In this 4 part series, we're going to take clear-eyed look at credit spreads:
In fact, I'm highly critical of how they're most often employed - because how they're most often employed involves a LOT of risk.
And most of the time, those who follow a credit spread trade recommendation service have no idea the risks they're assuming until AFTER they blow up their account.
That's because there are a million trade recommendation services out there that hype credit spreads (OK, maybe not a million) without truly explaining the risks, the dangers, and the downsides.
So that's what we're going to do with in this 4-part series on credit spreads.
So let's get started . . .
A credit spread is simply a spread where you simultaneously buy AND sell or write options - and you receive more premium for those that you sell or write than what you pay for those that you buy.
There are a number of different ways to construct credit spreads, but for the sake of this series, when I refer to credit spreads, I'm specifically talking about "vertical spreads" such as:
And to keep things as straightforward as possible, I'm mostly going to focus on bull put spreads in this series.
(But the same principles apply to all three versions of credit spreads above.)
When you write or sell a cash-secured put, you're basically offering to insure - or buy - shares of the underlying stock at an agreed upon strike price.
And you have 100% of the cash to back it up in the event that you get assigned (i.e. if the put holder exercises the option and forces you to buy the shares at that agreed upon strike price).
(You can also sell puts on margin - and have a combination of cash and margin that enables you to accept delivery of all the shares in question in the event of assignment.)
So if you sell a $30 naked put (it's called naked because it's alone, by itself, and not covered by an offsetting long put as with a bull put spread), then you technically have a $3000 obligation.
(Each option contract represents 100 shares of the underlying stock).
When you simultaneously sell a $30 put and buy a $27.50 put (with the same expiration date), for instance, the capital required to establish and maintain the trade is dramatically reduced.
That's because the long put at the lower strike price caps your potential maximum loss on the trade.
Imagine, for example, that you set up a $30-$27.50 bull put spread on a stock and then the stock totally implodes and is now trading @ $10/share.
Yes, you're on the hook to buy this $10 stock for $30/share.
But because you also have a $27.50 long put yourself, you have the right to unload those assigned shares right back to Mr. Market at $27.50/share.
So the maximum you can lose in that scenario is $250.
(The "max loss" also represents the capital requirements for the trade, so in this case, it's only going to require $250 - not $3K - to set up the trade.)
Pretty awesome, right?
We'll see . . .
(Again, a "naked put" is simply a short put without a corresponding long put - it doesn't tell you whether that short put is secured by cash or by some amount of margin.)
So it probably goes without saying that when traders go with a bull put spread over a naked put, they're doing so to dramatically lower their risk, right?
That's not how people think - or act - in the real world.
If $3K of cash allows me to write or sell a single $30 put, that same amount of capital will enable me to potentially set up 12(!) bull put spreads.
That's because you're sacrificing some of the premium you collect from the put you sell at a higher strike price to pay for the offsetting put you buy at the lower strike price.
The tighter the spread, the less profitable the spread will be, but the less capital it will require to set up, so the more of them you can construct.
But still, there's no question about it - for the same amount of capital, you can generate a WHOLE LOT MORE net premium from trading bull put spreads than you can from selling cash-secured puts (or from selling puts on margin).
And THAT is why traders choose bull puts over cash-secured puts - for leverage, not for safety or risk control.
We'll explore this point in more detail in the next article in this series, but my contrarian position re: bull put spreads is this:
In terms of capital, if you're not treating your bull put spreads as cash secured (or even margin secured), then you're overleveraging and assuming far more risk than you may realize.
That's because credit spreads can be extremely difficult to repair if anything goes wrong.
And the more of them you have, the more exponentially difficult trade repair becomes.
And the more likely your "maximum loss" becomes your guaranteed loss (multiplied by how many of these pissed off cobras you've released into your portfolio).
One of the primary reasons I'm such a proponent of selling cash-secured puts on appropriate stocks at appropriate times is because it's an enormously forgiving strategy.
(Inside the Leveraged Investing Club, I also teach a covered call version of the put selling based Sleep at Night High Yield Option Income Strategy for those who prefer covered calls over selling puts - which is just as forgiving.)
I talk a lot about the idea of never losing money in the stock market by selling puts.
It's not a joke and it's not hype.
Now obviously there are no guarantees about anything in life, and I can't or won't promise that you and I will NEVER lose money selling puts if we trade them the way I advocate.
But the point is that it's extremely rare that I ever book a loss at the end of the day selling puts - and the Sleep at Night Course and Leveraged Investing Club are designed to teach you precisely how and why this approach is so effective.
