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Options were originally invented for one main reason – to minimize risk. And they still do this today by making money no matter which way the market goes.
To make sure their risk is as low as possible, successful option traders use a variety of strategies -and one of them offers the highest probability possible.
Done right, this strategy starts you out with a 67% probability of success.
Here’s how to play it…
How Credit Spreads Can Hand You the Highest-Probability Trades in the Game
A few weeks ago, I introduced you to the wonderful world of credit spreads. On July 4, we talked about bear call spreads in particular, which offer twice the probability of profit than long calls.
Today, I want to dive even deeper into these spreads. I like to think of them as making money below a certain point – the strike price of the short call portion of the spread.
Here’s an example for you…
On 5/7/19, after setting a recent all-time high, the SPDR SP 500 ETF (NYSE: SPY) closed below strong $290 support on a volume spike.
Most traders would look at this chart and simply call this a bearish technical pattern, then buy puts with unlimited profit potential. But remember, puts will make money ONLY if SPY drops. If it goes up or trades sideways, the put will result in a loss.
In essence, a long put will only make money in one of three directions that SPY could go. That’s a 33% probability of profit.
Now, we could also place a trade that makes money anywhere below SPY’s $290 resistance. That means we profit whether SPY falls or trades sideways. That’s two out of three possibilities, or a 67% chance of profit.
I’m talking about a bear call spread. Now, this strategy is also called a bearish credit spread – because it yields a credit instead of a debit. To create a bearish credit spread, you buy the higher strike call and sell the lower strike call.
For example, if you buy the June 7, 2019 $292 Call for $3.96 and sell the June 7, 2019 $290 Call for $5.12, then you actually receive a net credit of $1.16.
Now remember, a bear call spread gives us a higher-probability of return with less risk. So, let’s calculate our risk and return on investment (ROI) for bear call spreads…
In this case, as long as SPY stays below $290, we’re looking at a 138% return. And if it doesn’t stay below $290, then we’re only risking $0.84.
Over the next 30 days, SPY dropped and recovered close to the short strike of $290.
Our bear call spread expired worthless – allowing us to capture an easy 138% ROI in 30 days.
One of my favorite credit spread rules of thumb is:
Sell Credit Spreads at Support/Resistance
Sell bear call spreads at or above resistance, which I just illustrated above.
Now, this rule applies if the stock is going up too…
Sell bull put spreads at or below support.
Use Bull Put Spreads When a Stock Is Moving Up
Now, for a bullish example…
On 1/7/19, the United States Oil ETF (NYSE: USO) crossed above both the 10-day and 30-day moving averages after a major correction, signaling a potential bottom in the stock.
The recent low bounced off long-term $9.50 support in the process – and it handed us the perfect place to sell a put spread.
So, we sold the February 15 $9.50 put for $0.32 and bought the February 15 $8.50 put for $0.11, producing a credit of $0.21.
Remember how we calculate risk and reward?
So, selling the bull put spread has a risk of just $0.79 for a 26% return over the next 39 days.
And remember – we’re expecting a long-term upward movement for oil, and this trade makes money anywhere at or above $9.50 support. So, you have an extremely high probability of profit here.
In this case, USO skyrocketed, leaving this credit spread worthless at expiration for maximum profit.
How to Exit a Credit Spread
Now, you don’t always want to let these spreads expire worthless.
Close down Bear Call Spreads if the stock closes above the short call (the call you sold.)
Close down Bull Put Spreads if the stock closes below the short put (the put you sold.)
Alternatively, you can place an order to buy the spread back for 20% of what you sold it for. By making this order good- ’til-canceled (GTC), you can take 80% of your maximum profit the instant it’s available.
The closing order would look like this:
Clearly, credit spreads like these offer some of the highest-probability profits in the game. And they’re one of the most advanced strategies out there – so I think you can now consider yourself an options pro.
Before I go, I want to make sure you’ve seen my latest question for you in the Network.
If you’ve already answered my prompt, I’ll be reading your response shortly.
But if not, you’re running out of time… And I really want to hear from you.
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Good trading,
Tom Gentile
America’s #1 Pattern Trader
