Categories

## Delta Can Make or Break Credit Spreads

One of the biggest topics I discuss in MTM’s daily Group Coaching class is how delta can make or break a credit spread. Option traders associate credit spreads as mostly a positive theta trade. I am going to show you why I believe delta is the bigger factor usually. When you think about selling a vertical credit spread as an option trader, probably the first thing you think of is positive theta. Of course, positive theta is a very important aspect to a potential profit. But if there are more than a couple of days to go to expiration, there is another option greek that can get you to your profit destination quicker than positive theta.

###### Vertical Credits

There are two types of vertical credit spreads: the bull put and the bear call. When selling a call credit spread (bear call), an option trader believes the stock will stay below a certain area like resistance for maximum profit. The trade is initiated by selling a call and buying a higher strike call with the same expiration. A put credit spread (bull put) is created by selling a put and buying a lower strike put with the same expiration. The option trader believes the stock will stay above a certain level like support for maximum profit. Let’s look at an example below.

###### Bear Call Example

Suppose an option trader expects the stock to stay below \$220 by expiration in 10 days. He sells the 220 call and buys the 225 call.

The maximum profit on the trade is the credit received. In this case it is \$1.30 (3.20 – 1.90) or \$130 in real terms if the stock closes at \$220 or below at expiration. The positive theta on the trade is 0.05 (0.27 – 0.22) a day. That means for every day that passes the spread’s premium will decline by the theta amount. Not bad right? But look at the negative delta on the trade. It is 0.11 (0.35 – 0.24). That means if the stock does move a \$1 lower and further from the 220 short call strike, the spread’s premium will decrease by that amount.

So, think of it this way, if the stock fell \$2 over 2 days, the premium would decline \$0.22 (0.11 X 2) from theta and 0.10 (0.05 X 2) from theta. Starting out with a credit of \$1.30 and keeping all other variables constant the new premium would be \$0.98 (1.30 – 0.22 – 0.10). A profit could be made of \$0.32 or \$32 in real money. The negative delta of the position contributed more to the profit than the positive theta in this case and truth be told that should happen more times than not.

###### Final Thoughts

Positive theta is very important when it comes to potential profit when trading vertical credit spreads. It will always be on your side provided the position stays above breakeven. That said, an expected move away from the short option as forecast can make the position a whole lot more profitable much sooner before expiration than theta alone.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

Categories

## A Call Credit Spread on AMZN

The market has been very volatile over the past several weeks and Amazon Inc. (AMZN) has been no exception. In the first part of December, we looked at a chart of the stock in MTM’s group coaching class and determined it was a good opportunity for a call credit spread (bear call spread).

Call credit spreads can be an effective way to profit when an option trader expects a stock to stay below a certain area. Many times this area is potential resistance in the form of pivot levels or maybe a moving average. Let’s look at how we can implement this trade strategy.

###### What Is a Call Credit Spread?

A call credit spread, or bear call spread as it is sometimes called, is created by selling a call option and buying a higher strike call with the same expiration. Maximum profit is the credit received and would be earned if the options expire worthless (at or below the short strike at expiration). The maximum risk on the trade is subtracting the premium received from the difference in the strikes. The breakeven point is adding the credit received to the short strike. Let’s take a quick look at a recent instance where a trader may have considered a bear call.

###### A Recent Example in AMZN

Here is an hourly chart of AMZN into the beginning of December.

The blue horizontal line represents potential resistance at the \$3,600 level. Clearly the stock had moved above that level late in November but retreated below it over a couple of days. It was Thursday, Dec. 2, and the market was bearish when we modeled out a 3600/3610 bear call spread with expiration the next day (Dec-03). The credit received was 1.25 (\$125 in real terms), which represented the max profit if the calls expired worthless (\$3,600 or lower). Max risk was the difference in the strikes (3610 – 3600) minus the 1.25 credit or 8.75 (\$875) in real terms.

###### Three Ways to Profit

The stock could move lower, trade sideways or rally up to \$3,600 by expiration the next day and the trader still could have earned the maximum profit. Both calls would have expired worthless. That gives the trade three out of four ways to potentially profit. For this trade idea, the expiration was short (the next day) but the stock was trading around \$3,450 that Thursday morning. It might have gapped and tried to move higher the day of expiration, but resistance still had better odds of holding than breaking.

###### Final Thoughts

With everything in option trading, there are risk/reward trade-offs. The trader is risking a lot more than the profit potential, but that comes with a high probability.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.