Tuesday, December 8, 2009

Credit Spread Entry Musings

When entering directional credit spreads (a single put or call spread, not a condor), which is more important- time to expiration or the chart pattern dictating your timing? Let's say you prefer to enter credit spreads approximately six weeks prior to expiration. What do you do when you find a nice bearish setup such as a down trending stock that has rallied up to resistance, but you're seven weeks to expiration. Do you enter now to exploit the imminent drop in price suggested by the chart or do you wait a week to get a higher theta?

Per the time decay curve displayed below, theta increases exponentially as expiration approaches.

Those that rely primarily on time decay usually focus on entering trades during a certain window of time such as 4 or 6 weeks prior to expiration. While this simple approach may work for delta neutral trades such as condors, I would argue it's too simplistic when it comes to directional trades. With directional trades, stock price movement (delta) is more important than time decay, especially when we're talking 6 to 7 weeks from expiration. In addition, it's not as if you're not compensated for selling a credit spread 7 weeks out instead of 6. Remember, there's going to be more extrinsic value built into option prices with more time remaining to expiration. Which means that a trader receives more credit when selling a spread seven weeks out vs. six (assuming volatility remains constant). As a result, I'm never really worried if I sell a credit spread outside of the "optimum time frame", as long as I'm receiving sufficient premium and have a solid setup.

By waiting a week, you also run the risk that the underlying drops significantly. Though you can relish in the thought that you have a higher theta, there will be much less credit available in the spread you considered selling. It's not a bad idea to have a "optimum time frame" when selling credit spreads, just don't be afraid of using some discretion in going outside of the time frame if you're presented with what you deem to be a great opportunity.

For related posts, check out: