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Learn the Top 3 Credit Spread Option Strategies for Generating Income.
In this video, we'll cover what credit spread option strategies are, and our top three picks for the most commonly used credit spreads.
Credit spreads are very popular among those who trade options for income, as credit spreads can profit in more than one way (making them high probability trades). Additionally, the three credit spread strategies discussed in this video have limited loss potential, which means a losing trade won't break the bank if sized and managed properly.
We use multiple examples to show you how to set up each strategy and show you historical trade examples using REAL option data to show you how each strategy profits.
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projectoption thanks for this Chris. One should craft out the trade based on the outlook. Guess a more relevant question is Condor vs strangle which you have backtested. One point to mention is in markets like India where exchange does not charge margin based on spread hense some of the risk defined strategies become impractical.
Iron Butterflies are great when you believe the stock price will trade in a pretty narrow range, or when you want better risk/reward compared to selling an iron condor.
When selling iron condors, it's very common for the profit potential to be significantly less than the loss potential, since iron condors are such high probability trades (in general).
With the iron butterfly, you typically will have much more profit potential relative to the loss potential because you're selling a straddle (iron butterfly) instead of a strangle (iron condor). The result is that you collect a lot more premium when selling iron butterflies.
It really depends on the situation/stock/trade setup, though.
Not necessarily. To profit on the position when you sell a spread, you need the spread price to decrease from the price you received.
For instance, if you sell a spread for $3.00 (collect $300 in premium), you need the spread's price to fall below $3.00. As an example, if the price of the spread falls to $2.00, you will have a $100 profit per spread [($3.00 Entry Price - $2.00 Closing Price) x $100]. If you decide to buy back the spreads for $2.00, therefore closing the position, you'll secure your $100 profit per spread.
The idea when selling options is to buy them back/close them at lower prices than what you initially sold them for.
Fortunately, when selling options, the passage of time helps you because the extrinsic value will slowly "decay" out of the options if the stock price does not move against you significantly. As a result, one benefit of selling options is that you can make money just from the passage of time.
I hope this helps!
Good video. My comment would be never to get into an iron Condor at once rather leg into the position for the best chance to win. When stock goes down sell the put spread and when it rises sell the call spread.
Thanks for the comment/feedback!
"Legging in" is a strategy that can result in an better overall iron condor position than entering both spreads at the same time, but it also opens up the potential that you'll have a worse position than entering both spreads at the same time.
For instance, if you sell a put spread and the stock price falls, you'll have to sell a call spread at lower strike prices (not ideal) to get the same overall credit that you could have gotten by selling both spreads simultaneously. The result is that your iron condor strikes will be closer together and you'll have a lower probability of making money on the trade (narrower short strikes = narrower max profit range = lower probability of the stock price remaining in that range over time).
I agree that legging into an iron condor CAN be advantageous IF you're correct about the near-term stock price movements, but for that reason, I personally think it's a gamble.
Hi Ghost, if the credit spread options are in-the-money at expiration, you'll get charged additional exercise/assignment fees if you let the options expire in-the-money.
Also, if just the short option ends up in-the-money and you hold it through expiration, you'll end up with a stock position.
For instance, if you sold the 100 call and bought the 110 call, if the stock is at $109.99 at expiration, the short 100 call will be converted into -100 shares of stock per call option (100 shares of short stock per short call) and the 110 call will expire worthless. That means you'll be left with 100 short shares per option contract that expired in-the-money.
In your situation, I always close the spread and I don't let it expire in-the-money.
Great question! I believe you're getting confused because of the difference between strike prices and option prices.
A "120 call" indicates that it's a call option with a strike price of $120, meaning the call option buyer has the ability to exercise the option and buy 100 shares of stock per call option at the strike price of $120. The strike price of $120 doesn't mean the option is worth $120.
In the example you're referring to, selling the 120 call and buying the 125 call results in a "net credit" of $1.93 because the premium collected from selling the 120 call is greater than the premium paid for buying the 125 call.
