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.
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.
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.
Senior Options Instructor
Market Taker Mentoring, Inc.