I’ve received an overwhelming response when I opened up a discussion with my subscribers…
And I believe some have been confused when it comes to trading vertical spreads.
One question I kept noticing was: “Can you explain how you use credit spreads?”
Today, I want to put to bed the notion that vertical spreads, more specifically credit spreads, are extremely complex.
So I’ll try my best to break down credit spreads…
An Inside Look At How I Use Credit Spreads
When it comes to credit spreads, I like to think about them in odds and probabilities.
Now before I get into the details of how I use credit spreads, let me show you a bit of the basics.
There are two credit spreads:
- The bull put spread
- The bear call spread
The Bull Put Spread
Now, the bull put spread is also known as the short put vertical spread… so don’t get confused when you hear either of these thrown around.
With the short put vertical spread, it’s actually a bullish strategy with defined risk.
Now, this specific credit spread is comprised of a short put and a long put at different strike prices with the same expiration date.
Depending on my outlook on a specific stock or exchange-traded fund (ETF), I may select strike prices that are further out of the money… or closer to where the stock is trading (at the money).
Keep in mind that the closer the strike prices to where the underlying stock is trading… the more risky it can be.
The beauty of this strategy is it allows me to place bullish bets on expensive stocks… without buying shares and exposing myself to overnight risk.
You see, with the bull put spread, my risk is defined and I know my maximum loss… as well as my maximum potential profit. This allows me to gauge my position sizing.
To set this strategy up, I would sell puts at a specific strike price (typically the stock will be trading above that strike price)… while simultaneously buying puts at a strike price below the short put strikes.
Here’s a look at the profit and loss diagram of the bull put spread at expiration.
The maximum loss is limited to the difference between strike price A (the strike price of the long put) and strike price B (the strike price of the short put), minus the net credit received.
The maximum profit is the net credit received.
The breakeven point is strike price B minus the net credit received when establishing the spread.
Now, with the bull put spread, I like to identify key support levels. Basically, I want to find an area where it’s likely for a stock to stay above.
That way, I can still express my bullish opinion on the stock without the need to put myself at the mercy of time decay and volatility crushes with buying calls.
On the other hand, there’s the bear call spread, or the short call vertical spread.
Bear Call Spread
With the short call vertical spread, it’s useful as an alternative to short selling stocks in my opinion… because the risk is defined here.
To set this trade up, I would sell calls at strike price A and buy calls at strike price B. Now, typically, the stock will be trading below the price of the strike price of the short calls.
I like to think of it as the opposite of the bull put spread.
Basically I just want to find a key area where I believe a stock will have a tough time getting above.
Here’s a look at the PnL diagram of the short call vertical spread at expiration.
The breakeven point is strike price A plus the net credit received when establishing the position.
The maximum loss here is limited to the difference between strike price A and strike price B, less the credit received.
The maximum profit here is limited to the credit received.
Doesn’t sound too difficult right?
If you want to learn more about credit spreads and how I use them to my advantage, click here to receive a complimentary copy of my latest eBook, Wall Street Bookie.