blog

# Option Credit Spreads Destroyed My Life

#### Options Trading 101 - The Ultimate Beginners Guide To Options

As Seen On
by Gavin in Blog

“Option credit spreads destroyed my life”.

Unfortunately, I have heard this before, which is why we will discuss what to do when credit spreads move against you.

## Contents

Suppose we had placed a bull put spread on Procter & Gamble (PG) when it made a new high in an uptrend.

And then it proceeded to breach the spread to expire with the price below the short strike price with no trading day ending positive.

These things happen.

## Bull Put Credit Spread Example

For this strategy to have a decent chance of working, the original credit spread must have been sold with at least 45 days till expiration.

And the risk to reward ratio must not be greater than 10.

Here is the bull put spread example that we were looking at.

We’ll use one contract to keep the math simple.

Date: Jan 6, 2021

Buy one \$120 PG Mar 19 put @ \$0.80
Sell one \$130 PG Mar 19 put @ \$2.08

Credit: \$128

Max Risk: \$872

Risk to Reward Ratio: 6.8

The planned take profit level is 50% of max profit, or \$64.

This did not occur.

Or at least not occurred based on the closing prices of each trading day.

## Rule 1: Hedge at 3% of the Short Strike

That means we need to hedge if the price drops below \$133.90, which it did on January 19th.

Some investors may prefer to hedge earlier, and that’s fine.

But 3% is the latest that one should let the price go before hedging.

We hedge with an opposing bear call spread with at least 45 days till expiration.

Keep the width the same as the other spread.

That way, the max risk on either side is the same.

Date: Jan 19

Sell one \$140 PG Mar 19 call @ \$1.685
Buy one \$150 PG Mar 19 call @ \$0.415

Credit: \$127

We need to keep detailed track of the credits and debits of each option leg, as well as their expiration date, in a spreadsheet.

A negative one contract means that we sold that option contract.

We end up with an iron condor payoff diagram:

The delta at which we sell the bear call spread will depend on this diagram and can vary based on the situation.

In this case, we were a bit more aggressive with the hedge by selling the bear call with the short strike at a relatively high delta of 30 to collect a better credit.

As can be seen, by the curvature of the T+0 line, this is just enough to neutralize the delta down to close to zero.

Some investors do not like to do a complete hedge, and it is unnecessary to do so.

Over-hedging can cause problems if prices reverse.

## Rule #2: Take Profits at 50% of Max Profit

On a daily basis, check if either spread has reached 50% of max potential profit.

This will be the case if we can buy to close the spread for less than 50% of what we paid for the spread.

On January 22nd, the bear call spread can be repurchased for \$59, which is less than half of the credit received.

So we close that spread to take profits.

Date: January 22nd

Buy to close one \$140 PG March 19th call @ \$0.83
Sell to close one \$150 PG March 19th call @ \$0.24

Debit: \$59

We update the spreadsheet by coloring the rows grey to indicate that those options have been closed out.

We immediately sell another bear call (at least 45 days away) to maintain our hedge against the bull put spread that is still in trouble.

Date: Jan 22

Sell one \$135 PG Mar 19 call @ \$1.97
Buy one \$145 PG Mar 19 call @ \$0.42

Credit: \$155

## Rule #3: Roll Spread For A Credit If Breached

On January 27th, the bull put spread was breached with price closing below the short strike. The short option is now in the money.

When this happens, we roll to a future expiration keeping the strike prices the same.

But only if we can perform the roll for a credit.

Adding money to the roll would be increasing our risk because we would risk losing the max lost on the spread plus the additional money that we would have added.

Date: Jan 27

Sell to close \$120 PG Mar 19 put @ \$1.92
Buy to close \$130 PG Mar 19 put @ \$5.95
Buy one \$120 PG Apr 16 put @ \$2.78
Sell one \$130 PG Apr 16 put @ \$6.83

Credit: \$2

## Rule #4: Repeat As Necessary

On February 10th, we take profit on the bear call spread and put on another one.

Date: Feb 10

Buy to close \$135 PG Mar 19 call @ \$0.88
Sell to close \$145 PG Mar 19 call @ \$0.16
Sell one \$135 PG Apr 16 call @ \$1.70
Buy one \$145 PG Apr 16 call @ \$40

Credit: \$57

Again on February 26th, we close the bear call:

Date: Feb 26

Buy to close one \$135 PG Apr 16 call @ \$0.76
Sell to open one \$145 PG Apr 16 call @ \$0.22

Debit: \$53.5

Sell one \$130 PG Apr 16 call @ \$1.40
Buy one \$140 PG Apr 16 call @ \$0.35

Credit: \$105

The bear call spread has moved so close to our original bull put spread that the short strikes touch, creating a butterfly.

