Credit spread (options)

Last updated September 07, 2023

In finance, a credit spread, or net credit spread is an options strategy that involves a purchase of one option and a sale of another option in the same class and expiration but different strike prices. It is designed to make a profit when the spreads between the two options narrows.

Investors receive a net credit for entering the position, and want the spreads to narrow or expire for profit. In contrast, an investor would have to pay to enter a debit spread. In this context, "to narrow" means that the option sold by the trader is in the money at expiration, but by an amount that is less than the net premium received, in which event the trade is profitable but by less than the maximum that would be realized if both options of the spread were to expire worthless.

Bullish strategies

Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the time frame in which the rally will occur in order to select the optimum trading strategy.

Moderately bullish options traders usually set a target price for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk because the options can still expire worthless.) While maximum profit is capped for these strategies, they usually cost less to employ for a given nominal amount of exposure. The bull call spread and the bull put spread are common examples of moderately bullish strategies.

Bearish strategies

Bearish options strategies are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the time frame in which the decline will happen in order to select the optimum trading strategy.

Moderately bearish' options traders usually set a target price for the expected decline and utilize bear spreads to reduce cost. While maximum profit is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put spread are common examples of moderately bearish strategies.

Breakeven

To find the credit spread breakeven points for call spreads, the net premium is added to the lower strike price. For put spreads, the net premium is subtracted from the higher strike price to breakeven.

Most brokers will let you engage in these defined risk / defined reward trades.

Maximum potential

The maximum gain and loss potential are the same for call and put spreads. Note that net credit = difference in premiums.

Maximum gain

Maximum gain = net credit, realized when both options expire out of the money.

Maximum loss

Maximum loss = difference in strike prices - net credit. Realized when both options expire in the money.

Submaximal loss

Submaximal loss = expected payout of the short option. Realized when the price of the underlying at expiration is in between the strikes of the options.

Expected value

Expected value = (credit received * short leg OTM probability) - (maximum loss * long leg ITM probability) - (expected short leg payout * (short leg ITM probability - long leg ITM probability)).^[1]

Analysis

Credit spreads are negative vega since, if the price of the underlying doesn't change, the trader will tend to make money as volatility goes down.
Credit spreads are also positive theta in that, broadly speaking if the price of the underlying doesn't move past the short strike, the trader will tend to make money just by the passage of time.
Credit spreads are also short gamma. As the short strike gets closer to in-the-money, then Delta will start to ramp up against the credit spreads

Examples

For example, one uses a credit spread as a conservative strategy designed to earn modest income for the trader while also having losses strictly limited. It involves simultaneously buying and selling (writing) options on the same security/index in the same month, but at different strike prices. (This is also a vertical spread)

If the trader is bearish (expects prices to fall), you use a bearish call spread. It's named this way because you're buying and selling a call and taking a bearish position.

Look at the following example.

Trader Joe expects XYZ to fall from its current price of $35 a share.

Write 10 January 36 calls at 1.10 $1100
Buy 10 January 37 calls at .75 ($ 750)

net credit $350

Consider the following scenarios:

The stock falls or remains below $36 by expiration. In this case, all the options expire worthless and the trader keeps the net credit of $350 minus commissions (probably about $20 on this transaction) netting approximately $330 profit.

If the stock rises above $37 by expiration, you must unwind the position by buying the 36 calls back, and selling the 37 calls you bought; this difference will be $1, the difference in strike prices. For all ten calls, this costs you $1000; when you subtract the $350 credit, this gives you a maximum loss of $650.

If the final price was between 36 and 37 your losses would be less or your gains would be less. The "breakeven" stock price would be $36.35: the lower strike price plus the credit for the money you received up front.

Traders often using charting software and technical analysis to find stocks that are overbought (have run up in price and are likely to sell off a bit, or stagnate) as candidates for bearish call spreads.

If the trader is bullish, you set up a bullish credit spread using puts. Look at the following example.

Trader Joe expects XYZ to rally sharply from its current price of $20 a share.

Write 10 January 19 puts at $0.75 $750
Buy 10 January 18 puts at $.40 ($400)

net credit $350

Consider the following scenarios:

If the stock price stays the same or rises sharply, both puts expire worthless and you keep your $350, minus commissions of about $20 or so.

If the stock price instead, falls to below 18 say, to $15, you must unwind the position by buying back the $19 puts at $4 and selling back the 18 puts at $3 for a $1 difference, costing you $1000. Minus the $350 credit, your maximum loss is $650.

A final stock price between $18 and $19 would provide you with a smaller loss or smaller gain; the break-even stock price is $18.65, which is the higher strike price minus the credit.

Traders often scan price charts and use technical analysis to find stocks that are oversold (have fallen sharply in price and perhaps due for a rebound) as candidates for bullish put spreads. Additionally, writing (selling) credit spreads with higher current IV (implied volatility) 50% and higher, will increase the prospects for a profitable trade.

Notice in both cases the losses and gains are strictly limited.

Related Research Articles

In finance, a put or put option is a derivative instrument in financial markets that gives the holder the right to sell an asset, at a specified price, by a specified date to the writer of the put. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. The term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.

In finance, a straddle strategy involves two transactions in options on the same underlying, with opposite positions. One holds long risk, the other short. As a result, it involves the purchase or sale of particular option derivatives that allow the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement.

In finance, risk reversal can refer to a measure of the volatility skew or to a trading strategy.

