Trading vertical credit spreads can be a profitable strategy in the world of options trading. These strategies allow traders to capitalize on the decay of time value and take advantage of price movements within a defined range. However, like any trading technique, there are risks involved. To maximize your chances of success, it is essential to establish a set of rules to guide your decision-making process. In this article, we will explore three key rules for trading vertical credit spreads that can help you navigate this strategy with confidence.

Rule 1: Trade With The Trend

The first rule for successful trading of vertical credit spreads is to identify high-probability setups. This involves identifying the trend and following it. For example, if the stock is trending up, then I want to be selling put credit spreads. If the stock is trending down, then I want to be selling call credit spreads. When I follow the big waves in the market, I can make easy money and dramatically increase my win rate.

Additionally, consider fundamental factors that may impact the underlying security. Earnings reports, economic indicators, or upcoming events can significantly influence stock prices. It is crucial to evaluate these factors and avoid trades that are likely to be impacted by unexpected news or events during the lifespan of the options contract. By focusing on high-probability setups, you increase the likelihood of success and reduce the risk of unnecessary losses.

Rule 2: Only Enter A Trade If You Can Make A 15% Return

Effective risk management is a cornerstone of successful trading, and it is especially important when trading vertical credit spreads. Vertical credit spread trades are defined risk trades. This means that your potential return is directly related to your potential max loss. This means if I have the potential to make 15% on a trade, then I have the potential to lose 85% (based on the collateral I put up for the trade). I have found that targeting a 15% return gives you a high win rate and is enough to offset any max losses that happen.

Consider implementing stop-loss orders to automate the exit process. By setting a stop-loss order, you ensure that your position is closed if the price of the underlying security moves against you beyond a certain threshold. This helps limit losses and protects your capital from significant drawdowns. To protect your capital and mitigate potential losses, it is crucial to implement proper risk management techniques.

Rule 3: No More Than 10% Of Your Account Size Should Go Into One Trade

Position sizing is crucial when it comes to trading vertical credit spreads because your max loss is way larger than your max profit. One loss can easily wipe out 10 winning trades if you aren’t careful. The best way to prevent a loss this devastating is to follow a strategy that has a high success rate.

I personally advise that people put no more than 10% of their account into any one trade. One trade being classified as the same stock during the same expiration. This is one of the golden rules in my Inner Circle Membership because it helps you survive any max losses that occur. I personally am more of a safer trader, so I only put 5% of my account into any one trade. This means this rule is subjective based on your comfort level, but you should still never exceed 10%.

Trading vertical credit spreads can be a profitable strategy when approached with discipline and a clear set of rules. By following the three rules outlined in this article – trading with the trend, having a potential profit of 15%, and having a max position size rule of 10% – you can increase your chances of success and minimize potential losses. Remember, consistent practice, continuous learning, and adapting your approach based on market conditions are key to becoming a proficient trader.

Thanks for reading 🙂
Austin Bouley
CEO & Chief Strategy Officer