Schaeffer's Senior Equity Analyst Joe Bell, CMT, talks credit spreads and Cincinnati chili
While call options are usually associated with bullish bets, and put options are associated with bearish positions, credit spreads essentially flip everything you thought you knew about options. With credit spreads, traders can use calls to bet on a ceiling for a stock, and utilize puts to play support.
Specifically, short call spreads are entered by simultaneously selling to open a call and buying to open a less expensive call, and vice versa for puts. The two-option trade is entered for a net credit, which the trader can pocket if the options expire out of the money (representing the maximum potential reward). Risk, meanwhile, is capped at the difference between the two strikes, minus the net credit.
Interested to learn more? I sat down with Schaeffer's Senior Equity Analyst Joe Bell, CMT, to get a trader's take on credit spreads and more (like the best Cincinnati chili).
- What are the advantages/disadvantages of credit spreads? Advantages: You can profit from moves and profit from lack of moves; time decay is on your side; you can profit despite a moderate move against your view; risk is defined when you enter the trade; there's a high win rate; and you can profit in all types of market environments. Disadvantages: Losses can often be a multiple of your potential reward, and credit spreads require much more patience than directional premium buying. One must have a high batting average if maximum gain is low relative to maximum loss.
- What prompts you to initiate a credit spread vs. a long call or put recommendation? Any specific indicators? Credit spreads we trade are traditionally out of the money and thus provide cushion in case you are slightly wrong on the direction. As long as the options stay out of the money, you earn the maximum profit. It is generally a more conservative strategy than a long call or put recommendation. In addition to the wealth of technical and sentiment indicators we focus on, you really want to be aware of implied volatility of options. The higher the premiums are, the more you collect when you sell a credit spread.
- Is there an "ideal" market environment or stock backdrop for credit spreads? You can utilize these strategies in all types of environments, but generally you will collect more premium when implied volatility is higher. This basically means options are expensive relative to the past. Credit spreads are also good strategies to use when you expect a stock or sector to take a "breather" and don't expect a big directional move in the future.
- What are the "ideal" contracts for these spreads? Short-term? Long-term? Weekly? Monthly? LEAPS? That all depends on your outlook and how different options are priced. You can trade credit spreads using any time frame you want. We generally focus options with a shelf life between 4-7 weeks, but occasionally this can be much shorter or longer.
- As far as trade management, what do you do differently, if anything, for a credit spread vs. a traditional call or put purchase? A credit spread is a completely different trade and type of mindset. Selling premium can often require more patience than buying premium. The one thing that is similar is my outlook. If my outlook changes for the underlying, then I need to address that with the management of my position. You have to also take into account how much time premium is left in the option for the credit spread. If the credit spread sold strike is penetrated and time decay is no longer in your favor, the credit spread has essentially become an aggressive directional bet and you need a big move in your direction right away. That is when trade management becomes very important and can have a major effect on your trading results.
- Anything else? One thing I always tell people who are new to options is that options are really just tools. For example, trying to use a saw to insert a screw into a piece of wood probably won't be too successful. That doesn't mean the saw is a bad tool, though; it was just used for the wrong job. With respect to options, there are no such things as bad or good strategies. A trader's long-term success will come by applying the right option strategies to their outlook and ultimately being right about their outlook. In addition, no matter what strategy you are choosing, the dynamics of risk and reward always apply. More risk means more reward. Less risk means less reward. Anybody that tells you otherwise is probably someone you should question a little more.
For Fun
- As a fellow Cincinnatian, how do you define yourself? In other words, Skyline Chili or Gold Star? Skyline, but try to stay away from both. (Editor's note: That is the correct answer.)
- If you could give one piece of advice to Young Joe Bell before his first-ever trade, what would it be? Learn how to accept losses, close things quickly when they aren't working and move on as soon as possible. Be disciplined about this process, too. It's not always about being right or wrong, but making sure you limit the losses when you are wrong and be prudent with management of profits. An undisciplined smart person usually loses more money trading than a disciplined dumb person.