QUICK LOOK — Credit spreads come with a few specific advantages:
- Credit spreads lower the barrier of entry to potentially high-cost single-option strategies.
- Credit spreads mitigate theta risk.
- In a declining volatility environment, credit spreads can give your trade an edge.
- In certain situations, they can appreciate in value even if the underlying stock doesn’t budge.
- Credit spreads maintain more directionality and delta exposure than many other popular premium collection methods like calendar spreads and short iron condors.
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Credit spreads involve selling short an option while simultaneously buying a cheaper option to hedge against risk. Their defined-risk status is part of what makes credit spread strategies a favorite among premium collectors.
But if you want to squeeze every ounce of potential out of this dynamic option strategy, you have to make sure the conditions are right. To do that, we put together a credit spread strategy checklist: 4 questions to ask yourself before you start trading credit spreads.
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1. What do I think of the volatility environment?
If your answer is “I think volatility will soon decline”, or “volatility is currently much higher than it should be” — that’s the right answer for a credit spread trader.
But if you’re thinking that the majority of stocks are about to take a big tumble, or that the VIX is running a little low, or that the IV rank of the underlying stock is low — then you’re trying to ride in the wrong trading vehicle.
Credit spreads (like all short-option strategies) are negative vega. That means they appreciate in value when volatility declines. On the other hand, long option strategies like debit spreads, calls, and puts are all positive vega — meaning they appreciate in value when volatility increases.
If you’re not sure how to gauge volatility, check out 3 must-know ways to judge volatility. But for a crash course, you’ll want to at least do these two things:
Check the IV rank of the underlying stock. IV rank is a measure of a stock’s implied volatility compared to itself over the past year. If an IV rank is 100% — it’s the highest it has been all year. If an IV rank is 1%, that’s the opposite — lower than it has been for 99% of the year.
Comparing the VIX to its average. The VIX is an index that measures the volatility of the S&P 500, but it’s often used as a pseudo-measure of macro market volatility. In situations where the VIX is below average, and especially when there are possible headwinds set to occur within the expiration of your trade, you may want to think twice about using credit spreads for your prediction.
In short: The best volatility environment for a credit spread is one where volatility is currently high, and about to be low.
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2. How big do I expect this price move to be?
If your answer is “measured”, or “relatively small”, then congratulations — you’re on the right track to perfecting your credit spread strategy.
However, if you’re expecting a massive move in the underlying stock, there are other strategies that would likely be better suited for your prediction.
Credit spreads place a cap on your potential profit — that means if a stock goes to the moon (or drills into the center of the Earth), you’re going to be left on the sidelines, watching long call and put holders have all the fun.
Credit spreads are better for situations where you expect a stock to move, but not expeditiously. Think more like “jazzercising with grandma”, less like, “running the tough mudder”. Of course, if the underlying stock does make one of those high-octane moves in a direction that benefits your trade, it isn’t going to hurt too bad. You’re just limited in your ability to profit on any price move outside the long strike of your credit spread.
In short: As long as you’re directionally correct, a big price move won’t necessarily hurt, but if that’s what you’re playing for, there are better ways to do it. But in situations where you expect a tiny move, credit spreads are a great tool to use.
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3. Is the credit spread you’re selling out-of-the-money?
If you answered, “yes”, then good. That’s where you should be selling these.
If you answered “no”, then you’re trying to play the wrong financial instrument.
The art of selling credit spreads is in taking advantage of theta decay — watching the vertical spread you sold decay to nearly nothing before the expiration, allowing you to buy-to-close the trade at a fraction of the cost you sold it for.
Of course, as long as the spread you sold expires out-of-the-money, you’ll be fine — but if you want to truly take advantage of the power that credit spread strategies offer, you’re often better off starting from an out-of-the-money position. This allows your spread to gain value even if the underlying stock doesn’t even move.
Remember: “out-of-the-money in this context means selling an out-of-the-money vertical spread — meaning one that is already fully within your max profit zone.
And after all, recall point number two: if you’re trading credit spreads, you aren’t searching for huge moves anyway. The goal of the credit spread strategy isn’t, “the stock is going to shoot past my strikes at a high velocity.”
In short: If you’re trading credit spreads, you’re looking to put as much probability on your side as possible — to play “the house”, selling low-odds lottery tickets to gamblers — not to be the gambler.
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4. What’s the timeframe on your credit spread trade?
If you answered, “short”, or are looking at a time frame around 14 days, that’s a great set-up for a credit spread. Even if you’re looking at a 30-day timeframe, that’s still alright.
But if you’re looking at a longer timeframe than 30 days, you’re probably better off using a different option strategy (perhaps one that is net long).
Remember that credit spreads and theta decay go together like peanut butter and jelly. They compliment each other. Credit spreads and long-term trading time frames go together more like bacon and ice cream — they both can be great, but not at the same time.
Recall that taking advantage of credit spread means leaning on theta decay to do the work for you. And theta decay does its best work when an option is around 14 days to expiration. That’s when theta is at max velocity.
For instance, if you’re selling a credit spread with 90 days to expiration, there’s so much possibility in the air — the option market isn’t going to give you much credit if 10 days pass and the underlying doesn’t change in value. The odds won’t have changed all that much. However, if you’re selling a credit spread with 14 days to expiration, and 10 days pass — the odds of the spread expiring in or out-of-the-money will have likely changed significantly whether the stock has moved in your favor or stayed put.
When in doubt, you can rely on this chart of the theta-decay curve to help you visualize the ramp up of theta-decay over time.
Source: Market Rebellion
In short: Short spreads work best on a short-term timeframe.
The Bottom Line
Credit spreads are great for situations where:
- You think volatility is about to decline
- You’re looking for a small, measured move in the underlying stock
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And you can power up your credit spread strategy by:
- Selling them out-of-the-money (fully within your zone of max profit)
- Selling them with roughly 14 days to expiration
- Closing winners before the day of expiration
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Asking yourself these four questions will help you decide if the credit spread is the best strategy to use for your trade, or if there’s a better strategy out there.
For a breakdown of other powerful option strategies that professional traders use, check out Market Rebellion’s FREE Professional Option Trading Strategy Guide.
