Selling out-of-the-money (OTM) credit spreads is an increasingly popular strategy among retail traders. I believe more traders are looking to this strategy because it removes some of the complications of forecasting an options trade.
When you sell a credit spread, you want both of the contracts to expire. For an OTM call credit spread, you want the stock to stay below your short call. For OTM put credit spread, you want the stock to stay above the short put. The trader needs only to determine which direction the stock will not move. If the stock stayed at the same price level until expiration, the OTM credit spread would expire unexercised with the trader profiting.
Because the spread is already OTM, the percentage chance that it will finish out of the money at expiration is higher. The farther out-of-the-money you sell the spread, the higher the probability that the spread will expire worthless. There is a trade off however, because the farther OTM you sell the spread, the less premium you will receive from selling the spread.
This strategy is in contrast to buying options, where you need to target a specific direction of the market, the magnitude of the move, as well as how long it will take to make that move. This is a rather tall order to get right consistently.
Traders selling these OTM credit spreads can increase the probability of the spread expiring worthless by putting technical barriers between the current price of the stock and their short strike price. These barriers can come in a variety of form, such as moving averages, over bought/sold levels, or even psychological price levels. Its not important want the indictor is as much as if the stock is holding true to the indication it is giving.
For example, if a stock has had a strong resistance level just above its current price, an options trader could sell a call credit spread at a strike price just above that resistance level. If this technical level holds true, the stock should have a hard time breaking thru that price level. The trader does not care if the stock stays at the same price or goes down. All they care about is that resistance level holds and the stock does not go up. Also, this technical level gives a clear ‘line in the sand’ that, when broken, the trade must closed or adjusted.
These technical indicators can give some rhyme and reason to why the market moves the way it does. They can give you the confidence to get into a trade and effectively execute a trading plan.
Check out the Options Institute’s Education Center to learn more on the specifics of the credit spread strategy and how to find technical support and resistance levels.
Josh Sampson is the Options Education Specialist at online investing firm Scottrade, Inc.. Scottrade customers can trade options through their Scottrade account or through OptionsFirst, Scottrade’s advanced options trading platform.