A Couple Thoughts on Short-Term Credit Spreads

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Posted on Tuesday, February 28, 2017 at 2:50 PM

There are several ways for an option trader to approach selling credit spreads. But probably two of the most common, are comparing a shorter expiration to a longer expiration. In today’s blog, we will specifically focus on selling credit spreads that expire in about a week or less; essentially using weekly expirations.

Quickly let’s recap the two vertical credit spreads. The vertical call credit spread (bear call) is selling a call option and buying a higher strike call with the same expiration. The option trader believes the underlying will stay at or below the short strike by expiration for maximum profit. The vertical put credit spread (bull put) is selling a put option and buying a lower strike put with the same expiration. The option trader believes the underlying will stay at or above the short strike by expiration for maximum profit.

The goal of a credit spread is to sell premium and then be able to buy back the spread for less than it was sold or to have the options expire worthless to profit. In essence, there are two ways that this can be accomplished. One is from option delta and the other is from option theta. One or both of these option greeks can lead to profits. Delta on the other hand can also lead to losses.

Option traders that are familiar with theta will probably know that positive theta is higher for shorter expirations. In addition, theta is highest at-the-money (ATM) which means that if the underlying is staying above the short put or below the short call, the short option decreases faster than the long option which is beneficial for the spread’s decrease in value.

Delta and specifically how option gamma changes delta, is where many option traders become a little less clear when it comes to vertical credit spreads. When a credit spread is sold and the underlying is trading out-of-the-money (OTM), the spread’s delta will either be positive or negative. It will have a positive delta for put credit spreads and be a negative delta for call credit spreads. This means that the spreads value will decrease if the underlying moves in the direction of the delta which can lead to a profit.

Now here is where it sometimes gets a little tricky. I like to say that “gamma is never your friend when it comes to OTM credit spreads”. The reason is simple. When the underlying moves with delta, the spread’s premium decreases but so does the delta. This means that if the underlying continues to move in the favorable direction, delta will get smaller which means the premium will decrease at a slower rate. If the underlying moves towards the options, not only will delta increase the spread’s premium, it will also cause delta to accelerate which means the premium will continue to grow at a faster rate if the underlying continues to move in that direction. As expiration approaches, gamma becomes even a bigger potential threat to your spread because gamma is bigger leading to potential bigger delta swings.

Take a look at the recent option chain below of Apple Inc. (AAPL).

Let’s pretend an option trader believes AAPL will stay above $136 before expiration in less than four days. The trader sells the 136-strike put and buys the 134-strike put. This spread produces a credit of $0.30 which is the maximum profit if the puts expire worthless at expiration (at $136 or higher). The current delta (which is rounded for simplicity) is +0.21 (0.32 – 0.11). This means the spread’s premium will decrease by $0.21 if the stock moves $1 higher. Positive delta and a positive move in the underlying leads to a decrease in te spread’s premium.

But what is stock moved against the position? In this case that means lower. Not only would the spreads value increase by $0.21 due to delta (we are not including theta or option vega into this equation), the new delta would increase to +0.29 (0.21 + (0.15 – 0.07)) due to the difference between the long and short strikes. Now if the stock continued to fall another $1, the spread’s premium would increase $0.29 based on delta alone. As mentioned above, the closer to expiration, the more dramatic the increases or decreases may take place. Certainly this is something to consider for weekly or near-term credit spreads and for credit spreads that are heading closer to expiration.

There are so many potential advantages to selling credit spreads with short expirations that were not discussed or not discussed with much detail like theta. But many option traders that do not understand how delta and gamma can alter a vertical credit spread, need to really explore this matter in greater detail. For premium sellers, it is practically mandatory!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

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