Using Delta to Help a Credit Spread

Using Delta to Help a Credit Spread

When you think about selling a vertical credit spread as an option trader, probably the first thing you think of is positive theta. Of course that is a very important aspect to a potential profit. But there is another Greek that can get you to your profit destination quicker than even theta sometimes and that is delta.

There are two types of vertical credit spreads: put and call. Selling a call credit spread, an option trader believes the stock will stay below a certain area like resistance for maximum profit. Trade is initiated by selling a call and buying a higher strike call with the same expiration. A put credit spread is created by selling a put and buying a lower strike put with the same expiration. The option trader believes the stock will stay above a certain level like support for maximum profit. Let’s look at a made-up example and how theta and delta can contribute to your profit.

Suppose an option trader expects the stock to stay below $165 by expiration in 10 days. He sells the 165 call and buys the 170 call (see below).

The maximum profit on the trade is the credit received. In this case it is $0.71 (1.02 – 0.31) for $71 in real terms if the stock closes at $165 or below at expiration. The positive theta on the trade is approximately 0.055 (0.1112 – 0.0565) a day. That means for every day that passes, the spread’s premium will decline by the theta amount. Not bad, right? But look at the negative delta on the trade. It is approximately -0.165 (0.2612 – 0.0959). That means if the stock does move $1 lower and further from the 165 short call strike, the spread’s premium will decrease by that amount.

So, think of it this way: If the stock fell $2 over 2 days, the premium would decline $0.11 (0.055 X 2) from theta and a whopping $0.33 (0.165 X 2) from theta. Starting out with a credit of $0.71 and keeping all other variables constant the new premium would be $0.27 (0.71 – 0.11 – 0.33). A profit could be made of $0.44 for $44 in real money.

Theta is very important when it comes to potential profit when trading vertical credit spreads. But a correct move away from the short option can make you a whole lot more profitable and sooner because of delta.

John Kmiecik, Market Taker Mentoring

Trader Education