What is a Credit Spread?
By Mark Wolfinger. Options Expert
I began trading options in 1975; only two years after the CBOE opened its trading floor. My strategy of choice was writing covered calls. In more recent times, I've written naked puts, sold put credit spreads and traded iron condors.
Credit Spreads: Background
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The Credit Spread
This trade places less money at risk when compared with taking a position in a stock (i.e. buying or selling shares). Profits are limited, but so are losses. This makes sense for the short-term trader who is not searching for stocks that double during the investment time frame. Contrast that with long-term investors who often dream of buying stocks that double again and again over the years.
Let's look at a bullish example, using put options. The idea is to buy one option and sell another.
That gives you a "spread" position. Spreads are used to hedge (reduce risk ). The spread is entered as a single order.
The option that you sell is more expensive (i.e. has a higher premium) than the option purchased. The difference in premium is your "credit" -- or the cash collected -- when initiating the trade. At some point in the future, you plan to exit the position by buying the same spread -- hopefully at a cost that is lower than your original credit. The difference (after subtracting commissions) is your profit.
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It is also possible to hold the position until the options expire.
XYZ is $58.23 and you like the near-term prospects for this stock. Rather than buying stock and hoping the price goes higher; rather than buying a call option and hoping that the stock price moves higher; trade a put credit spread instead.
Buy 3 XYZ Aug 50 puts
Sell 3 XYZ Aug 55 puts
Cash credit: $0.70
The spread earns a profit (but never more than the $70 premium) any time that the stock price moves higher. But it also earns a profit when XYZ remains relatively unchanged. Not only that, but you can earn a profit even when you were wrong about the stock price -- as long as the stock is not below $55 (the strike price of the option sold) when expiration arrives. If any of these three scenarios come to pass, the options expire worthless and you keep the $70 premium (less commissions) as the profit.
More good news: You do not have to wait for expiration. You can exit the trade and lock in the profit at any time prior to expiration. I strongly recommend doing that when you can exit by paying a small premium (perhaps $0.05 to $0.15).
The bullish put credit spread earns money in two ways:
- Time passes and the options lose value.
- The stock rallies and both options lose value. Because you sold the more valuable put option, it loses value faster than the option bought and the spread earns a profit.
The maximum profit is $70 ($0.70 per share * 100 shares per option). The maximum possible loss is $430 because the 5-point spread can never cost more than $500 to close the position, and you already have $70 cash in your account.
NOTE: When bearish, sell a call spread, using out-of-the money options.
Limited loss; limited gain; high probability of earning money: a very nice combination. BUT this strategy does depend on your ability to avoid stocks that move in the wrong direction.
As long as you are careful never to have more money at risk than you can afford to lose . this strategy is appropriate for traders with a market bias, even when they are employed full time.Source: options.about.com