Why I Like Options Credit Spreads by Chuck Phillips
I’ve been trading credit spreads for a long time. I like them for several reasons.
On paper, 2 ½ times out of 3 you are profitable
You get paid up front
You can get mid-price more often
You can trade looking for where price is NOT going
You can trade short term - even day trade
Basics of a Credit Spread
Let’s look at a basic credit spread on Costco using a Bull Put Spread.
Looking at the chart below, if I sell a put at a strike of $450 and buy a put under it at $445 this becomes a $5.00 vertical spread, also known as a credit spread and in this instance a bull put spread.
I have the obligation to buy COST stock at $450 but I have protected myself from a large downfall loss by buying the $445 put so the most I can lose is $5.00 per contract.
You might also notice the green and red circles on the chart. If you are not familiar with these they represent UFOs (UnFilled Orders - where institutional buying and selling is likely to take place. More on this later.)
At the top of my list I said that on paper 2 ½ times out of 3 you are profitable. Let’s look at this using the COST example.
Price can only move up, down or stay flat. So we have our 3 scenarios. If price stays where it is, at $452.27, no one is going to put the stock to me at $450 because they can sell it for the higher price of $452.27 on the open market.
If price moves up, which it looks like it will do based on the small amount of the chart shown, then we have the same scenario.
Now here’s the fun part. If price falls it can go all the way down to $450.01 and no one will put the stock to me because they can sell it for $0.01 more on the open market. So price can actually go against me and I still make a profit!
Let’s say I received $2.00 for my bull put spread. That means that price can fall to $448.01 and I still make $0.01 profit (Not accounting for commissions and fees). I only lose money if price moves a long distance past my strike. And even then I have covered myself and have limited my loss with the underlying put at $445.
So, if price goes up I make a profit. If price stays flat I make a profit. Even if price moves down a little bit I can still make a profit - 2 ½ times out of 3 I make a profit. Credit spreads are the only trading strategy I know where you can be wrong and make money.
Leverage and Getting Paid
Are you able to buy 100 shares of COST in your account? How about 500 shares? At the current price of $452.27 that would be $45,227 for 100 shares and $226,135 for 500 shares. With a $5.00 credit spread and one contract I can put up $300 ($5.00 spread - $2.00 credit for selling the spread) and control 100 shares of stock.
For five contracts I would have to put up $1500 to control $226,135 worth of stock. THAT is the beauty of leverage within options.
When you sell a credit spread you get paid up front. That money is yours and at most brokers you can use it right away for any other trade you wish to take. So with five contracts I would take in $1000 that I can immediately use for another trade.
With a credit spread you are trading two options, also called legs when paired together. Typically, you may have to sell the short leg at the bid and buy the long leg at the ask. But with a credit spread and doing them both together you can often get the mid-point price for each leg and save yourself some money. In fact, I always put in my credit spread trades for a mid-point and almost always get it. This savings easily covers the commission cost of the trade.
Short Term Positions
Most options traders take medium to long positions (4 weeks to several months) when they open a trade. But using credit spreads and weekly expiration dates can shorten your time in the market which means reducing your risk. A trader who opens a position and keeps it open for 2 months is at risk to market fluctuations for 40 trading days plus anything that might influence the market over 7 or 8 week ends.
A trader who opens a one week trade is at risk for 5 trading days and possibly not even a single week end. The last time I reviewed my credit spread trading I averaged 3 days in the market per trade.
Finding Opportunities to Trade
One of the hardest things a trader has to do is find good opportunities to get into a position. But not only do options traders have to find the entry they have to choose from the many different choices that are available to them in the options world.
For example, price is at a low and you think it is going to turn and go up. Do you buy a call, sell a put, sell a bull put spread, buy a bull call spread, or something more complex?
There is a new trading platform that changes all this.
TOP (Traddictiv Options Planner) is a unique trading platform that is specifically designed to trade options. There are far too many tools within TOP to even scratch the surface in this article. However, I would like to point out just a couple of them and give a very brief description of them and how I use them.
When looking for credit spreads to trade I have a watchlist and a scan that I use. Both look for stocks that are $100 or more in price. I used to think that if I wanted good premiums I had to look at higher priced stocks. TOP changed all that.
Look at this chart of CNK. This is a $21 stock - far below my usual $100 limit. But TOP picked it out as a good candidate. I evaluated it, took the trade and made a profit.
I opened a bear call spread of $20 x $25 on Oct 8 for a credit of $1.85 and closed it on Oct 11 for $1.10 as price had moved to my target and was basically at 50% of what I took in - another rule of mine.
I never would have found this opportunity without TOP.
How We Got There
Again, there are many ways to find opportunities to trade options in TOP but here we are going to look at the Matrix which allows you to find virtually any options setup. In my case, I set it to look for stocks that were breaking down near the bottom of the Bollinger Bands® that would provide a good opportunity for bull put spreads.
As you can see, there was only one stock that fit this day. (I run this every day in the first half hour of trading.) The next step is to look at the chart.
As you can see, price is just coming off a newly formed UFO and also is at the bottom of the Bollinger Bands® with sufficient room for profit on the up side.
The next step is to let TOP find a spread. Normally, I would take the nearest strike below current price and the nearest weekly expiration date. In this case, that would be to sell the $145 put and buy the $140 under it with an expiration of Friday, October 15. The day of this trade was Oct 14.
TOP has a feature called Strategy Builder that will look for all available option strategies such as bull put, bear call, iron condor, single leg calls and puts, etc. and report back on them. This is done almost instantaneously because TOP works on the server’s side and not on your computer.
Let’s see what TOP reported.
I set a target price of $157 (Current price was about $154.) TOP found 8 possible trades including 3 that would not be profitable. This information, what will NOT be profitable is a huge bit of information. It can save you a lot of money by staying out of trades you might normally take.
As the screenshot shows, the bull call spread on the top of the list would be more profitable than the bull put spread I chose. But that assumes price goes your way to the end of the trade and it also is a debit spread. So with only a $15.00 difference in potential profit I stuck with the bull put spread.
My rule said to take profit at the opposing 60 minute UFO zone. I opened the trade for $2.25 credit and closed it the next day for $1.40 debit as price had hit the 60 min UFO. This gave me $0.85 profit per contract for a trade where I was in and out the next day.
For the record, had I taken my usual trade from above I would have only made $0.08 profit.
Advanced Features in TOP
TOP is a unique trading platform that is specifically designed to trade options. There are far too many tools within TOP to even scratch the surface in this article. However, I would like to point out just some of the outstanding capabilities of TOP. As you can see by the slides below you can scan for dozens of conditions and further refine your scans by many factors within any given options strategy.
For the beginner options trader TOP will blow your mind with the ability it has to find and offer options trades. For the advanced options trader you will be even more amazed.
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