Managing risk is crucial in the financial markets, and options traders often turn to vertical credit spreads as a powerful tool. In this article, we explore how vertical credit spreads can effectively manage risk in options trading.

Understanding Vertical Credit Spreads

Vertical credit spreads involve buying and selling options contracts with the same expiration date but different strike prices. Traders typically sell an out-of-the-money (OTM) option while simultaneously purchasing a further OTM option. Additionally, the premium received from the sold option helps offset the cost of the purchased option, resulting in a net credit.

How To Structure A Credit Spread Trade

• Short (Sell) Option: Traders sell an option at a higher strike price, receiving a premium that acts as a cushion against potential losses.
• Long (Buy) Option: To limit risk exposure, traders buy an option at a lower strike price, with the premium paid as the maximum possible loss.

How To Manage Risk with Credit Spreads

• Defined Risk: Vertical credit spreads offer a clearly defined maximum risk, limiting the loss to the difference between strike prices minus the net credit received.
• Probability of Success: By selecting appropriate strike prices and analyzing market conditions, traders can determine the probability of success. This enables informed decision-making aligned with trading objectives.
• Time Decay: Options contracts lose value over time due to time decay. Traders benefit from this decay, potentially resulting in profits. However, monitoring the trade’s progress is crucial to staying within desired risk parameters.
• Adjustment Techniques: If the market moves against the position, traders can adjust the spread by changing strike prices or contract numbers to mitigate potential losses.
• Exit Strategies: Establishing predetermined profit targets and stop-loss levels is vital. These exit points help prevent emotional decision-making during volatile market conditions.

The 3 Ways I Use To Manage Risk

These three rules are taught exclusively in my Inner Circle program, but I’m going to share them with you today. This is super important to your long term success.

• Trade Sizing: I have a 10% max loss rule that states my trade size can’t exceed 10% of my account size. This means the max loss of the credit spread trade can’t be more than 10% of my account. I actually stay around 5% because I am more conservative.
• Early Exit Rules: I have found that you can statistically increase your win rate and return by exiting winning trades early. If there is more than 4 days left until expiration and you can close it for .05 or less, then you should.
• Stop Loss Rules: I personally don’t use a stop loss often. However, I do close trades early on expiration day if they are losing. You can typically close a trade for less than max loss on expiration day.

Vertical credit spreads are effective for managing risk in options trading. They allow traders to define maximum risk, benefit from time decay, and adjust positions as needed. However, it is crucial to thoroughly understand the concepts and market dynamics before using vertical credit spreads. Proper risk assessment, trade monitoring, and adherence to well-defined exit strategies are essential for successful risk management with vertical credit spreads.

Thanks for reading 🙂
Austin Bouley
CEO & Chief Strategy Officer