Let’s talk about our old friend the credit spread.  This is the trade where you can sell to open a put option, and buy another one with the same expiration, and lower than the current strike price.  For example, let’s say the stock is trading at $50/share, you could sell a 45 put for $1 and buy a 40 put for .40 (same expiration).  The trade itself would be a net credit of $.60.  That means that if the stock simply stays above 45 until expiration, then it will expire worthless with a profit of $.60.  The risk of course is the difference between strike prices minus the premium.  So, in this instance, the risk would be $4.40 (5 minus .60). 

This article will address short put spreads.  If you are bearish, you can likely do this same concept with short call spreads.

That leads me to a question I get a lot with talking about a trade like this.  Why would you risk $4.40 to possibly make $.60?  The short answer is simply to not risk $4.40, but it isn’t quite that simple.  But we will discuss that.

First off, allow me to explain my profit target on this trade.  I would likely buy to close the spread for a profit if I could do it for $.12.  That number was not decided upon by some random chance.  The reason that I chose $.12 is that it is equal to 80% of the potential profit of the trade.  Once I can close out a short premium trade (either a spread or a single leg option) for about 80% of the potential profit, I typically like to do it.

I like that percentage because it is a good general rule that I’ve used for years.  I like to compare the last 20% of short premium to water in a wet towel.  After you squeeze a towel over the sink, no matter how hard to squeeze, there will still be some moisture in the towel.  The only way that moisture will go away is to let the towel sit for a time and let it dry naturally.  By the same token, the remaining 20% of option premium is difficult to go away until expiration.  So, I simply try to avoid it.  Granted, I don’t always use this exact number, and when trading more higher priced underlyings with a single short leg, I will usually try to squeeze out more than 80% (although usually not much more), but this is a good general rule that I use when an underlying either stays flat or increases.

Now, let’s talk about what to do if the spread goes against you.  That $4.40 risk is not something that is a lot of fun.  So, the first thing that I would like to recommend is to come up with a point in the underlying that you know that you are wrong.  In other words, if the underlying were to go to 46/share, would that be the point that you knew that you wanted to get out?  If it is, that can be your point to exit this trade as well.  By getting out at that point, you will save a lot of money in losses.  If you were to wait until the underlying were to go to 32, and letting it expire there, you would be out the entire $4.40.

Typically, I like to exit on a loss at 2 different places.  The first one is that if the underlying were to go ITM.  I have two major rules with short spreads…..rule number 1, never let them go ITM, rule number 2, don’t forget rule number 1.  Once short spreads go ITM (or in the example above, when the underlying goes below 45), the losses become worse and worse.  The second exit that I like to take is when the cost of the spread is a price that I would have to pay roughly double the initial credit to exit the spread.  So, in the above example, I would likely exit the trade if the cost of the spread was around $1.20.  Once again, this will never be perfect, but this is a guideline that I like to consider.

Through the years, the thing that I’ve found hurts people the most when trading these types of spreads is that they wait too long to take action to manage risk.  I’ll sometimes get a phone call with a client who just wants an idea on how to get out of a spread that hasn’t gone his way.  The problem is that these same people typically wait until their short spread is very ITM and it is too late….they are already facing their worst financial nightmare.  Get out before it gets to this point and live to trade another day.

Thanks for reading.  For more information on what I do as a financial advisor, email me at mtosaw@stcharleswealth.com.