Investopedia describes credit spread as “a financial derivative contract that transfers credit risk from one party to another. The credit risk in this instance is that the risk associated with the particular credit will increase causing the spread to widen, which pushes down the price of the credit.”
In this manner, the way the option has been written has a huge impact on widening or narrowing the cash flow. The credit spread options occur in two important forms – both calls & puts and both ask for decent long and short credit options positions. The options can be given by a specific company’s holders to work against the risk of certain negative credit occurrences.
Here are some of the best option strategy ideas for credit spreads:
Research is vital: You may know how options work and how to make their best use but even the best player falls weak under certain circumstances. Make sure you are aware and well-versed with the latest market trends so you do not fall short in the long run. Research through the internet, talks to your peers and read books – make sure you are thoroughly prepared before hitting the market.
Work with strike prices that are side by side: By going with this method, you reduce risks to a certain point and also ensure safety while applying credit spread trades. While using this method, try to work with 5-point spreads especially while focussing on short-term credit spread trades. If available, also try using a smaller spread because the closer your spread is, the lower are your chances of risks.
Work with overpriced options: The reason why implied volatility is so high is to make sure there is no major fundamental risks involved while in the stocks before placing. Thus, it makes sense to invest in high volatile options if you are looking for long-term profits.
Work on a minimum-maximum credit ration: Weigh your options for both – tolerance as well as expiration time and work on setting the minimum and maximum credit needed for the same. Considering long-terms goals in this case will help you make better decisions.
Ask yourself 3 vital questions before opting for a credit spread:
Is there an obligation to purchase the said equity at the strike price?
Do I have the right to sell the mentioned equity at the strike price?
The last risk factor comes out of the difference that arises between these two actions.
Thus, in a nutshell, a credit spread works on the principle that – “One can never go broke before taking a profit!” With the end motto to make a profit and reduce any risks, doing it right will help you in achieving considerable success. Another objective is to focus on consistency – even if it means small amounts since this manner will also help you stay focused on the end target.
Be engaged, make honest efforts and treat trading like golf – a very skilled game requiring a massive amount of commitment, patience, and discipline at every move.