How To Trade Credit Spreads Part 2

by Gavin in Blog, Options Trading Strategies, Options Trading tutorials

May 3, 2011 • 3 comments

In part 2 of this tutorial on how to trade credit spreads, I will look at some of the risks involved and how you can manage these risks. When I first heard about this strategy, it didn’t make a lot of sense to me that you would risk such a large amount for only a small gain. With this strategy you are looking to have a lot of small winners while avoiding any big losses. I like to be very conservative when trading this strategy. There are a couple of strategies you can use to avoid these big losses:

1. Sell the spreads as far out of the money as possible – In this way the market would have to move by a significant amount in a short period of time for you to suffer losses. So, rule number 1 is be conservative. In the second example that I gave here, RUT would have to fall by nearly 15% within 1 month for me to lose money. Not impossible, but fairly unlikely.

One thing to note here is that this is purely looking at the trade at expiry. If the stock or index moves very quickly against you, even if it’s only by 4-5%, you will be sitting on unrealized losses, this is where you need to decide if you still think the trade is a good one or if the risk is too great. If you think the market will continue to fall, then you should probably take a small loss and exit the trade. You also need to set stop losses which leads me to my second point.

2. Stop Losses – You need to set a maximum level of pain before you close out the trade. Personally I use a 200% rule which is very common for options sellers. Using the same example above, the premium I received when opening the trade was $0.23, so if the premium on the spread rises to $0.69 I will close the trade. Therefore my maximum loss is only $1,564, not $33,218 as I will be out of the trade LONG before I hit that loss point.

The major risk with this strategy is the market making a sudden and very sharp move against you (usually this occurs on the downside). If you’re worried about this, what you can do is enter a stop loss order ONLY on your sold option. That way if the market moves quickly, you will get out of your sold option and hold only the long option. If the market continues to move against your original position, your long option will continue to make money and the gain will help offset the losses you suffered on the sold option. This can be a great way to protect yourself if you’re worried about a “flash crash” type event.

3. Market Analysis – Talking about the flash crash, before using credit spreads you need to be an experienced investor in the stock market. You need to have good market analysis to determine the trend of which way the market is headed. In the days and weeks before the flash crash the market had turned quite negative, so taking this into account you would want to have call spreads on rather than put spreads. Bear call spreads would have done well during the flash crash despite the increase in volatility.

4. Trade indexes not individual stocks – I rarely use this strategy on individual stocks, mostly I use it on indexes as there is less volatility due to earnings etc. Take RIMM for example which had a bad earning report last week and dropped about 15%. It is very rare that you would see an index drop by this amount in one day, but it is quite common with individual stocks especially stocks in the tech sector or small caps stocks. Also the bid-ask spread is much lower for indexes and index ETF’s.

I guess the main risky is a flash crash / Black Friday type event, but hopefully I have shown you a couple of ways you can protect yourself, at least partially. Even during the flash crash the RUT only dropped 8.72% at its lowest point and recovered about half of those losses by the end of the day.

Happy Trading!