The Curiosity of the Credit Spread

Welcome to what will certainly be the first part to a series on a very mythical strategy called the Credit Spread. My intention in writing this article, unlike other article series I have written, is not to teach traders how to trade this strategy, but to merely dispel some of the myths associated with them. I have heard too many stories, myths and almost superstitions about the strategy in my time as a trader, so hopefully this will put them back into perspective.

Like any trade, the Credit Spread carries with it a certain ratio of risk, reward and probability. Some Credit Spreads carry a healthy, almost equal mix of reward and risk; some carry a lot of reward and little risk but then a low probability, whilst others carry sometimes a very low reward and a high risk, and equally a higher probability.

The first question to address here is the probability. Let’s think as option traders now – when we say a certain trade has a low probability, what do we really mean? A low probability of being right on stock direction? A low probability of the trade expiring In-The-Money? A low probability of the trade expiring worthless? A low probability of making ‘some’ money? These are very important questions for the trader to ask before placing a Credit Spread, because how you construct and place the trade will depend on what your desired outcome is.

Some traders may want the spread to expire In-The-Money, some may want the spread to expire Out-Of-The-Money and worthless. Some traders may want to take some profit out of the trade and move on, whether the trade be In or Out of The Money. So the first conclusion here is that you need to be clear firstly on your outcome, and to do that you need a prognosis on the stock in regards to price, time, and IV.

Secondly you need to know what you want to do when your first step is near completion. For example, if you want the Spread to expire worthless and keep some of the credit, you will need to know what to do in those last few days before expiration, because managing the trade near expiration day can become a whole other ballgame depending what the underlying is doing. If you wanted the Spread to expire ITM, you need to be aware that there would be Assignment issues, you would need to be prepared for them and know how to deal with them.

However the conclusion here is simply, don’t just place a Credit Spread because of the lure of the juicy credit without regard to whether the Spread is ITM, ATM or OTM, and what you plan to do with it as expiration approaches.

Let’s now talk about the Credit. Sometimes novice traders are under the impression that with debit trades (like Long Calls, Bull Call Spreads) you have to earn some money to make a profit, but with Credit Spreads you are given your profit up front, so why not try to get as much Credit as possible!? The Credit Spread like other strategies, can have the illusion of ‘sucking’ regular amounts of money out of the market each month (like writing covered calls, which by the way has the same risk graph as selling a naked put!).

Unfortunately it doesn’t work like this. Although you are given a Credit up front when placing the trade, you have some money in your account margined off, or put aside to cover the risk. This effectively is the same as a Debit trade, because in a Debit trade you put forward a Debit, which you can’t use for anything else until the trade is closed, and you could lose the whole Debit should the trade go to max loss. It’s the same in a Credit Spread, you put forward margin, which is actually risk, which you could lose too if the trade went to max loss. Brokers never have to go chasing traders for money – they take what could be the max loss up front, whether that be in the form of a Debit, or the same amount of money margined.

But in the scenario of the Credit Spread you may ask, we still got a Credit up front where with the Debit spread we didn’t? It doesn’t matter. Here’s the crunch with ‘making’ or ‘keeping’ that Credit. Something has to happen for you to make profit on the trade. For example, if you placed the trade (received your Credit and were margined on the risk), and the stock didn’t move, IV didn’t change, and no time went by and you closed the trade, you would give the Credit back! Like in any strategy, something or a number of things need to happen for you to be right and start making a profit. In Platinum, the column to look at above the risk graph is not the attractive green ‘Credit’ number, but rather the ‘Profit’ column. This column is telling you NET what you will be left with if you closed the trade now (not including commissions of course).

Credit Spreads are an exciting strategy, and one that I trade all the time, but I hope this has given traders the opportunity to start dispelling some of the myths they carry.

Matt Baker