Playing The Probabilities With Credit Spreads

In this lesson we cover everything we will go over in Module 1:

• Option Basics

• Why We Use Credit Spreads

• Credit Spreads Basics

• Philosophy Behind Credit Spreads

In this lesson, we are covering the Options Basics.
There are 2 options Calls and Puts.
There are 2 ways to trade options we can buy (long) or sell (short).
This gives us 4 strategies when trading basic options:

1. Long Call

2. Long Put

3. Short Call

4. Short Put

In this lesson, we will discuss why we use credit spreads.

We use credit spreads to optimize our basic options, by capping both our rewards and our risk.

It does require compromise for us to cap our risk, so we will in turn need to cap our reward.

It is a way for us to trade individual options with an added layer of risk control and cost control.

There are 2 types of option spreads: Debit Spreads and Credit Spreads

Credit Spreads you are selling or collecting premium.

Debit Spreads you are buying or purchasing premium.

Here we will cover the 4 strategies for making an option spread.

1. Bull Call Spread (Debit Spread)

2. Bear Put Spread (Debit Spread)

3. Bear Call Spread (Credit Spread)

4. Bull Put Spread (Credit Spread)

Bull Call Spread (Debit Spread) - happens when we purchase a long call options and simultaneously sell a call option on the same underlying asset (stock) with the same expiration date but with a higher strike price. The maximum loss is restricted to the net premium paid for the position, while the maximum profit is equal to the difference in the strike prices of the calls less the net premium paid to put on the position.

Bear Put Spread (Debit Spread) - happens when we purchase put options while also selling the same number of puts on the same asset with the same expiration date at a lower strike price. The maximum profit using this strategy is equal to the difference between the two strike prices, minus the net cost of the options.

Bull Put Spread (Credit Spread) - happens when you sell a put option and simultaneously purchase a long put option on the same underlying asset(stock) with the same expiration date at a lower strike price. The maximum gain is restricted to the net premium received for the position, while the maximum loss is equal to the difference in the strike prices of the calls less the net premium received.

Bear Call Spread (Credit Spread) - happens when you sell a call option and simultaneously purchase a long call option on the same underlying asset(stock) with the same expiration date at a higher strike price. The maximum gain is restricted to the net premium received for the position, while the maximum loss is equal to the difference in the strike prices of the calls less the net premium received.

We will use Apple (AAPL) as an example.

Here I will show you the pros and cons of a Long Call into a Bull Call Debit Spread and how we mitigate single option positions with spreads.

We will use Apple (AAPL) as an example.

Here I will show you the pros and cons of a Long Put into a Bear Put Debit Spread and how we mitigate single option positions with spreads.

In this lesson, we discuss the greeks and spreads' effect on them.

We will also discuss what happens at expiration, it is important to realize these are options and act like a normal option would only we have boxed in the risk and reward to defined points by simultaneously buying and selling options on the same expiration and for the same amount.

We will use Apple (AAPL) as an example.

Here I will show you the pros and cons of a Short Call into a Bear Call Credit Spread and how we mitigate single option positions with spreads.

In this lesson, we cover order execution on Think or Swim.

There are 3 methods:

1. You can change the "Single" filter above the option chain to "Vertical". These will give you spreads but only between the strike price difference of the stock.

2. You can manually put together two single options by using the "Ctrl" key or "Cmd" key for Mac users, this affords the most flexibility because you can select whatever strike you would like with this method.

3. You can right-click on the dominant leg of the position and select either "Buy" or "Sell" then "Vertical" a buy would be a debit spread and sell would be a credit spread. Once the order is populated you can adjust the strikes and limit price to whatever criteria you would like.

For those that do not trade with Think or Swim, you can try to contact your broker or simply research on Youtube "how to put on an option spread with [Broker's Name/Platform]".

We will use Apple (AAPL) as an example.

Here I will show you the pros and cons of a Short Put into a Bull Put Credit Spread and how we mitigate single option positions with spreads.

In this lesson we cover everything we go over in Module 2:

• Methodology

• Bear Call vs. Bull Put

• Recommendations for Finding the Best Expiration

• Recommendations for Finding the Best Strike Price

• Technical Analysis Tips for Getting the Perfect Trade Entry

• Always Be Mindful of Volatility

• Managing Your Credit Spread Trades

In this lesson, we will cover the method we will be using to go over the next few concepts throughout this module.

We want to maximize our spreads for the most optimal price on either our debit spreads or credit spreads.

