Story of Interest
Written by: Carly Richer
Probability Trading with Credit Spreads
The COVID-19 pandemic has caused significant volatility in the financial markets and has also led to increased interest, and thus activity, in options trading by everyday retail investors. Volatility is an option trader’s best friend, as it provides plenty of opportunity for enhanced returns through risk-defined strategies.
Options trading is a numbers game. Trading strategies can be established with known expected values and probabilities can be deployed with small or modestly funded accounts, and can quickly grow through consistent and frequent trading.
What are Credit Spreads?
Credit spreads are risk-defined strategies that can be implemented in both bearish and bullish market outlooks. The strategy involves the simultaneous short sale and purchase of equal quantities of either call or put options, with the same expiration date and different, or ‘spread’, strike prices.
If an investor is bearish on an underlying security, she can sell, or ‘write’, one strike price call and buy one higher strike, less expensive call to cap risk at the difference between the strike prices, less the premium received. This is called a call credit spread, as the investor receives more money through the short sale than paid for the long call as protection.
If an investor is bullish on an underlying security, she can implement a put credit spread through selling one strike put and buying a lower strike, less expensive put-to-cap risk.
In both put and call credit spreads, the maximum profit is the premium received at the outset. The maximum risk is calculated as the difference in the strike prices, less the premium received, and any fees associated with placing the trade. Credit spreads to profit from a downward move in the underlying security and a drop in implied volatility, as the options decay in value and become worthless at expiration.
Selecting Candidates for Credit Spreads
As credit spreads are net credit strategies, the key is to initiate the position when implied volatility (‘IV’) is relatively high for the underlying security. Most Canadian trading platforms provide a metric called IV Rank which tells us whether the current level of the security’s IV is relatively high or low based on the past year of data, but it does not indicate the direction of future price changes. Options traders want to sell when IV Rank, and thus price is high and implement net buying, or debit, strategies when IV Rank is low. For credit spread strategies, seek underlying securities with an IV Rank above 60.
Once an investor has identified securities with a high IV Rank, she should then review liquidity. Securities with a daily trading volume of at least 100,000 and options with at least 1,000 open interest minimize bid/ask spread slippage. Next, she can develop either a bearish or bullish outlook on the underlying security.
Implementing Probability-Based Credit Spreads
With the credit spread strategy we seek to make small (position size under 5% of the portfolio), frequent trades that provide a high probability of success (~ 70%) through defined risk. The 45-day mark is when Theta, or time decay, accelerates and the option’s price begins decreasing at an exponential rate until it reaches zero, so look to place the initial trade at 45 to 60 days to expiration (DTE), and no further out than 80 to 90 DTE.
An option’s delta can be used to approximate the option’s probability of expiring in-the-money. Find the ‘anchor’ option that has a 70% probability of expiring out of the money (0.3 deltas, or less for less risk). The investor sells the anchor and purchases the strike price either above or below the anchor, depending on if she is using calls or puts, to cap risk.
A bearish investor implements a call credit spread by selling the anchor call and purchasing the call with a strike price just above it (or further above it for a higher spread). Conversely, a bullish investor sells the anchor put that has a delta of -0.3 and purchases a lower strike put.
To avoid watching charts all day, automatically capture profit and protect from extended losses through the use of limit orders. Traders are encouraged to take credit spread profits at approx. 50% of maximum profit, and cap losses at 15%. Taking profits at 50% usually allows for the closing of the position by 20 DTE, reducing the probability of the buyer exercising the options, which is usually done in the week of expiration.