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Vertical Credit Spreads: Your High-Probability Trade?

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February 23, 2017
High probability credit spreads for stock market investors.

Editor's note: Last week's Swim Lessons column looked at buying vertical debit spreads, and compared the purchase of a vertical spread to that of buying a single-leg call or put. This week we will assess the risks and potential rewards of selling vertical credit spreads.

In our daily Swim Lessons™ sessions, we aren't above the occasional sports analogy. Since my co-host, Scott Connor, is an avid tennis player, that sport is a popular one for comparison. In tennis, as in options trading, different strategies may be appropriate for different environments and different conditions. Sometimes, you see an opportunity that might have a higher risk, but you take it anyway because it seems like the right decision for the environment. In tennis, that might mean taking a wide-angle shot or charging the net. Other times, it makes sense to stick with the high-percentage shot—exchanging ground strokes to the middle of the court—and letting the opportunities come to you gradually as you grind it out. Though this strategy requires patience, it can offer its rewards.

In last week's Swim Lessons we looked at buying vertical spreads—a defined-risk options strategy in which you pay a premium for a near-the-money option and partially offset the premium paid by selling an option that's further out-of-the-money. And when buying verticals, though your risk is defined up front, and is limited to the premium paid (plus transaction costs), the strategy always starts with a debit to your account—you pay the premium for the spread (which is why it's also known as a "debit spread.")

This is akin to the "wide-angle shot" in tennis—that may have a lower probability of success, but is seen by you as an opportunity. Why? Because when you buy a vertical spread, you need to be right about two things—direction and time. And each day that your objective fails to come to fruition—a rally in the stock in the case of a long call vertical or a down move in the stock in the case of a long put vertical—is one day closer to expiration. Since at-the-money options typically have the most time premium (also known as “extrinsic value”) associated with them, the time value of the long leg in a vertical debit spread will usually decay more than the short leg. Remember, if both strikes are out-of-the-money at expiration, each will be worth zero, and you will have lost your entire premium, plus transaction costs.

Playing to the Middle of the Court?

So let's say you've identified a stock that you think has a good chance of going down in price—or at least looks to you to be unlikely to rally much. Perhaps it's had a decent run higher, but the rally looks to have hit a resistance point. Should you short the stock? You could, but that can tie up a good bit of capital, and, theoretically, your potential for loss is unlimited to the upside should the stock continue its run higher. You could buy a put or put vertical spread, but again, if you're not convinced that a pullback in the stock is imminent, this might not be an appropriate strategy.

 In this scenario, one potential strategy might be to sell a near at-the-money call and buy a further out-of-the-money call in what's known as a "call vertical credit spread" (it's a credit spread because you  take in more premium from your short leg than you pay for your long leg.) Your maximum profit is defined by the credit you took in, and your maximum loss is defined by the difference between the two strikes, minus the credit. And let's not forget those transaction costs, which are higher with spreads than with single-leg options because you’re placing multiple trades and incurring additional commission charges.

On our Swim Lessons™ show, we tend to refer to this strategy as "high-probability," like hitting those ground strokes to the middle of the court. Why? Well, have a look at figure 1, which shows a typical options chain. We've cued up an order to sell the 138 strike call and buy the 141 strike call, as a spread, for a total credit of $0.47.  Notice the second populated column from the left, under the heading "ProbOTM." Given the current price of the underlying stock, the number of days until expiration and the current volatility level implied by the market, the ProbOTM is the theoretical probability that an option will expire out of the money. At about 74% in this example, that's pretty high. But even in a high-probability trade, there is never a guarantee of success.

Vertical Credit Spread Example

FIGURE 1: HIGH PROBABILITY?

The theoretical probability that an option will expire out of the money is shown by the "ProbOTM" column in the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results. Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring.

And remember, your initial motivation for making this trade was that you believed the stock price to be headed down. With this strategy, it doesn't have to go down between now and expiration for you to make money. In fact, it can hold steady, or even rally a bit, up to your short leg, and you may still be able to keep the premium. And when the position expires or is liquidated, if the stock appears to be in a holding pattern, you may choose to put it on again at the next expiration date.

The Risks, and the Upshot

Sounds great, right? Well, there are always risks. First, if the stock were to rally to or above your short strike, these probabilities begin to change pretty quickly, so at that point it may be time to admit you were wrong, liquidate and move on. The good news is your loss will be limited to the difference between your strikes, less the premium you collected, times the contract multiplier of 100, minus transaction costs. So in the above example, the most you could lose is ($141, minus $138, minus the $0.47 premium, times 100) = $253 per contract. Even if the stock rallies another $100, the maximum loss is $253.

Your other risk is more of a missed opportunity than an actual loss. If your initial premise was right, and the stock price did go down, a lot, the most you would have made is the $0.47 premium you collected. In that case, you may have been better off shorting the stock, or buying the put or a put vertical spread.

The upshot? Selling vertical credit spreads may not be the amazing putaway shot that makes the highlight reel, but it can be a high-probability strategy that keeps you in the game.

Interested in learning more about this topic?

Join Swim Lessons on Wednesday March 1st at 10:30 AM CT as Scott Connor as and I dive into Vertical Credit Spreads and High Probability Trading!

TD Ameritrade clients can join Swim Lessons by launching thinkorswim®, and navigating to Support/Chat > Chat Rooms > Swim Lessons > Watch.

Not a TD Ameritrade client? You can still watch Swim Lessons by registering for a free, 60-day trial of thinkorswim paperMoney®.

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