3 Types of Hedging Techniques for Credit Spreads and When/How to Use it?

A credit spread is an options trading strategy that involves selling an option with a higher premium and buying an option with a lower premium, resulting in a net credit to the trader’s account.

Credit spreads can be used to generate income or to hedge an existing position in the underlying security.

There are several ways to hedge a credit spread, depending on the specific goals and circumstances of the trader. Some common strategies for hedging a credit spread include:

What is Hedging in Finance

Basically, hedging is when you open trades to offset another trade that you have already opened. The hedging methods require using a second instrument or financial asset to implement risk hedging strategies.

In essence, by opening this trade you’re offsetting the risk. Secondly, before opening a hedge trade you need to make sure that there is some sort of negative correlation between the two opened trades.

Hedging is an advanced technique for managing the trades. If not done correctly, can potentially cause max loss. If you’re completely new to this – I recommend to close the position and open another trade once the situation favors.

Hedging Techniques:

There are several ways to adjust a credit spread, depending on the specific goals and circumstances of the trader.

Some common strategies for adjusting a credit spread include:

Strategy #1: Adding a Vertical Spread:

Most simpler one for adjusting a credit spread is to add another vertical spread to the position with the same delta you opened initially.

And this will turn into an Iron condor.

Basically, you collect the premium for opening another spread and minimize the losses. Do not touch the challenged side. You open another spread opposite to the spread you which opened initially.

For example, if you are long a call credit spread and the underlying security moves against you, you could add a put credit spread below the current price to hedge the risk of further declines.

Strategy #2: Buying Insurance:

Quick and easy way to hedge a credit spread is to adjust the position by adding naked options to the spread.

When to use this?

Consider you have a monthly credit spreads and there’s an economic event this week. Once the news are released, you can buy a option contract as insurance to protect your credit spreads.

For example, if you are long a credit spread and the underlying security moves against you, you could add a low-cost OTM put option. For this spread, I recommend a 5:1 ratio. For 5 positions of credit spreads, buy 1 low cost OTM option.

Assume you open 10 monthly spreads with a delta 0.18–0.20 and receive a $120 premium. The stop loss should be set at 2x. Consider that the most you’re willing to lose is $240.

If you believe the spread will move in the opposite direction as a result of an economic event, buy two far OTM options with deltas greater than 0.20–0.30 to be delta neutral.

Let’s say you believe the stock rises 10 points in few days. Your profit would look like this:

2 contracts x (280 profit for a 10 point move) — (240 loss from the spread) = +$320

Consider you don’t set stop loss (-$830) and you’re willing to take the full loss from the spread, there are two outcomes it can happen:

1. If the momentum is favorable, SPY can move 20 points in one week on average (Based on the backtest). If there is a wild 20-point move, the option you purchased as a hedge can offset this loss. It would look like this: +1200–830 = +$370
2. There is strong evidence that markets trend only 30% of the time and are thus directionless the other 70% of the time. For example, if there is no momentum that week, you may face a maximum loss.

This is a hedging technique and thus it’s not intended to eliminate the potential for losses. However, it can help protect from further increases in volatility.

Strategy #3: Different hedging instrument:

Another way to hedge a credit spread is to use a separate hedging instrument, such as a futures contract or LEAP option, to offset the risk of the credit spread. This can be an effective way to diversify your portfolio and manage risk, but it may also involve additional costs and risks.

It is important to note that there is no one-size-fits-all solution for hedging a credit spread, and the best strategy will depend on the specific goals and circumstances of the trader.

I recommend carefully considering the risks and potential rewards of each strategy before proceeding, and seeking the advice of a financial professional if necessary.

Below is the weekly update on my $25k challenge:

Profit Screenshots:

Since the momentum was good, I opened some PDS to capture Vega spikes. I captured around 26% profit this week.

Overall 48% for the month when S&P 500 is down -8.6% for the month :)

I have written a complete book on Secrets of Credit Spreads where I have explained in depth on the below. This book is not just another technical analysis course. It’s my years of backtesting / hard work and my entire trading system condensed in a PDF document.

1. Charting techniques from the book which is worth $70
2. How do i measure volatility and the statistics behind it?
3. What are Option greeks?
4. The important greeks for spreads
5. Strategies I use to build the spreads which gives me $1000 per month
6. Walkthrough with live examples

If you’re interested in other articles, you can check it out here.