In the video titled “Steal My 7-Step Credit Spread Blueprint (Exact Entries & Exits)” by Options with Davis, you’ll discover a comprehensive trading plan for credit spreads. The plan consists of seven steps, including building a watchlist of index ETFs and individual stocks, identifying oversold or overbought conditions using indicators like the stochastic oscillator or RSI, and determining the number of days until options expire and the strike price of the short leg. You’ll also learn about exit strategies and the importance of capital allocation and risk management. This video provides valuable insights for beginners and experienced traders alike, offering a solid foundation for trading credit spreads safely and profitably.
Building a Watchlist
When it comes to trading credit spreads, one of the first steps is to build a watchlist of potential assets to trade. In this case, we have two options: index ETFs and individual stocks. While both have their merits, index ETFs tend to be the preferred choice due to their lower volatility compared to individual stocks.
Index ETFs offer a more controlled trading environment as they tend to stay within a narrower range compared to stocks. This is evident when we analyze the standard deviation moves. ETFs have a smaller standard deviation, which means they are less likely to have large price swings. For credit spread traders, this is ideal because we want the market to stay within the expected move or move in the opposite direction of our spread.
On the other hand, individual stocks have a wider range of price movement, making them more volatile. While this can present opportunities for quick profits if the market moves in our favor, it also carries a higher risk of blowing through our spread if the market moves against us.
Ultimately, the choice between index ETFs and individual stocks will depend on your trading style and risk tolerance. However, if you’re new to trading credit spreads, it’s recommended to focus on index ETFs for their lower volatility and greater stability.
Identifying Oversold or Overbought Conditions
Once you have your watchlist of assets, the next step is to identify oversold or overbought conditions. This can be done using technical indicators such as the stochastic oscillator or the relative strength index (RSI).
The stochastic oscillator is a momentum indicator that compares a security’s closing price to its price range over a specific period of time. It helps identify potential turning points in the market and can indicate when an asset is oversold or overbought.
The RSI, on the other hand, is a more general indicator that measures the magnitude of recent price changes to determine whether an asset is overbought or oversold. It ranges from 0 to 100 and is typically considered overbought when it’s above 70 and oversold when it’s below 30.
By using these indicators, we can identify potential entry points for our credit spreads. For example, if an asset is oversold according to the stochastic oscillator or RSI, it suggests that there is a lesser chance for the market to continue moving down compared to moving up. This is the ideal time to put on put spreads.
Conversely, if an asset is overbought according to the indicators, it indicates a greater chance for the market to reverse and move down. This is when we want to put on call spreads.
Identifying oversold or overbought conditions helps us determine the direction of our trades and increases our chances of success. It’s an important step in executing a profitable credit spread trading strategy.
Identifying Support and Resistance Levels
In addition to identifying oversold or overbought conditions, it’s crucial to identify support and resistance levels when placing credit spreads. These levels act as important price areas where the market is likely to turn or reverse.
Support levels are areas where the price has previously bounced and moved back up. They represent a floor for the asset’s price and indicate that buying pressure outweighs selling pressure at that level.
Resistance levels, on the other hand, are areas where the price has previously touched and reversed. They represent a ceiling for the asset’s price and indicate that selling pressure outweighs buying pressure at that level.
By identifying these levels, we can place our credit spreads beyond the support and resistance areas. This increases our probability of success by allowing more room for the market to move within our defined range.
For example, if an asset is oversold and we’re looking to put on a put spread, we want to place it below the support area. This way, if the support holds, the market may start moving up, resulting in profits for our put spread.
Similarly, if an asset is overbought and we’re looking to put on a call spread, we want to place it above the resistance area. If the resistance holds, the market may start moving down, resulting in profits for our call spread.
Identifying support and resistance levels is a key aspect of technical analysis and can greatly enhance our credit spread trading strategy.
Determining Days Until Options Expire (DTE)
The number of days until options expire, also known as DTE, is an important factor to consider when trading credit spreads. Research suggests that options with a DTE of 45 days or more have a statistical edge.
To understand why, let’s take a look at a study conducted by the Tastytrade team. They compared the expected move of options to the realized move over different time frames. The expected move represents the price range the market is expected to stay within, while the realized move represents the actual price range.
The study revealed that options with a DTE of 45 days or more had an expected move that was larger than the realized move. This means that the market tended to stay within the expected range more often than not during this time frame.
On the other hand, options with a DTE of less than 45 days did not show a consistent statistical edge. The expected move was either smaller or similar to the realized move, indicating that the market was less predictable during these shorter time frames.
Based on this research, it’s recommended to focus on options with a DTE of 45 days or more when trading credit spreads. These options offer a higher probability of success as the market is more likely to stay within the expected range.
By choosing options with a longer DTE, we increase our chances of profiting from the time decay of options and allow more time for the market to move in our favor.
Determining Strike Price of Short Leg
Determining the strike price of the short leg is another important step in executing a successful credit spread. The strike price of the short leg will depend on whether we’re placing a put spread or a call spread.
