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Understanding and Trading Credit Spreads

Mar 30, 2025,

Lecture Notes: Trading Credit Spreads

Introduction

  • Speaker: Dan Pasarelli
  • Topic: How to trade credit spreads

What are Credit Spreads?

  • Credit spreads involve selling one option and buying another of a different strike price with the same expiration.
  • Types of credit spreads:
    • Call Credit Spread: Sell a call and buy a higher strike call.
    • Put Credit Spread: Sell a put and buy a lower strike put.
  • Credit spreads are used to limit risk while profiting from options.

Why Trade Spreads?

  • Risk Management: Shape risk rather than a binary outcome.
  • Hedging: Protect and control capital expenditure and portfolio.
  • Leverage: Achieve a greater percent profit with lower dollar amount losses.
  • Profit from Time Decay: Options lose value over time, benefiting the seller.

Mechanics of Credit Spreads

  • Call Credit Spread: Use cases
    • Profit from low volatility and time decay.
    • Adopt a "not bullish" stance on stock.
  • Put Credit Spread: Use cases
    • Profit from time decay in low volatility environments.
    • Adopt a "not bearish" stance.

Setting Up Credit Spreads

  • Time Frame: Set up between 1 week to 2 months to expiration.
  • Strike Price Selection:
    • Call Credit Spread: Sell strike at or above resistance.
    • Put Credit Spread: Sell strike at or below support.
  • Probability & Risk:
    • Calculate maximum gain and loss.
    • Consider high probability trades and use out of the money spreads for more success.

Strategies and Considerations

  • Out of the Money vs At the Money Spreads
    • Out of the Money: Higher success rate but lower payoff.
    • At the Money: Greater payoff but lower success rate, used for more directional trades.
  • Technical Analysis: Utilize support and resistance levels to guide trades.
  • Volatility and Market Conditions: Avoid entering trades during earnings announcements or major market news.

Additional Insights

  • Trade Management:
    • Know your max profit and max loss before entering.
    • Use shorter-term expiration for better predictability.
  • Exit Strategies:
    • Take profits at 50-65% of maximum potential.
    • Roll positions to adjust losing trades.
  • Greeks Consideration: Understand gamma and theta impacts near expiration.

Q&A Highlights

  • Use iv percentile to identify overpriced options.
  • Adjust losing trades by rolling them to less risky positions.
  • Opt for shorter-term expirations for more consistent outcomes.

Conclusion

  • Key Takeaway: Use credit spreads to manage risk and profit from low volatility and time decay.
  • Encouragement to practice and refine strategies.

Remember that credit spreads are a strategic way to trade options with a focus on controlling risk and leveraging market conditions. Always be aware of the market environment and apply the strategies accordingly for better outcomes.

Full transcript