Turn Credit Spreads into Cash

In this article, I'm going to break down vertical credit spreads, one of my favorite income strategies in options trading, which I think is perfect for generating income with defined risk.

Let's get started!

What Are Credit Spreads?

Credit spreads are strategies that involve two trade legs, mostly a combination of a short and long option. The concept of this strategy is to receive more from the short options than what you pay for the long options, resulting in a net credit. When selling credit spreads, the goal is for all the options to expire worthless.

Now, one of the best things I love about credit spreads is its defined risk structure. When you sell a single call or put option, you are at risk of assignment, meaning you either need to sell or buy the underlying asset at the strike price, depending on the type of option. This has significant capital requirements and will most likely lead to losses.

However, with a credit spread, your long option serves as a hedge against assignment risk. It completes your obligation, should you get assigned, and the maximum loss is limited to the difference between the strike prices minus the net credit received.

Types of Credit Spreads

There are two common types of credit spreads: bull put and bear call. Let's start with the bull put spread, which involves selling a put option and then buying another put option at a lower strike price. The strategy's objective is for the underlying asset to trade at or higher than the short put strike at expiration, so all trade legs expire worthless. It's mainly used in neutral to slightly bullish markets.

Here's a quick example of a bull put spread. Let's say you sell a $100 strike put for $3 and buy a $95 strike put for $1. That gives you a net credit of $2 per share or $200 per contract upfront. Both options have the same expiration date.

When you sell this spread, it means you're bullish on the stock, expecting it to stay above the $100 strike. If it does, both options expire worthless and you make $200.

But if the stock dropped below $95, the spread is in the money, and you're out $500 on the $5 spread, but you still keep that $200 credit, so your loss works out to $300.

A bear call works similarly but in reverse. The strategy involves selling a call option and buying a call option at a higher strike price, with the expectation that the underlying price will trade at or below the short strike. It's primarily used for neutral to slightly bearish markets.

Here's a quick example: You sell a $100 call for $3 and buy a $105 call for $1 - both with the same expiration. The long call costs $1, while the premium that you collect on the short call is $3. That gives you $2 per share or $200 net credit up front.

This strategy suggests you're bearish or neutral on the stock and expect it to stay below $100. If it does, both calls expire worthless, and you keep the full $200 profit.

But if the stock rises above $105, the spread is fully in the money. You'll lose $500, but again, since you collected $200, your max loss is $300.

Max Profit, Max Loss, Breakeven

Now if you're wondering how I came up with these numbers, let me show you the formula to calculate it yourself.

For credit spreads, the maximum profit is limited to the net credit received, which is taken by subtracting the premium paid from the premium received for the trade, multiplied by 100 for every credit spread you sold. In our previous examples, you buy the long option for $1 and sell the short option for $3, giving you a $2 net credit per share, times 100. So, that's $200.

Meanwhile, the maximum loss is the difference between your strike prices, also called the width of the spread, and the credit received, then multiply by 100 for every credit spread you sold. In both examples, the difference between the strike prices is $5. So, just subtract $2, then multiply by 100, giving you a $3 maximum loss.

Now, it's important to know every aspect of your credit spread trade before trying it, so let me show you the calculation for breakeven prices.

For a bull put, the breakeven price is taken by subtracting the net credit from the short put strike. In our example, that's $100 minus $2, so $98.

For a bear call, you add the net credit to the short strike to get the breakeven price. So, $100 plus $2 equals $102.

Now, let's talk about the setup and risks.

Selling credit spreads with wider strike widths is safer and will lead to higher net credit and higher chances of profitability. However, the potential maximum loss is also higher.

On the other hand, if we sell credit spreads with tighter strike widths, the net credit will be lower, as are the chances of the trade being profitable. However, the maximum potential losses will also be low.

Finding the right balance between risk and reward will depend on your trading preferences, but usually, it's better to sell credit spreads with a high degree of safety. Besides, you can sell a lot of them if you want to, which improves your overall net credit but, again, potentially increases your maximum loss.

Time Decay and Probability of Profit

Now let's talk about some important factors that could affect your trade.

First, it is important to remember that all options lose value as they get closer to expiration. That's called time decay or Theta. With credit spreads like the bull put or bear call, a positive theta works in your favor because you want those options to expire worthless.

Beginner traders may get confused about "losing value". So, when I say the option loses value, I mean that their current premiums are going down as the options get closer to expiration. It doesn't affect the net credit you receive - that's entirely yours, regardless of what happens to the trade.

Now, with credit spreads, it's also important to know the risks. This is expressed in the probability of loss or the chance of the option expiring worthless. Again, the wider the width, the higher the chance of profit, and vice versa.

Ideal Market Conditions

We've covered how bull puts work well in sideways or bullish markets and how bear calls work well in sideways or bearish movements. Now, let's talk about implied volatility.

Implied volatility, or IV, is a metric used to predict how much the stock's price will move in either direction within a given period, based on its current options prices. A higher IV means the market expects more significant moves, which means premiums will be higher, while a low IV suggests a more stable market, leading to lower premiums.

