Using Credit Spread Options

While TrendExhaustion works well for long/short stock plays, the ultimate tool for a high win rate and overall return is credit spread options.

How do credit spread options work?

A credit spread is a defined risk/return trade that uses 2 options – simultaneously buying and selling either put or call options on the same underlying stock that expire on the same day, but at different strike prices (a.k.a. a “vertical spread”). ¹

The strike closer to the current stock price is sold (or written), bringing in a “premium” (like an insurance premium) and the other strike is bought, hedging the written option and defining a maximum risk. If the stock price is not crossed over the short (written) strike when the option expires, it is said to “expire worthless,” and you pocket the entire premium.

This means that a credit spread is profitable whether the stock moves the direction we think it will move, or it trends flat, or it trends against us moderately. The only time the trade becomes unprofitable is if the stock moves extraordinarily against us.

Advantages of TrendExhaustion Credit Spread Options:

1. When a stock shows a high TrendExhaustion Score, it has been on a directional streak, with abnormally high volatility. When volatility is high, options prices become inflated – the most lucrative time to sell.
2. We choose out-of-the-money credit spreads with at least an 85% probability of profit, and the average win rate is around 90%. A wider margin for error means fewer unprofitable trades. Fewer losses mean better capital preservation, helping you sleep better at night.
3. Using a modified Black-Scholes options valuation model, we calculate an “Expected Return” for you, subtracting potential loss scenarios from the “Max Return.” This is the most objective comparison tool for calculating the present value of options trades.

Let’s look at an example to illustrate this.

Today is September 10th. GameStop Corp. (GME) stock has been heading up at a rapid rate, and earns a TrendExhaustion Score of -8 (strong sell). We use the stock’s volatility to find a pair of strikes out of the normal range of this stock, meaning the stock would have to continue moving at an extraordinary rate to hit the closer strike.

We can write (short) the $25 October call option for $0.44, and buy the $26 call option for $0.34, for a net premium of $0.10. Our Max Risk would be $0.90 ([$26 - $25] – $0.10), so our Max Return on Risk is 11.1% ($0.10 / $0.90) in 39 days, or 168% annualized.

Using price volatility over the prior 50 days to calculate a normally-distributed probability curve, there’s an 87% chance of profit.

As you can see in the chart above, although the stock price (blue line) pushed a bit higher in the following week, it slowed and even reversed its extraordinary movement in the second half of September. 3 weeks later, the spread could already be closed out for $0.05 – a 6.7% return on risk in just 21 days – and the stock is only down 2.6%! The stock remained below the $25 stop-loss mark through the October 20th expiry date, meaning the option expired worthless, and we pocketed the full premium.

Let’s look at the trade alert you would receive for this spread: 

Let’s go through this line-by-line:

GME Oct 20, 2012 25.00/26.00 Call Credit Spread for a $0.10 Net Premium:

A summary of the trade, with underlying symbol (GME), option expiration date (Oct. 20, 2012), short / long strikes, whether it’s a call spread or put spread, and the net premium (short bid – long ask).

Short: Oct $25.00 Call (GME121020C00025000) Bid: $0.44, Ask: $0.47
Long: Oct $26.00 Call (GME121020C00026000) Bid: $0.31, Ask: $0.34

A look at each option “leg,” including the option symbol (in parentheses), and the current market prices for each leg. All calculations are done using the market price (short bid and long ask). If you can get a limit order filled for a higher premium than the market price, that is extra cash in your pocket, and even lowers your risk.

39 Days To Expiry

The number of calendar days before the option expires, from the time of the trade alert.

87% Chance of Profit

The spread’s breakeven point is $25.10 (short strike + premium, for calls; short strike – premium, for puts), which is a gap of $3.29. Based on price volatility in the last 50 trading days, there is an 87% chance that the stock price will not move up $3.29 before the option expires. See another example

11% Max Return on Risk, 168% Annualized

Our Max Risk would be $0.90 ([$26 - $25] – $0.10), so our Max Return on Risk is 11% ($0.10 / $0.90) in 39 days, or 168% annualized. This is our return if the stock price stays below the $25 short strike before October 20th, meaning our credit spread would expire worthless (best-case scenario). See another example

2% Expected Return, 23% Annualized

Expected Return is calculated using a modified Black-Scholes methodology. We take a series of potential unprofitable price outcomes for the spread, with stock movements ranging from breakeven to extremely unfavorable. We calculate a Black-Scholes option price for both the short and long legs at each scenario, and multiply the loss by the probability of its occurrence.

We subtract the value of these 10 potential negative outcomes and half of the bid-ask spread – $0.03 in this case (to assume we have to fill a stop-loss order at the market price) – from our initial premium to arrive at an expected return.

GME underlying stock last price: $21.81, TrendExhaustion Score: -8

The current stock price and the live TrendExhaustion Score of the underlying stock.

Typically, we hold the credit spread until it expires worthless on the expiry date, but if the underlying stock’s price crosses the short strike, we immediately send a stop-loss alert to exit the trade and prevent further losses. Even though most TrendExhaustion credit spread trades tend to be winners, a stop-loss strategy is an important preparedness step for every investor.

Go ahead, give it a try, and get your first month FREE! Go PRO today with Credit Spread Options for instant access to these live trade alerts.