Yes, we do everything in our power to determine what's more likely to happen and what's less likely to happen to a stock in the near term.
But what gives us the confidence that never losing money in the stock market is achievable in the first place is our proven ability to repair those trades that inevitably move against us.
Even some pretty ugly situations - the key is the 4 Stage Short Put Trade Repair Formula that's both sophisticated and straightforward, a tool that I personally developed, fine-tuned, and perfected over the years and now include in the Sleep at Night Course.
In contrast, ">credit spread trading services don't even talk about trade repair.
Their focus is on convincing you how great their winning percentage is and (hopefully) limiting the damage when (not if) a trade turns on you.
That's because they know there's not much you can do when a trade goes against you.
Well, yes and no.
If you treat your bull puts like cash secured puts and limit them to how many shares you could actually accept delivery of if assigned, then, yes, you can apply the 4 Stage Short Put Trade Repair Formula to the trade and repair away.
But, again, that's not how most credit spread trades are constructed - they're constructed as overleveraged, high ROI monstrosities.
(Like a werewolf walking around with a sign that reads: IT'S OK. YOU CAN PET ME. I'M SAFE.)
And, yes, I also cover credit spread false logic and faulty math in this series.
Ironically, it's those pesky long puts that are supposedly there to protect you.
One of the great structural advantages of being a seller of options vs. a buyer of options is that you can always add more time to your trade if you need to - and often still collect additional net premium in the process.
It's called rolling - you buy back one short option that's about to expire and simultaneously sell or replace it with another short option at a later expiration date.
And the closer the strike price is to the current share price (i.e. at or near the money), and the closer the old option is to expiring, the bigger net credit you're going to receive.
The opposite is also true.
But even with deeper in the money short options (e.g. you sell a put and then the stock tanks), you should always be able to roll the position forward for somewhere between a small net credit to a small net debit after commissions are factored in.
The 4 Stage Short Put Trade Repair Formula is a lot more involved - and effective - than that, but I'm just making a point.
With credit spreads, you don't have the same luxury or safety net.
That's because - in the case of a bull put spread, for example - if you need to roll, it's not rolling the SHORT PUT that's the problem.
Let's go back to that $30-$27.50 bull put spread example.
What happens if the stock sells off and shares are trading @ $28 with a day or two to go before expiration?
You may very easily roll the $30 short put out for a small to decent net credit.
But when you go to replace your $27.50 long put (which will have some, but likely not a lot of time value remaining on it) with a new $27.50 long put a month or two out, you're going to incur a very large net debit.
In other words, you're going to collect very little for selling back your expiring long put and pay a whole lot more to buy another one at the same strike expiring in 1-2 months.
For example, maybe you could buy a $25 long put expiring in 1-2 months for roughly the same amount that you would collect from selling back the $27.50 expiring long put.
But do you begin to see the problem?
Now your original $250 capital requirement and maximum loss per spread has doubled to $500.
That's not really an issue if - as I said earlier - you treat your bull puts as though they were cash-secured puts so that you have 100% of the capital (or even margin) to cover assignment.
They inherently overleverage the trade and aren't in much, if any, position to expand the size of the spread if the trade gets in trouble.
And rolling straight out for a small net credit or small net debit arguably isn't even a trade repair as much as it's just a form of stalling.
But when it comes to repairing a credit spread trade that goes against you, it's often the best you can hope for - and even then it's not easy to pull off unless you have a small position to begin with.
Straw Men and Devil's Advocates
Now I'm not trying to oversimplify or misrepresent the process.
As I said earlier, repairing credit spreads is not a topic you're going to hear much about.
In fairness, the credit spread model isn't based on repairing trades that go against you - it's based on guessing right a hell of a lot of the time and limiting the damage as much as possible when you guess wrong.
But the hypothetical scenario I laid out above?
That's the precise reason credit spreads and trade repairs DON'T get talked about.
If that works for you, then fine.
My problem with this conventional credit spread model is two-fold:
We covered a lot in Part 1 of this series.
In Part 2, we're going to build on this by looking at what I feel are much better uses of credit spreads than what often gets promoted and hyped.
KO - 125 shares
KMI - 100 shares
BP - 100 shares
MCD - 30 shares
JNJ - 25 shares
GIS - 25 shares
PAYX - 25 shares
Open Market Purchase Price: $20,071.83
Less Booked Option Income: $16,341.71
Tot. Discount: 81.42%
Adj. Div. Yield: 19.59%