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.

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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 while maintaining a limited risk profile.

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