Credit spreads are one of the most misunderstood option strategies out there.
Here’s why: Investors and even many traders tend to think in terms of buy and increase. The natural thought process is something like this; I’m going to buy this security with the expectation that it will go up. We are just conditioned to think in that way.
But we all know that even with the perfect system (and you may already know that I say it doesn’t exist), options and other securities frequently move opposite of what we think they’ll do when we buy them. Sh-t happens, right?
Earnings, economy or just plain irrational behavior sabotages the best laid plans once money is invested.
And we suddenly have a loser on our hands.
But what if you could structure a trade that would work NO MATTER WHAT earnings do, or the economy, or the irrationals?
This is exactly what credit spreads do. But there’s just no such thing as a free lunch, really; since you can make money regardless of what the market does with a properly constructed credit spread, you’re going to make a little less than if you buy a security outright with the intention that it will only go up.
So far we’ve got less risk, with a little less return. It would seem that way…
Billions of people buy into the stock market every day with their hard earned savings accounts knowing for certain that the market will drop between 35 and 45% based on history. Now that is risk.
But interestingly, those same investors think it is risky to enter a trade that has downside protection. In reality they just don’t understand.
Depending on entry and exit, buy and hold stock market investing may return about 11% on average over a very long time, before fees. That’s about .09% a month. But a credit spread can easily return over 2% a week WITH a clearly defined risk. No guessing games here.
Now which one is riskier…buy and hold stock market investing or option credit spreads?
But here’s the best thing of all; based on the industry established and accepted risk management tools that are available at every brokerage firm, you can structure credit spread trades that have a 70% plus proven probability of winning.
Can you say that about the stock market, especially after 4 legs up in an extended bull market?
Granted, buying a one legged security with the hope of it rising in value is much easier than investing with any type of hedge, but hedges reduce risk, plain and simple. This is exactly why blue chip corporations spend billions of dollars in trading and risk management personnel.
I learned the value of hedging firsthand back in the 1980’s when my trading group sold call options against physical crude cargos that we owned. This is how the big boys do it, and have for decades.
Why don’t private investors hedge? It’s been said that the thing that Americans fear the most is inconvenience. Thus, the microwave, fast food, and one cup coffee makes. In the financial world, it’s buy and hold investing and balanced funds.
But easier just isn’t always better! Keeping your money safe while having it optimally invested takes a little more effort, and sometimes more effort is slightly inconvenient; but it’s nowhere near as inconvenient as struggling financially.
I say that time and investment to master some simple tools that provide both a high return and defined risk for life, regardless of the overall market, the Feds or the economy is a small inconvenience worth having.
Bottom line; Get a respectable return from your investments, and above all, keep your money safe.