First, lets understand the common names associated with a credit put spread. As a new trader I know I was overwhelmed to learn that much of what I was hearing was basically in reference to the same thing. As stupid and as frustrating as it was and is, once I knew them it was easy.
Some common names for a credit put spread;
- Vertical put spread
- Credit put spread
- Vertical credit put spread
- Vertical put credit spread
- Bull put spread
- Put credit spread
- Bullish put credit spread
- Bull credit put spread
- Bull credit spread
- Bullish put spread
That’s ten distinct names for essentially the same exact thing! Truthfully, this list may not even be exhaustive. And yes, its ridiculous, but once you understand this type of trade you’ll look at each with no confusion whatsoever.
What is a credit put spread?
To open, and if you prefer to have one of the investment giants explain it to you here is a link to Fidelity.com regarding credit put spreads.
Now, in the simplest possible way I can explain it a put credit spread is the sale of and the simultaneous purchase of two options contracts. Setup as one collective trade. Being careful to pay attention to each trade in the spread for any errors at entry. Cannot describe with words the feeling you’ll have the first time you make this mistake, or the tenth time.
Lets consider the example below.
You’re bullish on At&t (T) over the next 60 days. At&t is hypothetically trading at $35 dollars per share today. Knowing that you may or may not be correct in your bullish assumption you elect to define your risk using a vertical credit spread rather than buying a long call option. As such, the trade would look something like this.
Short (-1) $34 Strike Put @ $.65
Long (+1) $33 Strike Put @ $.32
Total Net Credit = $.33 x 100 = $33.00
Total Risk $1.00 – $.33 = $.67 x100 = $67.00
The total credit received is the difference between the sold short strike ($34 strike) and the bought long strike ($33 strike). The total risk on this trade is defined to a maximum of the difference between the strike width ($1) and the credit received. Note however, the strike width could be ten dollars, twenty dollars, or any width. This becomes paramount to establishing quality trades.
When to use the short put spread?
Utilization of a short spread should remain limited to those times when a trader believes the market will not proceed any lower. Common sense would suggest this might occur after a short period of declining price. However, personal experience would suggest the opposite, enter the put vertical during a period of rising price. Neither is right or wrong, I suppose. I’ve just had better success using them in rising markets.
That said, there are a few other considerations the watchful trader might consider prior to assuming the risk of a trade. Namely, volatility. What does the implied volatility suggest about the current premium weight? It is preferable to enter a short trade when the premiums received are heavier, or richer. Meaning, using our previous At&t example, the trader might receive $.50 cents rather than $.33. This changes the trade dramatically from both a probability perspective. Therefore, it makes sense to let volatility guide your approach.
Please note that I did not suggest entering a trade haphazardly. There will be more days when a trade should NOT be placed than days there should. This isn’t logical though, given the number of optionable underlying available today. Thus, wouldn’t it make sense that at any time I could open the brokerage app and find an opportunity. Yes, it could be done but is it a good opportunity?
In total, I let volatility determine whether I place a trade or not. If the volatility is high and I cannot see anything in the near future that may detrimental to my position I’m usually clear to enter the trade. Of course, some level of research prior to initiating the trade is required. Volatility may be the rudder but someone has to captain the boat.
How to use this credit put spread?
The vertical is quite possibly the most powerful options trade available but can easily become the achille’s heel to the most discerning trader if unmindful. This occurs, in my experience in one of two ways. One, the trader doesn’t properly manage their strike widths. Therefore, assuming too much risk on a single trade. Two, over trading. As mentioned in the previous paragraph these are the financial equivalent to death by a thousand cuts or death by one big cut. Neither is good.
To properly utilize the short vertical it’s imperative the trader have a plan for the final pain point. When the point is reached, the position is promptly closed and re-evaluated. In my experience, this would be a great time to pursue another opportunity as it’s very likely you’ll maintain some inkling of your original directional bias. We’ve all been burned by altering direction only to have the asset move just as we’d hoped.
With a strangle hold on proper management the trader would do well to create a portfolio of high probability trades. I cannot say what number of verticals would constitute a portfolio for your specific situation but each trade could either help or hedge the others. The hope, if that were the selected method would be that over time the portfolio of positions would result in a net profit. Thus, a continual growth to equity.
Why should you place this trade?
Ideally, that should be clearer at this point. However, why you should place the trade is as simple as placing any other trade or making any investment. The hope is it becomes profitable and in the end, this is really the most important aspect to trading. Don’t fail to achieve this mission.
Additionally, this trade may benefit the beforementioned portfolio as well. This would be yet another logical reason someone might consider placing a trade. Perhaps the trader is short some deltas for his overall portfolio. Setting up a vertical spread would offer the benefit of being delta positive with distance from the money and strike width determining just how much.
This is very likely my favorite trade, If I haven’t mentioned it already. While it may be confusing initially it can just as quickly become a go to directional trading strategy. In fact, many traders use credit put spreads exclusively and given the never ending bull run we’ve seen since the financial crisis there is certainly good reason. Now, I must caution you. Please don’t elect to trade one directional. That could have catastrophic consequences for the inevitable declining market.
In all, the spread trade is a powerful directional tool. Set it up, manage it, and let volatility offer a guide. This may just be the best strategy you’ll have to finally tame the market.
May God bless and keep your trading profitable,