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Welcome to the third part of my series of articles on the Credit spread. So far in this series of articles it may seem all like doom and gloom, as far as dispelling some of the myths of Credit spreads, but in this week’s article I am going to show the reasons I like them.
Let’s go straight to chart 1, a risk graph of a Credit spread on the SPY (S&P 500).
Chart 1
click to enlarge
Chart 2
click to enlarge
We can see under Entry Credit, we are receiving a credit of $17. This is also our Max Profit. The credit is the most we can possibly make on this trade, should everything go our way. Notice our Max Risk is $83. This amount is what we are actually margined. It is effectively like putting on a debit strategy that has a debit of $83, and a Max Profit of $17.
What I like about Credit Spreads is often we can get 3 of the 4 Greeks on our side, and working for us. For a comprehensive study on the Greeks, as well as attending the Interactive Options Trading class (IOT), I have a series of articles, which will serve as a good start. Part 1 can be found here: www.optionetics.com/market/articles/19033
Lets then have a brief look at each Greek. If our view on the market was that the market would go down, or just sideways, then these Greeks could serve us well. Delta here is negative (-3.8), meaning that if the market goes down we will make money. We will certainly lose it though if the market goes up. Gamma is negative, telling us we don’t want the stock to move – if the stock falls as we expect in this example, Gamma will take value out of Delta, making Delta smaller. If the stock goes up Gamma will feed into Delta, which in turn is a loss for us. Vega (the trades sensitivity to IV movement) is negative (-$1.40), meaning for every 1% point that IV falls, we will make $1.40. This is possible as IV is high at the moment, but if the market falls as we possibly expect and IV goes higher we will lose some money because of Vega. But don’t forget if the market falls, we are making money from Delta!
The last Greek is Theta. Theta is a positive $0.55, which is the amount we will make each day from time decay. Theta will increase too as time passes. So even if IV increases and we lose some money because of Vega, we will still be making money from Theta, our time decay!
A beautiful thing – we make money every day the sun comes up. Just be aware though that Delta is a much more sensitive Greek than Theta. If the stock races up, we are going to lose money fast and at an increasing rate, much more than our positive Theta will offset. So the trade still has to be managed accordingly with good money management.
Credit Spreads can be very dangerous trades if you’re not sure what you’re doing. You can lose money very fast with a small move on the stock. But once you have a good understanding of them, they are a great advanced trading strategy. Welcome to the world of the advanced classes!
Manage your trades!
Matt Baker
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