For put spreads, the short leg strike price should be placed below the support area. This ensures that we have a wider range of profitability if the market stays above the support level. By placing the short leg below the support, we give ourselves a buffer in case of a potential market reversal.
On the other hand, for call spreads, the short leg strike price should be placed above the resistance area. This allows for a wider range of profitability if the market stays below the resistance level. Placing the short leg above the resistance ensures that we have room for the market to potentially reverse and move in our favor.
The strike price of the short leg plays a crucial role in managing risk and maximizing profitability. It allows us to define our range of profitability and ensures that our spread is well-positioned for potential market movements.
Capital Allocation and Risk Management
Managing capital allocation and risk is a crucial aspect of trading credit spreads. It helps protect our trading account and ensures that we have enough capital to take advantage of future trading opportunities.
Determining the spread width is one way to manage risk and allocate capital effectively. The spread width refers to the difference between the strike prices of the long and short legs of the credit spread.
When it comes to spread width, it’s generally recommended to prefer wider spreads over narrower ones. Wider spreads provide more protection and allow for a wider range of profitability. This is especially important in highly volatile markets where price swings can be significant.
By opting for wider spreads, we reduce the chances of blowing through our spread and incurring larger losses. It also gives us more room for the market to move within our defined range, increasing the probability of success.
Risk management also involves determining the maximum risk per trade. This refers to the maximum amount of capital we are willing to risk on a single credit spread trade. By setting a maximum risk, we ensure that we don’t overexpose ourselves to potential losses.
Overall, capital allocation and risk management are essential components of a successful credit spread trading strategy. They help us protect our capital, maximize profitability, and increase the probability of success.
Entering the Trade
Now that we have built our watchlist, identified oversold or overbought conditions, determined support and resistance levels, and selected our strike prices, it’s time to enter the trade.
One common way to enter a credit spread trade is by using a limit order. A limit order allows us to specify the maximum price we are willing to pay or the minimum credit we want to receive. This helps us control our entry price and ensures that we don’t overpay for our spread.
If the limit order is not immediately filled, it’s important to be patient and wait for the price to reach our desired entry point. However, if the price doesn’t reach our limit order, we may need to adjust our price if necessary.
To lower the credit price, we can use a technique called price discovery. Price discovery involves gradually lowering our credit price until we find a willing buyer or seller at our desired entry point. This allows us to potentially fill our order at a more favorable price.
Entering the trade at the right price is crucial for maximizing profitability and managing risk. By using limit orders and price discovery, we can ensure that we enter the trade with a favorable risk-reward ratio.
Exit Strategies
After entering the trade, it’s important to have clear exit strategies in place. There are several ways to exit a credit spread trade, and each has its own benefits and drawbacks.
One common exit strategy is a fixed take profit. This involves setting a predetermined profit target based on a specific percentage of the credit received. For example, we may decide to close the trade when we have achieved 50% of the maximum potential profit.
Another exit strategy is to exit the trade at 21 days to expiration (DTE). This is based on the concept that options decay rapidly in the final weeks before expiration. By closing the trade at 21 DTE, we reduce the risk of holding the options until expiration and potentially being assigned.
A third option is to combine both exit strategies. This involves taking partial profits at the fixed take profit level and closing the remaining position at 21 DTE. This strategy allows us to lock in some profits while still taking advantage of the time decay in the options.
Each exit strategy has its own benefits and drawbacks. For example, a fixed take profit allows for a clear profit target, but it may result in exiting the trade too early and missing out on potential additional gains. On the other hand, exiting at 21 DTE reduces the risk of early assignment but may result in more random profits and losses.
It’s important to carefully consider your trading style and risk tolerance when choosing an exit strategy. There is no clear “better” option, as each has its pros and cons. It may be helpful to backtest different exit strategies and analyze their performance to determine which one works best for you.
Focus on Risk Management
Throughout the credit spread trading process, it’s crucial to maintain a focus on risk management. Managing risk is an ongoing practice that should be integrated into every aspect of your trading plan.
One key aspect of risk management is managing the maximum risk per trade. This involves determining the maximum amount of capital you are willing to risk on a single credit spread trade. By setting a maximum risk, you ensure that a single trade does not have a significant impact on your overall trading account.
Choosing the appropriate exit strategy is another important risk management consideration. You can base your exit strategy on either profit or time. For example, you may choose to exit the trade when you have achieved a certain percentage of profit or when a certain number of days have passed.
It’s also important to regularly review and analyze your trading data to identify any patterns or trends that can help improve your risk management. By analyzing your trading performance, you can identify areas of improvement and make necessary adjustments to your strategy.
Risk management should be a top priority for any trader, as it helps protect your capital and ensures long-term success. By implementing risk management techniques, you can minimize losses and maximize profitability in your credit spread trading.
In conclusion, building a watchlist, identifying oversold or overbought conditions, determining support and resistance levels, and managing risk are all crucial steps in executing a successful credit spread trading plan. By following a comprehensive and well-thought-out strategy, you can increase your chances of success and achieve consistent profitability in your trading.