Call options at higher strike prices will have lower prices than call options at lower strike prices. Why? Because a call option with the ability to buy shares at a lower price (the 120 strike price in this example) is more valuable than a call option that has the ability to buy shares at a higher price (the 125 strike price in this example).
When we sell an option and buy another less expensive option at the same time, we end up with a "net credit," which just means we've collected more on the options we've sold than what we've paid for the options we've purchased.
Does this help clear things up? Let me know if you need more clarification!
I gotta give it you,you have the best program for novice traders...I love It... with all the garbage on youtube ,its sad that they mislead people who really want to learn something at the same time people can be so damn gullible,i read the comments people make and it just blows me away,but hey you learn the hard way.............anyway,i wish you the very best,keep up the good work
Thanks so much for this comment, Jose. I really appreciate the encouragement. Gives me more motivation to keep going!
You're right, the state of the online finance/investing space is really horrible for the most part. Most 'sell' people on the dream of trading options/stocks to buy Ferrari's and big houses, which is far from reality.
When I started projectoption my goal was to be completely neutral and not try to sell people on false claims. I'm just here to present complex information in an understandable way (though sometimes I fail at this!).
Trades can be closed whenever you choose to before expiration. Many traders like to set profit targets before entering the trade, and close the trades when the profit targets are reached.
For instance, if a trader sold an Iron Condor for $5.00 and wanted to take profits at 50% of the profit potential, the trader would look to buy back the Iron Condor for $2.50 ($5.00 Entry Price x 50%).
It really is up to you when you close trades, which depends entirely on your trading plan/style.
Nice catch! The slide is incorrect.
Since the short put's strike price is $216, the lower breakeven should be $216 - $1.18 = $214.82, as you've concluded.
Sorry for the confusion here and nice job noticing the error.
If you have a credit spread and at expiration and the stock price is where you want it to be and able to profit. Then why not enter a credit spread trade that perhaps expire weekly (or two) then wait for the 30+ days?
That's because you will collect less premium for the 7-day spread compared to the 30-day spread.
Also, the credit is not all earned at the expiration date.
For instance, if you sell a 100 put and buy a 95 put and collect $1.00 overall, you can make $100 on the spread if its price reaches $0. Let's say the spread has 30 days to expiration.
If the stock price shoots up from $100 to $120 in one day, the 100/95 put spread still has 29 days left, but its price might now be $0.05 since the stock price increased $20 and the spread has very little probability of expiring in-the-money.
Since the spread price went from $1.00 to $0.05 in one day, your unrealized profit would be $95 per spread. If you bought the spread back (closed it) for $0.05, you would keep the $95 profit per spread.
So, you don't need to wait until expiration to achieve high profit targets on spreads you sell. You can close the spread at a profit before it expires if the stock price moves in your favor or enough time passes (both lead to a decrease in the spread price).
Getting back to your question, let's say a stock is trading at $100.
If we looked at selling the 100 put and buying the 95 put expiring in 30 days, we might collect $1.00 ($100 profit potential and $400 loss potential) on that spread.
If we instead looked at selling the same spread with 7 days to expiration, we might only collect $0.30 ($30 profit potential and $470 loss potential) on that spread.
When you compare the same exact credit spread across expiration cycles, you will see that the near-term spreads with less time to expiration trade cheaper than the longer-term spreads with more time to expiration.
I hope this helps.
what I mean is, that if my strategy was to (i.e) sell the put at strike1 and buy a further away put strike 2 and wait for expiration to collect the credit ... why would I buy a contract that is 30 days away and not just a 7 day contract to collect sooner.. ?
Thank you for sharing. I like your delivery and clear voice. At 7.34 minutes into your presentation, the P&L portion of the charts may be incorrect. 59 days before expiration, the stock price is above the BE price, why would the credit put spread suffer a loss as P&L chart indicated? Will the P&L oscillation decrease compare to the stock oscillation as the time value of the option contract decrease? I look forward to your feedback.
