Put credit spread (also known as the bull put spread) stands out as one of my favorite options strategies.
It is a semi-bullish options approach akin to selling a short put – you stand to gain whether the market goes up, stays flat, or experiences a slight decrease.
The put credit spread involves:
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Selling an out-of-the-money (OTM) put
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buying a further OTM put.
The spread is defined by the difference in strike price between the long and short puts, limiting the risk so that you cannot lose more than the capital at risk.
Here's a standard risk profile for a put credit spread. As depicted, the trade's loss is limited, ensuring you cannot lose beyond the amount indicated by the lower expiration line.
By selling a put option with a strike price of $4865 and purchasing a put option with a strike price of $4815 as illustrated above, while receiving a premium of $700, you're essentially initiating a spread with a width of $50.
Since each options contract represents 100 shares, the maximum potential loss is limited to $4300 ($5000 minus the $700 premium received from selling the spread).
A Versatile Options Strategy
Before I discovered the power of credit spreads, I was only using the Wheel Strategy, which involves selling cash secured puts and covered calls.
Although the Wheel Strategy is one of my favorite options strategy, one drawback is that it poses a considerable obstacle for individuals with smaller accounts (<$15k or less).
The reason for this is that options contracts represent 100 shares each, making it difficult to afford contracts for more established companies, which typically have higher share price.
For instance, selling a cash secured put on Apple stock at a $160 strike price would require a capital outlay of $16,000, which may be out of reach for individuals with smaller accounts.
Even if you could afford to sell a cash secured put on those companies, you could potentially tie up all of your capital in a single trade, posing a significant risk to your account.
Therefore, credit spreads are a fantastic option for people with smaller accounts to sell options on top-notch stocks.
Plus, they're scalable for those with larger accounts too.
Like any other options strategy, it has the potential to devastate a portfolio if executed incorrectly.
Therefore, it is essential to have a robust trading plan in place to increase the probability of successful trades and a risk management strategy to reduce potential losses during market downturns.
Why Put Credit Spread?
- Defined-Risk Strategy
Arguably the most crucial factor of all is that credit spreads is a defined-risk strategy.
When selling a cash-secured put, you expose yourself to the risk of unlimited losses in the event of the stock price plummeting to zero (though the probability of this occurrence is low if you pick the right stock).
Put credit spreads, on the other hand, limits the maximum risk from the beginning, ensuring that you won't exceed your maximum loss potential defined by the width of the spread.
This approach enables traders to diversify their positions and reducing the risk of tying up all their capital in a few trades.
- Grant Entry to Previously Inaccessible Companies
Put credit spreads allow individuals with smaller accounts to access fundamentally sound companies that were previously out of reach due to their limited capital – including indexes such as S&P 500, Russell 2000 and Nasdaq 100.
For example, if you sell a put option on the S&P500 ETF with a $450 strike price, you will need to have $45,000 in cash to cover it.
On the other hand, setting up a credit spread with a $5 width on the same ETF will only require less than $500 of capital at risk.
- Higher Profit Potential
Put credit spreads offer a greater potential return compared to cash secured puts while exposing the same amount of capital at risk.
This can be advantageous for accelerating the growth of a smaller account.
For example, by selling a $10,000 cash secured put with a 30-day expiration targeting a 1.5% yield, you can generate $150.
For put credit spreads, even if you risk $5,000 (half the amount), you could sell ten $5 width bull put credit spreads earning $50 per contract, resulting in a total premiums of $500.
Important Note: This is just to illustrate the profit potential; however, it does not imply that selling ten $5 wide credit spreads is advisable for those with smaller accounts. Risk management strategies will be discussed later in the article.
Selling Credit Spreads On Index Options
In order to reduce risk and eliminate the need to find solid companies, I would recommend trading credit spreads on market indexes rather than individual stocks or sector ETFs - specifically the S&P 500.
This is due to the significantly lower volatility and the almost certain recovery of indexes following a market crash over time, which cannot be guaranteed for individual stocks.
It is also advisable to trade European-style options to avoid the risk of early assignment.
This could be advantageous compared to American-style options, where contracts can be exercised at any time before the expiration date.
Because of these considerations, it will be a good idea to look at options listed on Chicago Board Options Exchange (Cboe) which are European-style, cash-settled options without early assignment risk.
If account size permits ($15k or more), it is recommended to trade put credit spreads using SPX options due to high liquidity and tight bid-ask spreads.
Alternatively, there's another ticker better suited for those with smaller account sizes— XSP, which is a mini version of the S&P 500.
If you are an investor in the United States, both tickers also offer tax benefits, as they are treated as 60% long-term capital gains and 40% short-term capital gains.
Parameters of Credit Spreads
Numerous credit spread strategies exist, ranging from short to exceptionally long durations at different deltas.
From my own personal experience and extensive research, I've concluded that credit spreads with approximately 45 days to expiration (DTE) represent a sweet spot between risk and reward.
The trading strategy involves selling credit spreads that are $5-10 width and around 45 days to expiration (DTE) on SPX (for larger accounts) and .
The short put has a delta about 0.2, while the long put will be $5 - 10 away from the short put (delta 0.13 to 0.17), depending on how much you are willing to risk per trade.
For example, I could open a credit spread on the SPX with 44 DTE, set to expire on June 14, 2024 (at the point of writing).
I opt for a short put at a strike price of $4810 (with a delta of 0.2) and a long put at $4760 (with a delta of 0.16), receiving around $660 credit before fees.
Since the spread is $50, my maximum risk will be $5000 - $660 = $4340.
Why 45 DTE?
Choosing a 45-day time to expiration (DTE) is based on solid reasoning recommended by the TastyTrade team.
