Credit Spreads by Angelo Campione

If you could find a way to make money through the markets without having to second-guess which direction the markets were heading in and, without the stress of watching the market going through their daily gyrations, would you be interested?

If so, then credit spreads are a strategy worth considering.

Before we get into the mechanics of credit spreads, it’s good to have an understanding of how the mind works. The fundamental purpose of our mind is to keep us safe and to survive. It’s constantly assessing the environment for possible dangers and based on prior experiences, it’ll direct us to take certain action. Logic and emotion are the domains that dominate this area, with emotion, in most cases, having the greater power of the two when things get heated.

When it comes to trading, things tend to get heated quite a bit and that’s when we can find ourselves on an emotional roller coaster between gains and losses. It’s a hell of a ride. The end result is that we usually lose money due to the fear of making a loss or the greed of wanting more and then, we usually feel bad, depressed or angry about the loss. The reason for why we do this is generally because we have a need to be “right” and a fear of being “wrong”. From a young age most of us learn that if we make a mistake, we’re either “bad” or “wrong”. We learn to hate feeling this way because it brings up the inadequacy we felt as children, which fundamentally goes against our true nature. Ironically, our focus on the fear of losing money generally has the loss show up.

Over the years, this need to be “right” has certainly worked against me. If I’ve been in a trade that’s going well, I’ve thought, “it looks like the market is going to reverse soon, I better jump out and take the profit while I can”, only to see that if I had stuck to my strategy I would have made much more. This rationale is used to cover up the fear of being wrong, fuelled by the need to be right.

Alternatively, if I’ve been in a trade that has gone against me and it hits my mental stop loss, I’ve thought, “it shouldn’t go much lower so I’ll get out when it gets back to my breakeven point”, only to see it continue to sink and lose a greater amount. In many cases the need to be right covers up the fear of being wrong. This is painful, emotionally draining and a very powerless position to be in because you end up relying on hope. The moment you catch yourself hoping, you’re gone, you may as well be in a casino.

Once you’ve incurred a certain amount of losses, one of several things will happen. You’ll either stop trading, look for alternative strategies or analyze yourself and adjust course. In my case, after all three at some stage, I found that the style of trading where I needed the markets to move in a certain direction wasn’t suited to me, this realization only came when I began trading credit spreads. I was no longer constantly concerned about the direction of the market on a day-to-day basis, all that was needed, was for time to pass and I felt great knowing that the market had plenty of room to move without my position being in danger. The anxiety I had felt with other styles of trading was gone.

So what are the mechanics of credit spreads?

Credit spreads involve options, specifically, the simultaneous purchase of one option and sale of another (for the same underlying asset). In the Advantage Credit Spreads service, we use the S&P500 index. An example of a credit spread would be with the SPX now at around 1500, we may sell an October put option at 1350 and at the same time buy an October put option at 1340. As the sold put option at 1350 is closer to the market than the bought one at 1340, it’s more valuable and we may receive a premium of say $60 per spread for the difference in value between the two strikes. As long as the market closes above the sold option point (1350) by the time it expires, we simply keep the premium we received and do it all again the next month. When you do these spreads, your broker will require that you maintain a certain amount of money in your account that will be held as margin, this margin is to cover the broker for a worst-case scenario occurring.

The key behind this strategy is that an assessment needs to be made on what the probabilities are of the market moving within a defined range between now and expiry and this is the tough part. This is also the reason I don’t recommend that you embark on this alone. When used correctly this strategy can provide a hedge against your other assets.

In terms of performance, in the above example $60 represents a return of 6% for a month, if this sort of performance doesn’t impress you, take a look at this link on how it accumulates when you allow it to compound: Performance. Specifically, note the starting bank amount compared to the latest bank balance, that’s the power of compounding and these figures also have commissions taken out and therefore represent the net amount in your pocket.

If you like the sound of this strategy, I highly recommend you take up the no cost trials that some services offer and get a feel for which service feels right for you, also during that trial you’ll get a greater appreciation for the benefits of the strategy.

Cheers,

Angelo Campione