Credit Spreads

Discussion in 'Options' started by brook89, Dec 12, 2003.

  1. brook89


    I am thinking about writing credit spreads on oex options and would like comments on it.

    Basically i am thinking of selling either calls and puts closer to money and buying calls or puts 5 points away to collect .50 or .75 credit with about 2-3 days left on expiration.

    Lets say oex is at 525 with 2 days to expiration. If i am bullish i would sell 520 put and buy 515 put to collect a small credit. If oex stays above the 520 mark i will collect premium. Worst case scenario is i will lose 5 points.

    Any experiences or comments are appreciated.
  2. Maverick74


    Brook, I'll let you answer this question yourself. You are willing to risk 5 pts to collect a .50 credit? I think you know the answer to this question.
  3. I'd have to agree with Mav here, the risk reward seems poor. and I think the expectancy of the trade is likely negative. If you do choose that strategy, a stop loss might make it somewhat more attractive but still not overly attractive.
  4. sle


    Most interesting is that terminology is quite confusing - to me, credit spread is the difference in interest rates between defaultable (corps) and non-defaultable (govies) bonds.
  5. roperfam


    I am learning about credit spreads and want to start implementing using the SPY or DIA's with strike prices far "out of the money" (on both the long and short call or put), for a small credit spread but safe for a steady flow of income. I will put on the spread only for 1 month out.

    My question is, "if the price of the stock makes a large move in the wrong direction, and almost becomes "in the money" and I decide to bail and close out both positions, can I still lose money if the stock is still "out of the money", but only by a dollar or two?

    Everything I read, makes it sound like you wouldn't lose money if you close them out as long as they are still "out of the money".


  6. roperfam, YES, you can lose money doing that!!!

    Here's why: If you write far out of the money spreads, you will receive only a modest premium at best. As the stock price moves toward your strikes the options you have written may increase in value, and perhaps dramatically. A five point spread could easily change in value from a 0.20 to 2.00 and still be out of the money with only a few days until expiration remaining. You will be forced to make a very difficult decision-- do I hang on and hope that the spread really does expire out of the money, or do I sell and keep my losses at 1.80 (ie. 2.00-0.20) or take the chance that you could lose the entire 5.00. At that point, the probability of serious losses will be about 1 chance in three if you continue to hold. Of course, you might also have assignment/exercise issues as well, depending on whether you are using indexes or stocks.

    The central problem with writing these kinds of credit spreads is that you will win fairly often, but when you lose, you will lose quite a few month's gains if you don't nip the loss in the bud at a sensible point. Trust me, I'm not a paper trader and understand this from painful experience.

    I think that a few others such as maverick, dmo, coach, etc. will also confirm what I am telling you is absolutely true. This does not mean that you cannot trade credit spreads. What it does mean is that you need to watch them and trade them with care and sensible caution. You also should have at least a mental stop in mind when you initiate the the trade; it's even better if you write it down and actually follow it. TOS actually allows contingent orders based on the underlying, so you can set up the exit to be automatic (more or less).
  7. As written above you do not need a short option to move ITM to lose money on it in a credit spread. Credit Spreads make more sense once you understand the Greeks a lot a better.

    For the record, when VIX left the teens in latter half of 2007 I stopped doing credit spreads. Most people usually think backwards in that high vol environment is better for spreads. I actually did very well when VIX was 10 - 15 for those years because an average day on SPX would be 5- 10 points- lately now that is the opening gap on many days. Much easier to manage the positions when the index crawls to your strike than when VIX is 50 - 70 and a gap and run in the morning alone could wipe you out while stull being OTM by quite a few strikes.

    Credit spreads work under the right circumstances and it is my humble opinion that in the current market environment it is more difficult to use them. So at a minimum before considering them, master the greeks.
  8. A lot of good feeback- I'd like to add my personal opinion.

    I personally suggest looking at further out months, with strikes far out of the money- I think with the VIX where it is, this is almost a requirement. When volatility is more tame, I'd be more likely to get my feet wet with the front months; right now getting out of the position when it is going against you will cost you dearly in the fronts- where the further out contracts will move less (but still lose money for you in this instance).

    Definitely healthy premiums to be had these days, but there is a reason why they are this way.

  9. I would look at a 30 day iron butterfly, could run the spread each expiration set, and as it moves around you may have an opportunity to split the strikes in order to experience a nice profit if you are brave enough to drive it all the way to expiration.

    Best luck!