In finance, a butterfly is a limited risk, non-directional options strategy that is designed to have a high probability of earning a limited profit when the future volatility of the underlying asset is expected to be lower or higher than that asset's current implied volatility.

In finance, a collar is an option strategy that limits the range of possible positive or negative returns on an underlying to a specific range. A collar strategy is used as one of the ways to hedge against possible losses and it represents long put options financed with short call options. The collar combines the strategies of the protective put and the covered call.

In finance, a calendar spread is a spread trade involving the simultaneous purchase of futures or options expiring on a particular date and the sale of the same instrument expiring on another date. These individual purchases, known as the legs of the spread, vary only in expiration date; they are based on the same underlying market and strike price.

The iron condor is an options trading strategy utilizing two vertical spreads – a put spread and a call spread with the same expiration and four different strikes. A long iron condor is essentially selling both sides of the underlying instrument by simultaneously shorting the same number of calls and puts, then covering each position with the purchase of further out of the money call(s) and put(s) respectively. The converse produces a short iron condor.

In finance, a debit spread, a.k.a. net debit spread, results when an investor simultaneously buys an option with a higher premium and sells an option with a lower premium. The investor is said to be a net buyer and expects the premiums of the two options to widen.

In options trading, a bull spread is a bullish, vertical spread options strategy that is designed to profit from a moderate rise in the price of the underlying security.

In options trading, a bear spread is a bearish, vertical spread options strategy that can be used when the options trader is moderately bearish on the underlying security.

A naked option or uncovered option is an options strategy where the options contract writer does not hold the underlying security position to cover the contract in case of assignment. Nor does the seller hold any option of the same class on the same underlying security that could protect against potential losses. A naked option involving a "call" is called a "naked call" or "uncovered call", while one involving a "put" is a "naked put" or "uncovered put".

In options trading, a vertical spread is an options strategy involving buying and selling of multiple options of the same underlying security, same expiration date, but at different strike prices. They can be created with either all calls or all puts. The term originates from the trading sheets that were used in the open outcry pits on which option prices were listed out by expiry date & strike price, thus looking down the sheet (vertical) the trader would see all options of the same maturity. Vertical spreads can sometimes approximate binary options, and can be produced using vanilla options.

In finance an iron butterfly, also known as the ironfly, is the name of an advanced, neutral-outlook, options trading strategy that involves buying and holding four different options at three different strike prices. It is a limited-risk, limited-profit trading strategy that is structured for a larger probability of earning smaller limited profit when the underlying stock is perceived to have a low volatility.

Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options' variables. Call options, simply known as Calls, give the buyer a right to buy a particular stock at that option's strike price. Opposite to that are Put options, simply known as Puts, which give the buyer the right to sell a particular stock at the option's strike price. This is often done to gain exposure to a specific type of opportunity or risk while eliminating other risks as part of a trading strategy. A very straightforward strategy might simply be the buying or selling of a single option; however, option strategies often refer to a combination of simultaneous buying and or selling of options.

The backspread is the converse strategy to the ratio spread and is also known as reverse ratio spread. Using calls, a bullish strategy known as the call backspread can be constructed and with puts, a strategy known as the put backspread can be constructed.

Pin risk occurs when the market price of the underlier of an option contract at the time of the contract's expiration is close to the option's strike price. In this situation, the underlier is said to have pinned. The risk to the writer (seller) of the option is that they cannot predict with certainty whether the option will be exercised or not. So the writer cannot hedge their position precisely and may end up with a loss or gain. There is a chance that the price of the underlier may move adversely, resulting in an unanticipated loss to the writer. In other words, an option position may result in a large, undesired risky position in the underlier immediately after expiration, regardless of the actions of the writer.

<span class="mw-page-title-main">Option (finance)</span> Right to buy or sell a certain thing at a later date at an agreed price

In finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option. Options are typically acquired by purchase, as a form of compensation, or as part of a complex financial transaction. Thus, they are also a form of asset and have a valuation that may depend on a complex relationship between underlying asset price, time until expiration, market volatility, the risk-free rate of interest, and the strike price of the option. Options may be traded between private parties in over-the-counter (OTC) transactions, or they may be exchange-traded in live, public markets in the form of standardized contracts.

Stock option return calculations provide investors with an easy metric for comparing stock option positions. For example, for two stock option positions which appear identical, the potential stock option return may be useful for determining which position has the highest relative potential return.

A condor is a limited-risk, non-directional options trading strategy consisting of four options at four different strike prices. The buyer of a condor earns a profit if the underlying is between or near the inner two strikes at expiry, but has a limited loss if the underlying is near or outside the outer two strikes at expiry. Therefore, long condors are used by traders who expect the underlying to stay within a limited range, while short condors are used by traders who expect the underlying to make a large move in either direction. Compared to a butterfly, a condor is profitable at a wider range of potential underlying values, but has a higher premium and therefore a lower maximum profit.

In finance, a ladder, also known as a Christmas tree, is a combination of three options of the same type at three different strike prices. A long ladder is used by traders who expect low volatility, while a short ladder is used by traders who expect high volatility. Ladders are in some ways similar to strangles, vertical spreads, condors, or ratio spreads.

References

↑ "Stock Option Credit Spread Scanner". OMNIEQ. p. About. Retrieved 26 March 2019.

McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed.). New York : New York Institute of Finance. ISBN 0-7352-0197-8.

This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.

[1] "Stock Option Credit Spread Scanner". OMNIEQ. p. About. Retrieved 26 March 2019.

[1]