The price action last week may have been a signal of what’s to come.
With the market notching its biggest weekly loss in three months…
Some traders may be looking to get on the defensive at these levels.
While I have been playing the momentum and finding some success…
I believe now is the time to consider risk and have the necessary tools in case the market takes a turn.
Today, I want to show you the strategies I use to limit my risk, whether I’m bullish or bearish on stocks… while still putting myself in a position to lock in gains.
What are they and why do I believe they’re so important right now?
Reducing Risk With Credit Spreads
Whether I’m bullish or bearish on stocks, I believe credit spreads can be advantageous… especially when markets get volatile.
You see, to me, there are some advantages of credit spreads…
- Spreads provide an alternative to buying and shorting stocks.
- They can help lower risk if a stock moves against you (or in the opposite direction).
- There is limited risk and a lot of the time… you’ll know how much you’re risking right off the bat.
- Credit spreads can require less management because if you’re comfortable with the maximum loss amount… some traders like to set it and forget it.
- Some traders will hold until expiration, but that’s not necessary because they can actually close out the position before the expiration date as well.
- They provide a degree of versatility that stocks just don’t offer, in my opinion.
Not only that, but traders who use credit spreads actually can generate gains in multiple scenarios.
To me, the only downside is that the upside potential is limited.
So why do I think credit spreads can be useful right now?
Well, the level of implied volatility (IV) starting to rise… and credit spreads actually take advantage of the mean-reverting properties of IV.
Short Call Vertical Spreads
Now, let’s say you want to bet against the market and think things can actually pull back further.
Shorting stocks outright can be pretty dangerous… and buying puts can be expensive.
The alternative here would be to use the credit call spread.
This is also known as the bear call spread, or short call vertical spread.
With this strategy, one would try to generate income when they’re neutral to bearish on a stock.
With a bear call spread, also known as a short call spread, you sell calls at strike price A and simultaneously buy calls at strike price B.
Typically, you would want the stock price to be trading below strike price A. That said, this means you’re neutral to bearish. In other words, you think the stock will trade above a specific level.
For example, let’s say you notice a bearish chart pattern in a stock that’s currently trading at $100. Now, you think the stock will stay below $110.
That said, the bear call spread could be set up by selling $110 strike price calls, while simultaneously buying calls with a strike price of $115. Now, let’s assume you were able to place that trade and receive a net credit of $1.50.
That said, your breakeven is equal to strike price A ($110 in this example) plus the net credit received ($1.50 here). That means if the stock starts to trade above $111.50… you would start to lose money.
The maximum potential loss is equivalent to the difference between strike price A and strike price B, less the net credit received.
In this example, it would be $3.50.
The maximum profit is limited to the net credit received, or $1.50 in this example.
Now, if you look at the risk-reward here… you might be thinking it doesn’t make sense.
However, it’s important to take into account that:
- Time decay is working to the advantage of those who use credit spreads
- Credit spreads benefit from drops in implied volatility
- There are multiple ways to profit with credit spreads
On the flip side… if you actually want to buy the dip, the bull put spread could be advantageous.
That strategy works in a similar way to the bear call spread.
Except with the bull put spread, I would look to sell puts at strike price B and buy puts at strike price A… and the stock price should be trading above strike price B.
Now, if this is all unfamiliar to you… and you want to learn how to reduce risk when trading…
Then you’ll want to check out my new eBook… in it, I detail how I’m able to use credit spreads to try to stack the odds in my favor.