As with all investments, the name of the game is “risk versus return.” How much bang for the buck can you achieve for a given level of risk? For many option-buying strategies, higher risk takes the form of lower winning percentages. In fact, winning on fewer than half of your trades is quite normal. The payoff, of
course, comes from the much higher profits you can achieve with these strategies, often in excess of 100%.
With credit spreads, the risk/reward paradigm is reversed. You can reach winning percentages of 80% or higher using out-of-the-money options. However,
the return per winning trade will be much lower, most often within the range of 10% to 25%.
A credit spread involves the simultaneous purchase and sale of puts (or calls) that expire at the same time, but have different strike prices. Puts are used if you are bullish on the underlying stock or index, while calls are used for a bearish outlook. For out-of-the-money credit spreads, the strike price of the sold (or written) option is closer to the underlying stock’s market price than the purchased option, and therefore carries a higher premium – resulting in a net credit. The goal of a credit spread is for both options to expire worthless, allowing you to retain this entire net credit.
You may wonder why you would use puts for a bullish position and calls for a bearish position. This is because you want the spread to finish out of the money, so you can achieve your maximum potential profit on the play. Logically, then, puts will expire worthless on a bullish move, while calls will expire worthless on a bearish move.
Credit spreads offer two primary advantages over straight put or call purchases. First, by using out-of-the-money options, you can profit from a wide range of outcomes, including the underlying stock moving somewhat against your expectations. If you initiate a bearish credit spread with the sold call option 2% out of the money, you will keep the entire premium if the underlying security moves down, stays flat, or goes up 2%. Only when the sold option slips into the money is your position at risk of losing value. In addition, losses are generally capped at the difference between the strike prices of the options, minus the net credit collected upon initiation.
The second advantage is that no commission costs are incurred to exit your most successful trades, since the best-case scenario involves both options expiring worthless. This feature increases your net return on a winning credit spread trade. Moreover, unlike option purchases, credit spreads actually benefit from time decay, since neither option has any intrinsic value (as long as they stay out of the money), and the sold option will lose time value at a faster pace than the purchased option.
This is just one reason why we prefer to use front-month options for credit spreads. In addition to providing the greatest exposure to time decay, these shorter-term options allow less time for the underlying equity to move substantially against you. Such a move has a far more negative impact on a credit-spread position than the benefits of the underlying stock making a move in your favor.