QQQ Credit Spreads: Trade Nasdaq Drops for Profit (Options Strategy)

This article is based on a video response to a question about using credit spreads to profit from a declining QQQ (Nasdaq ETF). The responder, Adam, shares his insights and strategies, specifically focusing on call credit spreads.

Introduction to Credit Spreads

Complexity Compared to the Wheel Strategy

Credit spreads, and spreads in general, are inherently more complex to manage than a strategy like the wheel. The wheel strategy, while simple, can become problematic if the underlying stock continuously declines after assignment. Credit spreads, however, carry the risk of direct monetary loss.

• With the wheel, all outcomes can be foreseen except if you are completely wrong about the underlying stock.

• With credit spreads, you either make or lose money; however, active management techniques can influence the outcome.

Using Call Credit Spreads for a Bearish Outlook

To profit from a decline in the Nasdaq (QQQ), you would sell a call credit spread. This strategy is employed when you have a bearish outlook on the underlying asset.

• Selling a call credit spread involves selling a call option closer to the money (or in the money) and buying a call option further out of the money.

• The short call has a negative delta (bearish), while the long call has a positive delta (bullish). The negative delta of the short call is greater, making the overall position bearish.

Key Concepts: At-the-Money Options and Greeks

Extrinsic Value, Theta, and Vega

At-the-money (ATM) options possess higher extrinsic value compared to in-the-money (ITM) or out-of-the-money (OTM) options. This is due to the greater uncertainty and dependence on time and volatility. Because ATM options have higher extrinsic value they decay faster, meaning a higher theta, and they are more sensitive to changes in implied volatility, meaning a higher vega.

• Extrinsic Value: The portion of an option's premium based on time to maturity and implied volatility.

• Theta: Measures the rate of decay of an option's value over time.

• Vega: Measures the sensitivity of an option's price to changes in implied volatility.

Greek Impact on Credit Spreads

The leg of your credit spread closer to being at the money dictates the overall theta and vega of your strategy.

• For a call credit spread, the short call (closer to ATM) has a negative vega and a positive theta. The long call has a positive vega and a negative theta.

• Therefore, your overall strategy will have a negative vega and a positive theta.

Implications for Trading

• Positive Theta: Means you make money as time passes, if the short leg is closer to at the money.

• Negative Vega: Means you are short implied volatility. Therefore, selling credit spreads in high implied volatility environments is advantageous. A high implied volatility environment is one where implied volatility is high relative to the historical implied volatility of the underlying options.

• Selling in a high implied volatility environment allows you to benefit from mean reversion as implied volatility drops, further boosting your profits.

Strategic Considerations for Call Credit Spreads

The Importance of an Edge

Because there is a tendency for implied volatility to increase when the underlying stock price decreases, it's advantageous to establish a call credit spread in the highest implied volatility scenario possible. It provides a larger edge.

Distance From the Money

• Generally, credit spreads are sold out of the money (OTM) due to higher probabilities of success.

• The further OTM the credit spread is, the more likely it is to expire worthless, allowing you to keep the entire credit.

• However, extremely OTM spreads yield very small credits and have high maximum loss potential.

Balancing Probability and Potential Loss

Credit spreads aren't solely a probability game. A solid understanding of the underlying asset and a well-defined thesis are vital. Without this, the probabilities may not work in your favor, leading to a potentially large loss wiping out previous gains. It's often described as collecting "nickels in front of a steamroller."

• Diversification: Spreading your portfolio across numerous trades is essential for risk management.

Strike Selection and Risk Management

• If you have a strong conviction that the underlying stock will decline, don't sell excessively far out of the money. A more targeted approach offers a better balance between risk and reward.

• Options Profit Calculator: Tools like optionsprofitcalculator.com are valuable for analyzing profit and loss scenarios based on different strike prices.

• Assignment Risks: Be aware of the potential risks associated with holding spreads into expiration, particularly if the stock price is near the strike prices.

Adjusting Risk and Managing Positions

Adjusting The Width of Your Strikes

To increase risk and potential profit while keeping a similar probability of success, you can widen the distance between the strikes of your credit spread.

Managing a Position That Moves Against You

If the underlying asset's price rises against your bearish call credit spread, consider these actions:

1. Rolling: Roll the position out in expiration and up in strike price for a credit. This aims to move the spread back out of the money and avoid assignment.
2. Buying to Close: Accept the loss and close the position.

The Goal of Rolling

The goal of rolling is to eventually collect enough credit to offset any potential losses from assignment. If the total credit received exceeds the maximum loss, the credit spread becomes "free," meaning it cannot result in a net loss.

Short Term vs Long Term

It is better to trade credit spreads on a shorter-term time horizon as the theta decays the value of your short leg more quickly which is good because that is how you make money with credit spreads. Also, the opportunities to roll the option are easier.

Conclusion

Adam concludes by emphasizing that credit spreads are a viable way to make money if you give yourself an edge through implied volatility and because you make money as time passes if it's out of the money. With a solid market outlook and careful implementation, it can be a useful tool for your trading portfolio.