How to Generate Income from Credit Spreads
In the treacherous world of the stock market, investors are starting to crave new strategies for generating some income to add a cushion to their portfolio. Selling put credit spreads and call credit spreads is a powerful strategy to generate income. However, it is important to understand the risks and potential rewards before implementing this strategy. We'll walk through the process for how to generate income from credit spreads in the stock market. A put credit spread is created by selling a put option with a lower strike price and buying a put option with a higher strike price. The difference between the premium received for selling the put option and the premium paid for buying the put option is the credit spread. The goal of this strategy is to earn the credit spread, while also limiting the potential loss if the stock price falls. This is a bullish strategy that involves predicting that a stock will not drop below a particular price based on the short strike. The key to selling put credit spreads entails familiarizing the investor with a little bit of technical analysis. Nothing overly complex, but it's good to visually verify that the stock is in a longer term uptrend on at least an hourly or daily chart. Secondly, ensuring that the stock is sitting above its 200-Day moving average is good for ensuring that the probability of profit is very high, as stocks below this level have a tendency to drop irrationally. If these two rules are not followed, the investor can certainly still win; however, it can feel like a bit more of a guessing game. Now the million dollar question is when to enter the trade. There are dozens of different factors to take into consideration, but it's usually a good call to sell put credit spreads after 2-4 down days in a row where a stock has declined a bit (but not a lot). This will keep the premiums elevated on the put side, ensuring that the returns for making a trade are enticing. Additionally, it's crucial to locate at least one or two strong support levels above the short strike where the stock will most likely receive some buying interest to protect its price. Additionally, if it's at the low end of its recent trading trade, that gives the investor ample reason to believe it may be time for the tide to turn the other way. A call credit spread is created by selling a call option with a higher strike price and buying a call option with a lower strike price. Like the put credit spread, the goal is to earn the credit spread while also limiting the potential loss if the stock price rises. However, the goal is the exact opposite as the put credit spread's - here, an investor is predicting that a stock will not rise above a particular price based on the short strike. One key aspect of selling put and call credit spreads is choosing the right underlying stock. It is important to pick a stock that has a history of stable or slowly trending price movements, as a highly volatile stock can increase the risk of loss. Additionally, it is important to consider the company's financials and any upcoming events that may affect the stock price. The key to selling call credit spreads involves a similar mentality to that of the put credit spreads, but with the opposite perspective. Instead of looking for stocks that are bullish and trading up, the best stocks to hunt for are those that are in the midst of a broader decline, particularly those that are below their 200-Day moving average. If this condition is met, finding trades can entail looking for stocks that recently ran up to their 200-Day moving average (or near it) in a few bullish days, and predicting that the stock will not cross this level. Additionally, this strategy can even be used on stocks that are trading strong near 52-week highs, but in a weak market where breakouts are inconsistent such as 2022 & 2023 so far. Another important factor to consider is the expiration date of the options. Shorter-term options will have a higher premium but also a higher risk of loss, while longer-term options will have a lower premium but also a lower risk of loss. As a result, it is important to find the right balance between potential income and risk tolerance. It is also important to choose the right strike prices for the options. The strike prices should be close enough together to create a credit spread, but not so close that the potential loss is too high. Additionally, it is important to consider the stock's current price and any resistance levels that may affect the stock's price movements. When selling put credit spreads, it is important to keep in mind that the maximum potential loss is the difference between the strike prices of the options minus the credit spread. As a result, it is important to choose strike prices that are a reasonable distance away from the current stock price to limit potential loss. However, it is important to keep in mind that the potential loss is limited by the stock price reaching the higher strike price. While there is no magic formula for determining how much credit to receive or what strike price to choose, our suggestion is to choose a strike price that is at least 3-4 weeks out in the future, and around 10% or more OTM. Additionally, the amount of premium collected from the trade should be at least 10% of the total collateral being put up for the trade. So, if an investor is looking to sell the $90P on AMZN and buy the $85P, the minimum amount of credit for this trade should be $0.50 since the trade is $5.00 wide. Additionally, we prefer employing stop losses of 2-3x the credit received (depending on the credit amount) to ensure that we do not get trapped in a long losing trade with a big loss. It is also important to keep an eye on the implied volatility of the options. A high implied volatility means that the options have a higher premium, but also a higher risk of loss. As a result, it is important to choose options with a low implied volatility to limit risk while still earning a credit spread. This is a very brief overview of how to generate income from credit spreads, but it is important to understand the risks and potential rewards before implementing this strategy. By choosing the right underlying stock, expiration date, strike prices and implied volatility, investors can minimize risk while maximizing potential income. If you're interested in learning about our full, detailed strategies on how we make money with options, feel free to check out our course here.