The 45-day expiration is the “sweet spot” when trading credit spreads. This period is long enough to allow enough time for the trade to work in your favor without being too long to risk excessive gamma. Here’s why it’s effective:
Time Decay Works in Your Favor
As you get closer to expiration, time decay really starts to accelerate. This again is in favor of option sellers, as the sold options are losing value due to time decay. You are selling credit spreads in this scenario in which the options will expire worthless and the trade is profitable.
Avoiding Gamma Risk
Gamma risk shows up in the last two to three weeks before expiration. With expiry closing in, small moves by the underlying stock cause the prices of the options you hold to change dramatically. So, one needs to really minimize the exposure to gamma risk as it might instantly flip the tables on what was going well into a losing proposition. So, you get your 45-day expiry for a fair balance there where enough time is left for the trade to work out but not enough time so that the gamma risk is a concern in itself.
The Importance of the 25 Delta Approach
When structuring your credit spread, it’s important to select strike prices based on their probability of expiring worthless. One effective way to do this is by using Delta as a guide.
What is Delta?
Delta is the chance that an option will expire in the money. A 25 Delta option has a 25% chance of expiring in the money, or 75% chance of expiring worthless. This is a very sound strategy to ensure your credit spreads have a positive probability of success.
Selecting the Right Strike Prices
Using the Delta approach will see you choosing strike prices purely based on probabilities, thereby presenting you with a consistent systematic way of structuring trades. By focusing on 25 Delta, you then ensure that you are taking on a decent amount of risk for which you can expect a probable profit.
The 1/3 Rule for Credit Spreads
Of all rules for selling credit spreads, the most vital one in regards to keeping that optimal risk-to-reward ratio would be the 1/3 rule. This will tell you at least that you will get one-third of the spread’s vertical width. And here’s why it matters:
Calculating the Vertical Width
The vertical width is the difference between the strike prices of the options in the spread. In the example above, selling a $91 put and buying an $83 put, the vertical width is $8. The 1/3 rule dictates that you must collect at least $2.66 (33% of $8).
Risk-Reward Ratio
With this, you gather 33% of the vertical width. That’s a good risk-to-reward ratio. In the example above, if you collect $2.66 in premium, your potential risk would be around $5.34, giving you a risk-reward ratio of about 2:1. For every dollar you can make, you’re risking two dollars.
Maximizing Consistent Profits
The higher the chances of credit spread profitable trades, which can be achieved through the use of the 45-day expiration rule, a 25 Delta approach to strikes, and 1/3 risk management rule. Here’s the breakdown:
Probability of Profit
The Delta approach means you’re going to be picking those with a good chance of succeeding, while the 1/3 rule keeps the risk at bay, so you are more likely to make profits constantly.
Risk Management
Even though you’re taking on a risk of 2:1, the key to success is ensuring that 67% of your trades are winners. By carefully selecting your strikes and expiration dates, you improve the chances of your trades being profitable.
Conclusion
Credit spreads are a good way to trade options with limited risk and huge profit potential. Maximize your success by targeting the 45-day expiration sweet spot, using the 25 Delta rule in determining strike prices, and always trying to collect at least one-third of the vertical width for each spread. With these strategies in place, you’re well on your way to maximizing profits while minimizing risk in credit spread trades.