Today’s lesson will be about the pros and cons of the credit spreads.
First, let’s talk about the positive attributes of the credit spread. The reason most credit spread traders fall in love with this option strategy is because the trade can be designed to have a high probability of profit. By selling a credit spread really far out of the money, the option trader can create a probability of over 80%. Another attribute of the credit spread that traders typically fancy is that it’s relatively low maintenance when things go as planned. Often times a credit spread trader can put on a credit spread and basically set it and forget it. The credit spread can also yield 5 to 10% in a month when it’s placed out of the money. Those are some of the positive attributes of the credit spread that most option traders value.
Next, we will discuss some of the negative attributes of the credit spread. Although the out of the money credit spread has a high probability of profit, it also has a horrible risk to reward ratio. The trade can make 5 to 10% in one month, but when things go wrong, they go wrong in a very bad way. The credit spread can lose 100% of its investment, which is normally 10 times the amount that it can make if the trader sells a far out of the money spread. Therefore, one mismanaged trade that results in its maximum loss can wipe out an entire portfolio, or at least it will wipe out 10 winning trades.
Decay Rate Ratio™
Another obstacle with the credit spread is that it has a very poor Decay Rate Ratio™ between the short and long contracts. The Decay Rate Ratio™ formula is a trademark of the San Jose Options teaching methods. In the credit spread the long contracts decay faster than the short contracts, and this causes a Decay Rate Ratio™ of less than one. Although this trade has a positive Theta, it still possesses is a poor Decay Rate Ratio™.
If a credit spread trader chooses to use a really wide credit spread, then he/she runs the risk of entering into a trade that will perform like a naked position. Because of the poor Decay Rate Ratio™, the long contracts decay first and falls off the “totem pole”. Then, the trader is left with a position that behaves just like a naked position although on paper it looks as if the position is covered.
Another negative attribute of the credit spread is that the trade is very directional. If the underlying asset immediately moves in the wrong direction, then this trade can experience a draw down of much more than it will ever make. This puts the option trader in a very difficult situation. Many option traders, panic and close out the trade at a tremendous loss while others take on a tremendous amount of risk and sometimes lose the maximum investment of the trade.
Those are some of the highlights of trading the credit spread. If you choose to utilize this option strategy, then make sure you paper trade many of years before you ever go live with your trading account. As always, we wish you the best of luck with your trading and have a great day.