How to Use Credit Spreads to Control Your Trading Risk

Article Summary

You want to get into options trading but are worried that options trading is “too risky”.  You can control your risk with credit spreads.  In this article you’ll learn:

  • How to manage your overall risk through options trading with credit spreads.
  • Advantages and disadvantages of credit spreads.
  • A few criteria that must balance so you can get the risk/reward ratio that works for you as an options trader.

How Do You Control Your Trading Risk?

Most investors believe that options trading is too risky for their portfolio.  Well, of course, sometimes investors use options in very irresponsible ways. However, many options strategies also provide ways that are much less risky than stock trading.

And that is why we feel the need for this article! It is specifically for investors that use stop-losses on long stock positions. And also for those who want to learn how to control risk when trading options.

Read on, as we explore using credit spreads to control your trading risk.  This is certainly more robust than the stop-loss orders you’re used to.

Advanced Traders Manage Their Overall Risk.

Many advanced traders are moving from the blunt force of trading stock directly into the more nuanced and intellectual effort. These traders want to manage their overall risk through options trading.   See, with a credit spread, your position’s risk is always defined.  You can never lose more than the maximum loss from the structure of the spread.

Compare this to stock trading, and you will notice that all of your invested money is at risk.

Structure of Credit Spreads

Credit spreads are fairly straightforward for most investors.  They offer a variety of benefits such as the ability to know exactly what your risk exposure is before placing the trade.

Credit spreads are a way to define your risk by sacrificing a small amount of potential profit. When you enter the position, you can easily calculate your exact risk, thus making more informed decisions.

There are two key types of credit spread strategies—call credit spreads and put credit spreads—and both are useful based on your specific needs.  The call credit spread is sometimes called a bear call spread and the put credit spread is sometimes called a bull put spread.

Credit Put Spread Strategies

example of a bull put credit spread

A Typical Put Credit Spread

A traditional or uncovered short put leaves your money vulnerable as stocks could potentially drop all the way to zero. A bullish credit put spread strategy allows you to mitigate a portion of that risk and simultaneously selling and purchasing options contracts on the same underlying security.

While you’re bringing in less money than with an uncovered strategy, you still gain when establishing the position.  This works because the premium you pay for the option you purchase is lower than what you receive for the options you sell.

Credit Call Spread Strategies

Example of a bear call credit spread

 A Typical Call Credit Spread

Similar to the credit put spread strategy, the credit call spread is a bearish position that tends to place more premium on the short call instead of the short put.

When the underlying index or security is expected to move down, the credit call spread is a great choice.

The profit and loss equation is inverse from the credit put spread strategy.

Advantages and Disadvantages of Credit Spreads

As discussed, one of the key advantages of credit spreads is the ability to manage your risk very actively. This makes it impossible to lose more money than your account’s margin requirement.

You can quickly and easily adjust your portfolio’s delta and the spreads may require slightly less active monitoring than other strategies. Spreads are also incredibly versatile and use less buying power than selling an uncovered option.

Warning

On the downside, however, when you minimize your risk you also slightly minimize your profit. Plus, you’re essentially placing two orders, so you will likely incur commissions for two trades instead of one.

Evaluating Credit Spreads

There are many different variables that a successful options management platform is taking into account when making recommendations. Here are a few of the criteria that must balance. It is important to ensure that you are offered a risk/reward ratio that works for you as an investor:

Criteria to Consider with Credit Spreads

  • Annualized Return
  • Probability of Profit
  • Return on Capital
  • Moneyness
  • Liquidity Measures

The mathematics of Multi-Criteria Decision Making is a truly useful management tool. It’s perfect for options trade discovery, providing savvy investors with the information they need to mitigate their overall exposure.

Working with Brutus

Brutus is a next-generation tool! Brutus not only considers these options, but also returning personalized recommendations for your next investment. Where many options ranking platforms fall is criteria conflict and this is where the advanced mathematics and analytics platform really shines. The algorithms in this advanced engine balance the various alternatives based on a very personalized series of weightings. OptionAutomator‘s Brutus provides the best options available for you!

Take Brutus for a test drive for free! You’ll quickly see how the force-ranking system helps by bringing balance to your trading strategy. The magic happens when conflicting criteria aligns with your overall goals.

Invest with confidence, save time and see actionable results quickly and painlessly with Brutus. By taking advantage of this limited-time Beta offer, you will be able to use the powerful options recommendation engine free for life.

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Hi, this may be interesting you: How to Use Credit Spreads to Control Your Trading Risk! This is the link: https://www.optionautomator.com/blog/credit-spreads-control-trading-risk/