subject: How To Trade Credit Spreads [print this page] Today, I want to talk about how to trade credit spreads, some of the risks involved and also how you can manage those risks. With this option strategy you are looking to make small monthly gains while avoiding any large losses. In order to avoid these big losses you could:
1. Sell the spreads as far away from the current price as possible - In this way the stock will have to move by a large amount in a short period of time for you to suffer large losses. You can set up fairly conservative credit spreads that will profit if the market falls by less than say 8-10%.
One point here is that this is only looking at the trade on expiry. If the stock moves really quickly against you, even if it's only 4-5%, you will suffer unrealized losses, and this is where you need learn how to manage and adjust the trade if necessary. If you think the market will keep moving against your position, then you should exit the trade before the loss gets any bigger. Stop losses are also an important aspect of managing this strategy.
2. Stop Losses - You should set a maximum level of loss before you exit the position. I like to use a 200% rule which is fairly common for options sellers. For example, if the premium I received when opening the trade was $0.23, I would close the trade if the spread rose to $0.69. In this way, I will be out of the trade long before I hit my maximum loss point.
One of the principal risks with this strategy is a sudden and very sharp move against you (usually this occurs on the downside, so is more relevant for sellers of bull put spreads). If you are concerned about this happening, you could always enter a stop loss order just on your sold option. By doing this, if the market moves quickly, you will get out of your sold option, limiting your losses and hold only the long option which may end up making a profit if the market continues in that direction. These gains will help, and could potentially even outstrip the losses made on the sold option. If you're worried about a "flash crash" type event, this is one way to protect yourself.
3. Market Analysis - Speaking of the flash crash, you really need to be an experienced investor in shares before using credit spreads as an options strategy. You need to be able to analyze the market and determine the trend of which way the market is most likely to go. Generally the stocks favor the path of least resistance. Prior to the flash crash, the market had been fairly bearish, so an experienced investor would have been selling call spreads rather than put spreads. Bear call spreads would have been profitable during the flash crash despite the rise in volatility.
4. Trade indexes not individual stocks - Indexes generally have much lower volatility than individual stocks and for this reason, I rarely use this strategy on individual stocks. Using FFIV as a recent example, on one particular day, there was a negative news report and the stock dropped about 20%. While possible, it is incredibly rare that you would see an index fall by this much in a single day, but it occurs more regularly with individual stocks especially tech or small caps stocks. The bid-ask spread is also lower for indexes meaning you are not suffering a liquidity premium.
In summary, you should learn how to trade credit spreads as they are a great strategy for options traders, but you need to understand all the risks first and also how to manage and adjust the trade. It is an intermediate level strategy and not one that I would recommend for beginners.