By continuing to pick up credits, we reduced our max risk to \$538, which is less than our original max risk of \$872.

How did we compute \$538? Suppose if PG price goes to zero, then the existing calls would expire worthless, and we would lose \$1000 from the existing put spread.

Take \$1000 and subtract the \$462 (see spreadsheet) of credit that we got from the closed options, and we get \$538, which matches what the butterfly payoff diagram shows.

Once our initial bull put spread has been tested (price within 3% of short strike) and/or breached (price below short strike), that means that price had gone against us.

We would look to exit the entire position at breakeven or positive P&L (profit and loss).

No longer are we seeking the 50% of max profits.

On March 22nd, the P&L closed positive for the first time in the entire trade. So we paid \$398 to close out the position.

Date: March 22

Buy to close one \$130 PG Apr 16 call @ \$2.40
Sell to close one \$140 PG Apr 16 call @ \$0.19
Buy to close one \$130 PG Apr 16 put @ \$2.18
Sell to close one \$120 PG Apr 16 put @ \$0.40

Debit: \$398

The net result was a small profit of \$63.

Ironically, we came into profit one trading day after the original bull put spread would have expired.

The rolling of our spreads had given us additional time for the cyclicality of price movements to move just enough for us to come out positive.

In the following hypothetical example, we have one more rule to get us out of a trade if the price never accommodated us.

## Bear Call Credit Spread Example

Imagine if we had placed a bear call spread when Home Depot (HD) stock price made a lower low.

Date: March 4, 2021

Price: HD @ \$250.93

Sell one \$267.5 HD Apr 23 call @ \$3.41
Buy one \$282.5 HD Apr 23 call @ \$0.95

Credit: \$246

Max Risk: \$1254

Risk to Reward ratio: 5.1

And then it makes a crazy move like this against us:

Yes, you can purchase shares of HD to hedge when the price breached the short strike.

That can work and is a perfectly valid strategy.

But let’s apply the five steps of our adjustment strategy to see what happens.

## Apply Rule 1: Hedge At 3% Of The Short Strike

On March 9th, the price of HD closed within 3% of the short strike of \$267.5.

We hedge by adding a bull put credit spread with at least 45 days till expiration.

Date: March 9

Price: \$264.96

Buy one \$235 HD Apr 23 put @ \$1.64
Sell one \$250 HD Apr 23 put @ \$4.23

Credit: \$259

In this case, the bull put spread expiration happens to be the same as the bear call spread. So we end up with a payoff diagram of an iron condor.

## Apply Rule #3: Roll Spread For Credit If Breached

On March 11th, the price of HD closed at \$268.85, which is above the short call strike price of \$267.50.

The bear call spread has been breached.

We roll.

Date: March 11

Price: \$268.85

Buy to close one \$267.5 HD Apr 23 call @ \$9.88
Sell to close one \$282.5 HD Apr 23 call @ \$3.78
Sell one \$267.5 HD Apr 30 call @ \$10.83
Buy one \$282.5 HD Apr 30 call @ \$4.55

Credit: \$18

## Apply Rule 2: Take Profits At 50% Of Max Profit

On March 15th, we can close the bull put spread for a debit of \$87.

Date: March 15

Sell one \$235 HD Apr 23 put @ \$0.68
But one \$250 HD Apr 23 put @ \$1.55

Debit: \$87

## Apply Rule #4: Repeat Hedge

Our bear call spread is still in trouble. We continue to add a new bull put hedge.

We are putting that short strike at around 25 delta.

But this can be adjusted at the investor’s discretion.

Remember to sell the spread with at least 45 days till expiration.

Date: March 15

Buy one \$247.5 HD Apr 30 put @ \$1.81
Sell one \$262.5 HD Apr 30 put @ \$4.13

Credit: \$232

On March 19th, our bull put spread has more than 50% of max profit.

We close it and open another one all in one transaction.

Date: March 19

Sell to close one \$247.5 HD Apr 30 put @ \$1.51
Buy to close one \$262.5 HD Apr 30 put @ \$1.74

Buy one \$255 HD May 21 put @ \$2.17

Sell one \$270 HD May 21 put @ \$4.68

Credit: \$228

Note that the expiration dates on the two spreads need not be the same.

Home Depot stock keeps going up, which means that we keep taking profits on the bull put spread.

