Credit Spread Trading Strategy: A Detailed Guide
This article details a credit spread trading strategy, expanding on a previously shared strategy and addressing common questions about entry and exit rules. This system is designed for both beginners and experienced traders looking for a structured approach.
Entry Rules
The entry rules consist of several key steps to identify potentially profitable trades.
1. Stock Selection and Watchlist Preparation
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Bull Put Spreads: Focus on fundamentally strong stocks. These are companies with a history of profitability (at least 5 years) and increasing revenue and profit. These stocks are suitable for put credit spreads.
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Bear Call Spreads: The criteria for bear call spreads are simpler. Any stock can be considered, as the strategy aims to profit from the stock price decline.
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Create a watchlist containing potential stocks to cycle through when planning trades.
2. Identifying Oversold or Overbought Signals
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Utilize technical indicators like the Stochastic Oscillator (slow stochastic on a daily timeframe) or the RSI (Relative Strength Index).
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Look for oversold signals when planning a bull put spread. An oversold signal indicates that the stock may be poised for an upward movement.
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Look for overbought signals when planning a bear call spread. An overbought signal suggests a potential pullback or reversal.
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The stochastic setting are shared on the creator's youtube channel.
3. Avoiding Earnings Announcements
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Crucially, avoid trading stocks with upcoming earnings announcements within the next 30 days.
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Earnings can introduce unpredictable market sentiment that overrides technical indicators and support/resistance levels.
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Check the option chain for earning indicators (lines showing the earning date). Brokers like Tastytrade and Thinkorswim often provide this. Alternatively, use financial websites that list upcoming earnings.
4. Identifying Support and Resistance Levels
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Identify key support and resistance levels on the stock's chart. This is a critical step in adding probability to the trade.
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For bull put spreads (oversold signal), identify the previous support level (previous low). Draw a line across the chart to visualize it. The goal is for the short put strike price to be below this support level.
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For bear call spreads (overbought signal), identify the previous resistance level (previous high). The goal is for the short call strike price to be above this resistance level.
5. Selecting DTE and Short Strikes
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DTE (Days to Expiration): Aim for approximately 45 DTE. This timeframe is chosen because the implied move in options is more often than not less than the expected move, creating an edge for option sellers.
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Short Strikes: Target short strikes with a delta around 30.
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If a 30-delta strike cannot be found below (for bull puts) or above (for bear calls) the support/resistance level, wait for the price to move closer and re-evaluate the delta.
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Understand the trade-off: Higher delta means higher premium but lower probability of profit; lower delta means higher probability of profit but lower premium. 30 delta aims for a fine balance.
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Exit Rules
There are multiple methods to exit positions.
1. Fixed DTE Exit
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Exit the trade at 21 DTE, regardless of profit or loss.
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This strategy is based on statistical data. Over the long term, exiting at 21 DTE is statistically proven to produce better results overall.
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Managing at 21 DTE reduces the risk of early assignment.
2. Percentage Profit or Fixed DTE Exit
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Exit the trade when a pre-determined percentage profit is achieved, or at 21 DTE, whichever comes first.
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Set a percentage profit target (e.g., 50% or 75% of the initial credit received).
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For example, if you sold a credit spread for \$2, a 50% profit target would mean buying it back for \$1.
3. Discretionary Exit (Not Recommended for Beginners)
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Exiting based on technical analysis, indicators, or personal judgment.
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This method relies heavily on the trader's skill and market timing ability.
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If used, it should be rigorously tested against the other methods (1 and 2) over at least 100 trades to objectively assess its performance.
Stop Loss Considerations
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Credit spreads already have an embedded stop-loss due to the long option. This long option limits the maximum potential loss on the trade.
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The long option defines the risk to the trade, so an additional stop loss is redundant.
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TastyTrade studies suggest that having a stop-loss does not give better results than holding to expiration.
Putting It All Together: Examples
The article provides examples of applying the strategy to various stocks: 1. Stock oversold / overbought 2. Identification of resistance level 3. 30 Delta options or wait for it. 4. Exits at 21 DTE / percentage target.
The examples illustrate how to identify potential trades, find appropriate strike prices, and manage the positions.
The article ends by reiterating that no strategy guarantees a 100% win rate and that consistency and adherence to the system are key to long-term success.
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