The Inverted Credit Spread The purpose of an Inverted Credit Spread is to extend duration on an iron fly or iron condor in order to hold the trade longer, lower the trade basis and turn a losing trade into a winning trade. This trade adjustment relies are market or stock / ETF cyclicality to profit. The premise is that if you lower basis and stay in the trade longer eventually your underlying will cycle back towards its previous price. The move does not have to go all the way back to the original price it only has to go back partially. If you understand what and how an iron fly trade works you can skip to section 3. Section 1 Definitions In order to understand an inverted credit spread these basic definitions need to be understood. First what is an equity option? According to Wikipedia: Equity options are the most common type of equity derivative. They provide the right, but not the obligation, to buy (call) or sell (put) a quantity of stock (1 contract = 100 shares of stock), at a set price (strike price), within a certain period of time (prior to the expiration date). What is a spread? According to Wikipedia: Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates. The three main classes of spreads are the horizontal spread, the vertical spread and the diagonal spread. They are grouped by the relationships between the strike price and expiration dates of the options involved. Vertical Spreads, or money spreads, are spreads involving options of the same underlying security, same expiration month, but at different strike prices. Horizontal, Calendar Spreads, or time spreads are created using options of the same underlying security, same strike prices but with different expiration dates. Diagonal spreads are constructed using options of the same underlying security but different strike prices and expiration dates. They are called diagonal spreads because they are a combination of vertical and horizontal spreads. “At The Money” refers to a “strike price” as close to the actual stock or ETF price as possible. For example if TLT is trading at $117.89 per share then the 118 strike call and the 118 strike put are both at the money. “Out of The Money” refers to a “strike price” not “At The Money and not “In The Money” An “Out of The Money” Strike is away from the stock or ETF price and only holds extrinsic value. For example if TLT is trading at $117.89 per share then The 120 strike call is “Out of The Money” and the 116 strike put is “Out of The Money” “In The Money” refers to a “strike price” not “At The Money and not “Out of The Money” An “In The Money” Strike is away from the stock or ETF price and holds intrinsic value and can also have extrinsic value. For example if TLT is trading at $117.89 per share then The 115 strike call is “In The Money” and the 119 strike put is “In The Money” Credit Spread is a spread sold for a credit. Credit spreads are typically sold by a seller who would buy it back for a lower price in order to profit. Debit Spread is a spread purchased for a debt. Debit spreads are typically purchased by a buyer who would sell it back for a higher price in order to profit. Section 2 The Iron Fly The strategy taught in this guide The Inverted Credit Spread is a type of vertical credit spread. Which means the Inverted Credit Spread involves options of the same underlying security, same expiration month, but at different strike prices. Inverted Credit Spreads are used as an adjustment to an iron fly position. An iron fly is also a type of vertical credit spread. You can also use The Inverted Credit Spread as an adjustment to an iron condor. An iron condor is two vertical credit spreads usually one on the put side and one on the call side. To explain in detail lets use an example of an iron fly which we will eventually adjust into an Inverted Credit Spread. I will use the ETF symbol TLT: Symbol TLT IRON FLY POSITION Trade TLT Call Long Call Short Inversion Put Short Put Long Position DTE Date Value Strike Strike Amount Strike Strike Credit 6/16/2015 118.88 121.5 119 0 119 116.5 $ 1.56 7 The example above is an iron fly with 7 days until expiration on TLT. 6/16/15 = Date trade was opened 118.88 = TLT price at the time of trade 121.5 = The strike of call bought 119 = The strike of call sold 0 is the dollar amount between the sold call strike and the sold put strike 119 = The strike of put sold 116.50 = The strike of put bought $ 1.56 = The dollar amount collected The 119 short call combined with 121.5 long call is a vertical spread The 119 short put combined with 116.50 long put is a vertical spread DTE is the days until expiration. The options have a life of 7 days left as of 6/16/15 in the example. Each strike in a position is also called a leg. The vertical spreads contain two legs or two strike prices. The combination of the 119 short call + 121.5 long call + 119 short put + 116.5 long put is four legs. This combination of four legs is called an iron fly. An iron fly trade is when the at the money call and at the money put are sold in combination with purchasing an out of the money call and an out of the money put all in the same expiration cycle. This four leg combination can be positioned for any stock or ETF that has options available. What happens to this positions in 7 days when the options expire? Let’s look at 4 possibilities. 1. TLT price is 115.50 a. The 119 sold call expires worthless b. The 121.5 bought call expires worthless c. The 119 sold put costs $3.50 to buy back d. The 116.50 bought put can be sold for $1.00 The position losses $2.50 from buying the 119 put and selling the 116.5 put, but remember the position was sold for $1.38. Actual loss $2.50-$1.56= .94 loss. (This is the width of the spread minus the credit received) 2. TLT price is 118 at Expiration a. The 119 sold call expires worthless b. The 121.5 bought call expires worthless c. The 119 sold put costs $1.00 to buy back d. The 116.5 bought put expires worthless The position losses $1.00 from buying the 119 put, but remember the position was sold for $1.38. Actual gain $1.56-$1.00= .56 gain. 3. TLT price is 123 at Expiration a. The 119 sold call costs $4.00 to buy back b. The 121.5 bought call costs $1.50 to buy back c. The 119 sold put expires worthless d. The 116.5 bought put expires worthless The position losses $2.50 from buying the 119 call and selling the 120.50 call, but remember the position was sold for $1.56. Actual loss $2.50-$1.56= $.94 loss. (This is the width of the spread minus the credit received) 4. TLT price is 120 at Expiration a. The 119 sold call costs $1.00 to buy back b. The 121.5 bought call expires worthless c. The 119 sold put expires worthless d. The 116.5 bought put expires worthless The position losses $1.00 from buying the 119 call, but remember the position was sold for $1.56. Actual gain $1.56-$1.00= .56 gain. Remember each price is multiplied by 100. For example selling the iron fly for $1.56 is actually selling it for $156.00. With this particular iron fly any move up or down beyond $1.56 away from the strike price of $119 will be a loss at expiration. One advantage is that TLT could move to any level say all the way down to 110 or up to 130 for example and as long as it’s within $1.56 of the 119 strike at expiration the trade profits. This is one advantage of using options over trading stocks with stop losses. Section 3 The Adjustment Using The Inverted Credit Spread Now that you comprehend what an iron fly is and how it can make or lose money let’s go over how to keep the iron fly trade alive rather than taking a loss. Rather than taking a loss, adding more time to the trade until it can be profitable is commonly referred to as Extending Duration. To extend duration on an iron fly we can use an inverted credit spread. An inverted credit spread can also be use to extend duration on an iron condor. Why use an inverted credit spread? 1. We can stay with the trade longer which means it’s possible to turn a loser into a winner. 2. We can sell more premium and add more credit to lower basis and increases the possibility of turning a loser into a winner. This method relies on the stock or ETF to be cyclical. Cyclicality is the reason this adjustment strategy can profit.