Are you intrigued by the potential profits of trading credit spreads but worried about the associated risks? You’re not alone. Many traders share your concerns about credit spreads, including fears of assignment risk, large potential losses, and the possibility of market catastrophes. However, fear not! In this article, we’ll explore these common problems with credit spreads and reveal how you can address them effectively.

Credit Spreads 101

Credit spreads are a popular options trading strategy, known for their potential to generate consistent income. They involve selling one option while simultaneously buying another option with the same expiration date but at different strike prices. The goal is to collect a premium from the sold option while limiting potential losses with the purchased option.

Despite their advantages, credit spreads come with their share of concerns. Let’s delve into these issues and discover how to overcome them.

Problem #1: Assignment Risk

The Problem: Assignment risk is a significant worry for traders employing credit spreads. It arises when the option you sold (the short leg) gets exercised by the counterparty. This results in potential obligations, including buying or selling shares of the underlying asset.

The Solution: To mitigate assignment risk, you can implement a few strategies:

• Use Stop Loss Orders: Place stop-loss orders on your credit spreads. If the short leg of your spread is in the money and your stop-loss level is reached, your broker will automatically exit the trade, limiting potential losses.
• Adjust Strike Prices: Be strategic about selecting strike prices. Choose strike prices that align with your outlook on the underlying asset’s direction, increasing the likelihood of your spread remaining out of the money.
• Close Out Before Expiration: Consider closing out your credit spread position before expiration. This eliminates assignment risk altogether.

Problem #2: Large Potential Losses

The Problem: Credit spreads may seem to have an unfavorable risk-to-reward ratio. You risk a significant amount to make a more modest profit, potentially leading to concerns about sustaining losses.

The Solution: You can control and manage your risk with the following methods:

• Stop Loss Orders: As mentioned earlier, stop loss orders can cap your losses. By setting a predefined stop-loss level, you limit potential losses while maintaining a controlled risk-reward profile.
• Choose Adequate Spread Width: Be mindful of the width of your credit spreads. Opt for spreads that align with your risk tolerance and financial objectives. Wider spreads may offer a higher credit but carry increased risk.
• Position Sizing: Properly size your credit spread positions. Avoid overcommitting capital to a single trade, which can help you withstand potential losses without jeopardizing your entire portfolio.

Problem #3: Catastrophic Market Events

The Problem: Worries about catastrophic market events, such as market crashes or unprecedented volatility, can make traders hesitant to employ credit spreads.

The Solution: While it’s impossible to predict and prevent extreme market events, you can still protect your investments:

• Diversify Your Portfolio: Maintain a diversified investment portfolio that includes a mix of asset classes, such as stocks, bonds, and options. Diversification can help spread risk and reduce the impact of market downturns.
• Risk Management Rules: Establish clear risk management rules for your credit spread trades. This includes setting stop-loss levels and adhering to position sizing guidelines.
• Understand the Strategy: Fully comprehend the credit spread strategy you’re using. Having a deep understanding of how the strategy works and its risk-reward dynamics will empower you to make informed decisions even in challenging market conditions.

Conclusion

Trading credit spreads can be a lucrative strategy when approached with the right knowledge and risk management practices. While assignment risk, potential losses, and market catastrophes are valid concerns, you have the tools and strategies to overcome them.

Remember, it’s essential to continually educate yourself about options trading, practice sound risk management, and stay disciplined in your approach. By addressing these common credit spread challenges head-on, you can navigate the world of options trading with confidence and potential for consistent profits. So, embrace the learning process and enjoy the journey of becoming a successful credit spread trader!

If you want to have a 75%+ win rate while risking $20 to make $20 using credit spreads, check out the Inner Circle Program (only open for limited time)!

Thanks for reading 🙂
Austin Bouley
CEO & Chief Strategy Officer