Credit Spread - The Foundation Of Monthly Option Income
A favorite directionless investment method with option sellers is called the vertical spread or the credit spread. One reason it’s so well-liked is because it’s one of the easiest option strategies to understand. Another explanation for it’s attractiveness is that once the trade is placed there can be very little attention needed to supervise it - allowing the credit spread trader to go out and spend their time doing other things rather than sitting in a dark room staring at a trading screen all day long.
The credit spread trade is a basic building block of many if not most other more complex option trading strategies such as the iron condor spread, the butterfly, and the double diagonal trade. For example, the butterfly is created using one credit spread and one debit spread, while the iron condor is made up from two credit spreads, one on either side of where the underlying is currently trading at.
Option traders love to trade this strategy because the way these trades are constructed can allow the trader to be wrong and still make money. If the trader creates a particular credit spread position, he or she can win if the stock or index being traded winds up doing three out of four possible scenarios. If the stock goes down, the trader makes money. If the stock goes nowhere the trader makes money. If the stock goes up a little, the trader makes money. The only way the trader can lose money if the stock goes up far enough to threaten the credit spread that has been sold. And even then, there are management and adjustment techniques that can be utilized to hedge against losses.
For example let’s say our trader is bearish on the stock XYZ. XYZ is trading at a recent high and our trader believes that the stock will not move any higher over the next 30 days. So, he sells a bear call spread - a call option credit spread that benefits in a neutral to bearish scenario.
This trade can win in 3 of 4 possible stock movement scenarios by using this option spread. If the stock drops like our trader thinks it will, the spread trade wins. If the stock doesn’t move up or down - just stays pretty much in the same area as it currently, the spread wins. Even if the stock moves upwards - defying what our trader believes will happen - this spread trade could still be profitable - as long as it doesn’t move above a certain level. So, in each of these scenarios, this trade would be profitable. The only way they would not be profitable is if the stock moves up past the level that has been sold - in which case the trader would then need to either remove the trade for a possible loss - or adjust the trade in an attempt to make it profitable once more.
While credit spread trading can be a great way to generate passive income, of course like any investment method there are potential pitfalls one should be aware of before jumping in. To learn more about how to properly trade this option strategy, including how to correctly place, manage, and most importantly how to ADJUST them, visit our free video training website at Credit Spreads
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