The credit spread is a defined risk trade. The most you can lose is the width of the spread minus the credit received. If it is stressing you then you're trading too big. This is a trade where you manage your risk at order entry.
Of course it's impossible to get 3x return on risk on the OTM credit spread. There is a direct relationship between the probability of expiring worthless and the amount of credit received. Therefore when selling an OTM spread if you receive 1/3 the width of the strikes you are risking 2/3 but your probability of not losing money will be around 70%.
There isn't a "proper" way per se. But I trade pretty mechanically and look for the following criteria.
Liquidity...the stock as well as the options need to be heavily traded...with plenty of open interest and volume in the options. The bid/ask spread on the options needs to be pretty tight...less than a nickle on most maybe a little more on more expensive underlyings.
Volatility...I look for implied volatility rank above 50%. Nothing sucks more than selling a spread...being right on direction and not getting paid because of IV expansion.
And collecting at least 1/3 the width of the strikes. Then I look to take profits at or near 50% max profit and I never let a scratch or winning trade go near expiration...I may ride a losing trade up to the last day but I never let them expire. I look to sell premium as close to 45 days to expiration as possible to collect the sharpest part of the theta decay, take profits and move on to the next trade to keep the buying power working at max potential.
I may use weeklies if there is a binary event such as an earnings announcement and I'm just doing an overnight play. In this case the front expiration IV rank will be much higher than the next so in this case I'm just playing for volatility contraction. Otherwise I stay away from weekly expirations as the liquidity is never as good and I don't hold winning trades into the last week as the Gamma risk spikes in the last 7-10 days making it easy to erase your winnings with the slightest move in the underlying.
Volatility contracts after announcements so sell premium before the announcement to capitalize on the contraction.
If I want to make a play on something with low volatility I look to buy a spread...the only difference being that I look to pay about 50% the width of the strikes.
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That logic makes sense with longer term plays. But he's trading with "3-2-1-0 days before expiration on 5 or 20 minute periodicity. ". Dosn't hurt to wait a day or two extra to collect the remaining 50% when the trade is already heavily in your trade than to to open a new trade at breakeven (actually disadvantage because of spread slippage) and try to target 50% in that new trade.
The "new" trade 50% is going to make you the same amount as your "old" trade 50% (assuming you use same position sizing), you might as well pick one with a HIGHER odds (the old one - which is already in your favor). You also save on commissions and slippage.
The way I look at it this logic is especially important in short term trades as the Gamma risk to the options pricing will be at it's highest and going higher.
Let's say for example when you put on the trade you were risking half the width of the spread to make half. Then within a few days you are up 50%...this means you have a gain at 75% the width of the strikes with 25% left to gain...but now you are in an environment where the Gamma of the options has changed drastically and now you are risking the 75% to make 25%. At this point the price still has a 50/50 chance of moving up or down...but because there are only a few days left to expiration it is certain that the Deltas of the position will change much faster than when you put the trade on. Which means with any change in price of the underlying the rate of change of the options Delta will happen much faster than before.
Example...SPY JAN5 15 (4 days to expiration)1st OTM calls currently have a Delta of 49 with Gamma of 11...while the FEB 15 of the same strike have a Delta of 50 (pretty much the same) but a Gamma of 5. Means the Delta of the options will change at nearly twice the rate on the front month Exp than the back month. See Gamma risk.
Also there is the possibility that much of your gains were do to a contraction in volatility. So if for example the Implied Volatility Rank was at 60% when you put the trade on and then you find yourself at 50% max profit after IVR has contracted to say 45%...I would consider it more likely that IVR might revert to 50%, thus eroding your gains, than to contract further to 40%.
In the long run the probability of you being able to take the trade off at 50% max profit at some point before expiration is significantly higher than the probability of the trade expiring worthless. For me it is important to take advantage of this by consistently taking off winners at 50% max profit, or whatever makes sense, and giving losers a chance to get back to a gain or scratch and moving on to another position in a more favorable environment.
Creating more numerous opportunities by staying small and managing winners mechanically while trading highly liquid, penny or so, tight markets allows me the opportunity to let these numbers play out over time.
Just a thought.
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Thank y'all for this great insight.
Both on buying and selling verticals.
Some great insight in this posts on buying verticals.
I have been buying verticals at less than 25% of the spread, but have yet to ride one to sell 100% of the strike spread. Nevertheless it gives me from what appears better than 3x risk.
Buying verticals has time working against me, so my charting and timing skills are paramount.
It appears that selling verticals and having time work for me is not as crucial in regard to trade location, because I can be wrong and still benefit from the spread expiring worthless.
The credit selling strategy I presume is beneficial by selling as close to expiry on a Wed, or Thurs is entirely a Theta decay play and something I thought best after EPS or news announcements on names that are in declining IV situations such that the trade can overcome the gamma risk.
95% of my weekly credit spreads expired worthless, but my issue is yes Size, and the problem of risking 2/3 to make 1/3, nevertheless, the probability plays a role as I now understand.
The concern I have about this strategy long term is that one weekly blow up can erase several previous weeks gains.
Hedging through the use of adjusting the vertical or buying an outside strike have been the only ways that I currently know of to manage the risk on these types of trades.
The other strategy is to sell a weekly with 1-2 weeks expiry, but then 45 days may be the theta sweetspot.
The names I choose are TSLA, NFLX, LNKD, AMZN, GOOGL. or names having large time values and liquidity.
I have gotten lucky on M&A deals where the issue halts trading and the spread expires worthless. My best one was selling and collecting 90% of the spread and risking 10% and then having it halt the next day to later expire worthless. Now if I can find a consistent way on that.
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