What it is
A credit-spread sells one option and buys a further out-of-the-money option in the same expiration, collecting a net credit with a capped maximum loss equal to the width of the strikes minus the credit. A credit spread program is the systematic version: the same delta, the same duration, the same management rules, every cycle, on a small set of liquid underlyings, so that the results are measurable. This article is about the program, because the individual trade is simple and the program is where people fail.
The logic
The program collects the volatility risk premium in defined-risk form. Selling a 0.15-delta put spread is, loosely, being paid to take a bet with an 85 percent chance of expiring worthless; the price of the spread reflects implied volatility, which has on average exceeded realised volatility. The long option caps the loss so that a single bad month cannot end the program.
The other side is hedgers buying out-of-the-money puts and speculators buying out-of-the-money calls. They are paying for tail protection or tail upside. Most of the time the tail does not arrive; when it does, they are paid handsomely from your maximum loss, which is why the program's sizing rule is everything.
Setup rules
- Market: broad index ETFs and index options first (cash settlement, section-1256 tax treatment for index options in the US, no early assignment risk on European-style contracts); large-cap stocks second.
- Timeframe: 30 to 45 days to expiration; open a new spread each week so that the program has staggered expirations.
- Strike selection: short strike at 0.10 to 0.20 delta; width 5 to 10 points on an index ETF, wider on high-priced underlyings; credit at least one third of the width (so maximum loss is at most 2x the credit).
- IV condition: iv-rank above 25; the program is paused when IV is very low, because the credit is too small to justify the tail.
- Direction: put spreads by default in an index above its 50-day average; call spreads only in a confirmed downtrend or at resistance; both together is an iron-condor-high-iv.
- Event rule: no short strike expiring within 5 days after a scheduled fomc or cpi release unless the trade was sized for it.
Entry, stop, target
Sell to open for a credit. Profit target: buy to close at 50 percent of the credit. Loss rule: buy to close when the spread's value reaches 2x the credit received (a loss equal to the credit), or when the short strike is touched, whichever comes first. Time rule: close anything still open at 21 days to expiration to avoid gamma risk.
| Item | Value | Notes |
|---|---|---|
| Index ETF price | 450.00 | |
| Spread | Sell 430 put, buy 425 put, 38 days | Short delta 0.15 |
| Credit | 1.65 per share ($165 per spread) | Width 5.00 |
| Maximum loss | 3.35 per share ($335) | Width minus credit |
| Profit target | Close at 0.82 ($83 gain) | 50 percent of credit |
| Loss close | Close at 3.30 (loss of $165) | 2x credit |
| Approximate R:R | Risk $165 to make $83, about 0.5R | Needs a 70 percent or higher win rate to profit |
The R:R is below one by design; the program lives or dies on its win-rate, and the mechanical loss rule is what stops the rare maximum loss from eating a year of credits.
Position sizing and risk
Size every spread by its maximum loss, not by its credit or its margin. If your risk budget is 1 percent of equity per trade, the number of spreads is that budget divided by the maximum loss per spread ($335 in the example). Use /tools/position-size with the maximum loss as the stop distance. Keep the total maximum loss across all open spreads under the portfolio heat cap in /learn/risk-management, and remember that all your put spreads on the same index are one trade in a crash.
What breaks it
- Tail events. A 10 percent index drop in a week takes every open put spread to maximum loss simultaneously. The loss rule limits each spread to the credit, but only if you can execute it, and in a crash the spread's price gaps past your close level.
- Negative expectancy after costs. With a 0.5R payoff and a 75 percent win rate, the gross expectancy is small; two-legged commissions and spread crossing on entry and exit can turn it negative. Index options with penny-wide markets are the only place the arithmetic clearly works.
- Volatility regime. Programs started in high-IV regimes look brilliant; the same rules in low-IV regimes have thin credits and the same tails.
- Edge decay. The volatility premium in index options has compressed as short-volatility strategies have grown; the 2010s "sell puts and collect" results are not a forecast.
- Discipline. Not closing at 2x credit because "it will come back" is the single most common way credit-spread traders lose a year in a month.
How to test it
Use historical option chain data if you can afford it; otherwise approximate with a pricing model fed by the underlying's implied volatility index. Simulate the program for 15 or more years with your exact rules, and report win rate, average win and loss in dollars, expectancy per spread, profit-factor and the worst month. Then remove the loss rule and re-run to see what discipline is worth. Then double the costs to see how fragile the edge is. Paper-trade for 3 months with one spread a week before going live, and go live at one spread per week for another 3 months. See expectancy-system-evaluation and walk-forward-testing.
Variations
- Iron condor combining put and call spreads; see iron-condor-high-iv.
- Broken-wing butterfly that skews the risk to one side for a smaller or zero debit.
- Debit spreads on the same strikes as a directional bet rather than a premium-collection bet; see debit-spread.
Further reading
credit-spread, vertical-spread, delta, gamma, theta, iv-rank, implied-volatility, section-1256, win-rate, expectancy.
Related playbooks: iron-condor-high-iv, the-wheel-strategy, earnings-iv-crush, expectancy-system-evaluation