How to Use Credit Spreads to Generate Income with Little Money Up-Front
As I started learning more about options contracts I was excited about the possibility of selling options as a stream of income. Selling options made me feel good since I would have a large percentage of wins. The only problem was that no matter how many small wins I got it could all be wiped out with one big loser. Credit spreads allow you to sell option contracts while limiting the risk of loss.
Let’s say there is a stock trading at $20, if I were to sell a put option at the $17 strike price then the possible risk would be $1,700. The risk in this case would come from the stock dropping all the way to zero, I would be forced to buy 100 shares of this worthless stock at $17 per share. In trading, your winners must be larger than your losers on average, but with the possibility of a huge loss in selling options it is difficult to figure out if you will come out ahead in the long run.
Credit spreads are different from just shorting options since it involves buying an option further out of the money than the one you sold. Since option contracts are more valuable closer to the money than further out of the money, you will generate a credit using this strategy. This is why the strategy is called a “credit spread.” In the example of the $20 stock with a short put at $17, if you were to buy a put option at $16 your maximum risk would be $100 rather than $1700. Let’s say the stock drops to zero when you have a credit put spread rather than just the short put, you would be forced to buy 100 shares of the worthless stock at $17 but then you could immediately sell them for $16 per share. After both of the options are exercised you would end up with only a $100 loss.
Credit spreads would be better than selling options without protection for smaller sized accounts. If you have $2,000 in your account you would be very limited on how many options you could short. Using a credit spread strategy however you could take up to 20 positions with your account, if you were comfortable with that.
Once you understand credit spreads it is easy to understand a strategy called “iron condors.” An iron condor is simply a credit put spread and a credit call spread on the same stock and expiration date. The effect of iron condors is that you will make money if the stock stays between the short put strike and the short call strike at expiration. Knowing the iron condor strategy can be helpful since it does not increase the maximum possible loss of the trade as long as both credit spreads have the same distance between the short and long options. It can make the trade riskier however since there are two ways to end up with the maximum loss, which is having either long strike violated.