Date: March 26

Sell to close \$255 HD May 21 put @ \$1.04
Buy to close \$270 HD May 21 put @ \$2.06
Buy one \$270 HD May 21 put @ \$2.06
Sell one \$285 HD May 21 put @ \$4.33

Credit: \$125

We rolled up the bull put spread while keeping the same expiration dates since it is still further than 45 days away.

And again:

Date: Apr 5

Sell to close \$270 HD May 21 put @ \$0.91
Buy to close \$285 HD May 21 put @ \$1.83
Buy one \$285 HD May 21 put @ \$1.83
Sell one \$300 HD May 21 put @ \$4.28

Credit: \$153

## Rule #6: Don’t Let The Spread Get Closer Than 3 Weeks To Expiration

When a spread has 21 days or less till expiration, see if the spread can be rolled further out in time for a credit.

On April 9th, the bear call spread has only 21 days till expiration.

We can roll the spread further out in time for a credit. So we do so.

Date: April 9

Buy to close \$267.5 HD Apr 30 call @ \$51.18
Sell to close \$282.5 HD Apr 30 call @ \$36.88
Sell one \$270 HD May 7 call @ \$48.88
Buy one \$285 HD May 7 call @ \$34.55

Credit: \$2.50

We usually would roll to the same strikes, but there was no \$276.50 strike for the May 7th expiration.

So we had to use the \$270 strike.

Hence we rolled to the \$270/\$285 bull put spread to maintain the 15 point width.

On April 15th, the bull put spread is ready for profit-taking, and then sell another bull put.

Date: April 15

Sell to close \$285 HD May 21 put @ \$0.86
Buy to close \$300 HD May 21 put @ \$2.05
Buy one \$290 HD June 18 put @ \$2.39
Sell one \$305 HD June 18 put @ \$5.03

Credit: \$144.50

On April 16th, the bear call spread is at 21 days to expiration again.

We looked to roll to the May 14th, May 21st, May 28th, and June 18th expiration while keeping the same strikes.

But none of the rolls gave us a credit.

We don’t want to roll more than a month out because it would drag the trade on for too long, tying up capital.

Time to close this bear call spread since we don’t want to carry it closer to 21 days till expiration.

The final weeks of the spread are when gamma risk is high and is statistically where the most money is lost.

Date: April 16

Buy to close \$270 HD May 7 call @ \$57.88
Sell to close \$285 HD May 7 call @ \$42.85

Debit: \$1502.50

Since the original bear call spread closed, we will close our hedging bull put spread as well, exiting the entire position.

Date: April 16

Sell to close \$290 HD Jun 18 put @ \$1.85
Buy to close \$305 HD Jun 18 put @ \$3.88

Debit: \$203

The total P&L of the entire trade was a loss of –\$386.

This is about 1.5 times the original credit — also known as a 1.5X loss.

This is not too bad, considering that we are not anywhere near the max loss of \$1254.

Some investors may argue to continue with the bull put spread since it still has more than three weeks left.

That is a valid point, and one can continue that as a new trade if desired.

## FAQ

### What Is An Option Credit Spread?

An option credit spread is a trading strategy that involves selling an option with a higher strike price and buying an option with a lower strike price.

The goal is to collect a credit from the difference in premiums between the two options, while limiting the potential loss to the difference in strike prices.

### What Went Wrong With The Author’s Option Credit Spreads?

The author’s option credit spreads went wrong because the underlying stock price moved against the position, causing losses to mount and eventually triggering a margin call.

The author also made the mistake of not closing losing trades early, which exacerbated the losses.

Yes, option trading can be risky, especially if you don’t understand the potential risks and strategies involved.

Options can be complex and volatile, and losses can mount quickly if the underlying stock price moves against your position.

It’s important to do your research, have a trading plan, and use risk management strategies like stop-loss orders and position sizing to manage your risk.

### Can Option Credit Spreads Be Profitable?

Yes, option credit spreads can be profitable if executed properly and with a sound trading plan.

The strategy can generate consistent income by collecting credits from the difference in premiums between the options.

However, it’s important to manage risk by setting stop-loss orders, closing losing trades early, and avoiding over-leveraging or taking on positions that are too large for your account.

## Conclusion

Now you have some strategies and ideas to prevent credit spreads for destroying your life.

The main take-away is to roll spreads out for more time when it can be done for a credit.

Pickup credits by selling opposing hedges to reduce delta as well as max risk.

Hopefully, the cyclicality of stock prices will move the P&L back to breakeven from trades gone bad.