With so much market volatility all around us in the past few weeks, a lot of traders are trying to figure how to make money when markets seem not to have a clearly defined direction. This was typified by the Black Monday trade of the Dow when it opened with a 1,000-point slippage drop, then gained it all back before it closed the day slightly more than 500 points to the downside. If you are a retail trader, it would be very difficult to play this sort of scenario; it is hard enough for professional traders as it is. The question is: what do the pros do in this situation?
The pros look for strategies to ensure that their positions are covered and that whatever happens, they walk away with money. One of the strategies that they use is selling credit spreads.
The credit spread is an options trade strategy where the trader sells an option on an asset at a higher price while at the same time, buys an option on the same asset at a lower price. So the trader sells the expensive option and buys the cheaper option. The price differential is the spread and this is what gives the trade its name. The trader’s aim in setting up a credit spread is to collect the accruable spread income from the trade as profit.
Why Credit Spreads?
Research has shown that nearly 75% of options trades expire worthless. Professional traders use options to hedge their multi-billion dollar positions against market declines and serious price shocks such as that seen on August 24, 2015 (Black Monday). The problem with options is that they cost money to setup. Think of options as an insurance policy for trades held in other markets. You see, when an insurance company collects premiums from their clients (the insurance buyers), they are not obliged to pay anything unless there is some mishap which forces them to pay the insurance costs. But for as long as you keep paying your premiums and there is no mishap, the insurance company does business with your money, makes profit on your premiums and keep the profit. Even when they finally have to pay the insurance cost in case of accidents, fire or death, the insurance company would have made a lot of money from your premiums. You can imagine why Warren Buffett calls insurance his favourite industry, can’t you?
Selling credit spreads is like selling insurance. Selling credit spreads is one of the options trade styles that have a low risk profile. When you sell a credit spread, you are paid up front. Your losses are capped while profit potential is maximal. A typical credit spread trade example is as follows:
- Short 2 LXY 75 Put @ $3.50 per share ($700)
- Long 2 LXY 70Put @ $1.50 per share ($300)
In simple terms, you are selling 2 contracts (200 units) of stock LXY priced at $75 for $3.50 per unit, and at the same time buying 2 contracts (20 units) of stock LXY priced at $70 for $1.50 per share.
The difference in costs is $400 which you collect as a premium up front. Both trades are executed at the same time and on the same asset. The profit that the trader makes on this trade is the difference between the trade costs of both trades: ($700 – $300) = $400. Therefore the game changer here is for both trades to expire worthless.
A credit spread requires the trader to put up a cash collateral for using the asset in the credit spread. This collateral is a cash margin calculated as follows:
(Strike price of put – strike price of call) X no. of units in contract. For our example on stock LXY, this is ({75-70} X 400) = $2000.
The process of how to sell a credit spread is as follows:
- Determine which of the credit spreads you want to trade. You can trade a bull put credit spread or a bear call credit spread.
- Determine the trend of the asset. If the asset is bearish, play the bear call credit spread. If the asset is trending in a bullish manner, the right trade to take is the bull put credit spread. There are ways of determining the trend of the asset. For stocks, you need to check if there are any earnings reports on the horizon. You actually should not trade this if there is a fundamental factor that could radically change the trend in the asset. A good place to do trend analysis is on the INO website.
- Setup the trade using the parameters outline in (b) above.
- Sell the credit spread, making sure you have enough money in your account to cover the cash collateral required on the trade.
If you can try this out on demo, then you have just learnt how to sell credit spreads. But it does not end there. There are requirements to this trade and knowing how to sell the credit spread is only one aspect. You need to perfect your trend analysis using the INO website, and you need to know how to calculate your margin requirement as well as your expected return on margin so you know if a trade is worth taking.
The return on margin is calculated as follows:
- (Credit spread/cash collateral) X 100%.
Using our example above where the credit spread was $400 and the cash collateral was $2000, the return on margin is 20%. Ideally, the trader must practice good money management so that the amount invested as cash collateral is not more than 5% of his total equity.
Assets on Which Credit Spreads Are Sold
You can sell options on all kinds of securities – stocks, currencies, commodity futures, and stock indices. However, an interesting asset to sell credit spreads on would be ETFs, especially commodity ETFs. Due to the fact that the maximum loss on selling credit spreads is limited, you end up putting a lot less capital at risk in each trade, and use a lot less margin, which is a huge plus.
