How to Trade Option Credit Spreads
Credit spreads are one the most popular option trading strategies for option traders of all levels of experience. One of the reasons for their popularity is because time decay works in your favor. To further explain this, let me describe exactly what a credit spread is. I will start with a call credit spread. As of the close of today (February 20, 2013) Apple, Inc. was trading at $448.85. Now let's say that after reviewing AAPL's chart you didn't think it was going to go above $455.00 by the end of the week (keep in mind this is just an example not a recommendation, I haven't even looked at the chart this week).
To enter a credit spread in this scenario you would need to sell a February 22 call with a strike price of 455 and purchase a February 22 call with a strike price of 460. Based on the closing option prices, you would receive $190.00 for the 455 call and the 460 call would cost you $94.00 for a net credit of $96.00.
Keep in mind when you sell options you will generally get the bid price while you will have to pay the ask price when buying options. Okay, so what this means is that you received $96.00 in your account (commission not included) for opening this credit spread. If Apple's stock price closes below $455.00 on Friday then both options would expire worthless and you would get to keep the $96.00 less commission for opening the credit spread. Another nice feature of a credit spread is that if you are right in your analysis you will only have to pay commissions on one side of the trade as both options will expire worthless.
So you are probably thinking that sounds great, but what if I am wrong and Apple's stock climbs and finishes higher than $455.00 on Friday? Well, that is a great question and this is why you open a credit spread rather than just sell an option outright. By purchasing the 460 call you have limited your potential loss. Your maximum loss is simply the difference between the strike prices ((460-455)*100) less the money you received for opening the credit spread. In this example your maximum loss would be $500.00 minus $96.00 for a maximum potential loss of $404.00 (plus commissions). Now you only would only incur your maximum loss if Apple's stock price is above $460.00 at the close on Friday and you still hadn't closed your option position.
However, many traders have a stop loss in mind when trading credit spreads. One rule of thumb is to close your position when the option you sold becomes in the money. In this example, that would be when Apple's stock price crosses $455.00. Another often used stop loss is when the credit spread doubles in value you should close your position. For example, if you received $96.00 for entering the trade then the position should be closed when the value of this option credit spread is $192.00 thus limiting your loss to $96.00 (plus commissions) on this trade.
When trading credit spreads it is very important to have defined exit points. From experience I can tell you that even if you have a high percentage of winners a couple maximum loses will offset the profitable trades. Therefore, it is imperative to limit your losses. Without accounting for commissions, you only need to be right more than 50% of the time if you limit your loss to the amount of your net credit (this is the second stop loss example from the previous paragraph).
If instead you think Apple is going to close above $445.00 on Friday then you could use a put credit spread. In this example you would sell a February 22 put with a 445 strike price and purchase a 440 put for a net credit of $123.00 less commissions. The closer you have your credit spread to the current strike price the more you will receive for your credit spread. However, along with the bigger credit comes more risk. Obviously, the closer your credit spread is to the stock price the less it has to move for the option you sold to be losing money.
Using credit spreads is not a get rich quick system but rather a way to steadily earn money over time with a disciplined trading plan. Of course, like any trading plan, only risk money you can afford to lose and make well informed decisions doing your own due diligence. If necessary, contact a licensed professional to help you.