Credit Spread Is NOT A Passive Income Options Strategy
If you are new to options trading, you probably heard about credit spread as passive income strategy. They said that you can go out and start selling this spread and pocket easy money every time.
As an experienced trader, I can tell you with 100% certainty that is wrong.
Credit spread is NOT a residual income strategy.
First, let’s quickly go thru the mechanics of this spread with puts.
Selling a naked puts contract is always a big no-no idea. It is pretty much like running the red. You can get away with it once or twice but eventually it will stop working. And when it does, the consequence is very horrific.
This only profits in case underlying stock goes up or sideway. However, if it crashes, your naked puts trade will fall into the unlimited risk territory.
In order to limit this risk, you could buy a lower strike put to protect the short leg. That’s how the credit spread was born.
The money you collect when you sell a put is higher than the premium you pay for the protective put. It results in credit coming in your options account.
However, not only are you unable to spend this money right away, your broker will freeze some of your trading capital. This amount is how much risk your trade has if the market turns around.
For example, a credit trade on $20 XYZ stock as following:
- Sell 1 XYZ 20 Put for $5
- Buy 1 XYZ 18 Put for $4.5
You would collect 50cent in credit but the risk risk $1.5 (distance between 2 strikes minus the credit). You will see your account value increase by $50 (x100 for 1 contract) but your cash is lower by $150.
This is because your broker has to take into account in case of the worst. If market reserves and the trade falls into the loss territory, they have the money to back it up.
If they don’t and you run or die, they are the one who get struck with a ticking bomb.
The credit you bring in the moment you got filled for this spread only realized in cash once you buy it back or the whole trade expires worthless.
So as you can see, you only profit if you are right. No 100% guarantee.
Sorry if I kill anyone’s dream.
Happy Trading,
Category: Credit Spread
