One of the hardest things about investing is waiting on the sidelines with idle cash. The way the market has been going lately it is hard to buy with anything other than reoccurring investments. However, there is a solution for letting your idle money work; credit spreads. Whether you use a bull put spread or bear call spread, this is a way to make money with defined risk and benefits.
What is a Credit Spread
There are two types of vertical spreads, a debit spread and a credit spread. For purposes of simplification, we are only going to be discussing credit spreads today. Essentially a credit spread works by selling and buying a contract on the same underlying security on the same expiration date. The goal of this spread is to open a position for a net credit and use time decay to collect premium with a defined set of risk.
There are two different sets of credit spreads that we can use depending on our overall sentiment regarding the security. If we are moderately bullish we can use a bull put spread. This involves selling a higher strike price contract and than buying a lower strike price contract at the same time for a net debit. Our maximum profit is achieved if the security is above our short contract at expiration. Our maximum loss occurs if the underlying security is below our long put which would cause a loss of of the width of our strike prices.
Bull Put Spread Example
To give you an example, let’s say XYZ is currently trading at $50 a share today on 3/10/2021.
We decide that we have a short term, moderately bullish view on XYZ so we decided to open a put credit spread. We open a $45/$44 spread for $0.10 in premium for the 4/16/2021 expiration. Each spread that we open has a defined risk of $100 from the spread width while we receive $10 up front for each one. We will have a return 10% at maximum profit (if XYZ is above $45) and given there are 37 days between today and expiration, an annualized return of 98.65%. Our maximum loss would be $100 per spread. Pretty fantastic returns for playing with our idle cash.
Bear Call Spread Example
What if we have a short term moderately bearish view on XYZ in this situation? Then we can flip to using a bear call spread instead of a bull put spread.
In this situation we might take a look at selling a call at $55 and buying a call at $56 for the same expiration date of 4/16/2021. This results in the same defined risk of the spread of $100 and lets assume we also receive $0.10 in premium for this. It gives the same risk and reward profile. However, our maximum profit is achieved if XYZ is below $55 and our maximum loss is above $56 for this trade.
Why Use Credit Spreads
Credit spreads are a great way to utilize your cash for short term positions to create extra income. They are close cousins to poor man’s covered calls in the sense that your using options to cover your position. Also a quick shoutout to the folks over at r/thetagang for some of their research into different strategies for utilizing time decay.
You see time decay is one of the foundational principles of option strategies. When you are buying options, you are usually racing against time decay to achieve your desired payoff. When selling options, you are hoping to speed up the clock so time decay can work its magic. Time decay actually speeds up the closer we get to expiration, allowing us to lock in the premium we are searching for quicker. You can use the below chart for reference.
The green arrow represents an option contract that is a few months out and how little time decay we see. On the other hand if you look at the red arrow, that is where most the time decay is effecting the intrinsic value of the option contract. That is why when I am trading credit spreads I am usually looking between 30 and 45 days to expiration. I want to get the most premium decay I can to increase the likelihood of a successful trade.
Managing a Credit Spread
There are a couple things we can do as investors to manage our credit spreads. The first is to pay attention to earnings. Usually when earnings are set to be released by a company there will be more implied volatility, resulting in juicier premiums. We want to avoid these periods if we can, as tempting as they may be. It removes a degree of volatility from our portfolio and we are looking for stable returns.
The next thing we can do is knowing when to pull profits. I usually shoot for 50% of maximum profit before I close my position and allocate my capital elsewhere. If I am able to achieve 20% in the first week I tend to close the position even earlier. Remember, bears and bulls make money, it’s the pigs that get slaughtered.
With that being said, it is also important to identify losing positions and cut them early. We would much rather lock in a 50% loss than wait and see if a position turns around. This is how you quickly get yourself in a position in which your maximum loss is achieved.
Credit Spreads: A Recap
Credit spreads can be a great way to generate some premium when they aren’t tied up in other securities. This can be a way to boost returns in the current interest rate environment. Credit spreads are also a way to get more familiar with option trading because they have a defined risk.
Are you currently trading credit spreads or other option strategies? Let me know in the comments below how it’s been working for you!
I look forward to continuing this conversation on Twitter. You can find me over @CaveMillionaire feel free to send me a tweet or a DM with your questions!