Throughout this module, we will be using one example over the next few weeks, and the goal is to show you some adjustments and trouble that spreads can run into and how to make changes when needed to turn a loser into a profitable position.

This is the true power behind credit spreads and why you can become consistently profitable with them. You can box in your risk and reward and increase your probability of success even when you start with significantly high probabilities of success to begin with.

These are the opposites of one another.

We will put on a Bull Put and a Bear Call.

Bear Call

• (Positive) Vega goes down as the position goes against you.

• (Positive) Vega Negative, Theta Positive

• (Positive) Markets go Up they grind Up = more time to adjust.

• (Negative) Delta and Gamma working against you.

Bull Put

• (Positive) Normally more expensive because of shareowners buying puts for protection on their stock. If same Delta.

• (Positive) Vega Negative, Theta Positive

• (Negative) Vega, Delta, Gamma Works against you with Price Drop.

• (Negative) When Markets go Down they crash generally 2 to 3 times faster than they go up = less time to adjust

Given that we are trading credit spreads our primary mode of making money is time decay (Theta). The closer we get to expiration the less time value so its maximum time decay has already been spent essentially.

So we really want to pay attention to our time. Consider the trade-off of the amount of premium, and how long you would like to be in the trade, as well as the possibility you are giving for the price to move against you the closer the more management would be required.

Trade Hack - 1 standard deviation is equal to approximately a .16 delta.

Standard deviation fluctuates with time.

The factors to consider again are your time you would like to manage the trade, against how much you would like to earn, and how risky you would like to be.

Understanding the width of the strike price and calculating really quickly your risk and reward.

Quick Math if we are using 80% as a rule of thumb we can be

8 out of 10 we will win

Premiums and margin

System automatically takes into account the next available strike price.

Vega shows the sensitivity of Implied Volatility.

We use VIX to measure Volatility in stocks.

When Vega is high great time to sell a spread.

But too high might indicate trouble.

Managing your trade goes back to knowing your lifestyle and how much time you are willing to invest in monitoring your trade.

If you take more premium you are taking on more risk and as such you will need to monitor your trade at least daily if not 2-3 times a day and be ready to adjust if needed.

Another thing to consider when it comes to managing your positions is position sizing. We will cover adjustments in our next module but in order to make those adjustments, you will need to have a cash reserve in your account. So as a rule of thumb only trade no more than 20% on any spread in your account and try to leave 30% of a cash reserve at the bare minimum for adjustments. I will generally use a 60/40 rule where I have no more than 3 spreads at 20% and leave 40% in my account for adjustments.

Something to also consider with this is setting up a separate account entirely to manage these positions.

In this lesson we cover everything we will go over in Module 3:

• Adjustment - Delta Neutral Hedging

• Adjustment - Delta Neutral Hedging Part 2

• Adjustment - Rolling

• Insights for Exiting Your Trades Profitably

Delta Neutral Hedging - will be the first adjustment strategy we will cover, it is a very useful and powerful method to repair a losing position.

In order to transform a spread into a delta neutral position, all you have to do is buy to open enough at the money or in the money single long calls and long puts to offset your position when it comes to spreads the general rule of thumb is 1 expiration out and 1 contract for every 10.

The goal of this adjustment is to profit from the position when it moves against you by offsetting the losing leg with a delta positive long call or long put.

Calculation # of contracts X (Delta X 100) = Position Delta

Then divide the ATM or ITM delta by the position delta to get the number of contracts to buy.

In this lesson, we will be continuing our discussion on Delta Neutral Hedging...

For this adjustment strategy, you will be getting close to expiration and losing more than your reward.

For our Netflix example, we sold for a 50 cent net credit.
500/505 bear call spread = net credit of +.55 cents

Let’s say now we are getting close to expiration just 1 week and now the position net is 1.25

So we would be losing .70 cents on 10 contracts that are -700 dollars pretty scary, for whatever reason we didn’t delta-neutral hedge, so what can we do is roll the contracts out.

What this does is simultaneously sell our losing position, we collect the initial premium, pay the debit to buy to close the position at a loss, then opens a new bear call position further out in strike and in time.

For this example, we sell the 530/535 bear call with 48 days left and we collect +1.10 cents. When we add these up we have turned a loss into now a potential winner. If NFLX can stay under our new strike of 530.

Take Profits when you are Emotionally Happy with the profit you are making.

Delta Neutral Hedging can be used when you are 50% up in the trade and you feel the move has been made you can leave the position on to expire and make your money and try to trade the options long as well.