Mastering Credit Spreads: A Step-by-Step Guide to Profitable Options Trading

In a market ruled by volatility, opportunities abound for those who know where to look. When options premiums are inflated—as they have been in recent times—selling options becomes a preferred options strategy.

What if you could approach the stock market like a casino—where the odds were tilted in your favor? That’s the essence of credit spreads in options trading. These strategies don’t rely on predicting market direction; instead, they leverage probabilities and volatility to give you an inherent statistical edge. When volatility spikes, options premiums inflate, creating prime opportunities for option sellers. But here’s the question every trader asks: “What’s the best stock for credit spreads?”

The answer isn’t a specific stock—it’s a process rooted in probabilities. Options trading allows you to make calculated decisions based on measurable odds, ensuring that you’re not leaving your trades to chance. This guide will show you how to identify the best stocks for credit spreads by focusing on liquidity, implied volatility, and the probability of success. With this step-by-step framework, you’ll learn how to stack the odds in your favor, manage risk effectively, and trade with the confidence of a seasoned professional. Let’s dive in.

Step 1: Liquidity is Key

Options trading without liquidity is like trying to sell a painting in the dark: it’s inefficient and frustrating. Illiquid options are plagued by wide bid-ask spreads, which mean poor pricing at every stage—opening, adjusting, and closing trades.

Out of approximately 3,200 tradable stocks with options, only about 14% meet the liquidity criteria I deem essential. That includes 3% classified as highly liquid and roughly 11.5% with medium liquidity. Always prioritize stocks with high options liquidity to ensure efficient execution and avoid unnecessary slippage.

A liquid option is one that can be easily bought or sold without significantly affecting its price, ensuring smooth execution and efficient trading. Liquidity is critical as it ensures fair pricing, reduces transaction costs, and provides flexibility in entering or exiting positions. Key factors defining liquidity include:

1. Tight Bid-Ask Spreads: Liquid options have small differences between the highest bid price and the lowest ask price. For example, Apple (AAPL) options typically have tight spreads, reflecting strong competition among buyers and sellers.

2. High Open Interest: This indicates the number of outstanding contracts. Options like SPY (S&P 500 ETF) often have high open interest, ensuring active markets and easier trade execution.

3. High Trading Volume: Volume reflects the number of contracts traded in a given period. For instance, QQQ (Nasdaq 100 ETF) options have consistently high volumes, making them highly liquid.

4. Proximity to Current Price: Options with strike prices close to the underlying asset's current price (at-the-money) tend to be more liquid. For example, at-the-money Tesla (TSLA) options attract substantial trading activity.

5. Closer Expiration Dates: Short-term options, such as weekly expirations on SPY, typically have higher liquidity compared to long-dated contracts.

6. Popular Underlying Assets: Widely traded stocks and ETFs like AAPL, SPY, and QQQ have highly liquid options due to their large market participation.

7. Established Exchanges: Options traded on major exchanges like the CBOE ensure standardization and active markets, which enhance liquidity.

Why Liquidity Matters:

• Better Pricing: Tight bid-ask spreads minimize slippage and transaction costs.

• Ease of Trading: High liquidity allows large orders to be executed without moving the market.

• Lower Risk: Liquid options reduce the risk of being unable to exit or adjust positions effectively.

For efficient trading, prioritize liquid options as they provide consistent opportunities with reduced trading friction.

Step 2: Know Your Implied Volatility (IV)

Each stock has a unique implied volatility (IV) range, representing the expected movement in its price over the life of the option. Current IV provides a snapshot of the premium you can expect, but it doesn’t tell the full story. Context is everything. How does today’s IV compare to the past year? That comparison helps determine whether volatility is inflated, subdued, or somewhere in between—critical for selecting the right options strategy. It’s essential to know how the current IV compares to historical levels.

• High Implied Volatility: Ideal for selling strategies like credit spreads or iron condors.

• Low Implied Volatility: Better suited for buying strategies, such as long calls or puts.

Step 3: Calculate IV Rank

How can you determine whether the implied volatility of a stock or ETF is high or low? The answer lies in two key metrics: IV Rank and IV Percentile.

IV Rank is your compass for navigating implied volatility. This metric compares the current IV to its range over the past 12 months, expressed as a percentage.

Here’s the formula for the mathematically inclined:

IV Rank = 100 × (Current IV – 52-week low) ÷ (52-week high – 52-week low)

For example, if a stock’s IV has fluctuated between 20 and 40 over the past year and its current IV is 30, the IV Rank would be 50%. This percentage shows whether current IV is elevated or subdued relative to its historical range, helping you tailor your approach.

Step 4: Understand IV Percentile

IV Percentile takes the analysis a step further. It measures the percentage of trading days in the past year when IV was lower than it is today. The formula is straightforward:

IV Percentile = (Days IV was lower than current IV ÷ 252 trading days) × 100

For instance, if a stock’s IV Percentile is 70%, it means that 70% of the time over the last year, implied volatility was lower than its current level. Like IV Rank, this measure helps pinpoint when volatility is elevated, signaling prime opportunities for selling options.

Step 5: The Expected Move

The expected move is the forecasted price range of a stock based on its current IV. This range, updated in real-time, offers traders a valuable guide for setting strike prices and managing risk. For example, with Apple trading for 234.40, if Apple (AAPL) has an expected move of $220 to $250 (as seen below) over the next 46 days, you can structure trades accordingly, ensuring that your positions align with the projected or expected range.

Step 6: Choose the Right Strategy

With volatility as your guide, you can select the most appropriate options strategy. High IV often signals a seller’s market, favoring strategies like vertical spreads, iron condors, or covered calls. Low IV, on the other hand, might steer you toward long options strategies.

Selling strategies—such as credit spreads—offer a statistical edge in high-volatility environments. By targeting strikes outside the expected move and with probabilities of success between 68% and 85%, you can position yourself for consistent, risk-adjusted returns.

Step 7: Embrace Probabilities

Quantitative trading is a game of probabilities. Once you’ve identified an opportunity, use probabilities to guide your choice of strikes. For instance, in a bear call spread, you might select a strike price above the expected move, ensuring a high probability of success—typically above 80%.

By combining probabilities with disciplined risk management, you can design trades that maximize reward while minimizing downside. The goal is to let the law of large numbers work in your favor over time. A great example of this can be found in the bear call spread I discussed at the bottom of my January 9, 2025 post. You can find the details here: [Bear Call Spread]

Volatility: The Common Thread

At the core of every successful options trading strategy is one fundamental driver: volatility. Volatility isn't just a background metric—it actively shapes options pricing, defining the premiums you can collect and the risks you take. For credit spreads, in particular, understanding volatility is not optional; it’s essential. High volatility inflates options premiums, making selling strategies like credit spreads and iron condors particularly lucrative. On the other hand, low volatility favors buying strategies, offering cheaper entry points with potential for significant upside.

To succeed, traders must move beyond the notion of finding the "perfect" stock for credit spreads and instead focus on building a robust, methodical framework. This includes analyzing liquidity, implied volatility (IV), IV Rank, and IV Percentile to gauge market conditions and choose the most appropriate strategies. By aligning your approach with the rhythm of volatility, you create trades that are not only statistically favorable but also grounded in measurable probabilities.

Ultimately, the best opportunities don’t come from chasing the market or following fleeting trends. They come from disciplined decision-making, a clear understanding of volatility, and a willingness to adapt strategies to what the market offers. By mastering these principles, you can sidestep illusions of quick wins and focus on consistent, long-term success in options trading.

Keep your portfolio balanced and your risk managed,

Andy Crowder

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