Warrior Trading Blog

How to Trade Like A Casino: An Introduction to Credit Spreads

Credit Spreads

How to Trade Like A Casino: An Introduction to Credit Spreads

Modern casinos have one of the simplest yet most brilliant business models in the contemporary business world: for every dollar that is wagered in the casino, they are likely to win $1.05 back.

While they will not win every gamble, averaged over millions of wagers the ‘house edge’ guarantees this approximate rate of return based on the precisely engineered balance of odds and payouts that underpin every game on the casino floor.

Take a simple game of roulette, for example. The gambler has a 1 in 38 chance of guessing the right number on a spin of the roulette wheel. So the payout should be $38, or more, for a correct guess, right? Wrong. The payout for correctly guessing the number on a spin of the roulette wheel is $36. This is the house edge, and this is why, in the end, the house always wins.

So how can you set up your trades to ensure that you have your own house edge?

Credit Spreads

The most popular method of trading like the house of a casino is to use credit spreads. Credit spreads involve the simultaneous purchase and sale of two options contracts, either both calls or both puts, with the same expiration date but a different strike price.

The idea behind a credit spread is you are looking to capture the net credit you bring in from opening the position. The option you sell is going to be at a higher strike price or closer to the money than the option you purchase, resulting in a credit for the trade. If both strikes expire out of the money (options will be worthless) then you will get to keep the credit. Your max loss is the difference between the strikes plus commissions.

The reason this trade is in your favor is theta, or time. As the trade gets closer and closer to its expiration your options will start to experience time decay which decreases the value of the options and this is exactly what you want! So, even if the underlying stays at the same price or even slightly against the way you want it to go, you will profit.

For credit spreads with calls you want the underlying to stay at or below your highest strike price while with puts you want the underlying to stay at or above your highest strike price. However, like I said before, the underlying can actually move against you but you can still profit because of time decay.

Credit spreads is a high probability income based strategy that caps your gains but also minimizes your risk. Basically you are just letting time take its toll on your option premiums while you sit back and collect on expiration day.

Trading Like the House

The actual pricing of options is based on incredibly complex mathematical models that use past prices to determines the likelihood of any specific strike price on any specific future date.

While any retail trader is unlikely to be able to outsmart the highly sophisticated institutional trading programs that dominate the derivatives industry, and identify any undervalued (or overvalued) options contracts, this does offer a sense of security that the values you are trading represent a near universal consensus given the existing available information (the historical price data).

Since most retail traders don’t have access to highly sophisticated software, you can look at using credit spreads as a way to gain an edge by using time decay. You can even sharpen that edge by adding other parameters like selling credit spreads when a stock gets really extended or waiting for implied volatility to spike before opening a credit spread.


Final Thought

Credit spreads, although they aren’t as fun as smashing a momentum trade in a couple minutes or seconds, can provide consistent income over time, which is exactly what Vegas looks to do; take base hits on high probability outcomes and collect.