David, absolutely. Personally, if a spread goes against me and I have losses early in the trade, but the stock is not through my breakeven/spread strike prices, I'll hold it.
In fact, I'll always hold spreads no matter what, until I either close the spread for a loss at expiration or it hits my profit target beforehand.
Yes, I do take profits before expiration if the stock moves in the right direction and the spread loses value. For instance, if I sell a spread for $1.00, I'll likely aim to close it for $0.25 (75% profit).
I hope this helps!
Does this mean that hold the urge of selling when the spread value go south in the early days of the contract but the stock price is above the BE point? Do you consider take the profit along the way if stock is moving in the right direction? Thank you!
David, thank you for the comment. I appreciate the feedback!
Regarding the spread P/L, a put spread will increase in value if the stock price falls towards/through the strike prices in quick fashion.
It doesn't matter if the stock is above/below the breakeven price. If the spread value increases from the initial sale price, the trade will have losses.
For example, let's say a stock is at $120 and I sell the 105/100 put spread expiring in 60 days for $1.00. If the stock price falls to $110 the next day, the 105/100 put spread will surely be worth more than $1.00, let's say it increases to $2.00.
In that scenario, the stock price is still well above the spread's breakeven price of $104, but the 105/100 put spread now has a much higher probability of expiring in-the-money compared to when the stock was at $120, which results in a higher price on the 105/100 put spread. If the spread's value increases to $2.00 from our initial sale price of $1.00, we'd be down $100 per spread on the trade, even though the stock price is at $110 and our breakeven is $104.
Regarding P/L fluctuations, it really depends on where the stock is relative to the strike prices. If the stock price is trading around the short strike of the spread, the P/L fluctuations will actually be less volatile with more time until expiration. As expiration gets closer and the options have less extrinsic value, the P/L fluctuations will be much more significant if the stock price is fluctuating around the short strike of the spread.
I hope this helps and please feel free to send any follow-up questions.
If you're trading in a margin account, you'll need sufficient money available to cover the margin requirement of the trades.
If you're trading in a retirement or cash account (no margin), you'll need 100% of the loss potential to put the position on.
For instance, if you're selling a 50 put on a stock for $5, you'll need about $4,500 in available capital to sell the put option since the maximum loss potential is $4,500 per put option sold.
In regards to selling put spreads, you'll typically need enough available capital to cover the maximum loss potential of the trade (unless the spread is extremely wide, in which case the position will be margined like a naked short put).
I hope this helps!
In the options world, 'credit' usually just means you collected option premium when you entered the strategy. In other words, you sold a position as opposed to buying it.
Credit is synonymous with 'collecting premium'.
You could say 'short premium spreads' or 'credit spreads' to refer to spreads you've sold.
I hope this helps!
It depends on your broker, but typically you'll need to pay commissions to close your trades.
However, if all of the options expire worthless (out-of-the-money), you will not be charged any commissions/fees. The expiring out-of-the-money options will simply disappear from your account.
I'd double check with your broker just to be sure, but I'm confident the above will hold true!
Hi there, quick question, I know we do not need to do anything if the option expired worthless, but if the security expired below the selling strike price of credit spread, do I need to spend additional option fees to close it or just let it be expired and the broker (i.e. eTrade, or Merrill Edge) will take care of it at end of the Friday weekly option expired day?
Thanks for the videos. You explain stuff so clear a big plus compared to many others. You have helped my trading go from just covered call writing to selling puts and credit spreads. But I'm clearly still a newbie.
I don't hear anything about SELLING ITM PUTS. Perhaps even weekly. Example on a stock like BAC Bank of America stays right around $29-30. Why not sell a put at STRIKE 33-34 ITM. You can then buy back the option expiration so you don't get assigned. Also if the stock stays below the ITM STRIKE , won't it decay and make it cheap to by back?? I thought that options are not assigned until AFTER EXPIRATION?? the premiums are good and seems fairly low risk. ?? Thanks for you help.
