When Should I Close Credit Spread Trades?
You can get stock tips from your neighbor, your dentist, even your cab driver! But can any of these people tell you when to sell your investments? Knowing when to exit a position is every bit as important as understanding what to invest in. And today, we’re going to talk about when (and how) to close credit spread trades.
Editor’s Note: This is part five of a multi-part series on credit option spreads. See also:
- Part I – Credit Option Spreads: Great Tools for Income Investors
- Part II – Bull Put Spreads: Income from Stocks Moving Higher
- Part III – Bear Call Spreads: Profit From Stocks Trading Lower
- Part IV – Spread Trade Permission: A Must for Income Investors
Stay tuned for more great credit spread content to come!
Three Reasons To Close Credit Spread Trades
When you invest in shares of a stock, you’re immediately met with a new challenge: Under what circumstances should you sell your investment? Should you lock in profits if the stock trades higher? Should you cut your losses if it trades lower? This is a grey area that many investors — even professional investors — never master.
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I like the fact that credit spreads always have a limited time frame. At some point, the trade will disappear from my account. This is because the option contracts have a limited time horizon.
Most of the time, I allow my credit spread trades to expire. My winning trades capture the maximum expected gain when the underlying stock moves in my favor. And if the stock moves against me, My trade will typically be closed out for a limited loss.
But occasionally, I do close out my spread trades early. There are basically three potential reasons for this:
- I may close credit spread trades to lock in profits.
- I may close credit spread trades to reduce potential loss.
- I may close credit spread trades to avoid a stock position.
Let’s take a closer look at each of these scenarios.
When to Close Credit Spread Trades For Profits
You set up a credit spread trade, and everything worked out the way you planned. Hooraaaayyy!!
But now what??
You could wait for your option contracts to expire. And in many cases, this is the best option. Why pay your broker a commission to close out a trade. After all, when your option contracts expire, you’ll realize the maximum profit and the trade will be complete.
Still, there are two reasons you might want to go ahead and close your trade:
1) Opportunity Cost
When you set up a spread trade, a certain amount of cash in your account is set aside. This is to cover the risk of the trade moving against you. That cash could be used for other opportunities.
So in some cases, it makes sense to close out a credit spread trade at a profit, just to free up that cash for another opportunity.
2) Managing Risk
Often when a stock moves in your favor, you wind up with the following scenario:
You have the opportunity to close your trade and book 90% of your expected profit. And your risk is giving up all of this profit, and potentially accepting a loss if the stock reverses.
In this case, the risk of losing your profit may far exceed the incremental profit you stand to gain from letting your position expire. So in this scenario, it often makes perfect sense to pay a small commission to go ahead and close your spread trade.
Keep in mind, when you close credit spread trades early, you won’t be realizing the maximum possible profit. But you’ll still be capturing most of the profit you were expecting.
And if you close your trade early, you’ll free up cash for other opportunities, and eliminate the risk of giving this profit back.
When to Close Credit Spread Trades For a Loss
Not every trade will work out as planned. That’s just the way investing works.
One of the beauties of credit spread trades is that your potential loss is limited. No matter how far the underlying stock moves against you, you won’t lose more than your planned amount.
Still, sometimes it makes sense to close credit spread trades early.
Think about this decision from a statistical perspective…
If your stock has moved against you, you may be down $150 per contract. Your maximum loss for the trade may be $200 per contract. So if you allow the trade to expire, you’ll lose an additional $50 per contract.
Now, what is the statistical probability that the stock will reverse? How much would you gain if the stock traded higher?
Let’s say you estimate there is a 10% chance that your trade will reverse. In this case, you expect to make back your $150 decline and actually book a $150 gain. So your position would improve by a total of $300.
Of course, the other side of this coin states that there is a 90% chance you will lose $50 if you stay in the trade.
in this case, you’re better off statistically to close the trade and forego the potential profits if the stock reverses. You would never risk $50 to have a 10% chance of making $300. That scenario would lose money over the long-run.
Statistically speaking, you should close credit spread trades for a loss if you can take a smaller loss than planned. But only if your probability of a rebound is very small.
When to Close Credit Spread Trades to Avoid a Position
If you enter a credit spread trade and the stock closes between your two strike prices, you’ll be required to buy or sell shares of stock at the higher strike price.
This is because you sold an option contract that is ultimately exercised. (However you will not exercise the put you bought. That’s because the other contract is set to expire “out-of-the-money.”)
If you do not want to take a position in the stock, then you must close out the “in-the-money” contract that you sold when entering the spread trade.
For bull put spreads, you must buy back the put contract with a higher strike price that you sold. For bear call spreads, you must buy back the call contract with a lower strike price.
This way, you won’t buy or sell shares of stock.
You could either take a gain or a loss when you close spread trades this way. In almost every case, the loss will be less than your maximum expected loss (from when you set up the trade). Or your gain will be less than the maximum expected profit (from when you set up the trade).
As a general rule, I like to allow my credit spread trades to expire naturally. That way I don’t have to pay commission costs to close out these trades. But as you can see, sometimes it makes sense to proactively close these trades and move on to the next opportunity.
Next, we’ll talk about the practical side of executing a spread trade. So be on the lookout for the next credit spread trade article!