Investors that are starting their options trading tend to have smaller trading accounts with the aim to be able to grow the account. While this is not very easy, there are some best practices and strategies investors can use that provide an edge for smaller accounts ($2k - $5k). Some popular strategies such as Covered Calls are an excellent way to generate a continuous stream of income for investors using shares they already own. Unfortunately, Covered Calls require that the investor owns at least 100 shares of the underlying stock to be able to sell the call option. This is something that small account holders may not have. So what strategies should you focus on to grow your trading account? There are some strategies that are better suited for smaller accounts but the most important aspect of growing a small account is discipline. Having discipline when trading helps build confidence, gain consistency and provides a clear understanding of the strategy. Using a simple options strategy with repeatable steps is the best way to go for smaller accounts. Credit Spreads are a powerful strategy for small account holders and are a great way to generate consistent growth in your options account.

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Account Requirements

To use the Credit Spread strategy, investors are required to have an options account with Level 3 clearance. This allows investors to trade spreads. Investors are also required to have a margin account with a minimum of $2000. Account sizes that are less than $2000 can be difficult to grow. Arguably the most important requirements are access to education, practice and tools. This empowers investors with the knowledge, best practices and confidence to gain consistency in their options trading.

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The Strategy: Credit Spreads

Credit Spreads are a powerful income generating strategy for options traders. This strategy tends to have a high probability of profit as it is quite forgiving in that the strategy can still be profitable on a bullish or bearish trade, even if the underlying stock remains neutral. While Credit Spreads do limit the maximum profit to the credit received when selling the spread, the high probability of profit can provide the consistent returns needed to grow a small trading account and also gives the investor confidence by being profitable in the majority of the trades when used correctly. Credit Spreads are a limited risk and limited reward strategy. Should the underlying make a significant adverse directional move, the investor is protected and will not lose as much as selling a naked call or put option. 

A Credit Spread is a 2-legged option strategy that involves selling a near or at the money option and buying an out of the money option. This results in a net credit received which represents the maximum reward of the trade. The aim is to buy back the Credit Spread at a lower price than what is was originally sold for. There are 2 types of Credit Spreads:

• Call Credit Vertical Spread – Bearish/Neutral
• Sell an at the money Call option
• Buy an out of the money Call option
• Moderately bearish/neutral directional view
• Put Credit Vertical Spread – Bullish/Neutral
• Sell an at the money Put option
• Buy an out of the money Put option
• Moderately bullish/neutral directional view

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Example: Stock $BMO is trading at $100. The investor has a bullish outlook on the stock and will therefore sell a Put Credit Spread:

• Sell to Open 1 $BMO $100 Put @ $5.00
• Buy to Open 1 $BMO $95 Put @ $3.00 
• Net credit received = $2 (max gain)
• Max loss = $3 (vertical width – net premium received) ($5 - $2)
• Breakeven stock price = $98 (short strike – net premium received) ($100 - $2)

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If the $BMO rallies higher, the value of the spread will decline and the investor can buy to close the Credit Spread at less than $2, resulting in a net profit. The long strike ($95) represents the cut off point for the maximum loss If the stock were to decline, losses are capped at the spread width minus premium received. In the example above, even if $BMO declined significantly below $95, the spread will still have a maximum loss of $3 at expiration. The maximum profit is achieved as long as $BMO stays above $100 by expiration. If it expires between $100 and $98, a partial profit is made from the trade. In the event that $BMO expired between the short strike, $95 and the breakeven stock price, $98, a partial loss is incurred. 

It is important to note that Credit Spreads are a positive Theta strategy – they benefit from time decay eroding the value of the spread. This is why Credit Spreads are still profitable even if the stock does not move. 

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When to use Credit Spreads

Generally, Credit Spreads should be used at areas where a price reversal is likely as it provides a better risk/reward trade setup:

• Support and resistance – Put Credit Spreads should be used at support as they are a moderately bullish strategy that will become profitable should the stock rally. Call Credit Spreads should be used at areas of resistance where a decline lower can be expected. 
• Overbought and oversold indicators – these indicators give a sense of whether a stock has rallied or declined too far and a price reversal is likely to happen. An example of this type of indicator is the RSI. It is always best to prioritize the price action of the underlying and use the indicator for confirmation rather than only relying on the indicator itself.
• Trading ranges – trading ranges occur when a stock is moving sideways between a support and resistance level. Utilizing credit spreads at support (Put Credit Spreads) and resistance (Call Credit Spreads) allows investors to profit should the underlying remain in the trading range. 

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Best Practices for Credit Spreads

Using the following best practices is key for investors to achieve sustainable and consistent growth in their trading accounts:

• Open Credit Spreads at 45 days to expiration – this timeframe usually gives a good premium payout and investors can take advantage of the acceleration in time decay that occurs for shorter dated options compared to longer dated options. 
• Sell the 50 Delta and buy the 25 Delta – our research shows that using the 50/25 Delta rule provides the best risk/reward for Credit Spread trades as it generates a decent premium while limiting the downside risk. This results in a net 25 Delta for the trade which allows the trade to profit immediately should the underlying make a favorable directional move rather than simply waiting for time decay to erode the value of the spread. 
• The 33% rule – investors should always look to receive a minimum of 33% of the vertical width in premium. A $10 credit spread should receive at least $3.33 in premium for it to be considered optimal. The more premium collected, the better. 
• Stop Loss and Take Profits – The general rule of thumb is to take profits at a 50% gain and cut losses at a 100% loss. If a Credit Spread is sold for $3, the take profit for this trade is at $1.50 and the stop loss is at $6.00
• The 21 Day rule – this refers to always closing a Credit Spread at 21 days to expiration (if the take profit or stop loss level has yet to be reached). This is due to Gamma risk. Gamma represents the rate of change of Delta and increases significantly after 21 days to expiration. This means that a small adverse move in the underlying could take a bigger than usual chunk of unrealized profits. It is usually at 21 days that Gamma outweighs the positive effects of Theta working in your favor. 

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Risk Management

Even by using a powerful strategy like Credit Spreads, growing a small account can be challenging and utilizing sound risk management principles is arguable more important than the options strategy itself. Good risk management is usually the differentiating factor between profitable traders and traders that blow up their account. In addition to the best practices for Credit Spreads, investors should also follow a set of rules that govern their risk tolerance and how they trade:

• The maximum risk of a trade should not be more than 2% of your account
• The maximum number of open trades should not exceed 5 (10% total risk)
• Do not roll a losing position. Learn to let losers go
• Think long term. Prioritize trading another day instead of making an “all or nothing bet”

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Summary

Growing a small account takes patience, discipline, confidence, and a good understanding of the options strategies you want to use. It is always best to keep things simple and keep your trades small to avoid account blowups from one or a few bad trades. Practice your strategies using paper trading services and trade often to gain a fundamental understanding of how these strategies perform. By using the best practices mentioned above and keeping risk management top of mind, growing a small account becomes that much easier!

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