The previous post covered debit spreads, when you pay a debit looking for a stock or ETF to move in a certain direction. Credit spreads are just the opposite, with traders collecting premium upfront in hope that the stock won’t move a certain way.
What a Credit Spread Is
Credit spreads are the mirror image of debit spreads, with each part of the strategy reversed.
You sell options closer to the money, which are worth more. You buy an equal number of cheaper contracts further from the money. This will result in an upfront credit.
For example, say stock XYZ is at $100 and you expect it to move sideways. You might anticipate some chopping up and down, but not see it going under $95.
- Sell the $95 puts for $2.
- Buy the $90 puts for $1.
Including the money coming in and going out, a net credit of $1 will be added to your account.
Because you’re short the $95 puts, you want them to expire worthless. That will happen as long as stock XYZ remains above the $95 strike price.
So why buy the 90 puts? Those are a hedge against being wrong. They may lower your profit potential but also reduce your risk.
Create an Edge with Defined Risk
Remember that put buyers have the right to sell a stock. However put sellers have an obligation to buy shares if they’re under the strike price. This can turn into a potentially huge liability when a big selloff occurs.
For example in the case above, stock XYZ can hypothetically go to zero. That would create a staggering $95 loss per share in your account. While such declines might be rare, they can happen.
The credit spread mitigates this hazard by owning puts at the lower strike. In the case above, the 90 puts would limit their potential pain to just $5. Not fun, but not fatal either.
Call credit spreads have a similar structure to the upside. You sell calls near the stock price and buy cheaper calls at a higher strike. In this case, you’re hedging against a big rally.
Putting Time To Work
Time decay is the basic principle of credit spreads. We know that out-of-the-money options expire worthless. Credit spreads simply capitalize on this process while hedging to limit risk.
Still, there are some nuances. The pace of time decay accelerates closer to expiration, so it often makes sense to sell put spreads with no more than 2-3 weeks until expiration. This lets you capture the quickest premium destruction. (Which is good because you’re short!)
Second, events like earnings can distort time decay. Instead of premium disappearing at a smooth and predictable rate, it may occur all at once after the news passes. That’s why traders should know companies well before writing credit spreads. It’s important to understand the types of catalysts that can impact share prices.
Getting an Edge with Technical Analysis
Traders are always looking for an edge, or advantage to tilt the odds in their favor.
This is especially true when you’re selling credit spreads because the profits are limited to the income collected up front. You can’t count on a few huge winners to offset losses. Therefore it’s even more important to have positive expectancy.
Technical analysis is one of the most common ways to achieve this. Support and resistance levels can influence where a stock moves, and where it stops moving.
Sellers of credit spreads can benefit from these chart patterns. They might sell put spreads when a stock holds a support level or sell a call spread when it hits resistance.
Alternately, indicators like oscillators can help identify when a move is extended and poised for a reversal. This might include using the Relative Strength Index (RSI) or Bollinger Bands. Traders thinking a stock is oversold could sell put spreads, or call spreads if it appears oversold.
Beware of Volatility
Recent years have featured some dramatic volatility events. These caused painful losses for some traders who sold options to generate income.
While credit spreads include a built-in hedge, it’s also important to realize that they often work better at times of calm. When volatility slams the entire market, certain patterns stop working. Support levels don’t hold and ranges widen. This can throw a giant monkey wrench in a probability-based trading system.
That’s not an argument against credit spreads. It’s just something to bear in mind.
Remember that the goal is to capture time decay — not necessarily to short volatility. That requires predictability, which is easier when swings are less extreme.