Credit spreads are generally the strategy of choice around here at tastytrade since they are a fairly easy to grasp strategy and are risk defined (meaning you know how much you stand to gain or lose before you even place the trade).
There are two types of credit spreads:
- Vertical Call Spread - used when you have a bearish assumption of the market
- Vertical Put Spread - used when you have a bullish assumption of the market
Instead of going in depth on the topic of credit spreads, we instead wanted to break down a few of the things you should think about before placing a credit spread. Without further ado, here are four keys to trading vertical credit spreads...
1) Get Paid For Credit Spreads
A credit spread is simply a spread that you sell (regardless of whether it is a put spread, or call spread). When you sell a spread, you receive a credit for the trade. What does that mean exactly?
That means you receive cash up front for the trade! The amount you sold the spread for is instantly added to your account. Credit spreads are risk defined spreads so your max profit and max loss are both defined before you even place the trade.
Max profit is the credit you receive for selling the spread - you can't make any more money than the initial credit received. Max loss is the difference between the width of the spread and the credit received for selling the spread.
2) PICK A DIRECTION: CALLS OR PUTS
As we mentioned before, when you sell a vertical put spread, your market assumption is bullish. If you are selling a vertical call spread, your market assumption is bearish.
So what do you think? Up or down?
3) FIND HIGH IV UNDERLYINGS
Once you’ve decided on a direction, you should look at the market conditions to maximize returns from your credit spread.
The ideal time to sell verticals is when the underlying has a high IV Rank. Why is that exactly?
The basic answer to that question is that when an underlying has a high IV rank, option prices are more expensive so you can receive a bigger credit up front than you would from an underlying with low IV rank.
4) USING PROBABILITIES TO GAIN AN EDGE
So how do you know what a good price is for a trade (aka how much credit you should collect from the trade)?
That is a tough question to answer, but what might be more important for new traders is deciding on a probability of profit (P.O.P.) that you are comfortable with.
Probability of profit is a calculation (the calculation is built into the tastyworks trading platform) that will show you what the probability of you making at least $.01 on a trade is (based on statistics and historical pricing data). Rather than focusing on how much credit you should receive, focus on the probability of your trade being successful!
Oh, and one last thing...you can use credit spreads to get a higher return on capital while at the same time taking on less risk and using less buying power than doing something like selling a naked option.
There you go...Four simple keys to figuring out vertical credit spreads...and trading better with them!
Learn more about options trading with Step Up to Options.