I really like the butterfly trade that I've been trading a while, but it's a complex position that sometimes requires a number of adjustments. I like the ability to adjust it and control risk each day, but not everyone wants a trade that takes so long to unfold or requires at least some knowledge of trading by the Greeks.

On the Couch Potato Portion of the site, for example, Dot Hazlin often sets up credit spreads on the weeklies. She might sell a call credit spread if the SPX is below the 20-day moving average and sell a put credit spread if the SPX is above that moving average.

Why does she do that? Why does she choose a moving average as the benchmark? And, why does she suggest selling a credit spread for what is a directional trade, rather than simply buying a long call or a long put?

I can't speak for Dot, of course, but back in 2008, I wrote a Trader's Corner article titled It's Not Rocket Science. The gist of the article was that would-be directional traders might pick a key moving average or trendline and use it as a benchmark for entering bullish or bearish trades. For example, let's look at the OEX with relationship to its 20-ema. Remember that my articles are roughed out and charts snapped a number of weeks before publication. Prices are not current.

OEX, Daily, with 20-EMA:

I chose the OEX for the illustrations because not as many of us watch the OEX closely these days as used to watch it. We might be more objective when looking at the chart. Often in my Wraps, I comment on rally or other patterns. The OEX, like the SPX, tends to establish a rally pattern in which it's bouncing from a rising moving average. Clearly, when it's behaving that way, a bullish trade is in order, and selling a put credit spread is a bullish trade.

I often note in my Wraps when that rally pattern is changing. It tends to change in one of two ways. Either a decline is sharp and soon well established, with daily candles hanging underneath a declining key moving average, or else price action undergoes a period of disorganization. When it's disorganized, daily candles tend to chop back and forth across that key moving average, often flattening the moving average and rendering it useless as a benchmark for the time being.

When prices barrel lower, with daily candles hanging from a descending moving average, it's clearly time for bearish trades. A sold call credit spread would be one type of bearish trade. However, it's that other possibility--the disorganized chopping back and forth across the moving average--that would cause problems for the directional trader.

Or would that be true if the directional trade was a sold credit spread?

There's a reason that Dot and others sometime choose credit spreads (and, sometimes, for some traders, debit spreads) over a long call or put purchase. The spread can benefit from choppy movement, too, as long as the chop is contained and not wildly volatile.

On the first chart, an arrow points to the period from mid-July to mid-August when the OEX was chopping to either side of the 20-ema. By Thursday, August 1, the OEX had spent several days with closes beneath the 20-ema, but Thursday itself, price had closed back above the 20-ema. A trader planning a directional trade that morning and employing the 20-ema as a benchmark might have chosen to sell a put credit spread the next morning. An OEX trader wouldn't have found the amount of premium that Dot recommends for a credit spread with the sold put having a delta near -15. I'm not suggesting that traders employ the OEX (or, rather, the European-style OEX-based XEO options) for this purpose without backtesting it first. I'm simply employing the OEX for this article to illustrate how a credit spread behaves differently than a long call or put.

With the OEX at 762.75 on Friday morning, August 2, a trader could theoretically have sold a weekly 09 AUG 13 750/740 XEO put credit spread for $67.50 minus commissions.

OEX Put Credit Spread:

For reference, our hypothetical trader could have theoretically bought an ITM long 09 AUG 13 755 XEO call for $8.50 at the same time. That call would have had a delta of 84.26. When I was trading directionally with long calls or puts, I preferred options with deltas that had an absolute value at or above 70, so they at least moved somewhat in concert with the underlying's price action.

That day, Friday, August 2, the OEX continued higher after the trade entry, climbing to a close of 765.70 before beginning a several-day drop that was going to take it back below that 20-ema. Yet, if the price movement is not too big, the credit spread seller can still profit. Price action doesn't have to go in the "right" direction in order to profit: it just can't go too far in the wrong direction. Did it go too far in the wrong direction this time?

Although the OEX headed down off of Friday's closing high, by early morning, Monday, August 5, the bullish credit-spread trade showed a theoretical profit of $42.50, including round-trip commissions.

Theoretical Position as of 9:40 am ET, Monday, August 5:

What was the 09 Aug 13 755 call worth when the credit spread reached that profit? Remember that the OEX had continued higher Friday afternoon, after entry, so that Monday's pullback hadn't yet taken the OEX back below the entry point. The mid-point of the call's price was $10.05. The call had benefitted from further gains on Friday, after the call was priced that Friday morning, and that benefit had overcome any weekend-related time decay. By Tuesday morning, however, with the sold credit spread still showing a profit, although a lesser profit, the 755 call's value had begun dipping well beneath the entry price. By 10:30 that Tuesday morning, the 755 sported a midprice of only $5.60, a 34 percent loss of the original $8.50 value, while the sold credit spread still showed a $12.50 profit after commissions both ways.

Especially if a trader fails to practice sound trade management of the type Dot always counsels or if a Flash Crash type situation hits, it's possible to lose big when selling credit spreads. The credit spread mentioned could have lost far more than the potential income it brings in, as is made visible in both the expiration and "today" profit-and-loss lines to the left side of the chart. However, over a short adverse price movement, the credit spread can produce profit. The long call or put depends price movement in the right direction that is sharp enough to overcome the option's decay. Obviously, the long put or call has the potential to make more money than a spread, with the spread's capped profit. However, that long call or put is not going to make money if there's any adverse movement from the entry price and is even going to lose money if it doesn't move far enough in the right direction to pay for the time decay of the extrinsic value in the option's price.

Choosing a bearish/bullish benchmark such as a moving average or trendline isn't rocket science, but it can be a reliable trade decision-maker that is worth backtesting. You may want to add it to your trading repertoire if you like the results. Be sure to check Dot's suggestions and results, too, including her suggestions for trade management. Those suggestions often include a decision not to enter short-term directional trades when uncertainty appears high.

Whatever your decision, trade management can't be ignored, ever, when selling credit spreads. That trade management should always include a long consideration of the size of the trade. I'm an old fuddy duddy who believes that what "can't" happen will indeed sometimes happen. That's likely one of the reasons that Dot keeps her suggested trade size small. Keep the risk--the maximum that it's possible to lose and not just what you plan as your maximum loss--in mind when employing credit spreads. Never let that amount be more than you can afford to lose and still keep trading.

Linda Piazza

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