Bull Credit Spreads

This year, I’ve spent a ton of time learning how to trade options to create a new stream of income for myself. Options trading, though more complicated, allows you to be much more creative with your investing and also contrary to popular belief; can allow you to be more conservative as well.

Today I want to walk you through one of my favourite strategies, Out-of-the-money (OTM) Bull Credit Spreads.

OTM Bull Credit Spreads are the best way to conservatively trade stocks, that I want to own, while allowing me to have the highest return on my money deployed.

Today, I want to walk you through:

  • What a Bull Credit Spread is
  • Why I use this strategy
  • My checklist for finding opportunities
  • An example of a recent Bull Credit Spread

What is an OTM Bull Credit Spread?

An OTM Bull Credit Spread is a trading strategy where you are neutral-to-bullish on the given equity and want to capitalize on a slow in the dropping price of the stock (volatility) and the passing of time (theta decay). This trading strategy allows you to make money if:

  • The stock goes up
  • The stock trades sideways
  • Even if the stock goes down a little bit

The stance which I am taking with this strategy can usually be summarized as:

I do not think the stock will go down much further, in the near future and in the case that it does go down further, I am happy purchasing the equity at a lower price than it is currently priced at.

Interestingly with this strategy, you are not too concerned about the stock itself appreciating — however it does help.

A OTM Bull Credit Spread consists of two option legs:

  • An OTM Short Put
  • A lower priced OTM Long Put

Both these options have the same expiration date but have different strike prices. I usually aim for a 5$ spread, which means that my Short Put leg has a strike price which is 5$ higher than my Long Put.

By writing a Bull Credit Spread, you have a defined max loss, a defined max profit and are able to profit as long as the stock does not drop too far by the date of the option expiration.

To give you an example, of what it might look like, let’s imagine company XYZ is trading at $52.50 on the market on August 1st. An OTM Bull Credit Spread could consist of a:

  • August 31st Short Put with a $50 strike which you sell for $0.65
  • August 31st Long Put with a $45 strike which you buy for $0.10

*As all options deal in blocks of 100 shares of stock, a single option which is valued at $0.65 is worth $65.

With this example trade you have:

  • A max potential gain of $55: (65–10 = 55)
  • A max potential loss of $445: [((50–45)*100)-55]
  • 30 days until expiration: (August 1st — 31st)
  • a 5% margin of safety: [($52.50-$50)/$50]

We are therefore betting that stock XYZ will not be trading 5% lower than the current price by August 31st and by making this bet we are given the opportunity to make 12.36% in 30 days.

Why I use Bull Credit Spreads

Bull Credit Spreads are my favourite trading strategy as it allows me to enter a bet with both a margin of safety and a high return on capital deployed. I also have more directional forgiveness as I am betting on where the stock will not go rather than where it will go.

When you buy a share of stock, the stock has to go up for you to win, giving you only one outcome to capitalize on. Even worse, when you buy a long call option, the stock has to go up in a given period of time for you to win and every single day that it spends not trading in that direction it costs you in the form of theta decay.

As a Bull Credit Spread writer we can make money, when the stock goes up, when the stock trades sideways, and even if it trades downwards a little. We make money on a slow in volatility, the passage of time, and neutral-to-bullish price action in the stock.

We have more advantages working for us and on top of that, if the trade goes against us, you still have options available to you to turn the trade around (more on that later).

My Checklist for Bull Credit Spreads

  1. Find a stock which you are long term bullish on.
  2. Wait for an event which causes a volatile sell off in the given stock.
  3. Find a 5$ OTM spread in the option chain with about 15–45 days to expiration that allows you to make at least $55 after commissions.

Three important caveats on top of this:

  1. Only write Bull Credit Spreads on stocks which you are long term bullish on. This gives you flexibility to turn the trade around if it goes against you. You can actually convert a bull credit spread into taking ownership of the stock and then begin to write covered calls on the equity to get out of the stock and still take home a great return on capital.
  2. Do not write all your credit spreads in one industry or on one stock. If a sell off comes, ideally it only comes in a few of your positions. You can therefore spend your available resources on fixing the spreads which make the most sense to fix, while your other spreads continue to profit. As sectors and industries rotate all the time, I believe it is crucial to make sure you have your spreads across Nasdaq, S&P and DJI stocks, rather than having them all in the Nasdaq which leaves you highly vulnerable to swings in tech.
  3. Keep cash on the sidelines to repair trades that go against you. I only use up to 25% of my account for credit spreads and make sure the remainder of the account is ready to deploy should I need need to repair my credit spreads. I also keep a Line of Credit open in the case I need extra cash in a pinch. Having the ability to repair your credit spreads, allows you to turn a trade that has gone against you into a large profit, but you must have cash available to do so.

By following this checklist, you ideally can create situations where you can make over a 10% return on 25% of your account each month with fairly conservative trades. On a $100,000 account this would equate to a monthly return of $2,500 or 30% annual return (not compounded).

Alright so as promised;

An Example Bull Credit Spread Trade

On August 3rd, 2021, GM reported earnings which caused the stock to dip from $57.88 to $52.72 by end of the next trading day (~9% decline). I am long term bullish on GM given their low P/E and the opportunity I believe they are well suited to capitalize on in the Electric Vehicle market in the coming years. This event therefore allowed me to enter the following trade on the afternoon of August 4th.

September 10th 50/45 Bull Credit Spread with a $0.95 premium.

This means that I had to put up $405 for up to 36 days for the opportunity to make $95 (23.45% return on margin) per spread.

As of writing, Sunday August 8th, GM has closed at $55.05 roughly up about 5% from where I wrote the credit spread, but my credit spread has exactly 60% decay. Which means that I could give back 40% of the $95 premium I collected and exit the trade for $38. If I chose to exit the spread that would mean I made 57$ on $405 (14% return on margin) invested in two trading days.

How has my credit spread returned 60% when the stock has only moved by 5%?

Volatility crush.

One of the main components in the pricing of options is the implied volatility. This is the measure of how much the market is expecting the equity to move within the time to the expiration. Since I wrote the option during the extremely volatile day after earnings which caused GM to move 9% (which is a big move for GM), volatility was high which caused the option prices to be high as well. As I am an option seller in this scenario, this is great as I can collect a higher premium than normal.

However, in the following days GM did not move 10%, it actually climbed back up a few percent and then traded up an additional percent the following day. As the stock recovered some of the losses and did not trade in a huge range in these two days, it caused a ‘crush’ in implied volatility and consequently caused a depreciation in option prices.

As a Bull Credit Spread writer this is exactly what you want as you enter the trade by selling the spread at one price and your goal is to either buy it back at a lower price or let it expire worthless.

This is why one of my criteria for finding a good credit spread writing opportunity is looking for an event which causes the stock to sell off and I can therefore capitalize on a crush in volatility.

My end goal with the trade is to buy back the spread early at 80% decay (19$). I will likely be able to do this much earlier than September 10th given that GM stays relatively flat or even continues to recover. However regardless of the price action, I know that I have time on my side, as with each day that passes, theta decay will be working in my favour and devaluing the credit spread, helping me inch closer and closer to my 80% decay goal.

Additional Reading

Want to know what happens when a Bull Credit Spread goes against you?

  • Check out my other article on how I handled a Bull Credit Spread gone wrong, here.

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Aspires to be a nerd, amateur at sports, average in school and always trying to live life to the fullest.

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Mike Solty

Mike Solty

Aspires to be a nerd, amateur at sports, average in school and always trying to live life to the fullest.

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