When considering an investment opportunity you examine 3 factors: potential return, risk of losing money, and effort required to maintain the investment. For example, when buying a stock you put a fair amount of effort into finding the best company to buy into, and you check up on the company every quarter to ensure that your strategy remains sound. Before buying, you estimate your overall return based on your assumptions, and you prudently consider how much you might lose if the trade goes against you. When comparing investment opportunities you leverage your experience to estimate values for the 3 factors—but these estimates are subjective.
Why Are Option Credit Spreads So Great?
In contrast, upon placing an option credit spread trade your 3 factors are pretty clearly defined. Your return is dictated by the credit you receive, and due to the very nature of an option credit spread your risk is defined by the difference between the lower strike and the higher strike minus the credit. The effort, too, is defined if you have a consistent strategy. In other words, there is almost nothing subjective about trading option credit spreads. Very few investment opportunities allow you to define all 3 factors up front.
What’s the Catch?
The catch is if your strategy is not well planned or implemented with discipline. Meaning that what makes the 3 factors so definitive when trading credit spreads is implementing a brilliant strategy with fidelity. Yes, you will lose money on some trades, but your strategy should be properly backtested so you can account for those losses.
A Word on Effort
Credit spreads are not without effort, though most of the effort is up front when you are developing your strategy. For example, I like to sell credit spreads on the SPY because I have already spent a great deal of time perfecting when to buy and sell the spreads and how much to risk in each trade—that’s my upfront work. Now I need to devote only a few minutes a day to actually executing these trades. In one of my accounts I even have custom software I wrote to do the work for me so the effort to maintain the strategy is almost nil. This characteristic distinguishes a credit spread strategy from typical investment opportunities, which usually require more intensive ongoing effort.
The Magic of Options
The magic of options trading is that you can craft a strategy that synthetically mirrors any type of investment. I dislike relying on subjective reasoning to make investment decisions—which is why I favor option credit spreads. I can build an option strategy that has the same risk and reward of just buying stock. Or, I can build an option strategy that mimics buying rental property. Option credit spreads are just one example of an investment strategy you can craft to meet your needs.