What is a credit spread?

Introduction

It is a options strategy that consists of buying one option and selling another option in the same underlying. Both legs, or options, should have the same expiry and a different strike. This represents a neutral strategy, in which you can profit for guessing the future movement or even if the underlying keeps trading in a range. One of the best parts of this strategy is that the investors or traders receive a net credit only for entering into this strategy. And this credit can be used to finance other investments or the margin to trade different products. I wouldn´t recommend using the Premium to make new trades.  In order to apply this strategy, you should have a good knowledge about options. The credit spreads are part of the vertical spreads.

What is the structure of these strategies?

Depending on your thoughts on the future movement of the underlying you can adapt the strategy. If you think that the uptrend will continue in the underlying, you can do a bull put spread. If you are bearish, you should apply a bear call spread.

• Bear call spread involves selling a call option in the money (because it’s worth to exercise) and simultaneously buying a call option with the same expiry but higher strike.

• Bull put spread, consists of selling a put option and buying another put option with the same expiry but lower strike.

Steps

The first step is to study the underlying. Once you know if you would buy or sell the underlying, you can have a look at the options available and the time frame you desire. After deciding the strikes and the expiry, you should place the orders. There is an important execution risk if you want to place limit orders because there is the possibility of being filled only in one of the legs. You can ask your trading platform administrators if they support this strategy, in that case, there is no risk of execution because as soon as you are filled in one of the legs they will send a market order to the other leg. At this point, congratulations, you have your credit spread but you should monitor carefully and close the position if it goes against you. You should always respect your risk management rules. Losing a small amount makes you trade tomorrow, and surviving is the most important thing. Check my post about asymmetrical leverage here.

Example

Let´s imagine that we want to apply the strategy we have just learnt in the stock “X”. This is how the “X” is trading. One trader thinks that it had a big rise and he’s showing some weakness in the up-trend. So, he believes that the stock can rise without breaking the resistance highlighted in yellow. And after that, the sellers will be back to the market and this stock will fall.

     Own elaboration, Stock “X”, daily

The markets are moving a lot and the trader doesn´t want to take excessive risks with this stock so he decides to make a credit spread. In this case, he will sell the call with 121 as a strike and he will buy the call with a higher strike and the same maturity. After checking the prices he will buy the 123 call.

     Strikes used for the bear call spread, own elaboration

Once we have the idea, let’s check how the strategy will perform in different scenarios (it’s recommended to do it before entering in the position)

        Bear Call Spread payoff, own elaboration

This is only one example without real prices. As you can see the maximum profit you can get is the net Premium received for the position (In that case we collected 1.1$ for selling the call option at 121 level, and we paid 0.5 for buying the call option at 123 strike). The worst scenario is that the underlying keeps rising because the strategy can lose 1.4$, which is the difference between the strike prices used in the strategy less the net Premium received. (2$ minus 0.6$ = 1.4$)

Conclusion

This is one of the easiest option strategies but a good knowledge about options is required. The advantages are the following:

• It’s a neutral strategy and the traders can profit from betting the side in which the underlying will go or even from sideways movements in the underlying.

• You get credit for entering in the strategy.

• You can hold the position for weeks or months.

• You can apply this strategy to any kind of underlying, stocks, index, commodities …

The disadvantages are the following:

• First, a let me repeat myself, deep knowledge is required.

• You need a trading platform that supports options and with specific functions to avoid the execution risk

• You should monitor the position and close if it goes against you As always, risk management is one of the most important things

I hope you like it.

Have a good trading!

Disclaimer

I wrote this article myself, and it expresses my own opinions that shouldn't be used as a trading advice. Trading carries considerable risk due to the high leverage involved

#trading #options  #tradingstrategies #verticalspreads #creditspreads