Credit Spreads: The Mirage Refuted

Mirage in the desert

This article, “Credit Spreads: The Mirage Refuted,” originally appeared at Option Elements

I have a beef with option educators who mislead people with false and inaccurate information to help sell their products and services.  Everyone has a right to sell his or her wares but only in an ethical manner.  You might not have control over an affiliate’s words, but the copy on your own website should be accurate and truthful.

So what got me all riled up today?

I came across an article at SJ Options about Credit Spreads that really rubbed me the wrong way.  Morris Puma made a few statements in his article on credit spreads.  I’m quoting Morris, who said:

1. The truth is that Credit Spreads have a high probability of making a profit

2. Sooner or later, virtually all option traders who use only Credit Spreads wipe out their trading accounts

3. This is one of the riskiest trades that you can do with options

Let’s examine these statements to see why I disagree with each one.

1. The truth is that Credit Spreads have a high probability of making a profit

This is only true for far out-of-the-money credit spreads with a low delta of the short strike option.  This is something you would typically see as part of an iron condor.  You can estimate the probability of the short strike being it-the-money at expiration by the absolute value of the Option Delta.  For example:

XYZ Stock is at $100

120 Call is @0.30 with a 6 delta

115 Call is @0.65 with a 12 delta

Sell the 115 calls and buy the 120 call is a $0.30 credit.  The short 115 call has a delta of 12, so there is approximately a 12% chance the option will expire in the money, or an 88% chance this spread will expire worthless.  This is the example Morris is thinking of, but it is not the only way to trade a credit spread.  Here’s another example:

XYZ Stock is at $100

100 Call is @5.00 with a 50 delta

95 Call is @8.00 with a 71 delta

Buy the 100 calls and sell the 95 calls for a $3.00 credit.  In this case, the short delta is 71 so there is roughly a 71% chance it will expire in the money.  Because the short strike is your maximum profit, your breakeven occurs above this price slightly.  The probability of profit will normally be around 40-45%.   This leads us to several observations:

– The higher the delta of your short call, the lower the probability of profit will be.

– The higher the delta of your short call, the better reward to risk ratio you have

If you want a high probability of profit, sell low deltas.  If you want a lower probability of profit with a better return (but more risk), sell a larger delta.

2. Sooner or later, virtually all option traders who use only Credit Spreads wipe out their trading accounts

I know several option traders who use credit spreads to trade directional opinions and do fine with them.  The key is having a trading plan and following it.  One example is to take a spread off if it makes 50% to 70% of the maximum possible profit and exit if you are down 25% to 50% of the maximum profit.  You have to do your own research for the trades you put on to get the numbers appropriate for you.  The key takeaway is having a plan.

Your plan might be to set and forget it but this will typically not work due to slippage and commissions over time.  If you assume options are fairly priced, then slippage and commissions will result in a negative outcome mathematically.  This is true for ANY option trading, not just credit spreads.

You need a trading edge

To get a trading edge, you have to be better than the market at something… prices (market makers have this advantage), directional forecasting (are you really better than average at picking direction?), adjusting or something else.   You need to do something better than average.  You don’t need to be the best at it, just better than some of the other market participants. What’s your edge?

3. This is one of the riskiest trades that you can do with options

Really Morris?  Really?  This is the craziest statement he made in his short article.  He’s contradicting himself.  Earlier in the same article, he says Credit Spreads have a high probability of making a profit.  Then he says it’s the riskiest trades you can do with options.  Which is it Morris?  You can’t have it both ways!

I can think of a LOT of riskier option trades.  How about buying far out-of-the money put or call near expiration with a delta under 5?  That’s a 5% chance of making money.  I’d say that’s a LOT riskier than the vast majority of credit spreads.  As long as your short option delta is > 5%, you’ll have a higher probability of profit than that long put or call.

Credit spreads don’t have as much volatility risk as a long call or put too.  Some of the risk might be hidden with the long call or put but the credit (or debit) spread minimize the effects of Vega because you are buying and selling similar amounts of Vega.

In conclusion

Morris is not alone in making outlandish statements to scare option traders.  Don’t be fooled with this drivel.  Credit spreads are no more or less risky than any other type of option trade.  You can have aggressive or conservative credit spreads.  It’s all up to you how you want to trade it.

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