A Credit Spread is a strategy that combines receiving an edge from selling option premium and making a directional bet on the underlying. A spread combines both a long and a short option of the same type (ie. put or call) and in the case of a Vertical Spread the risk is spread across a range of strikes and in the case of a Calendar Spread the risk is spread across different expirations. We have some “rules” at tastylive when establishing Credit Spreads. What are these “rules” and why did we choose them?
The first rule is actually a pair of qualifiers. We only choose out-of-the-money (OTM) strikes and high Implied Volatility (IV) and IVR environments. Since it is a Credit Spread, the short strike is closer to-the-money. We then establish the long strike at a level in which the credit received is equal to approximately ⅓ of the width of the strikes. That credit though has to be high enough for the risk. A risk graphic comparing different width vertical spreads was displayed. The graphic showed that the higher the credit gave us a lower probability of profit (POP) but a much better risk-to-reward ratio.
The reason we have these “rules” is because no trader is perfect. The rules enable us to be profitable when we are right yet still give us room and make a profit even when we are wrong. A graphic displayed the Delta risk of two different vertical spreads with the same space between the strikes but differences in Delta. The graphic showed that the higher Delta vertical spread will see more price movement and provides the ability to manage winners. The lower Delta spread would have to see huge moves in the underlying or be held to expiration to see profits. When we collect more premium and put the risk-to-reward more in our favor, we allow for directional profits should the underlying move our way while still benefitting from Theta (time decay). Tom and Tony noted that they “prefer the ⅓ risk metrics because it helps offset the transactional costs and to build a series of mechanics that you will never forget.”
Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the valuable takeaways and for an understanding of how and why we select our strikes when establishing vertical credit spreads.
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