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Credit Spread Trading Systems

Generating consistent cash flow by trading bull put and bear call option spreads with an effective, but simple trading system.

Developing A Credit Spread Trading System

Using basic technical analysis principles, a simple but effective trading system can be easily developed for entering short-term credit spreads. These trades rely upon theta decay to draw value out of the option until it expires worthless, thereby creating a profit for the trade. For this reason, credit spreads are most effective when placed within 60 days of expiration as it is in the last 60 days that theta decay begins to accelerate at an increasing rate. To truly maximize theta decay, the trades can be placed within 30 days from the options’ expiration date.

Credit Spread Trading System DevelopmentBy following a handful of stocks or indices, a trader can develop a feel for the individual security allowing for quick identification of support or resistance on those familiar charts. Indicators can and should be fine tuned to the particular security. Having developed the familiarity with a small handful of candidates, it is then possible to structure the trade to take advantage of these areas where a stock is likely to halt, or at least pause, in its movement. By following trends and using support and resistance, we can structure a trading system that carries a high probability of success.

The key to successful implementation of such a strategy lies in the trader’s skill as a technician and their discipline as a trader. Trades should be entered when the charts reveal an opportunity to enter under favorable conditions. In an up trending market, this may be at the conclusion of a momentary pull-back. It would be inadvisable to enter a bullish position when the market is extended, as such a trade would likely expose the position to downside risk without the benefit of nearby technical support to protect the short option. The goal is to put probabilities on the side of your trade.

Credit Spread Exit Strategies

It is always necessary to formulate and document an exit strategy prior to the trade being entered. Modification of the exit strategy following trade entry is permissible, but should not be made in an emotional moment. Preferably, any change in trading plan would be made when the market is closed to provide the trader with a period of dispassion to fully evaluate the contemplated alteration to his or her trading plan.

One guiding principle that may assist in selecting or devising an exit plan is to remove one’s self from any trade when there is a detrimental change in the character of the underlying security. For example, if a stock were to break through an area of support or resistance in a manner detrimental to the trade, there is no longer a reasonable expectation that the stock will be contained behind that area of prior support or resistance. Because that expectation is no longer present, the trader should consider whether the trade can still be safely maintained with a high probability of success.

Once an exit is called for, the manner of exit must be decided upon. The simplest method is to simply place a closing order to repurchase the short option and sell the long option, thereby closing both sides of the trade. A more aggressive approach may be to repurchase the short option, but to maintain the long position for potential profit should the underlying security continue to move adversely to the original trade. The benefit of such an approach is that it can offset a loss on the short option or, possibly, result in a profit. The downside is that the market again reverses and the loss on the trade is further increased.

If the trade is still fundamentally sound, but requires some additional time to allow the underlying stock to return to its expected course, the trader may also consider a “roll-out” to the following month. A “roll-out” can be accomplished by closing out the current month’s spread and selling the same, or a similar, spread in the subsequent month. Other adjustments are also possible, but should only be attempted if you fully understand their operation and consequence.

Because we have devised a high probability strategy, we should more often than not experience a successful trade. If the market acts in accordance with our expectation, we should find ourselves in the pleasant position of watching our short options expire worthless following expiration Friday. This end result is doubly sweet because it represents a maximum return on our investment and does not require us to place a closing trade, thereby incurring no further commissions.  

Paying no commissions and realizing a maximum profit is an ideal outcome.  Nonetheless, wisdom will often dictate that these trades are best closed out when 80% of their maximum profit is realized.  The reasoning is that you have essentially 'won' by capturing 80% of the spread's maximum return and that you are now risking a substantial loss to realize the remaining 20% of the trade's potential profit.  A quick turn in the market could wipe out the profit and produce a loss, a risk that simply may not be worth taking.  However you choose to close your vertical credit spread trades, make sure you apply the exit rules consistently across all of your positions.

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