Credit Spreads The Mirage Explained


This is just a response to someone who pushes credit spreads, a trade that has caused many trader to lose their entire life savings. The bottom line is, the OTM credit spread is a poorly designed trade. It’s trading without a safety net. If you want to be exposed to 20% to 50% losses at all times, then do this trade. Next time we have a flash crash of 5% to 10%, you’ll wish you were not loaded up on OTM credit spreads. This trade will work for months and sometimes for many years straight, and then it will blow up your account. Just look at what a 10% move does to a 30 day credit spread. My article was about OTM credit spreads. Trading results could be different with high Delta credit spreads. The author’s rebuttal is irrelevant since he wrote about ITM credits when my article was about OTM credits. Obviously, he just wrote his article to gain traffic by using my personal name. His article is misleading the public. Be warned and do not be fooled by this author. Do your own back testing. Credit spreads will only work if you create an adjustment system, but when the market free-falls in minutes, no adjustment system can save this trade. Do not rely on POP calculations because the numbers do not add up over time.

Here is proof that traders lose their accounts daily using this type of strategy. The credit spread is one of the most popular trading strategies of all time thanks to authors like the one below pushing this high risk trading method.



Credit Spreads: The Mirage Refuted
October 29, 2011 by Karl 5 Comments

I have a beef with option educators who mislead people with false and inaccurate information to help sell their products and services. Everyone has a right to sell his or her wares but only in an ethical manner. You might not have control over an affiliate’s words, but the copy on your own website should be accurate and truthful.

So what got me all riled up today?

I came across an article at SJ Options about Credit Spreads that really rubbed me the wrong way. Morris Puma made a few statements in his article on credit spreads. I’m quoting Morris, who said:

1. The truth is that Credit Spreads have a high probability of making a profit

2. Sooner or later, virtually all option traders who use only Credit Spreads wipe out their trading accounts

3. This is one of the riskiest trades that you can do with options

Let’s examine these statements to see why I disagree with each one.

1. The truth is that Credit Spreads have a high probability of making a profit

This is only true for far out-of-the-money credit spreads with a low delta of the short strike option. This is something you would typically see as part of an iron condor. You can estimate the probability of the short strike being in-the-money at expiration by the absolute value of the Option Delta. For example:

XYZ Stock is at $100

120 Call is @0.30 with a 6 delta

115 Call is @0.65 with a 12 delta

Sell the 115 calls and buy the 120 call is a $0.30 credit. The short 115 call has a delta of 12, so there is approximately a 12% chance the option will expire in the money, or an 88% chance this spread will expire worthless. This is the example Morris is thinking of, but it is not the only way to trade a credit spread. Here’s another example:

Duh, obviously there are a numerous amount of Deltas to sell to create a Credit Spread. My article was about the most popular type of credit spread, the high prob type. You are rebutting about a completely different trade, a low prob credit, and therefore your entire rebuttal is pointless. When I write an article about ITM credit spreads, then please do comment.

XYZ Stock is at $100

100 Call is @5.00 with a 50 delta

95 Call is @8.00 with a 71 delta

Buy the 100 calls and sell the 95 calls for a $3.00 credit. In this case, the short delta is 71 so there is roughly a 71% chance it will expire in the money. Because the short strike is your maximum profit, your breakeven occurs above this price slightly. The probability of profit will normally be around 40-45%. This leads us to several observations:

– The higher the delta of your short call, the lower the probability of profit will be.

– The higher the delta of your short call, the better reward to risk ratio you have

If you want a high probability of profit, sell low deltas. If you want a lower probability of profit with a better return (but more risk), sell a larger delta.

2. Sooner or later, virtually all option traders who use only Credit Spreads wipe out their trading accounts [Read NY Times article as proof, which is based on an academic study.]

I know several option traders who use credit spreads to trade directional opinions and do fine with them. [Again, this is irrelevant because I didn’t analyze high Delta credit spreads, only OTM].

The key is having a trading plan and following it. One example is to take a spread off if it makes 50% to 70% of the maximum possible profit and exit if you are down 25% to 50% of the maximum profit. You have to do your own research for the trades you put on to get the numbers appropriate for you. The key takeaway is having a plan. [Note how author has changed the topic entirely, and he is talking about a completely different trade. You can’t possibly make 50% to 70% on an OTM credit spread].

Your plan might be to set and forget it but this will typically not work due to slippage and commissions over time. If you assume options are fairly priced, then slippage and commissions will result in a negative outcome mathematically. This is true for ANY option trading, not just credit spreads.

[This is 100% wrong too. The author does not even have a basic understanding of options. For example, if the credit spread calculates to a negative profit mathematically, then it’s counterpart, the debit, is mathematically profitable. The trades mirror each other. Author once again is misinforming the public and doesn’t understand basic math. Also, if you set it and forget it, then commissions are much less. When you actively manage a trade, you’ll spend much more on commissions].

You need a trading edge

To get a trading edge, you have to be better than the market at something… prices (market makers have this advantage), directional forecasting (are you really better than average at picking direction?), adjusting or something else. You need to do something better than average. You don’t need to be the best at it, just better than some of the other market participants. What’s your edge?

[Yes, what is your edge? A credit spread? lol]

3. This is one of the riskiest trades that you can do with options

Really Morris? Really? This is the craziest statement he made in his short article. He’s contradicting himself. Earlier in the same article, he says Credit Spreads have a high probability of making a profit. Then he says it’s the riskiest trade you can do with options. Which is it Morris? You can’t have it both ways!

[This is not a contradiction at all. Hello? I’m just stating the facts. The OTM credit has a high POP, but it also has a poor risk to reward, and it’s totally exposed in the event of a fast move. This author is misleading the readers again.]

I can think of a LOT of riskier option trades. [I bet you can Karl! You seem to be a master of high risk trades. But the question is, can you think of a safer one?]

How about buying far out-of-the money put or call near expiration with a delta under 5? That’s a 5% chance of making money. [Is it really a 5% chance? Since when has Delta = probability? You need to further your education before trying to teach the public. They may be similar but not the same.]

I’d say that’s a LOT riskier than the vast majority of credit spreads. As long as your short option delta is > 5%, you’ll have a higher probability of profit than that long put or call.

[Really? Bring in some facts. Have you spent any time back testing or trading in a real account?]

Credit spreads don’t have as much volatility risk as a long call or put too. Some of the risk might be hidden with the long call or put but the credit (or debit) spread minimize the effects of Vega because you are buying and selling similar amounts of Vega.

[Really Karl? It sounds like you are new to options. You need to continue studying Vega and price to volatility correlations. I know an advisor who took a 2 Million dollar account down to $500K in days trading credits and condors when IV went through the roof. Please learn more about Vega before you attempt to teach the public about Greeks. This poor information will cause a lot of harm to a lot of traders.]

In conclusion

Morris is not alone in making outlandish statements to scare option traders. Don’t be fooled with this drivel. Credit spreads are no more or less risky than any other type of option trade. You can have aggressive or conservative credit spreads. It’s all up to you how you want to trade it.

[Please be warned. Here we have a serious situation of the blind leading the blind. Trade credit spreads at your own risk. This author knows nothing about trade design or risk management. To say credit spreads are as safe as other trades clearly demonstrates he only has very basic knowledge of options and has not discovered safer methods. Again, academic studies show option traders lose 4.5% per month on average. It’s because most trade credit spreads. The Author doesn’t even know that some trades are mathematically profitable. Be warned. I’m just trying to help you from losing your life savings.]

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