Income investing is popular among investors in or approaching retirement, but there are few good choices during periods of record-low interest rates. Exchange-traded options provide an easy way to generate extra income in a portfolio with limited risk. While covered calls are the most popular income strategy for options, credit spreads have become a popular alternative.
Let’s take a look at how to generate an income with credit spreads and when you should consider other strategies, such as conventional income investments or covered call options.
What Are Credit Spreads?
Credit spreads are option strategies that involve purchasing one option and selling another of the same type and expiration date but different strike price. As its name suggests, the goal of a credit spread is to capitalize on the narrowing spread between two options. There are bearish, bullish and neutral credit spreads, making it an extremely versatile strategy for investors.
Call Credit Spread Payoff Diagram – Source: The Options Bro
There are several advantages of using credit spreads:
- Limited Risk: The max loss for a credit spread is equal to the difference between the premiums for both options and occurs when both options expire in-the-money.
- Low Margin: The margin requirement for a credit spread is significantly lower than for uncovered option strategies, making it more accessible for investors.
- More Versatile: Credit spreads can be applied in bullish, bearish or neutral markets with a variety of different combinations of options.
- Less Monitoring: There’s less monitoring required for credit spreads compared to other strategies thanks to their predictable performance.
There are also some disadvantages to keep in mind:
- Limited Profit: The profit potential for a credit spread is limited to the difference between the premiums of both options.
- Higher Commissions: Since there are two options, the commission costs associated with credit spreads are higher than a single uncovered position.
- Active Management: Spread traders will need to regularly place a new round of options as well as speculate on the future direction of the stock.
Credit spreads may be attractive to investors since they generate an immediate income from the difference in option premiums and entail limited downside risk. Unlike covered call options, investors don’t need to hold any long underlying stock, which means that the position may be lower cost (but higher risk) than conventional income strategies for options.
Credit Spread Strategies
There are three different credit spread strategies to consider depending on your outlook for the market. For example, you can use a call credit spread if you have a bearish outlook or a put credit spread if you have a bullish outlook. You can also structure the strike prices to adjust the level of bullishness or bearishness to suit the specific situation.
The three primary credit spread strategies include:
|Put Credit Spread||Call Credit Spread||Iron Condor|
|Max Profit||Credits Received x 100||Credits Received x 100||Credits Received x 100|
|Max Loss||(Width of Strikes – Credits Received) x 100||(Width of Strikes – Credits Received) x 100||(Width of Wider Spread – Credits Received) x 100|
|Breakeven Point||Short Put Strike Price – Credits Received||Short Call Strike Price + Credits Received||Upper: Short Call Strike Price + Credits Received, Lower: Short Put Strike Price – Credits Received|
Note: A bullish directional indicates that the strategy benefits from a move higher in the stock price and vice versa for a bearish directional bias. Positive time decay indicates that the strategy benefits as expiration approaches.
Most investors leverage credit spreads during periods of consolidation. For example, they may use S&P 500 index credit spreads and sell vertical bull put spreads that are significantly out of the money. You can generate a consistent income during these times by laddering different expiration dates using weekly and monthly strikes.
There are a few tips to keep in mind when using these strategies:
- Use Out-of-the-Money Options: Credit spreads can technically be written at the money, but there is a greater risk of assignment. By using far out-of-the-money options, you reduce your income, but also increase the probability of success.
- Seek Out High Implied Volatility: Option traders look to write overpriced options and buy value-priced options. When using credit spreads, you should try to sell overpriced options with high implied volatility to maximize your income.
- Keep a Narrow Spread: Strike price should generally be within five points for short-term credit spreads in order to minimize risk, although you may use wider spreads when placing intermediate or long-term credit spread trades.
- Be Smart About Catalysts: Place short puts at or below key technical support levels and avoid establishing positions when a scheduled event, like earnings, could cause unpredictable levels of volatility.
Credit spreads are just one of several option strategies that can be used to generate an income during retirement. For instance, covered call strategies involve selling call options against a long stock position to generate an extra income. Many long-term investors use covered calls to generate an income that’s greater than possible with just dividends.
The Snider Investment Method is a long-term strategy designed to create income from a portfolio of stocks and ensure cash flow in retirement. Using covered call options, the strategy seeks to maximize income potential above and beyond dividends without stressing out about the day-to-day selection of options and management of positions.
Snider Advisors’ Lattco Trading Platform – Source: Lattco
In addition to options, fixed income investments, master limited partnerships and dividend stocks enable investors to generate an income rather than relying on selling stock to generate capital gains. The downside of these strategies is that they may not yield enough income to meet retirement requirements.
The Bottom Line
Credit spreads are a popular way to generate income from options. Unlike covered calls, credit spreads do not require an upfront investment in long stocks and have a limited potential for loss. Like covered calls, the strategy has limited upside potential. The downside is that the positions may be slightly riskier and entail higher commission costs. Many option traders begin with covered calls and then look for more complex strategies. Although credit spreads are a common next step, many of these same investors find themselves back at covered calls because of their simplicity and consistent income.
If you’re interested in generating income from a portfolio of stocks, take our free e-course to learn how to select the right stocks for covered call strategies or inquire about our asset management services for a done for you portfolio.