit potential and also limits your risk.

The "credit" means that this strategy results in a credit to you. The money received from selling the options is more than the cost of buying the options which are farther out-of-the-money.

The spread is a vertical spread if you buy and sell the same number of contracts with the same expiration date.

You can create a diagonal spread which means the expiration dates are different.

You can create a ratio spread which means the number of contracts you sell differs from the number of contracts you buy.

You can create a calendar spread which means the strike price and number of contracts are the same, but you sell options with a near term expiration while buying options with a longer expiration (or versa visa).

I like credit spreads because the three sets of variables (direction, time, and magnitude) required for profiting are stacked in my favor.

1. Direction. Only one of the three possible directions can hurt me. The other two directions are on my side.
2. Time. Each day that passes increases the probability that I will keep my premium.
3. Magnitude. Each day of market movement that is consistent with historical volatility increases the probability that the stock will not move far enough to hit my near strike price before expiration date.

I only have to be right on one of these three factors to keep my premium. And I often do.

The odds are in my favor especially if I enter a trade that is consistent with the current market trend.

My Favorite Credit Spread

I prefer the vertical spread.

Ratio spreads do not fit my risk tolerance since credit ratio spreads usually result in selling more contracts than you buy.

I occasionally use calendar spreads, but only when the market is going sideways. A trending market does not work well for calendar spreads.

I have tried several different diagonal spreads but have not been satisfied with the delta or theta from those positions. I continue to look for different ways to create the perfect diagonal, but so far haven't found one that beats the vertical spread.

Many traders like the Iron Condor. I do not trade these during trending markets. When the markets are not trending I prefer to use the calendar spread because they are less complex. It's a personal preference.

My Credit Spread Rules

These are the rules I use when developing a credit spread.

• Pick a near strike price that is out of the money that has less than a 30 percent chance of expiring in the money by expiration using historical volatility. I will place the strike on the other side of a technical resistance if I can find one.
• Pick the width of the spread. I don't want the position to risk more than 1% of my portfolio.
• Pick the expiration date. I don't want the expiration more than one month out. Time decay is largest during the month prior to expiration. I don't want to give the underlying stock time to move.
• Watch the position.

  I will close the position if the underlying stock closes half the distance to the near strike within the first half of the trade duration. For example, let's say the stock is trading at $10 and my near strike is at $16 when I enter the trade (1-month expiration). I will close it out if the stock closes above $13 within the first two weeks.

  I will also close the position if the underlying stock closes above the near strike price during the remaining two weeks.

  If I enter a trade and the the spread has only 2-weeks to expiration, I would exit the trade if the underlying stock travelled half the distance within the first week.

  You may question why I do this. It is my method for risk management. There are a million ways to do it. You should establish rules based on your risk tolerance.

How much profit should you expect?

Let's use two examples. Both strategies profit if the stock market continues to go up (the current trend is up):

Example 1: Bull Call Spread.

SPY trades at $133. You buy one 135 call contract for $0.89 and sell one 140 call for $0.05, both with the same expiration date.

The net debit for this trade is $0.84 (or $84.00 since each contract is worth 100 shares), and it is your total risk. The potential gain is $416 ($500 minus the $34 debit), which is upwards of a 500 % gain on the amount at risk. The potential risk is the $34 debit you already paid.

Example 2. Bull Put Spread

SPY trades at $133. You sell one 130 put contract for $0.83 and buy one 125 put for $0.55, both with the same expiration date.

The net credit is $0.28 (or $28.00 since each contract is worth 100 shares). Your potential gain on the amount at risk is 5.6%. Your risk is $472 ($500 minus the $28 premium).

Notice the first example is a debit spread while the second example is a credit spread.

Many inexperienced options traders would place the trade in Example 1 because of the profit potential. However, in placing that trade you need the market to move $7 (over 5%) in one month. This is probably unreasonable to expect given historical volatility.

More experienced traders will go after Example 2. The potential gain is 5.6% on the money you have at risk. But to lose your money the market will have to break its trend and then fall more than 5% within the time to expiration. Your trade rules should get you out of the trade before that happens. The probability of success is on the side of the trader in Example 2 considering the market conditions.

Additionally, the 5.6% monthly gain results in a 60+% annual gain. Placing these credit spread trades month after month will result in substantial gains to your portfolio.

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