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Most traders have a pretty good idea of how to make money in an up market. Some traders, though fewer in number, know how to make money in a down market. However, very few traders realize that profits can be made in sideways moving markets as well by using the appropriate option strategies. One of my favorite strategies is a calendar spread, but for this article, we are going to discuss another sideways trading strategy called a credit spread. 

A credit spread is a vertical spread that is placed for a credit. When using calls, a trader would sell a lower strike call and buy a high strike. This type of trade would be neutral to bearish in nature. When using puts, a higher strike put would be sold, while selling a lower strike put. This is similar to selling naked puts, but without the unlimited risk. Let’s go over an example of when a credit spread might be used.

The chart below is a daily chart of the S&P 500 ($SPX). Notice how the 1,010 area has been resistance, with the 1,000 area providing resistance on a weekly basis.

Figure 1: Daily Chart, SPX

Depending on our outlook for the SPX, we have several strategies we could enter. However, I am looking at the chart and seeing resistance that isn’t likely to be broken in the next month. However, I’m not so sure a large decline is going to occur either. When this is the case, we can enter credit spreads to benefit from sideways to down movement in a stock or index. The one negative to entering a credit spread on the SPX is that implied volatility is very low so it might be difficult to get a large enough reward to risk ratio.

As far as reward to risk goes, we aren’t going to get high ratios like we do on debit vertical spreads. However, our odds of success are much higher. A stock or index can do three things: Go down, move higher or move sideways. When using credit spreads, we profit in 2 of these 3 scenarios. This means that without any regard for technical analysis, we should be able to win 67 percent of the time when using a credit spread.

Using the option data for the close of trading on August 26, we could sell a September 1005 call for about $12.50 and buy a September 1015 call for about $9.25. This gives us a credit of $3.25 when we enter the trade. Our max risk is figured by taking the difference in spreads, which is 10 points, and subtracting the credit of 3.25. This leaves us with a potential max loss of 6.75 per contract. However, this max loss would only occur if the SPX closed above 1015 at September expiration. A profit would be made as long as the SPX closed below 1008.25. The max profit would be achieved as long as the SPX closes below 1005.

By looking at the technical status of the SPX, we should be able to garner better odds of the trade being profitable. Not only is there resistance at 1,000, but the CBOE Market Volatility Index ($VIX) is at a historically low price. This tells us that the next big move is likely to be lower, not higher. If the SPX does move through its 52-week high, traders could exit the trade and take the loss at that time.

Below is the data for this mock trade:

August 26, 2003
S&P 500 ($SPX)
Sell 1 Sep03 1005 Call @ 12.50 IV=15.1
Buy 1 Sep03 1015 Call @ 9.25 IV=15.4
Credit received = 3.25
Max risk = 6.75
Breakeven = 1008.25

We’ll track this trade through option expiration to see how it performs and update it each week. Please feel free to post any questions or comments on my forum. Great observations and questions are posted on this discussion board each day, so take advantage of it.

For more on credit spreads in a sideways market, please see Hot Shots: Using a Credit Spread on AMZN, by Jody Osborne, 8/26/03.
 

Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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