Credit Spreads – higher reward yields lower risk, well sort of

The most common credit spreads are the Bear Call, Bull Put and Iron Condor. These spreads have an interesting property. The greater the reward, the lower
the risk. Think about that. The lower the risk, the greater the reward. That is only considering the mathematical risk, not the probability.

First let’s define the credit trades:

Bull implies Buying the Low strike and Selling the High strike,
BLSH. So a bull put is when you buy the lower strike put and sell the higher strike put. Typically placed using the front month options and the short
strike is at or below support. The risk in the trade is that you have an obligation (the short put) to buy at a higher price/strike than you have a right
(the long put) to sell. The difference is the risk in the trade. BUT you take in a credit that you get to keep so the actual risk is the spread minus the
credit.

Bear implies the opposite. Buying the high strike and selling the low strike. So a bear call is when you buy the higher strike call and sell the lower
strike call. Typically placed using the front month options and the short strike is at or above resistance. The risk in the trade is that you have an
obligation (the short call) to sell at a lower price/strike than you have a right (the long call) to buy. The difference, the spread, is the risk in the
trade. BUT you take in a credit that you get to keep so the actual risk is the spread minus the credit.

Notice how similar the two trades really are. In fact some of that was cut and paste. The risk is calculated the same. They are really mirror imagines of
each other. I tell the students just to learn the bull put and stand on their head to understand bear calls.

The iron condor is just a bear call and bull put placed at the same time. Since only one of the spreads can be at a loss at expiration, the broker only
reserves the risk for one side, the side with the larger spread. Once again the actual risk is the spread minus the credit.

The closer you place the spreads to the stock price the greater your credit. Since the risk is the spread minus the credit, the greater the credit the
lower the mathematical risk. Of course the closer you get to the stock price, the more likely that a short will go in the money and result in a loss. So
the risk is less but so is the probability that the trade work.

I trade a lot of credit spreads. I say that strike is probability. If you use the same strike and spread but place the trade further out in time, you get a
greater credit. So your mathematical risk goes down and your probability stays the same. Or does it? While strike is probability, time must be factored in
to that probability. For some equities, probably most equities, the longer the time frame the more the price will move. So as you go out in time with your
credit spread your mathematical risk goes down but your probability goes down also which could make it a risky trade.

So chose your risk and your probability with a credit trade. The possibilities are many.

Ken Bailey
OptionsANIMAL Instructor

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