Credit Spread Screening – How to Identify the Best Credit Spreads
Tips for Final Credit Spread Candidate Screening
Credit spread screening should not be a seat-of-the-pants exercise.
When we are screening potential credit spreads for income investing, our task goes far beyond finding the spreads with the greatest net premium. At least the investor better look beyond the absolute amount of premium available; if not, he or she is more likely to end up with losses rather than income over the long run.
As with all investment instruments, the “best” candidates for a successful credit spread trade involve balancing on a three-legged stool, the “legs” being risk, reward, and probability. Our proprietary credit spread screening process must accommodate all three variables, as would any sensible approach to identifying the best credit spread candidates from among the thousands of possibilities.
Whether you use “The Monthly Income Machine” technique for identifying and managing credit spread trades each month, or some other objective, rules-based approach for selecting trades, there will be times when you identify a relatively large number of credit spread candidates that conform to your entry rules. Essentially, you are faced with an “embarrassment of riches.”
When multiple credit spread candidates all meet our trade entry rules with respect to risk, reward, and probability, we surely can find a better solution than flipping a coin in order to narrow the choices down to the best-of-the-best.
Narrowing Down the “Conformings” List
The “Monthly Income Machine” technique we use involves a series of specific numerical values for trade entry criteria that must be met for the credit spread to be considered. If a potential credit spread meets ALL the entry rules when being evaluated, it joins the “conformings list.”
The entry criteria rules involve the three legs of the stool enumerated earlier: risk, reward, probability. Some of the criteria the income investor should be evaluating include (but are not limited to):
- Minimum acceptable distance of the credit spread option strike prices from the current price of the underlying stock, ETF, etc. = a critical risk control variable;
- Minimum acceptable net premium collected up front on the credit spread = a reward control variable;
- Delta value (a measure of the probability of the option expiring in-the-money) = a probability control variable involving volatility.
But once we have a list of credit spread candidates that meet these and the rest of our specific entry criteria, the question of which are the most promising candidates arises… which are the “best of the best” so to speak.
A. Support/Resistance Refinement
- Consider favoring those “conforming” bull put spreads where the desired risk control stop out point is slightly below a chart support level. Similarly, there may be an extra benefit to a bear call spread when the desired stop protection is slightly above a chart resistance point.
- The benefit of this consideration is that if support or resistance is substantially breached, it often signifies a trend change thus may signal exiting from the bull put spread if support is surpassed, or from a bear call spread if resistance is taken out.
B. Diversification Refinement
- Credit Spreads are considered essentially non-directional (you can prosper no matter which way the underlying moves, so long as it doesn’t move too far in an adverse direction). Because they are typically non-directional instruments, there is not the same strong case for diversification that could be made for a portfolio of stocks.
- That said, the investor may well reason – correctly – that in the event the overall market makes a sudden very large move up (or more likely, down), it would be helpful to have some of his working credit spreads be bull spreads and some bear spreads, rather than having all of the spreads be of one type going the wrong way.
C. Interval Between Strike Prices of Spread Refinement
- When establishing a credit spread, the greater the interval between the long and the short strike price options of the credit spread, the greater the net premium will typically be.
- However, the wider interval between long and short strike price, the greater will be the negative impact of an adverse move.
- Thus, choosing between conforming ABC spread with the strike prices $5 apart, and conforming DEF spread whose strike prices are $10 apart, gives the investor the opportunity to select based upon where he is most comfortable along the risk-reward spectrum. If his focus is more heavily on minimizing risk, he may opt for ABC; if he’s focused more on reward, the DEF spread may be the more appealing choice between the two conforming candidates.
D. Overbought/Oversold Refinement
- This can be quite helpful in enabling an investor to choose his credit spread from a series of candidates that all meet his basic entry requirements. The rationale is to favor a particular bull put spreads when its underlying is clearly oversold and a bear call spread when the underlying is significantly overbought. (see also white paper: https://safertrader.com/overbought-oversold-markets-how-to-recognize-and-profit-from-them/.)
- There are several methods for identifying when a stock, ETF or Index is overbought or oversold. Again, the technique I favor for measuring overbought/oversold is discussed
E. Rate of Return on Margin Refinement
- The purpose of a credit spread is to provide the investor with a net premium that will be his income return on the trade. The absolute amount of that net premium is dependent on several factors – how close the strike prices are to the underlying when the spread is established, how volatile the underlying is, how near to expiration the options are, etc.
- In choosing among a series of credit spread candidates that all fully conform to your entry rules, you may want to further refine your choices by favoring those with the higher “return on margin.”
- Thus, if ABC options credit spread expiring in 24 days is offering a $42 net premium with a margin requirement of $500, and DEF option credit spread with the same expiration date offers $72 net premium, but requires $1,000 margin, by simple arithmetic the ABC spread that provides only $42 is offering the better return on margin employed, i.e. has a higher potential profit margin.
F. Stock Market Seasonality Refinement
- While option credit spreads are essentially non-directional, they are not absolutely so; an extended adverse move can threaten a credit spread’s profitability.
- Accordingly, the investor can include seasonal market trends in his final selections from a group of otherwise conforming bull put and bear call credit spread candidates.
- Historically (1929-2011), April, July, and December have been the strongest months for the Dow-Jones. These months have produced an average of 1.4 to 1.5% gains.
- Over the 1929-2011 period, September – with an average decline of 1.3% – has been the weakest month.
- While the average yearly gain has been 6.55%, a very strong difference emerges between broadly defined winter (November -April) and summer (May-Oct). “Winter” averages 5.2% growth; “summer” gains only 1.28% on average.
- As with any “statistical result, these seasonal tendencies may be useful in paring down a group of good candidates, but they cannot be depended upon blindly. There are plenty of exceptions to the general monthly average results.
G. Bid/Ask Spread (liquidity) Refinement
- The bid/ask spread is significant to all investors – especially those contemplating larger orders.
- Spreads tend to be substantially wider when the option has lesser trading volume and lesser open interest.
- Wide spreads between bid and ask prices are unfavorable because “slippage” due to the wide bid/ask spread impacts fill prices whether entering or exiting a trade.
- Accordingly, the investor may favor the more liquid conforming options over those less frequently traded and/or having relatively little open interest.
- As noted, this can become a major consideration in choosing among conformings when the investor is seeking to establish a relatively large position in a particular conforming credit spread.
Credit Spread Screening Conclusion
Just as monthly credit spread screening can – and I believe should – be an organized, disciplined, objective exercise in identifying potential credit spreads that conform to the investor’s screening criteria, we can employ a more rigorous approach than simple “hunches” in determining which of a series of conforming trade possibilities we will commit to with orders.
Examples of criteria that can be employed in pinpointing the “best-of-the-best” among those credit spread candidates that already meet the investor’s basic selection rules are considerations of:
- Interval between strike prices of the credit spread
- Rate of Return on margin
- Liquidity (bid/ask spread)
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P.S. Here are other SaferTrader “white paper” articles that also involve credit spread selection: