The Dozen Do’s of Designing Winning Credit Spreads

Credit spreads should be a mainstay of your trading game plan. So much of your success in this trading strategy begins with the proper design and implementation of the trade. The following 12 tips will help you on the road to credit spread stardom.

1. Begin with a bullish or bearish selection from the Market Timer Algorithm.

2. I favor selections that are consistent with the overall trend of the market, so if the market is trending bullish, I will focus on bullish selections and if trending bearish, then bearish picks.

3. The “Margin of Safety” refers to the placement of the short option strike price as it relates to where the stock is trading. I like to have the short option at least 8-10% away from price. That kind of a margin will allow the stock to move against the trade and still produce a winner. It will allow more room to adjust if a “shock event” occurs.

4. Associated with point #3 is the use of probabilities when considering the placement of the short strike. I prefer a probability of at least 85% or a delta of .12 to .15. This is important to take note of, as adjustments can be made as it relates to the change in delta which we will cover in a future article.

5. The spread should be placed so that the short option is at or below strong support as defined by a confluence of indicators such as trend lines, major moving averages, chart patterns such as double and triple bottoms, Fibonacci levels and major reversal candlestick patterns. The aforementioned criteria should be confirmed by the presence or absence volume and key oscillators such as Stochastics and the MACD.

6. Trade only highly liquid stocks that exhibit at least one million shares of daily volume. There should be at least 100 contracts of open interest at each of the strikes in the credit spread.

7. The stock chart should reflect a stock that trades smoothly with little or no gapping activity.

8. No fundamental events such as earnings should be present during the options cycle because that could act as a catalyst for movement which would be counter to what the credit spread trader would desire.

9. I stay away from Bio Tech stocks due to the unexpected nature of FDA announcements which can quickly move a stock.

10. Check the message board on Yahoo.com on the stock you are trading for any unforeseen events or news that you may be unaware of such as rumors of take over’s, product recalls, lawsuits etc. All of this type of activity could be a catalyst to move the stock and subsequently hurt your trade.

11. Consider the width of the spread as it relates to ROI and Risk. Sometimes you can get a superior return on a smaller spread; however, you may need to increase the number of contracts in order to generate enough of an absolute dollar return to make the trade attractive. Determinethe amount of dollars you are willing to risk as a percentage of your portfolio and let that be a guide as to the spread width, risk and return.

12. I encourage you to consider closing the trade early when the majority of your potential return has been achieved. If you can stay out of expiration week and collect your reward early, that is a bonus.

Next time we will talk about the adjustments that can be initiated if the credit spread trade is threatened. Adjustment strategies can help you mitigate loss and turn an otherwise losing trade profitable.

Mark Espy

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