Questions about credit spreads!!! Help me!

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zunonline

Questions about credit spreads!!! Help me!

Hello all, this is my first post in here! Nice to see you guys!

I have previous option trading experiences in long call and long put but I never tried short selling options... So I guess I might move to credit spread to earn some monthly income.

I am planning to get into index options but I have some questions would like to ask:

Lets say I am going to sell a bear call spread (being bearish)

1] Is it always a good idea to keep the two strike prices close together as I realized that the further the two strikes, the risk/reward ratio increase which means I am risking more money for earning the little increment of reward that I can take?

2] I always heard that the good thing about credit spread is, you can always choose the probability of winning, e.g. in this case, the delta of the short call option is approximately 0.25 which means there is approximately 75% that the option will expire worthless and I can keep the profit, but I realize that the further OTM, the risk/reward ratio also increase rapidly, so in general, for credit spread, what is the optimum risk/reward ratio and should I consider much closer to ATM or still keep some distance OTM but not too far away?

3] Is it possible to construct a trade in credit spread with expected return greater than zero such that credit spread trading will be profitable to me in long run?

4] What is the formula of the expected return? I suppose the formula is as follow:

Expected Return = P1R1 + P2R2 + ...+ PnRn
P is probability and R is the return.

So I deduced that expected return of credit spread is:


Expected Return=(1-D)(P/T)+(D)(L/T)


D: Delta of the Short Call
P: Premium received from the Short Call
T: Total capital required for the trade (margin required for the Short Call and the cost of the Long Call)
L: Maximum loss of the trade (indicate as negative number)


PLEASE CORRECT ME IF THERE IS ANY COMMENT OR ADJUSTMENT SHOULD BE MADE ON THE FORMULA...

It seems that to me, no matter how I adjust, I can hardly get a positive expected return, any ideas?

5] In order to keep profiting in long run, is that I should avoid taking maximum loss whenever possible, such as making adjustment to the trade when the price breaks resistance lines or when it touches the strikes or breakeven points? Any ideas how you adjust the position for credit spread trade to ensure long term success?
 
Best advice is don't. ALL option strategies are zero sum. It does not matter if you buy or sell or combine 100 different legs. In order to gain a positive expectancy you need to be right on direction and magnitude or on vol. You cannot simply arbitrarily sell credit spreads and make money. And please, this is a major pet peeve of mine, there is no such thing as an "income strategy". Anyone who trades anything is trying to earn a positive return. That's not exclusive to premium sellers.
 
If you insist on going this route, you could look up the threads by "Old Nemesis" including one titled "Conservative Option Trades." I think a lot of what he does is credit spreads but on single names, not the indices.

Even though he and the departed "Put Master" seemed to approach things from a similar starting point - fundamental analysis and then a directional decision on how far the market wouldn't go, the Put Master just sold puts, let them ride, and adjusted/was assigned when things didn't work out.

Old Nemesis, on the other hand, seems to sell a lot of bull put spreads, which Put Master claimed was idiotic because "nearly everyone that sells credit spreads over leverages because it seems so easy/safe/a sure thing." They got into pages of arguments about that issue. If you can wade through it all, you'll learn something about strategies and what to watch out for.

Re adjustments, that's a can of worms. Some people say if you need to adjust, get out of the trade (the whole thing/all legs), look at the underlying with a fresh set of eyes, and establish a new position if you wish. Others regularly make adjustments, but you better know what you're doing because your trade can quickly become larger, riskier and lopsided (aggregate Greeks way outside of your trade plan) if you don't.
 
Best advice is: DON'T

90% of option traders lose money and wash out their account.

Also 90% of what you read on this forum is pure insanity. Don't believe any of it.

It is unlikely you will gain enough experience and judgment to be profitable before losing your shirt.

If you really want to do it, do paper trading. Everybody knows that, but they greatly underestimate how long they need to paper trade. I would say 5 years. At least.

If you paper trade an 'income' strategy (i.e. collecting premium and benefiting from theta) you are 'picking up nickels ahead of a steam roller'. It will take a while for you to get enough steam rollers under your belt to qualify as an experienced enough trader to be profitable.

My trading is not for 'income'. It's purely recreational. I would never risk large amounts of money on option spreads, short puts etc. A lot of fun but too much risk for serious money.

About the difficulty of getting a positive expectancy you are absolutely correct. It IS very very hard to find... and even then is even harder to reliably exploit.

Still interested???

Also I agree completely with Brighton and Maverick above.
 
Quote from Maverick74:

Best advice is don't. ALL option strategies are zero sum. It does not matter if you buy or sell or combine 100 different legs. In order to gain a positive expectancy you need to be right on direction and magnitude or on vol. You cannot simply arbitrarily sell credit spreads and make money. And please, this is a major pet peeve of mine, there is no such thing as an "income strategy". Anyone who trades anything is trying to earn a positive return. That's not exclusive to premium sellers.
More...

i agree with mav...his advice can save you what i have learned the hard way and many others.

q to mav:

have you moved on 100% from option strats? i will admit to playing with atm stuff on individual equities and work the spot long, short together with the options..but my main trade is futures currently.
 
hmmmmm... sounds pretty discouraging...but maybe its true..cuz i did lose plenty of money previously. Well, so you guys advise not to touch it at all?
 
Yes, you can sell spreads and find success at doing so. But it's not going to come from any probability or profit formula. Success will come from the times you adjust/manage your trade when the market ultimately moves against you.

Choosing how wide to make your spreads, or how far OTM to sell them, only gives you the ability to tailor a trade to some risk/reward and probability numbers you're comfortable with; not to give you any "edge".

You might consider sticking with indices instead of an individual equity, just to remove the company specific risk from the trade. I know that that risk is priced into the index trade, but it's still a shocker when it happens.
 
Quote from zunonline:

hmmmmm... sounds pretty discouraging...but maybe its true..cuz i did lose plenty of money previously. Well, so you guys advise not to touch it at all?
More...

Of course you lost money. You were trading long options. Everyone loses money trading long options. To be profitable with long options you have to be right about the direction and right about the time. On top of that, you can be right about the direction and right about the time and still lose money.

I don't think there is any question credit spreads have a higher probability of success than long options. You are on the right track in that your thinking is improving.

If you are going to trade credit spreads I won't try to discourage you but I will suggest you trade small while you learn and stick to major indexes rather than playing with individual stocks.
 
Quote from sellindexvol66:

i agree with mav...his advice can save you what i have learned the hard way and many others.

q to mav:

have you moved on 100% from option strats? i will admit to playing with atm stuff on individual equities and work the spot long, short together with the options..but my main trade is futures currently.
More...

Probably 80% options and 20% futures.
 
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