Finding good credit spreads is more of an art than a science. You are attempting to pick up bread crumbs in front of a steam roller so it is key that you turn the odds in your favor by picking the correct underlying and strikes.
For a refresher on breakevens, max loss, and max profits check out these guides on bull put spreads and bear call spreads. This post will worry less about the calculations and more about the nuances of how to find good credit spreads and what makes an underlying a candidate for a credit spread.
Table of Contents
- What are credit spreads?
- When do credit spreads work?
- How do you sell credit spreads profitably?
- How to pick an underlying stock to sell credit spreads
- How to create a portfolio of credit spreads
- How to use credit spreads to meet margin requirements
- Conclusion
What are credit spreads?
Credit spreads are the combination of a short and a long option. The short option leg exposes you to unlimited risk in the case of a short call or the full strike in the case of a short put. We combine the short leg with a long options of the same type (put or call) to limit our risk to the difference in strikes.
Credit spreads are very attractive to new traders because they don’t require a lot of capital, have defined risk, and a high chance of profit. That being said, new traders are also very likely to blow up their accounts with credit spreads when they start selling closer strikes, relaxing their risk management, and selling them just because they can.
When do credit spreads work?
Bull put spreads work when the underlying moves sideways or up. Bear call spreads work when the underlying moves sideways or down. The underlying must remain outside of the short leg so that both options expire worthless and we keep the credit received.
One thing to note is that credit spreads are an income strategy. Income strategies are best when the market is moving sideways or drifting slowly in a direction. If a market has direction, directional strategies are much more profitable and will trump any income strategy you can come up with.
Just because you use income strategies does not mean they are the best strategy to use. You should always tailor your strategy to your overall view of the market or the underlying.
Why Selling Credit Spreads Eventually Ends in Disaster
Any time you enter an options position you are choosing to expose yourself to a specific part of the underlying’s return distribution. When you are short an option you are selling a portion of the underlying’s return. When you are long, you are buying a portion of the return.
One of my favorite ways to conceptualize this is to look at the probability lab in Interactive Brokers. Click here to open an account with them (Affiliate Link). Here we are looking at the market implied probability of the SPY Feb 18′ 2022 strike date.
As you can see, $465 where the peak of the distribution is. The SPY is unique in that the left tail of the distribution is much heavier than the right. The distribution doesn’t follow the standard normal curve. This is the case because the SPY is a common portfolio hedging tool. Many investors purchase out-of-the-money puts to protect their portfolios which raises the prices of the puts on the left side.
An example
Let’s say you have a belief that the probability of SPY being under 400 is closer to 0% than the ~5% the market is implying. Let’s sell a $5.00 credit spread on that belief. If we purchased the spread at the market we receive $1.50 for the short put and pay $1.28 for the long put for a total credit of $0.22. It takes $500 of margin so if we are correct and the options expire worthless we make a return of $22/$500 = 4.4% over 30 days, annualized: 52.8%.
The crucial part of this trade is that the actual probability be less than the market implied 5%. Even though that part of the distribution has a probability of less than 5%, the price still has a 5% chance of being in that range. The max loss you will incur 5% of the time will lead you to net zero — if the options are priced efficiently. This is why options are considered a zero-sum game.
For context: it takes 23 trades to break even if you incur the a max loss of $500 (500/22). If you placed this trade an infinite amount of times you would actually lose money. (95%*$22)+(5%*$500) = $20.9 – $25 = -$4.1.
Even worse is when the probability is greater than 5%. It’s like playing a poker hand with a probability of 95% like it has a probability of 99%, you are going to go bust eventually. This is why a lot of traders blow up their accounts with this strategy.
How do you sell credit spreads profitably?
As I explain in my post on How I Think About Options, the only time you should place an options trade is when you have a belief that the probability distribution is different from what the market is implying. For credit spreads, that means selling the spread on a part of the distribution which you think has less of a probability that the market implied probability.
To be more clear, if you are selling credit spreads and the market implied probability is correct, you will net zero — and actually lose because of transaction costs. The only way to profitably sell credit spreads long-term is to trade when the market implied probability is incorrect.
Here are some key points for selling credit spreads.
Sell Short-Dated Options
Any time you are short an option, you want to sell short periods of time. Theta (time-decay) increases as you get closer to the strike date so the less time the better. Typically, CSP are sold between 30 and 45 days to expiration. This is the point at which theta starts to make a larger impact on an options price.
Why not sell 1-5 days to expiration? Very short dated options typically do not have enough premium to compensate you for the loss you will incur if your strike is breached. Short dated options have very high gamma so small changes in the underlying can lead to very large changes in the options price. This is why Wall Street Bets like short-dated out of the money options.
When you are buying options for $.01 to $.10 and the underlying makes a very large move, your options could suddenly be worth $1.00 and you’ve 100x your position. In contrast if you are selling them the option for $.01 you could suddenly be down 100x.
30-45 days is the sweet spot for time decay while still having enough room for the underlying to move.
Don’t hold the credit spread until expiration
A common rule on prop trading desks is to sell at half of your potential gain. If you sold a credit spread for a $0.50 credit, you would buy to close it for $0.25. This halves your holding period which increases your ROI and decreases the probability of loss.
Stop losses are set at 2x the potential gain. Looking at the same credit spread, the stop loss would be set at $1.00. This would mean a $.50 loss or double the potential $.25 gain.
If we take a look at the break even probability, they need to be correct 2/3rds of the time to break even. This means that when you are selling credit spreads with 80% probability of profit, you should be making a profit.
How to pick an underlying stock for credit spreads
Stocks with high implied volatility are prime candidates for credit spreads. I typically look for an implied volatility of more than 30% for stocks and 20% for ETFs. This fattens the premiums and makes selling credit spreads much more worthwhile.
