November 11, 2004

Some Credit Spread Tricks
by John Brasher, CallWriter Publisher

Plenty of CallWriter members like to write a credit spread, which is the sale of a call (or put) and simultaneous purchase of a call (or put) that is further out of the money. The call purchased is cheaper than the premium received for the call sold, which generates a net credit on the trade. That's right, you get paid to run the trade. If the trade goes wrong, then of course a loss can be realized. But as with every trading strategy, there are tricks to the trade. This article will cover some of the more useful ones.

What is a Credit Spread?

A credit spread is the simultaneous sale of one call (or put) and the purchase of a call (or put) that is further out of the money (OTM) than the call or put sold and therefore less expensive. There are two types of credit spreads: bear call spreads and bull put spreads. The "spread" is the difference between the two strike prices.

Here are examples of the two spreads on hypothetical stock XYZ, when the stock is trading at $20 per share:

The net credit is the difference between the premium received for the call (or put) sold and the cost of the call (or put) purchased - in other words, the amount the trader pockets. The net spread is the difference between the spread and the net credit received. The net spread is the maximum amount the trader is at risk if the trade goes wrong. The breakeven point is the strike price of the call sold plus the amount of the net credit, or in the case of a put spread, the strike price of the put sold minus the net credit. The credit spread is a type of covered write, actually; the call or put sold is not naked because the long call or put bought positions the trader to buy (sell) the underlying stock at a set price. The call or put sold is "naked" only to the extent of the net spread - this is the net amount not covered by the long call or put.

If the stock price stays below the call strike sold (22.50 Call in the above examples), or stays above the put strike sold (17.50 Put in the above examples), the credit spread generates its maximum profit - the original net credit. In the examples above, the $20 stock has to advance $2.50 to begin putting the bear call spread in danger, and has to fall $2.50 to start putting the bull put spread in danger.

The trader's objectives are to (1) pocket the net credit, and (2) if the opportunity presents itself due to a collapse in the option premiums, close the spread at a profit by selling the long call or put and buying back the short call or put.

The bear call spread is bearish in nature, and the trader creates it when the stock is expected not to advance before expiration as high as the call strike sold. The bull put spread is bullish in nature, and the trader creates it when the stock is expected to advance or at least stay above the put strike sold. It is not necessary that the stock advance or decline for the trade to win; it only needs to not rise or fall too much by expiration.

Credit Spread Tricks

1. Create them out of the money.   Credit spreads should be created out of the money, in order to leave room for the stock to oscillate. For example, if the stock is 29.50 and you create a Short 30C/Long 35C bear call credit spread, you have left only $0.50 of room for the stock to advance before it starts eating into your breakeven. The strike sold (much less the entire spread) should never be in the money, or even at the money.

2. The ultimate credit spread stop loss secret.  We don't find it useful to set a stop loss on a credit spread in relation to the stock's price or the spread's breakeven point. When writing a credit spread, only write one with a strong resistance level (bear call) or support level (bull put) between the current stock price and the strike price of the short call. In other words, construct the trade so that the stock has to break a significant support or resistance level in order to put the trade under water. If the support or resistance level is broken, you should close the spread before the breakeven is violated. Make the stock work hard in order to hurt you - in other words, put every obstacle possible in the stock's way. To enter a stop order, use a contingent order: if the stock hits the stop price, the broker should close the spread.

Example:  In the hypothetical XYZ trades above, there should be a strong resistance level between the $20 stock price and the short 22.50 Call if a bear call spread is created, or there should be a strong support level between the $20 stock price and the short 17.50 Put if a bull put spread is created.

3. Be picky; be very picky.  Volatile stocks are poor choices for credit spreads, as are stocks expecting major news before expiration. For bear call spreads write lousy stocks or those that otherwise present little chance of advancing, and for bull put spreads write good solid stocks very unlikely to fall. As with covered calls, we use a combination of technical analysis and fundamentals. Keep in mind that stocks can move hard after the bell, at a point when you cannot close the spread.

4. Look for early closing opportunities.  Sometimes the implied volatility causing high option premiums will collapse, allowing the spread to be closed (sell the long call and buy back the short call) at a nice profit. This will not happen in every spread, but be looking for the opportunity.

5. Will you be exercised early?  If you are exercised when the short call is in the money, a loss is possible, but how likely is early exercise, really? US equity options can be exercised at any time before expiration. They are only exercised when in the money, of course, and generally are exercised before expiration only when there is no time value left (and thus no point waiting for expiration).

How to Find Good Credit Spreads

Whenever you see a play on CallWriter's Real Time Lists™ that you suspect might permit a good credit spread, it only takes a few seconds to figure it out. First, click on the option symbol on the list, which will pull up the CallWriter Research Page with covered call chains displayed. Simply change the Chain Type from covered calls to put spreads or call spreads for the month desired, which will bring up a list of possible spreads.

Credit spreads put instant money in your account, which is very nice. And unlike the case with debit spreads or long option trades, the stock does not have to move in order to make the trader money. Done properly on non-volatile stocks and those not expecting significant news, credit spreads are a walk in the park.

Good luck and good trading!