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Learning all the different types of options strategies can be overwhelming at first, so today we’re going to explain the ins-and-outs of the first strategy any options trader should learn: the credit spread.
For most of you, you would have already created a Tastyworks account and are looking to follow along and put your first trade on.
If you still haven’t created a Tastyworks account, check out our 4 Steps To Start Trading Options at Tastyworks.
A credit spread is a simultaneous selling of a closer-to-the-money option while buying a further-out-of-the-money option. If that just went right over your head, don’t worry. We’ll show you a real example using the Tastyworks platform to walkthrough selling a put credit spread, even though such strategy could also be done using calls.
Looking at the Tastyworks platform above, the current stock price is right around $62.50, as indicated by the circle on the price bar going across the middle of the screen. In this put credit spread, we are selling the $62 put and buying the $61 put. The 62 put is closer to the stock price of 62.50 than the 61 put. But, because the 62 put is closer to the stock price, it has a higher value than the 61 put, resulting in a $0.36 credit, in option terms. In real-dollar terms, you would collect $36 on this position because you are selling the spread.
If you’re not sure what a put option is, here’s some additional information on put contract basics.
As indicated by the red and green zones, this position loses money if the stock price goes down and stays below the 62-strike put. If you look at the trade metrics, you have a max loss of $64 if the stock price goes anywhere below $62.
However, there are three ways this position can make money:
Because this trade makes money if the stock goes up, this is known as a bullish position.
The opposite of a put credit spread is a call credit spread. This is the same idea as the put credit spread, but the call credit spread is termed a bearish position, meaning you are counting on the stock price going/remaining down.
Because a credit spread has 3 ways it can make money, such a position has a high probability of success— good prospect for profits! In fact, if we look at the probability of profit of this trade, it has a 57% probability of making at least a penny. Probability of profit is calculated using complex statistical analysis, which we’ll cover more in-depth in later articles. This is a big step in the right direction given that trading stock is a 50/50 bet!
The best time to sell a credit spread is during high volatility. The simplest way to measure a stock‘s high volatility is by looking at its implied volatility rank, or IVR. In simplest terms, IVR is a measure of where a stock’s volatility is currently, relative to its range for the last year, on 0-to-100 scale. An IVR over 50 is a good range to be in to indicate whether a given IVR is high, thus signifying the relative optimal time for selling the underlying spread.
On the Tastyworks Platform, you can see the IVR of each stock on the “watchlist tab.”
You can see, for example, that TGT has an IVR of 76.9 meaning that right now it is at the higher end of its volatility range.
If the IVR is high, the underlying option‘s premiums are also high.
Since we are selling the credit spread, we want to sell things that are more expensive than they usually are, with the hopes that they become cheaper in the future.
If you already have a profitable credit spread, it is best to take the position off at 50% of the initial credit received. In our previous example, you received a $0.36 credit or $36 in dollar terms. To further increase you probability of success, you would close the position for a $0.18 profit, or $18.
On the Tastyworks Platform, you can easily set an order to close a position at 50% of the initial credit received so that you don’t even have to do any calculations. Such an order will close the positon for you automatically – you don’t have to be at the screen to cash in your trade.
The reason for taking just $0.18 instead of the entire $0.36, is that the actual risk in the position increases are time goes by. It is not worth the additional risk to collect the last 50% of the credit received or the last $0.18.
Moreover, at the point where you have a bare, technical winner, you have an asymmetric risk-reward payoff because you end up having your initial risk of the position to be traded, plus you are risking unrealized profits to potentially gain the last 50% of the credit received.
If you take a look back at the put credit spread we set up earlier, it has a probability of profit of 57%. That is the probability of the trade making money at its expiration. However, that put spread also has a 73% probability of making 50% of the initial credit. This can be seen using the “P50” metric on the Tastyworks Platform. This is a dramatic increase in the probability of making a profitable trade, just by moving quickly and closing the position early and not holding it to potentially collect the more of the total credit.
Finally, if you have a losing credit spread trade, DON’T DO ANYTHING! There are no reliable management techniques for a credit-spread trade. You just have to let the probabilities play out.
Remember to check out our trades on OUR TRADES PAGE to watch how we trade credit spreads.
If you learned anything about selling option credit spreads, let us know in the comment section below!
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