What is a credit spread?

 

Video Transcription

Okay. I'm really excited for you to see how to trade in the stock market targeting a high probability of success. So basically what we're talking about today is credit spreads. Now, for those of you who are brand new to options you might be thinking, "Okay, I don't know if I'm getting in over my head." I want to reassure each and every one of you, everyone can learn options, trust me. There are four options instruments that you need to understand, once you understand those all the rest of it really falls into place. Everyone can trade options.

So what we're talking about, this is actually one of my favorite strategies trading in the stock market, period. I love it. It's similar to an insurance salesman. So, okay, don't worry about the whole negative stigma with insurance, how does an insurance salesman make money? They're selling you something every month, right, let's just take your car. You're paying maybe $100 a month for insurance for your car, and in the event that something happens they're going to pay your claim. What if you could do the same thing in the stock market? And that's really what we're talking about today. You can do this, have a high probability that nobody's ever going to really need you to pay their claim, it happens occasionally, but you're targeting that consistent monthly income and this is something you can do with options, so it's really pretty fun.

What we're going to look at first is the definition. So, a credit spread. Really a credit spread involves the purchase of one option and the sale of another option in the same class, in the same expiration month. Investors are going to receive more money from the option they sell than from the option they purchase, so that's why they call it a credit spread; you're getting paid a credit. This is a spread, so meaning your risk is limited, so we're going to talk about that a little bit as well.

Now let's give you an example of what I'm talking about. So if we look over here, today being November 25th, not sure exactly what day you're watching this video but that doesn't matter. SPY on this day, so an ETF here was trading at $207.40 when I was looking at this example earlier this morning. So being that that's the case let's go and look now at this little chart that I've drawn up. So basically sitting at $207, November 24th, within a four week window we just need SPY to stay somewhere between a certain range, and if it stays in a certain range we're going to make our money.

So first off let's look at a bear call spread, so this is for if you want to trade the call option side. So you could go out there and sell, say 10 contracts, sell 10 December 212 strike price call options, I know I'm throwing a lot of terms at you if you're brand new, so again, don't worry. You can do this stuff, we'll teach you in future classes how to get somewhere with all these terms and what they mean. This option, the important thing to remember is this would have paid you 37 cents, from the time I was looking at this. Now that's our primary instrument with this trade.

Now what we're going to do is buy 10 contracts at the same expiration month, December 215 strike price call option. This one only costs us 14 cents. This is our hedge, he had a total credit of 23 cents. So if we look at just this trade what does that mean? How do we make money? So look at the chart, basically all we're saying is that within the next four weeks we need SPY to stay below 212. So if you notice I drew just a mock example of what could happen, ETF could go clear up to maybe 211, clear down to maybe 203 and change, and as long as it stays in range within that four week period, the end, if it's still within that range you're going to make your full target profit here of 23 cents. So it's a great way to target a consistent income.

Now that's one trade, this is one of the credit spreads I think you're going to love. This one's actually one of my favorites, the bull put, so it's just on the bottom side of this ETF. So now we look at selling, say 10 contracts, December 200 strike price, put option, this one would have actually paid you 69 cents as I looked at it just a moment ago. Now what you do as a hedge you go buy 10 contracts, December 197 strike price, put option, this one cost you 45 cents. So notice again you have a credit of 24 cents. So in this one it's going to be the inverse to what we just talked about on the call spread, the put spread all you need is within this four week window for SPY to stay above 200, and if it stays above 200 you will capture this full target profit.

So those are two of my favorite credit spreads. Now, probably the most favorite one that I have, and I'm actually going to draw this up for you, is when you combine these two. So I'm just going to put a little addition sign here. When you combine these two this is known as an iron condor. So basically now what you're doing is you're taking advantage of both credits. You get the 23 cents credit, you get the 24 cents credit and now you just need it to stay somewhere between 200 and 212. So you have some wiggle room.

Now one thing I want to point out here; what if you're wrong? What if within this four week period maybe SPY goes up to 215? Typically with a credit spread you have a risk to reward of somewhere, say four to one, or five to one, it can even be a little bit higher sometimes. What do I mean by that? If you're targeting say 24 cents here, when you're wrong, just that one out of five times, typically these are 75-85% of the time you'll be right, statistically speaking. But on that time you're wrong times this number by five and that's your loss. So just say $1.20.

So the way to avoid that big loss that wipes out the profits is to go through what we have here at OptionsANIMAL, learn how to fix this trade. We're the only options educator that teaches this, we're not going to get into that in this, I don't want to overwhelm you just yet, we'll get into that in some future webinars, but you can do things like ratio spreads. There's a lot of different things you can do if you're okay taking the stock sometimes that's how you can get out of avoiding a loss, turn it into things like collar trades. I know I'm throwing a lot at you, so I don't want to overwhelm you just yet, but the idea is we have a 92% success rate on our trades over the last five and a half years. We're just scratching the surface of showing you things that we do. We had actually become the only accredited options course as of November in 2013.

So anyway, really excited for you to use credit spreads, it's a really good way to target a consistent monthly income, and again remember, the most important thing in my opinion is having that backup plan. These hedges are important, having a hedge so that you're not just exposed to unlimited amounts of risk. This is a really pretty safe way to trade, but the most important thing for me is having that backup plan to actually fix that trade because, yeah, these trades, one out of five are going to go the wrong way typically. What are you going to do to fix it? And that's what we'll cover in some future webinars.