Options Trading: Are Credit Spread Options For You?

San Jose Options invites you to analyze the popular Credit Spread Option to see if it's the trade for you. Is this strategy really neutral or is it directional? Take a look and find out.

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Options Trading Are Credit Spread Options For You?

Video Transcript

Hi everybody! Welcome to San Jose Options Mentoring program. In this short tutorial, we’ll be discussing credit spreads and we’ll be talking somewhat about the risk. So is the credit spread right for you? Let’s get started.

First of all, what is a credit spread? Let’s go ahead and explain. A credit spread is created by simultaneously buying a call or a put and selling a call or a put closer to the money. Credit spreads can be created with either calls, which is called a bear call spread, or with puts, which is called a bull put spread. Once again to summarize, a bear call spread is created by buying a call and then selling a call which is closer to the money or create a bull put spread which is buying a put and then selling a put closer to the money. These are created simultaneously in your brokerage account as a pair. You don’t need to log in to these trades. So why would one even consider such a trade? Let’s take a look.

So when the option trader creates this type of strategy, they’re selling an option that has a higher price than the one they’re buying. If you look here, the call or put sold has a market price higher than the call or the put bought. The option trader brings in the credit to his account on this trade. The reason for that is because, closer to the money, has more time premium. All of these options, we’re buying or selling in this case, are out of the money and the complete price is actually just time premium. The one we’re selling is closer to half the money, and half the money has more time premium. We’re bringing the credit into our account.

The next step is, the option trader hopes both calls or the puts will expire worthless. This means that the long and the short call or put, depending if you have a bear call or a bull put spread, you hope they’ll both expire worthless so you can keep the credit brought in. people oftentimes talk about the rewards of this strategy but what about the risk? Let’s go ahead and take a look at some risk graphs.

This is a typical risk graph of a high probability credit spread. This is actually a bull put spread where bullish on the trade. You can see as underlying moves up, you make money. As underlying moves down, you can lose money. But if the underlying stays above this point here until expiration, then you can actually make on this trade, for example, $190. However, let’s look at the risk. The risk in here, we’re actually risking $1,800. Let me go ahead and move over the camera. Let me move it a little bit farther. Sorry! If you look right here, look at these, the green numbers, you’ll see we’re risking $1,800 on this trade and this is a typical credit spread. Now, as I go move the mouse over here, look at the green number, you’ll see the maximum reward is 190. Again, this a typical credit spread. This is bringing in about 10% but you are risking $1,800 to bring in the 190.

For that type of risk-reward, you would think that this would be a very laid back, stress-free type of trade. Well, let me point out some of the risks and point out some of the things that can actually happen to you while you’re trading this type of strategy. Let’s take a look at our probabilities. Take a look at this line here. You can see this is 9%. We actually have a 9% chance of falling over here and being at risk $1,800 on this trade. That’s actually just from the first day of this trade. Let’s look over here. Let’s bring it to 50%. Here at 50%, we have a 50% probability of being behind on this trade $250. Essentially, we’re only trying to make 190 but you can see we have a 50% change of being behind $250 on this trade. That’s pretty uncomfortable for me. Let me also point out, watch as I move this wand around. Actually let me move the camera down just a second. Look at the numbers below down here where it says delta. Now the delta is how much we make or we lose per unit movement in the underlying. For example, if we have, right now you see a 36 delta here, for every point the underlying moves up, you make $36 but for every point it moves down, you lose $36. Obviously, this is a directional trade. This type of trading is not a delta neutral where you can relax and have that entry point in your trade. Like for example, a big ship compared to a little boat. This is a little boat type trade. That’s what I call it. When I enter a trade like this, I’m on my toes. I don’t feel comfortable because I can immediately losing money if the market starts moving down. Just follow the wand and you’ll see how much you can actually lose immediately if this underlying moves to the downside. Likewise, if it moves up, you can make money. But again, this is a very directional trade and it is the risk that’s involved when you take on this type of position. Once again, you do have, for example, a 50% probability of being down $250 on this trade.

Another think to look at in this trade is look at our theta compared to our delta. Our theta is only bringing u in $5 a day but this delta is a rather large number. This is really, again, just confirming for me, that this trade is very directional. This is not so much a time spread or an income strategy where you’re making so much daily by being in the position from theta. You’re actually making more money, in this case, from the delta which is a directional trade.

If you want to be in a directional trade, then this might be the strategy for you because it’s directional and it does have a little time on its side, but not a lot. However, if you like to be in some trades that are more comfortable, less stressful, and actually have a better risk-reward, then you might consider taking our course because we teach strategies with high probabilities but we focus more on safety than other course. We don’t lie quite as much on these directional trades where you’re really jumping into a fire when you enter into this type of trade. From my experience, it’s a very uncomfortable trade to be in and it’s not really one of my favorites, to be honest.

Thank you once again! I hoped you enjoyed this video and please take a moment to visit our website at sjoptions.com. Thank you very much!