Credit spreads strategy is the best option to generate consistent income in this crushing or strengthening trade market environment. On trading forum, you may have read that with credit spread strategy, traders can determine the amount they will lose or gain, even before they establish a position. It is true, let’s understand this easy to grasp tactic.
Credit spreads kinds
- Vertical put spread – Applied when market is assumed to be bullish
- Vertical call spread – Applied when market is assumed to be bearish
Steps to for successful credit spread positioning
When you sell spread, credit for the trade is received. This means, you get upfront cash for trade. The amount gets added in your account. In credit spreads maximum profit and loss is known in advance, before establishing a position.
- Maximum profit on sell spread will be the initial credit received and no more.
- Maximum loss will be the difference between spread width and credit received for spread sell.
Determine a direction
What is your assumption – Is it call or put? – Is it up or down? Is it bearish or bullish?
Find underlying with high IV rank
After determining the direction, look at market volatility, so as to increase your profits from credit spreads.
Perfect time to sell options is when underlying security has high IV ranking. It means the option prices are expensive and your chances to receive significant credit upfront increases in comparison to underlying security with lower IV rank.
Determine probabilities for profit
Probability of profit will depend on how much money you are comfortable to invest in a position. Calculate your probability of successful trade, which is more crucial than concentrating on percentage of credit you need to receive.
Credit spread goal
Credit spread goal is to generate net credit, which is your regular income. You cannot earn more money than the received credit. Credit gets generated when you purchase option at low prices. Alternatively, premium received on selling the option are comparatively high.
This difference in strike prices is termed as ‘Spread’. For example, in case strike prices fall five points at a distance and you –
- Sell for $1
- Risk is $400
- Reward is $1
When spread amount reaches .05 -.10, you can purchase it back again and put on new spread. In case, if you predict that strike prices will not be met let it expire valueless then keep the net credit.
Happenings are unpredictable
Each time a trade is made you wish to sell spread that expires valueless, so as to keep the total credit, but things occur.
If the stock moves away more from current price then things occur because market does not exist in ideal emptiness. Therefore, to maintain flexibility, you can have spread options close earlier, so as to avert potential risk happening, at expiry.
Credit spreads are regarded as bearish or bullish but expert traders find selling them OTM with low ITM odds, at expiry a neutral approach to generate income.