New Strategy: Credit Spreads

Credit Spreads: Leveraging Margin for Large Gains

Some History

In the past, the EAF portfolio has shied away from any and all risk. By investing in Dividend Champions we ensured that given a long enough time scope, we would be winners. Even when we started trading options we used these same blue chips as the underlying stocks. Our portfolio has made modest gains split 2/3 in favor of holding stocks and 1/3 in favor of selling options. Last week we decided to adjust our strategy.

The more you learn, the less you know

Often times you can discover things while searching for answers to unrelated things. So it was with our discovery of Credit Spreads as a means to generate a high level of profit from our capital. I could rehash a lot but it has been said better before and I will instead share one of the most informative sites about the subject that I was able to find: http://www.swing-trading-options.com/creditspreads.html . The short of it is we will be engaging in credit spreads to leverage our capital by selling options once again instead of the buy and hold strategy that we were going to use. We are shooting for 10% monthly. Coming from a 6.6% gain over a year's time that is an enormous switch but not without its risks.

Why not just sell options?

The reason why selling credit spreads has such a large increase in profit capability is because it is trading on Margin. Margin is the stock broker's willingness to loan you money. Just like Options you will have to apply to use Margin in your account but once you can you can literally multiply your capital potential.

I'm going to cover this shortly as the article that I linked is all inclusive with this but doesn't cover the benefit of Margin exactly for this strategy. With Credit Spreads you are assuming a risk from the actual spread, not the stock underneath. The spread has two legs at varying premium levels for whatever kind of option you are selling. For this trade you are only covering the premium difference.

So, sell a call at $3 and buy a call at $4 (your two legs). They have a difference of $1. Times that by 100 (100 stocks in an options contract) and viola, you can do this trade with $100. Lets say $0.15 is the premium for the sell, $0.05 the premium for the buy. That's $15 minus $5 for a profit of $10 or 10%. That simple (P.S., be sure to remember your trading costs as they can eat into lower profit or large contract number trades).

Make a Plan and Follow it

Over the next few months I will be taking the 1/3rd of the EAF portfolio we were using for simple options selling and instead trade credit spreads with it. I am shooting for 5% but hoping for 10% per month. I'm going to be using a strategy of >70% probability with the calculator and >70 point trend including long, medium, and short indicators. All options will expire in less than 60 days. If a trend is strong enough I will roll the spread but only if the indicators meet the criteria we have set down here. I am also prepared to liquidate the holding (taking a loss) if the underlying price reaches within 1.5% of the lower leg. I will be posting results as trades are made and if any action is taken (including expiration).