Trading credit spreads with underlying securities with high IV will result in more net credit, sure, but it also puts you at more risk since everyone expects the asset's price to move drastically.

Risks and Adjustments

You always carry assignment risk with any option strategy that involves short options. If your short option expires in the money, that's automatically assigned. Also, the buyer can exercise the option at any time - even if it doesn't make sense.

So, how do you avoid this? Well, there are a few things to do. The first is trading credit spreads with a lower probability of expiring out of the money. That means wider spreads with higher net credit and potentially higher max losses - though, again, that's offset by the lower chance of it expiring in the money.

If the stock moves close to the long option's strike, you can also “roll” your option. Let's say you have a call credit spread with a short $100 strike and long $105 strike, and the underlying's price is getting way too close to $100 for your comfort, to avoid assignment, you can buy to close that $100-strike short call, then sell another one, perhaps at $104. Or, if that strike doesn't exist, you can close the entire trade, and sell another spread at a higher strike, or move on to other opportunities.

Now, let's say your trade is going your way, but you still want to avoid assignment. Well, you can close your trades before expiration or at a specific level. Usually, what I would do is assign a take-profit price. If at any time before expiration, I can close the trade and keep 50%-75% of my net credit, I close the trade. Still in the green, and I no longer have to worry about assignments and I can move on to the next trade. I almost never hold credit spreads or any strategies with short options to expiration.

Trade Setup Tips

Now, when finding credit spreads to sell, it's important to consider your trade details. Like with any market, trading options on higher-liquidity assets is often good idea- so you won't have to wait long to get a fill. Look for index funds like SPY, QQQ, or bigger companies like the ones in the magnificent seven or mega-cap stocks.

The next consideration is the days to expiration, or DTE. I typically trade 30-45 DTE credit spreads, which gives me a lot of time to make a move. Remember, you don't need to keep your trades open until expiration. Just close them at acceptable profit or loss.

Also, when trading credit spreads, it's best to start out of the money. This gives you a better chance of profiting within your chosen DTE.

Then, of course, consider the risk/reward ratio. It's a balancing act: keep yourself safe from assignment, but get enough credit to cover your trading fees and make you happy. Now, credit spreads can have high risk/reward ratios, especially for ones with higher chances of profit. In my experience, reasonable risk/reward ratios for credit spreads trading around 70-80% probability of profit is about 4 or 5 to 1. That means you could lose four to five times your net credit if the trade goes against you.

Real Example or Demo Trade

Now, let me show you a real example of a credit spread and we'll have a look at Barchart's new charting tool, which can help visualize the results.

So, first, go to Barchart.com, then search for your desired underlying asset. For this example, let's take Nvidia. As you can see on the chart, Nvidia is moving in a sideways to downward trend, so this could be a perfect setup for a bear call spread.

To get the trade details, go to the left-hand menu and click on vertical spreads under options strategies. Then, set the DTE. For this example, I'll set the expiration date to May 2, which is 34 days from the date of the screen.

Next, choose your short strike price. Remember, Nvidia's stock price must stay below the short strike at expiration or when you close the trade to profit, and now it's trading at $109.67. So, let's say you think Nvidia will not exceed $115 by May 2. Just type in 115 in the strike field and hit apply.

Now, here are your choices for the $115-strike bear calls. I can arrange the results based on any of the column headers here, so I'll arrange it from lowest to highest loss probability.

And here we have the top trade with a 29.2% loss probability or a 70.8% probability of profit. The trade involves selling a $115-strike call for $4.20 per share, then buying a $140-strike call for 29 cents. The breakeven price is $118.91, and you'll receive a $3.91 net credit for this trade. Its risk/reward ratio isn't looking too bad either, at around 5 to 1. Meanwhile, the max loss is $21.09 per share.

If you're an experienced option trader, you're probably already able to visualize the trade in your head. However, it can be difficult for new and intermediate traders. So, to get a visual representation of the trade, you only need to click on the chart icon beside the expiration date. And here you go, the profit/loss chart with all other relevant trade details. Green for profit zones, red for losses, and the dashed line for the breakeven price. It's that easy.

If you want to dive in further, you can click on the tabs at the top, like the options Greeks. Then, onto expected move, which I absolutely love. This charts the expected price movement of Nvidia. So in this case, It looks like the market expects Nvidia to trade somewhere between $120 and $99 by May 2, well below the $140 long strike.

Next, the volatility tab also shows where IV may be headed. As you can see, it says volatility is falling, which is good because that means lower chances of big price swings.

Then, you can also look at the trend tab, where it shows the historical price movement of the stock based on Barchart's Opinion and Trend Seeker® features. It looks like Nvidia is in for a rough ride, at least for the next few months.

So, yeah, everything you need to know about your trade is right here.

Summary & Final Tips

Credit spreads are defined-risk strategies that work best in low to moderate volatility environments. Always manage your risk carefully, because position sizing can make or break your trade.

If you're new selling credit spreads, I recommend using a paper trading account to build confidence before trading with real money. And don't forget to check out the Options Learning Center for more information about all the options trading strategies that exist. The more you understand pricing and volatility, the better your edge. Stay patient, stay consistent, and let the probabilities work in your favor.