In the pursuit of market returns, many new traders naturally gravitate towards basic directional strategies (Calls and Puts). The goal is often to identify a stock that is poised for a significant move and capitalise on that momentum. While purchasing directional Call or Put options can offer substantial returns if the market moves sharply in the anticipated direction, these trades require precision in two areas: direction and timing.
For a directional trade to be successful, the stock must move the right way, and it must do so quickly enough to overcome the time decay (aka ‘theta’). If the stock remains stagnant, the position may still result in a loss.
However, more sophisticated/advanced traders tend to seek strategies with a higher relative probability of success which is referred to as ‘credit spreads’.
To understand why this strategy offers a different risk profile, it is important to understand the components of option pricing. When an investor buys an option, they are paying a premium for the right to buy or sell stock. They are essentially purchasing exposure to volatility.
Conversely, when a trader sells an option, they collect that premium. In this scenario, time decay (Theta) works in favour of the seller. As expiration approaches, the “time value” portion of the option’s price erodes, potentially benefiting the seller.
The Strategy: Credit Spreads
A Credit Spread is a risk-defined strategy that involves selling an option to collect premium, while simultaneously buying a further out-of-the-money option to act as a hedge.
- Bull Put Spread: Used when the outlook is neutral to bullish. The trader sells a Put option below the current market price and buys a lower strike Put for protection.
- Bear Call Spread: Used when the outlook is neutral to bearish. The trader sells a Call option above the current market price and buys a higher strike Call for protection.
This approach is widely considered to have a high relative probability of profit because the trade does not strictly rely on the stock moving in a specific direction.
The Statistical Advantage
The primary reason professional traders utilise credit spreads is the probability of profit. Unlike a long stock position which requires an upward move to generate profit, a Credit Spread can reach maximum profit in three distinct market scenarios:
- The market moves in the anticipated direction.
- The market remains flat/sideways.
- The market moves slightly against the position (but stays away from the sold strike price).
By selling options that are Out-of-the-Money, the trader is positioning themselves outside the expected move of the stock. Provided the stock price remains within a specific range, the trade can result in a full profit.
It is important to note the trade-off inherent in this strategy. While the probability of the trade expiring profitable is higher, the risk-to-reward ratio often reflects this. In the example above, the trader is risking $3.50 to make $1.50.
This inverted risk/reward ratio is the “cost” of having a higher statistical chance of success. Successful execution of this strategy relies not on hitting “home runs,” but on consistent management of probability and strict adherence to stop-loss rules.
Trading is ultimately an exercise in managing probabilities. By utilising Credit Spreads, traders can structure positions that do not require perfect market timing to be profitable. While no strategy is without risk, selling premium offers a disciplined way to generate returns in a variety of market conditions.