Trading stock options credit spreads

Hi everybody and welcome to this section on credit spreads. In this class today we will be debating the importance of adjustments and what can happen to you if you don’t know how to properly manage your options positions. One of the more popular option spreads on the market is known as a credit spread. We will be looking at this particular spread today. Some people believe that this is a high probability type of trade but until you actually work with this strategy, you may not know or understand the risk involved. An options credit spread can be particularly risky if it is traded alone, meaning that it isn’t being hedged by any other option position.

The credit spread is one of the more popular option spreads traded today. The reason is because the credit spread is simple, it makes money over time and it’s a trade with a high probability. But this probability rating can be very misleading. The dangers of the credit spread are rarely addressed in books and online credit spread courses. The sad fact is that most people teach the credit spread because it is a good business, but not because it is a good option strategy. It’s actually a very risky trade and very directional.

It is very well known that we are able to construct an options credit spread with a probability of 90 %, but how much money will be carried out with a 90% probability options trade? Not very much at all… Usually we can make between five and 10% in one month. This sounds like a great deal of money, but what are the risks involved? What happens to your portfolio when this trade goes against you? Catastrophic losses can and will occur to your trading capital if you get the least range short-term credit spreads.

Option courses pushing credit spreads don’t talk to you about the risk. They don’t tell you how far you can be behind on this trade only a few days after you enter it. They do not value how you can lose 90 percent of your trading capital in one month. They do not tell you how this 90% probability trade can lose the first month of its existence. Just because the trade has a 90% probability, does not mean it makes money nine times before it loses once. This just meant that it makes money 90% of the time out of a consignment of trades. You might have to do 1000 trades before his trade averages its 90% probability.

Credit spreads are actually very directional trades. If you look at a risk graph of a credit spread, then you understand what I am saying. Even though this trade is listed on its side, the Gamma is so high that it makes the trade extremely risky. If this trade goes against you, you’ll lose money really fast. If you’re trading short-term credit spreads, and often times you’ll find yourself at the side of a drop and about to lose all of your money.

Unfortunately, the options credit spread is one of the early trades learned by all option traders. I think most option traders are first attracted to this option spread, for it is very simple, it makes money over time, and it has a very misleading high probability rating. The other reason most beginning option traders begin using this strategy is, as it is all over the Internet. However, it isn’t publicized all over the Internet and in basic option trading courses because it is a major strategy, but rather, it is very simple to learn and to teach. This is the main reason that it’s all over the Internet.

The 90% probability credit spread is very popular on the Internet today. This is a very well-known option strategy. But how much can we make on a 90% probability trade? Usually we can make between five and 10% in one month, but is this really easy money? I think not. Those of you who’ve traded credit spreads for a while already know what I am talking about. When this trade goes against you, it really goes against you. It’s very easy to do a great deal of money on his trade.

Salesman do not tell you how far behind you can rest on a credit spread in a few days if the trade goes against you. Salesmen do not talk about how you can lose 90 percent of your trading capital the very first monthly trade credit spreads. Salesmen do not tell you this stress related but this particular option trade. They do not tell you that you will not be in a position to sleep at night.

The problem with the credit spread, in particular, the short-term credit spread, is that it is a very directional trade. Even though it has Theta on its side, it has Delta and Gamma working against it. You are picking up even more danger by trading this option spread with very high Gamma, for the small amount of Theta that you get from a short-term credit spread. What this means is that, because the price of the underlying changes, the profit and loss on the trade also changes very quickly. This type of trade is much more volatile and risky than most beginning option traders know.

In conclusion I would like to say that the credit spread definitely has a place in my options trading portfolio. However, I only use credit spreads in conjunction with other option strategies. As a standalone strategy the credit spread can expose your trading capital to enormous risk. So if you insist on trading credit spreads, then please make sure you’re trading safely by hedging them with other option spreads.

FAQ’s: Do you have to use margin to do an option credit spread?
For trading inexpensive call and put stocks? say-Blockbuster or Fannie Mae?

  • You have to have a margin account to make this trade. The reason is that even though you are establashing a credit when initiate the trade the brokerage house is basically giving you a credit line since there is a chance you will have to pay additional $ to close the trade at a later date. Any option trading where there is a chance that you will have to put up additional $ at the end of the trade will require that you be approved for margin trading. Call spreads, put spreads, diagnol spreads and many other multi leg options will fall into this category.

  • I have traded simple option spreads (both same expiration) in my IRA with what my broker calls "cash margin". For a long spread you should not need margin because before expiration you are not required to exercise the option that would be farther in the money, and you could sell the spread or cover the short with the long at a profit. For a short spread they just put a hold on enough cash to cover the spread. It would be a good idea to have cash or margin available in case someone exercises your short end, but if necessary you could exercise your long end. You may want to close the spread if there is a chance it could expire within your spread. For a naked short put with cash margin they put a hold on enough cash to cover the strike price. Most stocks do not immediately go to near zero unless the company goes bankrupt, but some have been known to suddenly drop 30-50%. For a regular margin account check what your broker requires.