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By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 4, No. 7 on April 13, 1995. 

Credit spreads using options are a popular strategy. In this article, we'll define them, see how they work, and attempt to assess their true profitability. They have been growing in popularity recently, partially for the wrong reasons, as we will see later in the article.

Credit spreads are either bull spread or bear spreads. They normally consist of being long one option and short another option, with the same expiration month, but different striking prices. A bullish credit spread is constructed with put options, while a bearish credit spread is constructed with calls. Here are some examples:

Suppose OEX is trading at 475. Then examples of credit spreads would be:

Bullish Credit Spread     Bearish Credit Spread
Long OEX June 450 put     Long OEX June 490 call
Short OEX June 460 put    Short OEX June 480 call

In each of the above spreads, the option being sold is more expensive than the option being bought, so the execution of the total spread brings a credit into the account — hence the name, credit spread. If both options in the spread expire worthless at expiration, the option trader keeps the entire credit as his profit. Also, that is the maximum amount of profit that can be made from the spread. The maximum loss is limited by the fact that the position is a spread position. That maximum loss is equal to the difference in the striking prices, less the amount of the initial credit taken in when the spread was established.

Philosophy and History

A look at the philosophy behind the credit spread, plus some historical evidence, will help to explain the popularity of the strategy. Most option traders "know" that selling options is the more profitable way to approach option trading, because 1) time decay works in their favor, and 2) everyone says option buyers lose a lot of money. Many novice traders are convinced that professionals sell options almost exclusively, so they want to do what the "pros" do (it is my personal experience, however, that most professional traders attempt to establish backspreads if they can).

The main problem with selling naked options is that one's broker — assuming you pass the suitability tests and have enough equity in your account — wants collateral of 20% of the value of a stock or 15% of the value of an index in order to allow you to sell a naked option. With OEX at 475, this is a requirement of $7125 to write the 475 call or put naked (15 times $475). However, the requirement for a credit spread is only the difference in the strikes, less any credit received; thus the spreads in the previous example would require less than $1000 apiece to establish — quite a savings over the $7125 for a naked option.

Of course, the profitability of the sale of an option is reduced by buying the other option that creates the credit spread. This is a negative to some traders, but after the crash of 1987, when many naked put sellers were carried out on their shields, the limited risk nature of the credit spread caused it to gain tremendously in popularity.

Do Credit Spreads Really Win 90% of the Time?

I have seen proponents of the credit spread advise establishing the spread with extremely far out-of-the-money options, so that there is a very large chance of making money. For example, with OEX at 475 at the beginning of April, they might recommend the April 450-460 put spread for a 1/2 credit ($50). The probability of OEX falling 15 points in two weeks is small. Therefore, they reason, there is a good chance of making money. In fact, this type of spread has been very consistently profitable for nearly 5 years — the length of the current bull market.

But what's the risk of the spread? It's that OEX could fall to 450 or lower, thereby causing a loss of $950. So you're risking $950 to make $50, but the probability of making the $50 is far greater than that of losing the $950. Let's just say that there's a 95% chance that the options will expire worthless, and a 5% chance that the maximum loss is realized. These are not the true mathematical numbers — and we haven't allowed for any possibility of OEX being between 450 and 460 at expiration — but they will suffice for this simple example. So we have a 95% chance of making $50, which means our expected gain is $47.50 ($50 × 0.95), and a 5% chance of losing $950 — a $47.50 loss! Therefore, our expected result is that we would make nothing and lose our commissions if we operated the strategy long enough.

Proponents of the strategy usually counter by saying that they would never the let the spread lose its maximum amount — that they would close it out if OEX fell to some predetermined level, usually before either option gets to be an in-the-money option. This tactic means that you might only lose a point or less on the spread if you had to buy it back prematurely.

Mathematics would then tell us that you have greatly reduced the probability of both options expiring worthless, because there is a much greater chance that OEX could fall to 460 at any time before expiration, than there is that it would be below 450 at expiration. So now, maybe there's a 70% chance of making $50, and a 30% chance of losing $100 — again, not much better than an even money proposition after commissions are included.

Why does the math seem to belie actual fact? The math says "don't waste your time with these spreads", while in actual fact, they have been very profitable. For one thing, the math is assuming a random market and we have been in a mostly bullish market for the past several years. However, this doesn't mean the math is wrong. If one were to flip a coin 100 times and got 90 heads, would you say that the probability of getting heads on the next toss was greater than 50%? You might, but you would be wrong — it's still 50%.

Moreover, if there is a volatility skew — as exists in OEX options — certain credit spreads may be more attractive than normal. With out-of-the-money OEX calls being relatively cheaper than their at-the-money counterparts, then a credit spread in OEX call options currently has a built-in extra advantage. Of course, the volatility skew has had this same shape in OEX for 8 years now, so that "edge" has existed all of that time. The "edge" has been tempered, of course, by the fact that the market keeps going up, which means it's working against the credit call spread. The bottom line is that credit spreads, like any strategy, are applicable in certain places and not in others. As we often say, you can't blindly follow one strategy all of the time.


This article was originally published in The Option Strategist Newsletter Volume 4, No. 7 on April 13, 1995.  

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