Strategies for Trading Credit Spreads

2021-10-15 | Taylor Horton

My trading changed for the better when I committed to making option credit spreads my primary focus. Though they can be complicated on the surface, trading credit spreads can be a consistent and low-stress way of seeing trading results. After years of struggling with other strategies, learning how to sell options allowed me to carve out my niche in the market, and I’ve seen many other traders accomplish the same. 

What are Credit Spreads?

When we buy (go long) calls or puts, we’re looking to benefit from options gaining value. While being long options does offer “unlimited” upside potential, you need perfect timing to catch a move in your favor quickly. In other words, you need to be right. If the stock doesn’t make the move you’re looking for, your options quickly begin to deteriorate via theta decay. 

When we sell a spread, we’re looking to benefit from options LOSING value. As many of us learn over time, options lose value much easier than they gain value, and this is where credit spreads offer a tremendous edge. 

When selling credit spreads, premium decay is your best friend. You don’t have to be right in order to make money – you simply need the option you sold to stay out-the-money (OTM). For example, if TSLA is trading at $800 per share and you’re bullish, you could buy the $800 strike calls. This means, of course, TSLA must quickly make a move to the upside to put you in a position to profit. Should the stock trade sideways to lower, your call does nothing but lose value. 

Instead of buying the $800 strike calls, you could sell the $780/$770 put credit spread. In this situation, all the stock has to do is stay above $780 in order for you to profit. TSLA can trade higher, sideways, and even a bit lower, but the paycheck is yours so long as the stock stays above $780 approaching expiration. Can you see the edge there?

Here’s an example of a put credit spread I opened on April 6th and closed on April 13th, 2021. 

 

Put Credit Spreads vs. Call Credit Spreads

There are a lot of confusing names for credit spreads that get tossed around in the trading community, but we like to keep things simple. A put credit spread is a bullish trade, and a call credit spread is a bearish trade. 

When we sell a put credit spread, we’re looking to benefit from puts losing value. OTM puts lose value over time so long as they stay OTM, and they lose value even quicker when a stock rips to the upside. When structuring a put credit spread, you SELL an OTM put while simultaneously buying a cheaper put as protection. These two-legged orders are known as “verticals”.

For example, if HD is trading at $340 and you’re bullish on the stock, you could sell the $335/$330 put credit spread. To do this, you’d simply sell the $335 strike put while buying the $330 strike put as protection. As long as HD trades above $335 into expiration, you’ll steadily collect premium as the options deteriorate. 

Now instead let’s say you’re bearish on HD, and you think the stock will trade lower over the next few weeks. In this instance, you’d want to sell a call credit spread. A good example would be the $345/$350 call credit spread. With this vertical, you’d sell the $345 strike call and buy the cheaper $350 strike call as protection. So long as HD trades under $345 into expiration, you’ll steadily collect premium as the options decay. 

My Favorite Setups for Selling Spread

While spreads tend to be stronger bets in nature, we don’t want to sell them on just any stock or setup. The key to creating consistent results by selling premium is to focus on setups where there’s a strong likelihood of a move in one particular direction. We want to focus on setups that have all the criteria of a stock ready for an explosive move, and our goal is to sell spreads in the opposite direction.

When it comes to selling put spreads, here’s the criteria of my go-to setup:

  • A stock in a strong weekly uptrend (above the weekly 21 exponential moving average (EMA) + positively stacked EMA’s)
  • A stock in a daily squeeze at the 21EMA, with positively stacked EMA’s + a positive histogram

When a setup fits the criteria above, there’s a strong likelihood of a rapid move to the upside. These are my favorite setups to sell put credit spreads on. Why? Well I’m essentially placing a bet that the bullish setup won’t unfold in the complete opposite direction.

Getting short premium on the opposite side of a strong setup is a great way to stack the edge in your favor as a trader, and one that can lead to consistent results over the course of time.

 

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