The Truth About Credit Spreads - Part 2

01/26/2016 8:00 am EST

Focus: OPTIONS

Just because something is labeled as a credit, it doesn't mean that you're receiving any money, says Greg Loehr of OptionsBuzz.com.

In the ?rst part of this series, we looked at the fact that all opening option trades are really "debit" transactions, regardless of being labeled as a "credit" trade. This idea is often a very difficult concept to accept because we have been conditioned to think in terms of "debit" trades as trades in which we pay out money; and "credit" trades as trades where we collect money.

While it's true that you can spend the credit you get, the broker has to protect itself from the possibility of a trader selling a credit spread, withdrawing the cash from the credit, and then leaving the broker with the risk that the spread goes out at full value. You might need that credit to close the trade. That's why you don't increase your spendable cash until the trade is closed*, and closed for a pro?t.

So, not only are the terms "credit" and "income" actually misnomers, these terms have also incorrectly come to mean the same thing in the retail trading world. But now you understand that you don't receive a credit, and there is no "income" until a pro?table trade is closed. And now you no longer need to feel cornered into just a handful of strategies that can be very difficult to adjust, are commission intensive, and may not be suitable for the current market conditions you are facing.

Since every trade is really a debit trade, does that mean that every possible strategy can be used as an "income" strategy? Technically, yes, since we're really just looking for a pro?table trade. We could buy a call spread or sell a put spread, and run the same 50/50 chance the stock moves in our favor. But "income" traders are generally looking for something else: higher probability, which means "safety" to a lot of traders and investors.

Here lies another big hurdle which retail traders need to pass. Higher-probability trades necessitate the existence of higher risk. While most "income" traders I've met, both personally around the world and online through my live classes, are initially comfortable with this high-probability/high-risk relationship in their trades, very few of them have found the ability to successfully navigate their way out of a problem when the markets move against them**.

That's one of the problems with selling OTM put spreads and iron condors: the small credit you hope to keep can quickly be lost (with even more money) when the market moves against you and adjustment possibilities quickly evaporate. Taking even half of the maximum risk on a high probability trade can easily wipe out your next several successful trades.

Most probability numbers retail traders look at can only be accurately used when taking the trade all the way to expiration. Expecting to take a trade all the way to expiration is wrong for more reasons than we can go into here. Suf?ce it to say that "expecting an option to expire worthless" shouldn't be part of anyone's trade plan.

So..."credit" trades aren't really credits, and high probabilities aren't all they're cracked up to be. Hasn't someone created a better mouse trap for the "income" trader? The answer is yes, and this is where the weekly options come in, but probably not like you think.

If you're reading this, then the chances are that you've already read the ?rst article. That's great because it shows you're more committed to successful trading than most people are.

*The credit from call options sold as part of a covered call strategy CAN be spent immediately. But that is because you've paid out money to buy the stock, and the stock 'covers' the risk of the short call.

**This doesn't even consider the traders that risk far more than they're actually willing to lose because they never believe the full loss can happen. Which it can.

By Greg Loehr of OptionsBuzz.com

Related Articles on OPTIONS