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Credit Spread Option Strategy

SJOptionsTrading.com talks about the common Credit Spread and why it might not be a good stand alone trade.

Credit Spread Option Strategy by San Jose Options

Video Transcript

Hi there everybody! This is Morris over at San Jose Options and we’re going to have a quick tutorial on the credit spread trade. What we’re looking at here is a very directional trade which you can see.

This is your, at the money mark. Over here you have your breakeven point. You have your maximum loss over here and anywhere above this area is your maximum return. In this case, you can see the maximum return is $2,500, that’s what we call the bar. And your maximum risk in this case is 17,500. Right away you can see that the risk-reward in this type of trade isn’t so great. One thin to be aware of is, for myself this is more of an adjustment technique that you might use along with other trades but I certainly don’t recommend doing this type of trade all by itself.

Let’s talk a little bit about the Greeks in this trade. As you can see down here at the bottom, your delta, in this case we have a hundred contracts. We’re looking at IWM, it’s a popular vehicle that people trade and we have a delta position of 670. If you think this is a mutual trading strategy, well just look at this number: 670. That means as IWM moves one point to the right, you’re looking at a $670 profit. For each point it drops this direction, you’re losing approximately $670.

The next thing to notice is, as you go this way even further, notice your delta. Watch down here and you can see how it gets worse and worse. You start to lose money even faster as the trade goes against you. That’s some of the risk there involved with the credit spread – very directional trade. The next thing to notice: the theta position. This is why some people like this type of trade, it does have a positive theta. However, look at the delta. This is where most option traders go wrong. They focus solely on the theta, they ignore their delta, they ignore the vega. And they think that theta is going to be the primary component in the trade. Let me tell you, that is disaster waiting to happen.

When you’re an option trader, this should be your least priority. At least try to keep it flat, maybe a little positive if you can but definitely pay attention to your delta, pay attention to your vega. Your vega is actually the strongest part, strongest component of the option pricing model. And second down here is going to be your delta, and your third, theta.

Let’s move the calendar here a little off the screen. Let’s go through little time and see how the trade reacts. So notice as we go through, this was about 2 weeks then your breakeven point moves a little bit out to the left. However, the odds of the underlying simple moving this far, they’re really actual very great. You have 5% here, 10% over at this line. So this is only about a 1.8% move. And that can certainly happen very easily at two weeks, it can actually happen in one day. Very low probability type of trade. I know there’s a lot of traders out there that try to succeed with this strategy, but it’s very difficult.

That’s about all I want to say today in this basic credit spread class. It’s a very simple option trading strategy, again, where you sell a strike here closer to the money, buy a strike out the same number of contracts a little bit farther out of the money. You bring in a credit and you just hope that the underlying symbol goes sideways or goes the right way, if it goes the wrong way, you’re looking at a pretty bad situation. Anyway, thank you very much! This is Morris from San Jose Options and we’ll see you in the next tutorial.