Most traders that join my LottoX service only know how to buy options.
They haven’t explored the world of selling them…
Until I show the glory of credit spreads,
But then they ask a most important question…
When do you buy options and when do you sell spreads?
And it deserves an answer.
While there’s no hard and fast rules to live by, there are some key concepts that help make the decision.
It starts with understanding the differences between the two strategies as well as the key influences.
Then we align that to the trade idea, going through a series of simple questions to guide you to the answer.
So, let’s begin, shall we?
Most of us are familiar with buying an option contract.
Much like a stock, we buy the contract and hope to sell it at a higher price – simple and elegant.
When new traders hear about selling options, they automatically think about naked options with undefined risk and a huge loss potential.
That is a strategy, but not one I use.
Only the studious few make it to the next round, learning about credit spreads.
And congratulations, that’s you!
Credit spreads are defined risk trades that cap your risk by buying an offsetting option contract against one you sell.
Here’s how they work.
Imagine I want to bet against stock ABC. I would sell a call credit spread.
My bet is simple: ABC will hit expiration below both of the option strikes that I choose.
If that happens, I get to keep the credit I received for putting on the trade.
Let’s use an example.
I sell a call credit spread on stock ABC which is trading at $100.
- I sell the $105 call contract that expires in one week for $3
- I buy the $110 call contract that expires in one week for $1
- That pays me a credit of $3 – $1 = $2 x 100 shares per contract = $200
- This is the maximum amount I can make on the trade.
- My total potential loss is the difference between the strikes minus the credit I received
- $110 – $105 – $2 = $3 x 100 shares per contract = $300
- If stock ABC gets to expiration and it’s at or below $105, I get to keep the $200.
What’s neat is I can take this trade off at any time, allowing me to lock in partial profits.
A put credit spread works very similar, except you sell one put contract and buy another at a lower price. In that case, you want the stock to be above the strikes by expiration (bullish bet).
Here’s a diagram of what they might look like.
Why sell a credit spread
Why would I cap my potential profits with a trade like this when buying an option also has defined risk?
All things being equal, these trades have a higher probability of success.
Plus, when you sell an out-of-the-money credit spread, each day that ticks away works for you.
When you own an option, each day works against you.
Credit spreads won’t be as sensitive to price movements, which can reduce volatility in your portfolio.
There is one main influence worth discussing and that is implied volatility.
Implied volatility is the market’s expectation for a percentage change in the stock price.
A better way to think about it is it’s the demand for options.
Implied volatility is mean-reverting. That means over time, it often moves back to the average.
Plus, in regular markets, it tends to decrease as it gets closer to expiration.
That means you have two potential things working against you when you buy an option but working for you when you sell an option.
Choosing the right fit
Here are a few questions to ask yourself about whether a credit spread or long option is ideal:
- Do you expect a lot of price movement?
- Long options work better when there is a lot of price movement.
- Credit spreads don’t need any price movement. They just need the stock to stay away from the strike prices.
- Is implied volatility really high or low?
- Looking at the last year, if implied volatility is really high, that increases the odds it will work against long options.
- Conversely, if it’s really low, expansion in implied volatility (increases) will work for you.
- How expensive are the options?
- Some options can get extremely expensive, especially with high priced stocks. Amazon call options often run over $10,000 for just one at-the-money call option.
- Credit spreads can be more capital efficient, especially for traders with smaller accounts.
Again, there are no hard or fast rules. But, I use these as guidelines to help my decision making.
Learn how to do it from an experienced trader
One great option to learn these concepts and ride along with an experienced multi-million dollar trader is to hop on to LottoX.
LottoX offers trade ideas every week, live training, as well as a live stream of my portfolio and orders for you to learn from.
There’s so much to learn, I’m excited to share it with you!