The Problem with Income Trading

In the world of retail trading, selling credit spreads is a very popular strategy. Mostly, credit spreads are taught as so-called income trades. According to the gurus, income trades are “non-directional” trades–i.e., theta-driven positions that don’t really depend on the direction of the underlying.

Rather than trade based on where they think price will go, “income traders” use credit spreads to express their view on where price will not go. Those traders look for strong levels of support/resistance and then sell premium behind that level of support or resistance. The underlying can go wherever it wants–or go nowhere at all–as long as it doesn’t break that structural level.

In theory, this makes income trading simple and high-probability. Income traders typically sell vertical spreads far out of the money–with short strikes at delta 15 or even delta 10. Put on the trade, collect the credit, and let it ride. The spread has a 85-90% chance of finishing out of the money, in which case the trader doesn’t even have to close the position; just let it expire worthless. Teachers of “income trading” will often say the strategy has such a high probability of success that you can, essentially, decide how much money you want to withdraw from the market each week and just scale your trades accordingly. Sounds nice.

I traded credit spreads for quite a while and learned from some very good teachers. But I was always frustrated by a few aspects of the strategy and the way it was presented. I’m not claiming that OTM credit spread trading is illegitimate. I’m just sharing why this strategy didn’t work for me.

Selling premium is a powerful tool. It’s fundamental to the delta hedging approach we use here at Vega Options. But it’s a tool for specific jobs, not a one-size-fits-all strategy to bend the market to your will.

To understand how to sell premium more tactically , we first need to talk about all the reasons that the one-size-fits-all “income trading” thing may not be so great.

First, the risk/reward ratio from selling OTM premium is bad. Like, really bad. The farther out of the money you establish your position, the greater its likelihood of success. But nothing in the market is free. And the further out of the money you go, the less credit you will get for the position. And many gurus will say, “Yes, the r:r is bad, but we minimize the risk by selling short-dated spreads. So you only have to be right for 1-3 days.” Right, but you know what shortening the time to expiry does? It reduces the credit you’ll collect for that trade even more! Think about it. For you to sell a spread, somebody has to buy it. And if your spread has an 85% chance of success for you, that means it has an 85% chance of loss for your counterparty. How eager do you expect that counterparty to be to pay you for a position that is most likely a loser?

(For those of who you understand option skew, you’ll understand that part of the reason that credit spreads collect so little credit is that they are almost always misaligned with the skew. In other words, in terms of implied volatility, you will almost always be selling a cheaper option and buying a more expensive one.)

Here’s an example in $AAPL that is the sort of OTM credit spread I used to trade all the time. It’s a 5-wide put credit spread, 5 days to expiry, with the short strike positioned at delta-15. We’re collecting a $45 credit…and risking $445! This is why many traders call premium selling strategies “picking up pennies on the railroad tracks.”

Second, even though the strategy is marketed as non-directional, a credit spread is a directional trade. At the beginning, it is a very directional trade. That directionality lessons over the lifetime of the trade, but it never goes away. A move toward your short strike is never desirable.

Here’s that AAPL position again:

Most credit spread gurus would tell you this is a non-directional trade. “You have an 85% chance of collecting the full credit,” they’d say. “AAPL has to move over $8 before you even start to lose money.” Nonsense. In the real world, you don’t manage a trade according to the expiration graph. You manage it by the T+0 line. This spread starts out long nearly 10 delta. If AAPL moves toward your position, you will immediately lose $10 per point. Nondirectional? But there are even more problems lurking in those greeks.

Third, gamma! Gamma is the rate of change in delta per dollar move of the underlying. Gamma is what gives options “convexity.” When it’s working for you, it’s what creates explosive profits you can only get with options. But gamma cuts both ways. And with credit spreads, it cuts the wrong way. Let’s look at our AAPL example:

This trade is short 1.44 gamma. As we saw above, our position starts out long 9.34 delta. So if AAPL moves down $1, this position will lose $9.34 (delta). But if it moves down another dollar, we don’t lose another $9.34, we lose $9.34 + 1.44, or $10.78 (delta + gamma). And here’s the fun part, as the price of AAPL continues to drop, our short gamma increases, meaning that our delta will get exponentially longer. In the image above, I modeled a $4 drop in the stock from $140 to $136. You can see that we didn’t just lose 4x our initial delta ($37.36) or even 4x our initial delta+gamma ($43.12). Instead, we lost $51.60. And we’re now long almost 16 delta and short 1.66 gamma.

(A credit spread’s gamma also gets shorter as time passes, making the position “edgier” the closer you get to expiration, especially if the price of the underlying is near the short strike.)

Fourth, vega! OTM credit spreads are short vega. If volatility rises, your spread starts losing money. As we saw above, a $4 move against us early in our trade resulted in an open loss of $51.60. But imagine that drop in price happened quickly or on a morning gap down. In that case, volatility would rise. A lot. And that increase in volatility would add to our losses. If volatility were to rise 10% (a pretty realistic scenario) would increase our loss to $69.07. That’s 34% worse.

Fifth, bid/ask spreads. In the real world, the risk in your trade at any given moment is defined by what you could pay to buy it back. And that is determined by the bid/ask spread. If markets start moving fast, or there’s a major news announcement, or a gap open market makers will protect themselves by widening the bid/ask spread. $AAPL is a very liquid stock, and the bid/ask spread on its options is usually just a few pennies wide. But open with a gap down on major news, and that spread could be significantly wider. If you get stopped out and have to market-order out of your position, you’ll mostly likely have to pay to cross that spread. And when your best-case scenario in this trade was to make $0.45, paying to cross a wide bid/ask spread really hurts.

How are we feeling about this “non-directional” position right about now? The truth is, the example above is mild. It is very, very easy to lose many times the losses shown above on a position like this.

Obviously, income trading gurus need a way to address this. But they can’t tell you to stop out of the trade when your setup breaks down, because if they did that, then you’d be stopping out of trades as much as any other trader and your 85-90% win rate would disappear. And they can’t tell you to take profits too often because that will reduce your paltry credit even more. So they usually have rules about only stopping out if your open loss is 2x or 3x the value of the credit you earned on the position. And the more sophisticated teachers will have rules about not stopping out of positions that gap against you until a certain amount of time after the open, hoping the position will recover. Or they have elaborate rules about rolling or dollar-cost-averaging. All of these rules increase your win rate–and increase the cost of each loss.

Sixth, the inherent structure of credit spreads makes them difficult to hedge. And the adjustments you can do rarely make economic sense because the cost of the commissions for the adjustment really eat into that tiny credit you’re collecting.

If you take a 3x loss on a credit spread trade, you need to win the next three trades–for full credit–just to get back to where you started.

So those are the structural challenges with credit spreads. Those things don’t make credit spreads bad. They’re just characteristics of the position. My problem with income trading is that it tries to make trading “easy” and “predictable” by imposing a one-size-fits-all approach on the market. And doing that has some truly harmful side-effects.

The odd-based approach of income trading encourages traders to bargain with the market. Because their trades are “supposed to win” most of the time, income traders can end up holding onto losing positions way longer than they should, compounding their losses. If you trade both “non-directional” and directional setups, this mentality of negotiating with charts can really destroy your trading.

And because the credits collected for each trade are so small, it creates a powerful incentive to take irresponsibly large positions, in order to make the “income” you want.

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After all of this, you might think I hate credit spreads. I don’t! We use them all the time at Vega Options, though usually to hedge deltas in positions opened for a debit. But I also trade credit spreads outright sometimes. But when I do, I use them to respond to specific market conditions that leverage the unique benefits of a credit spread. And I treat the position like the directional trade that it is.

Questions?