In essence, longer-term options experience slower decay, while short-term options are more volatile. Around 45 DTE is kind of a sweet spot where options begin to decay more rapidly without becoming excessively volatile.
Why Put Credit Spreads at 0.20 Delta?
There are three main rationale behind selecting this specific delta value.
- Higher Probability of Profit
A smaller delta indicates a greater likelihood of making a profit, as the strike price will be further away from the current market price.
At 0.20 delta, there's a theoretical 80% chance of the trade expiring OTM by the expiration date, which is quite a decent win rate.
- Higher Implied Volatility (IV) Skew at Lower Delta
Stock index options exhibit an IV skew, causing lower delta puts to have higher IV than higher delta puts.
As a result, the price of lower delta puts is increased relative to higher delta puts, leading to a more exaggerated IV and greater probability of profit than suggested by the delta alone.
- Optimal Theta Decay
The spread’s theta (expected decay from one day passing) is optimal when the average of the two put deltas falls within the range of teens.
I stumbled upon this point while reading the findings of Data Driven Options in this post.
However, in the context of spreads, it is the difference in thetas between the two options that matters, not the individual values.
When deltas are higher, the difference in theta becomes less significant for the same width between strikes, resulting in the cancellation of Thetas.
As deltas decrease to below 0.10, there is insufficient remaining theta, leading to a decrease in the difference. The optimal range for minimizing theta cancellation falls within the teens.
When you open a put credit Spread with the parameters mentioned above, the Deltas are right at this sweet spot.
Capital Allocation & Risk Management Strategy
Since risks are predetermined for credit spreads, traders often fall into the trap of over-leveraging by simultaneously initiating too many put credit spreads.
As such, I suggest imposing a limit on the capital allocated for trading credit spreads, ideally ranging from 30% to 50% of your capital.
To enhance safety margins, I suggest disregarding the premium received and instead concentrating on the full width of the spread (for example, a spread that's $50 wide equates to $5000 in capital at risk).
If your portfolio amounts to $15,000 and you aim to allocate no more than 40% of your capital to credit spreads, refrain from opening credit spreads that put more than $6,000 of your capital at risk.
Instead of initiating all credit spreads at once, consider staggering them (e.g., opening one spread initially and adding more spreads if the market declines).
Personally, I prefer to maintain at least one spread open to seize opportunities in an upward-trending market.
Exit Strategy
Having a well-defined exit plan is crucial for a successful options strategy.
Credit spreads does require some level of management, albeit less than certain other option strategies.
While you could opt to simply wait until expiration and accept the outcome, by proactively managing the position and avoiding holding it until expiration, the likelihood of success can be enhanced and potential losses mitigated.
A solid approach to handling put credit spreads involves aiming to secure profits when they reach a 50% gain, while managing the trade as it approaches 21 DTE to reduce gamma risk.
Various scenarios will arise depending on the market type.
- Upward Trending Market
In an upward trending market, the premium on the position will decrease rapidly, presenting an excellent opportunity to close the position and secure 50% profit.
This could occurs within a timeframe of 1 to 2 weeks if market condition is favorable, which is the most desirable outcome.
Afterward, you may consider opening another put credit spread with the same delta as outlined by the strategy.
It might also be prudent to wait for a slight market decline before opening another credit spread, as it helps to reduce the overall risk slightly.
- Sideway Market
If the price of the underlying security remains relatively stable from the time the put spread is sold until expiration is 21 DTE, it is likely that the premium will decay by around half or more of its initial value.
At this stage, the position has fulfilled its purpose and it is more favorable to close the position to lock in the profit (even if it is less than 50%).
After which, you could open a new position back at 45 DTE to restart the decay process to have a higher probability of profit.
This outcome is also favorable, so it's advisable to secure any profit and move on.
- Downward Trending Market
Occasionally, the market experiences a downturn, causing put spreads to end up at the money (ATM) or ITM. In such instances, the premium increases and the position incurs a loss.
In this situation, it’s crucial to remain calm and avoid overreacting. Fortunately, you are trading European-style options credit spread, so there’s no need to be concerned about early assignment.
Typically, I will wait until there are approximately 21 DTE until expiration before taking any action. At this stage, there is still considerable time value in the options for you to make strategic decision.
Managing Losers
If the position remains in a loss by 21 DTE, there are several methods for managing losing positions, all subject to personal preference and comfort level.
One potential strategy is to roll the position to 45 DTE for a credit, if possible.
It may even be possible to roll down a strike or two while collecting a credit for doing so and slightly reducing risk.
If rolling for a credit isn't viable, you might consider rolling for a debit with the expectation that the market will rebound, allowing you to exit the position.
Some traders prefer not to adjust their positions by rolling them, whether for a credit or a debit.
Instead, they simply close the position if it's at a loss and begin again with a new credit spread that has a better chance of making a profit.
There's a good reason behind this approach.
At this juncture, the market would likely have undergone a substantial decline, potentially resulting in a notable increase in IV.
As a result, a 0.20 delta would push the short put even further OTM, making the trade more likely to profit when the market bounces back and IV goes down.
The good news is that if you handle losing trades at 21 DTE, you'll rarely experience the maximum loss.
Usually, you can expect to close the position at half of your expected maximum loss or even less.
It's crucial to find a management method that works for you and stick with it. This helps you stay disciplined and prevents your emotions from taking control.
Conclusion
Credit spreads can be a really profitable options income strategy for your portfolio, as long as you have a strong risk management plan in place.
Despite the high theoretical win rate using the strategy outlined in this article, it's important to recognize the possibility of occasional market corrections.
Therefore, it is essential to have clear entry and exit strategies in place to keep your trading systematic.
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