Wednesday, November 25, 2009

Mail Time- Credit Spreads

Let's take a breather from the relative performance discussion and tackle some viewer mail. NGBSTL posed the following question in response to my introduction post, A Primer on Relative Performance.

I enjoy credit spreads b/c my view is they are one of a few ways you can profit from 2 outta the only 3 possible behaviors of underlying (up,down,sideways): so it can either go away from you or slosh around where it is, and you profit in both those instances. My criteria for finding ideal candidates this far has been limited to seeking some sort of technical line of defense between short strike & current price. But I'd love to learn more 'sophisticated' criteria for finding such candidates...maybe a future post? thx!

NGBSTL,

Thanks for the comments and question. The higher probability of profit inherent with selling out-of-the money credit spreads is certainly one of the advantages to using them. The idea of winning the majority of the time is an alluring prospect for traders that hear of this type of strategy (whether it be selling call spreads, put spreads or both). As with most strategies where those on one side of the trade win the majority of the time, we must keep in mind that the occasional losers can easily dwarf the winners. Your success with selling credit spreads isn't so much dependent on how you manage the winning trades, but rather the losing ones. So, I would hope that you have some type of rules in place helping you to minimize losses on credit spreads that go awry.

In terms of finding candidates, I've seen a few different approaches. For directional trades (selling call or put spreads individually), I simply use technical analysis. If I have a strong up trending stock, I'll look to sell put spreads on the dips. For bearish candidates I'm looking for down trending stocks that have rallied to resistance. Bottom line is I have to see some type of bullish or bearish price pattern before I pull the trigger. Implied volatility also plays a part. Ideally I like to be entering when implied volatility is too high and see it diminish throughout the duration of the trade.

The other approach commonly used for Iron Condors, though it could be used for directional trades as well, is simply using the same underlying month to month. You'd obviously want to choose an underlying that has liquid options with tight bid/ask spreads. A good example could be the SPY or RUT. Those that use this approach tend to focus on indexes or ETF's thereby avoiding earnings announcements and other potential company news events that could disrupt the normal ebb and flow of price action.

Here's an example of my two most recent directional credit spreads. The graphics pretty much speak for themselves.

[Source: EduTrader]

5 comments:

Preetham Gowda said...

I am loving your posts Tyler.. Keep them flowing..

How would you manage a credit spread that's gone wrong? I have lost a lot of money selling far OTM spreads and then the stock turning against me. I dont seem to know when to get out of the trade.

Tyler Craig said...

Preetham,

Good to hear from you. It's been awhile. If you look back at my post title "Roll Ups" from April 13, I highlight a few management techniques. I usually use one of the following:

1. Exit if the stock breaks above resistance. If my trade was based on the premise that the stock is neutral to bearish, breaking resistance would negate that, so exit.

2. Exit when I lose a percentage of max loss such as 30%. So if I'm risking $8 on a $10 spread, I'll bail if I'm ever down $2.40 (80%)

3. I may consider an adjustment such as rolling further OTM.

Good Trading-

Justin said...

Preetham, I would also suggest picking a delta point where you would exit the short side, such as 30 or 35. Set this as a rule and follow it.

Tyler Craig said...

Great point Justin. The exact delta chosen for exit probably depends on 2 things:
1. What delta you sold to begin with. Assuming your short call or put had a delta of around 15 at inception, using a 30 or 35 delta gives it a decent amount of breathing room. If you sold a delta of 25 to begin with, then 30 may seem a bit too close.

2. Personal Preference. There's obviously not one 'magic' delta that should be used for every trader. Some traders may be willing to use a higher delta in an attempt to get stopped out less. The obvious trade-off is they incur a larger loss by waiting longer before exiting.

QUALITY STOCKS UNDER 5 DOLLARS said...

A very sound plan.