For bull put spreads, you want an underlying in which you are neutral or bullish. For bear call spreads, you want an underlying in which you are neutral or bearish.
I always stress that you must have a view on the underlying, whether you think it is going sideways, up, or down, that should be the basis of your options position, rather than just using an options strategy because it’s the only one that you know. “To the man with a hammer, everything looks like a nail”.
A common pitfall is to sell credit spreads on high volatility stocks that you do not want to own or that are so volatile that you cannot predict the direction of their price with any accuracy. These types of stocks give you high premiums but their fluctuations make you a lot more likely to end up with a loss. These stocks are better candidates for volatility strategies than an income strategy like credit spreads.
An example of this would be AMC, their forward month options have an IV of more than 110%. While this is great for premiums, fluctuation in their stock price makes them much less desirable as a candidate for spreads.
An Example: GM
First, start by having a view on the underlying. I use fundamentals to set price targets etc. but you can use technical analysis, momentum, moon reading, whatever you like.
We’ll look at GM as an example. The 30 day options have an implied volatility of 42.9% so premiums are nice and high. I am bullish on GM so I am looking to sell put spreads.
If we look at their chart, they’ve traded in a range between $53 and $64 since March of 2021. I don’t much believe in technicals but looking at their chart, I look to sell bull put spreads at GM gets close to the $53 support level. By selling the spread when the stock is near my strikes, I benefit from the higher premiums. I like to wait for larger than average moves to sell the spreads. As the underlying reverts to the mean, I then close my position.
I also don’t mind owning the stock, if it falls below my strikes. If GM were to fall below the short put strike, I might use it as an opportunity to take a position in the underlying and begin selling covered calls. You can do this by selling the long put and allowing assignment. You can likely sell the long put for a profit which will lower your cost basis on the position.
Don’t sell the spread just because you can
I don’t sell put spreads on the stock every month. I look for drops in the price to sell spreads nearer to the money for higher premiums. Rather than selling spreads every month, I am looking for opportunities.
If I were to sell puts on GM every single month, some months I would get very low premium compared to the risks I’m taking. As an example, if I sold a put spread around Jun ’21 after the huge run up, I would likely incur the max loss as GM hit the resistance and fell back down to support at $53.
The key to being profitable with credit spreads is to sell them on opportunities rather than just because you can.
Why sell credit spreads on ETFs?
A good alternative is to pick an ETF with historically lower volatility than implied volatility implies. You typically don’t see this on the single stock level and this is why ETFs are prime candidates for selling options, a.k.a. selling volatility. Take a look at IJH – iShares Core S&P Mid-Cap ETF’s historical volatility over the last year. Note: IV is forward looking so the white line tries to predict the spot on the orange line 30 days later.
Why should you look for lower historical volatility than implied?
Any time you sell an option, you are making a bet against volatility. ETFs generally have lower volatility than what the IV implies so the premiums on ETF options are stretched.
Volatility, the options greek Vega, works against you in a short options position. Increases in Vega lead to higher premiums. By selling on volatility spikes, volatility can work in your favor. High volatility rarely ever remains so you can benefit by selling spreads when premiums and volatility are high and close the spreads when volatility returns to normal.
You may know an iron condor as a way to benefit from lower volatility than implied. Credit spreads are just a single side of the iron condor. A common strategy is to enter an iron condor one leg at a time. By selling the spread when the underlying is near a strike, you benefit from the higher premiums.
Creating a portfolio of credit spreads
It’s important to diversify credit spreads across underlying, strikes, and assets. A portfolio of only credit spreads is very likely to blow up if volatility spikes and correlations converge. You can mitigate this risk by diversifying the spreads that you sell.
Don’t sell on one side of the market
Unless you are aiming to have a directional bias on your spreads, you should be selling both bull put spreads and bear call spreads. As the market moves up or down, one side will always be making money. A delta neutral portfolio is one in which deltas cancel out so movements in the underlying should net zero, only time decay and volatility have an effect. Since credit spreads are primarily a theta play, being delta neutral means that you cancel out market movements.
Diversify across strikes
Rarely do I sell spreads on a single strike. Just like dollar cost averaging, it can make a lot of sense to slowly build a position. If the underlying moves against you, and you are comfortable increasing your position, you can sell at a farther strike to move your break-even. This is because as the underlying moves against you, Vega (volatility), has likely increased.
Diversify across assets.
A mistake that new traders often make is diversifying within a single asset class. Even if you have 10 different underlying stocks, if the overall market drops, your spreads will all drop with it because they are all equities. Conversely, if you sell spreads across assets: for instance, a portfolio of spreads on commodities, real estate, and different equity styles, you are much more likely to survive market drops.
How to meet margin requirements using credit spreads
Any time you have a short option leg you can limit your risk by purchasing a long option leg. The long option cancels out the short option loss. Once the underlying passes your long option strike, the short option stops losing money. You can use this to your advantage when needing to meet margin calls.
If a short option moves against you, you can buy a long option to decrease your margin requirement. Credit spreads have defined risk so your required margin is just the difference in the strikes. If you are short a call at a $50 strike, you can buy a call at a $55 strike. This limits your max loss and reduces your margin. It can be costly but is an easy way to manage your margin in a pinch.
Conclusion: How to find good credit spreads
- Find an underlying with high volatility
- Have a view of the underlying
- Sell spikes in volatility
- Diversify across underlying, strike dates, and strike prices.
Please leave your comments and questions down below. What are your favorite stocks or ETFs to sell credit spreads?
Disclaimer: This article is not intended as financial advice. All investments carry the risk of loss, you should consult with a financial professional before taking on any investment.