Credit spreads is a limited risk option strategy can be used to generate income from a modest bullish, bearish or even neutral view on a stock or ETF. However, this strategy is not ideal when a large move is expected. Credit spreads are popular due to their high probability of profit but this is traded off by risking more than what is received. This strategy is also short Theta and Vega, meaning that time decay and low volatility works in the favour of the investor selling the credit spread. There are 2 types of credit spread strategies that can be used:

Example: Consider BMO currently trading at $100

1. Bullish/neutral outlook - a bull put vertical spread can be used

• Sell $100 Put @ $4 Credit
• Buy $90 Put @ $1 Credit
• The maximum reward is the $3 income received. ($4 Credit -$1 Debit)
• The maximum risk is $7 (the difference between the 2 strike prices – premium received)

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For a bull put vertical spread, an “at-the-money” put is sold while an “out-of-the-money” put is bought. Even if there is a bullish outlook, selling a put alone has unlimited downside risk. By buying an “out-of-the-money” put, the net premium received is reduced from $4 to $3 but the risk is capped to the difference between the 2 strike prices minutes the premium received. At expiration, if BMO is trading:

• Above $100 – Maximum profit of $3 
• At $97- Breakeven ($0 profit)
• Below $90 – Maximum loss of $7
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2. Bearish/neutral outlook – a bear call vertical spread can be used

• Sell $100 Call @ $4 Credit
• Buy $110 Call @ $1 Credit
• The maximum reward is the $3 income received. ($4 Credit -$1 Debit)
• The maximum risk is $7 (the difference between the 2 strike prices – premium received)

For a bear call vertical spread, an “at-the-money” call is sold while an “out-of-the-money” call is bought. Even if there is a bearish outlook, selling a call alone has unlimited downside risk. By buying an “out-of-the-money” call, the net premium received is reduced from $4 to $3 but the risk is capped to the difference between the 2 strike prices minutes the premium received. At expiration, if BMO is trading:

• Below $100 – Maximum profit of $3 
• At $103- Breakeven ($0 profit)
• Above $110 – Maximum loss of $7

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Credit Spread Strategy

The most important guideline to remember about this strategy is that it should only be used during neutral market conditions or when there is a modest bullish or bearish sentiment. High volatility events such as earnings announcements should be avoided as there is a higher probability of the stock making a large move against the trade. Credit spreads are best utilized when the stock or ETF is trading in a range between a support and a resistance level. Overbought/oversold indicators or reversal chart patterns such as double tops/bottoms can be used as confirmation to enter a credit spread trade while the market is moving in a sideways range. 

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OptionsPlay’s research shows that bull put verticals have a slight edge over bear call verticals due to the effects of Vega. Because credit spreads are a short Vega strategy, lower volatility increases the likelihood of profit. During oversold conditions when bull put verticals are used, there are elevated levels of implied volatility and therefore, volatility contracts when there is a reversal and the stock or ETF rallies. The opposite is true for overbought conditions where bear call verticals are used. Due to muted implied volatility at the top of a rally, volatility expands when there is a reversal and price declines. 

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Is There an Optimal Credit Spread?

The key to finding the optimal credit spread is to find the right strike prices for your risk profile. Strike prices that are “near the money” allow for a better risk/reward ratio but have a lower probability of profit. Strike prices that are “far out of the money” have a high probability of profit at the expense of a worse risk/reward ratio. It may be tempting to use strike prices that are “far out of the money” that have a 90% probability of profit, however, our research shows that further out of the money strike prices do not generate enough income to account for when there is a big loss.

To find the ideal strike prices to use for credit spreads, stocks in the S&P 500 were analyzed over a 10-year period. The outcome of this research showed that the most consistent strategy that yielded the best results over the long term met the following requirements:

• The options should have expirations between 4-6 weeks 
• Sell 50 Delta call/put
• Buy 25 Delta call/put

When using the above guidelines, the income received per trade is usually around 1/3 of the distance between the 2 strike prices. This equates to risking $200 for every $100 received and has a 60% to 70% probability of profit. Because credit spreads are a short Theta strategy, shorter expirations are used to maximize the use of time decay as weekly options are affected by Theta more than monthly options. 

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Managing a Credit Spread

When to enter a credit spread – Ensure price is moving in a sideways direction and look for overbought/oversold conditions where a reversal is likely.

When to exit a credit spread – The goal for this strategy is to let it expire worthless and keep the entire credit received. The guidelines to taking profit and cutting losses are more complex:

• If you have made more than a 50% gain with more than half the time to expiration, exit the trade. This is because the risk of credit spreads gets higher the closer it gets to expiration.
• If the credit received is greater than 1/5 of the difference between the 2 strikes, cut losses between 75%-100% of the premium received. 
• If the credit received is less than 1/5 of the difference between the 2 strikes, cut losses between 100%-200% of the premium received. 

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Summary

Credit spreads are a forgiving strategy that allows for income generation even if the stock moves in the opposite direction of the intended outlook. This is traded off by risking more than the income received when the stock moves significantly against the expected outlook. It is important to remember that this strategy should only be used under neutral market conditions and not when a large move is expected. By following the guidelines and best practices, credit spreads are a great way to generate a consistent stream of income for your portfolio.

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