Credit spreads are a very forgiving strategy that carries a higher probability of success. It is perfect for beginners because of the following reasons:
Mild Directional View
You do not have to have a strong thesis about the movement of the stock. As long as you can identify a stock that is trending higher, lower, or sideways, you can set up a credit spread.
Limited Risk, Limited Reward
This attribute lets you know precisely how much money you may make or lose before you enter the trade. This helps to avoid large losses and enhance risk management.
Higher Probability of Success
Because of the nature of credit spreads, many traders win more than 50% of the time, especially with such setups as those in this example.
How to Structure a Credit Spread: Step-by-Step Example
Let’s walk through a real example of how to structure a credit spread with Marvel Technology, a semiconductor stock that has been trending higher recently.
Stock Overview
Marvel Technology (MRVL) has been moving higher over the last month, making higher highs and higher lows. This provides a suitable opportunity for a credit spread setup.
Trade Setup
- Expiration Date: December 27th (43 days away).
- Sell the $91 Put: This is an at the money option and lines up with a mild bullish to neutral view on the stock.
- Buy the $83 Put: This has lower strike price, so it serves for protection and will reduce possible risks on the trade.
Net Credit Collected
- Sell $91 Put for $5.75.
- Buy $83 Put for $2.55.
- Net Credit Collected per contract: $3.20.
This setup reduces risk significantly, from a potential $9,100 on a single contract (if selling the $91 put alone) to just $480 (the net risk after purchasing the $83 put). This is a risk reduction of nearly 95% in exchange for a smaller credit of $320.
Understanding Risk and Reward
In this trade, the distance between the two strikes (91 and 83) is $8. The potential profit is the credit collected, which is $320, and the total risk is the difference between the two strikes minus the credit collected, which is $480.
Hence, the risk-to-reward ratio is 1.5:1. For every $1 of potential profit, you’re risking $1.50 on the trade.
Break-Even Point
This trade has a break-even point of $87.80, that being the strike price of $91 minus the $3.20 credit you collected.
If the stock is kept above $87.80, then you are profitable with this trade.
Potential Outcomes
Let’s explore the three potential outcomes with this trade:
Stock Advances (Bullish Outcome)
If the stock moves higher or is held above $91 you get to keep the full $320 credit. That’s a good outcome.
Still Stocks Remain at or Near $91 (Neutral Outcome)
If the stock does not even budge, so long as it stays above the break-even point of $87.80, you’re getting the full $320 profit.
Stock Pulls Back Slightly (Moderate Loss)
If the stock falls below $91 but remains above $87.80, you will still get a smaller profit, and it gets smaller as the stock moves closer to the break-even point.
Stock Drops Significantly (Losses Start to Accumulate)
If the stock falls below $87.80 but remains above $83, you will lose, but it will be limited to $480 (your maximum risk).
If the stock falls below $83, you will realize the full loss of $480, but no more than that.
Why This Strategy Works for Small Accounts
Credit spreads are especially appropriate for traders who have relatively small accounts. You may trade multiple contracts, given the reduced risk, allowing you to manage your exposure. For instance, in case you could only risk $1,000, you could risk two contracts of this trade without going beyond your threshold.
Key Takeaways
- Credit spreads have a limited risk and a limited reward, and thus one can calculate his or her maximum loss and potential profit beforehand before entering into a trade.
- For around 43 days, you obtain a time decay “sweet spot,” avoiding excessive gamma risk, which can grow large when getting close to the expiration date.
- The spreads in credit are highly tolerant of price and offer higher successes in execution; hence, spreads make good small accounts for even beginning traders.
- Making better judgments of how the trade will go regarding reward and risk will work together in managing your trading decisions.
- By following these guidelines, you can leverage credit spreads to generate consistent income with a small account, minimizing risk while maximizing potential profit.