Selling ITM puts is synthetically the same thing as a covered call, except you only have one position (the short put) as opposed to long stock and a short call.
Also, you are always at risk of early assignment if you sell an in-the-money put, especially if the put's value consists of very little intrinsic value.
The only issue I see with selling ITM puts is that the put's value consists of lots of intrinsic value, which does not decay. So if you sell an ITM put for $3 but it has $2 of intrinsic value, you will only be able to make $1 from time decay if the stock price remains the same. If you sold a deep ITM put, the value would mostly be intrinsic, which means you'd have even less profit potential from time decay. Selling ITM puts is a bullish play that profits the most when the stock price increases to a value greater than your put's strike price over time.
I'd recommend watching our videos on intrinsic/extrinsic value, as well as exercise/assignment:
I hope this helps.
A fantastic explanation of the iron condor!!! Keep up your excellent work.
Q. I trade Forex, where besides money mgmt, the minimum reward:risk is 1:1, but using "cut losses short & let profits run" logic. In practice, we aim for 2:1 or more. Don't options with 1:2+ (risk $2 to make $1) go against capital preservation? Thank you.
Thank you for the feedback! Very much appreciated.
The short answer is yes, with high probability trades you have more loss potential than profit potential.
Many options traders prefer to sell options because of the high frequency of winning trades, despite losses having the potential to be large. With that said, you can always implement a loss-taking strategy in an attempt to minimize losses when things inevitably go wrong (the stock price moves against you significantly). However, with limited-risk strategies such as selling iron condors, many traders will not take losses, especially if the unrealized loss gets close to the maximum loss potential on the position.
+projectoption thanks! I'll keep all of that advice in mind. While I've been looking for a platform to trade on, everyone I've come across requires $2000 margin in order to trade spreads. This is a problem for me because I don't have $2000 but my whole strategy going into options trading was to look for opportunities to sell vertical spreads. Is there any way around this?
I am sure David has a great answer for this one, but I feel obligated to jump in and provide some insight based on my experience.
NEVER perceive inactivity as a bad thing when trading. Many options traders teach you that you need to be trading a lot to be successful because you need lots of occurrences.
It is true that more occurrences will be better over the long-term, but the occurrences must be completely independent of each other. If you put on two similar strategies in two different stocks at the same time, those occurrences are not independent because they'll most likely perform similarly if the market makes a big move in either direction.
In my personal opinion, focusing on a few positions with larger size is a much better approach than trading more positions with smaller size.
1) The more positions you have, it's more likely that some of your positions have overlapping risk, which means overall portfolio losses can be larger than you anticipated when all of these positions move against you at the same time (which will happen eventually).
2) It's very challenging to monitor a portfolio of 10-20+ short-term option positions.
3) If your strategy involves adjusting positions that have gone against you, it's going to be near impossible to adjust a portfolio of positions when the market becomes highly volatile. The reason is that during extremely volatile trading sessions, bid/ask spreads widen substantially and getting filled on your trades becomes incredibly difficult at a good price.
These are just a few reasons for why I feel so strongly about this. Many may completely disagree, but I wanted to offer my opinion.
The bottom line is that you should never feel like not making a trade is a bad thing. Often times doing nothing and sitting on your positions is the best thing to do.
If I could offer one tip that will help you the most in the long-term, it's to find a particular strategy you believe in and create a trading plan for the strategy. The plan should include strict entries, exits, and consistent trade sizing. Everything should be quantifiable and nothing in the plan should be based on your opinion/emotions at the time of entering/exiting/sizing trades.
I personally choose options with 30-60 days to expiration when trading credit spreads. Another important point to mention is that if you sell short-term spreads, you'll have to position your strikes much closer to the stock price to receive any premium. The reason is that the expected movement of a stock over a few days is substantially less than the expected range over 1-2 month periods.
However, some traders who primarily buy options much prefer the near-term expiration cycles since the premium is so cheap and the options can experience extremely high returns if the trader is spot-on with their timing of a move.
Sounds like this could be a good topic for a video!
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